Traders and Hedgers in Energy Investing - dummies

Traders and Hedgers in Energy Investing

By Nick Hodge, Jeff Siegel, Christian DeHaemer, Keith Kohl

Oil and natural gas present many different ways to invest beyond just the Exxons and BPs of the world. Trading energy futures is one such opportunity. So what exactly does futures trading entail?

This is one of those cases where it sounds exactly like it is: Futures are simply an investment instrument whereby someone agrees to buy or sell a specific amount of units for a specific price with a set delivery date in the future. The only variable in place is the price of the contract.

There are two main types of futures traders:

  • Speculators: Although the mere phrase oil speculator conjures harsh images of greedy billionaires hiking oil prices and causing the average Joe considerably more pain at the pump, there’s a little more to it. Speculators are driven to take a long or short position in a commodity to make a profit. They’re taking a gamble, and they aren’t as evil as you may first think.

    In fact, speculators play a critical role in the futures market. Remember, these investors don’t manipulate the market as if it were a puppet on strings but instead identify a specific trend and then successfully profit from it. Speculators take on the risk that other people want no part of, and in the process, they make the market more fluid.

  • Hedgers: An individual or group hoping to minimize their price risk will establish a short or long hedge in a commodity. Their goal is to effectively manage the risk of future price volatility. Oil and natural gas companies routinely lock in a price for future production.

    For example, Encana Corporation has approximately 1.5 billion cubic feet per day (Bcf/d) of its 2013 natural gas production hedged using fixed price contracts at an average of $4.39 per million cubic feet (Mcf) on the New York Mercantile Exchange (NYMEX), well above the average spot price projected for the year.

Hedgers employ two different techniques:

  • A short hedge is a strategy producers can use to secure a price of the commodity for future delivery. The hedger essentially establishes a short futures position while still owning the commodity. If the price of the commodity falls, the value of the short position offsets some of the revenue lost upon delivery.

  • A long hedge involves taking a long futures position to protect against future price increases.

In addition to these specific categories, the style you adopt for trading futures contracts also directly affects how you trade contract futures. Futures traders typically fall under one of two classes:

  • Day trading: Day traders conduct several trades throughout the day. They’re focused on getting in and getting out in a relatively short period of time. The average individual investor simply doesn’t have the time or discipline to properly day trade. Day trading is difficult for beginner investors to learn, and you can also quickly rack up commissions and fees that can reduce your overall return.

  • Position trading: This style of trading is your typical buy-and-hold strategy. It’s much easier than day trading to learn and doesn’t require being in front of a computer all day.