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Sunday, September 25, 2005

Hedging Against Energy Prices, Part 3:An Improved Energy Hedging Strategy?

The first and second posts in this series look at my Exxon and Chevron investments and how well they have hedged against my increased monthly gas spend as a result of higher gas prices.

This post details my proposed idea to make a investment hedging strategy that combines two ideas, the use of investment hedging against energy with the benefits of dollar cost averaging.


Overview
Anyone today who uses personal finance software such as Quicken or MS Money can easily track their monthly gas spend. You can combine this very valuable information with the dollar cost investing technique to create an investment/energy hedge strategy I think offers some pretty neat benefits - lets take a look.

The Idea
Budget a fix amount every month to spend on your household gas expenses and energy hedge investment. At the end of the month, any amount remaining that you haven't spent on gas invest in your energy hedge.

Step by Step
Step 1) Calculate your monthly gas spend for each month for the past 12 months. In my case the table below represents the last 12 months:


Sep-04

Oct-04

Nov-04

Dec-04

Jan-05

Feb-05

$ 76.16

$ 121.31

$ 61.33

$ 48.03

$ 92.25

$ 97.04


Mar-05

Apr-05

May-05

Jun-05

Jul-05

Aug-05

$ 254.88

$ 214.95

$ 189.76

$ 185.00

$ 239.63

$ 80.06




Step 2) Calculate the amount you want to budget toward monthly gas spend + hedge investment. To keep it simple I decided to set this amount at roughly twice my current average monthly gas spend, however it could be any amount that is above your monthly gas spend. I decided on twice my average because I just moved in July and my move should reduce my monthly gas spend. If I hadn't moved I would have selected 3 times my average spend (see simulation below).

Average Monthly Gas Spend = $138.37
Budgeted Energy Spend = Roughly 2 * Avg Monthly Gas Spend
Budgeted Energy Spend = ~(2 * $138.37)
Budgeted Energy Spend = ~($276.74) = $280.00

Step 3) Determine your energy investment. This series of posts has detailed (Exxon and Chevron as possible choices) two energy investments that I currently have positions in. Based on the review of these stocks I would like to continue to add to my Exxon stock holdings because I feel it has performed very well as an energy hedge.

Step 4) At the end of the month, deduct your monthly gas spend from your budget, and invest the remaining amount into your investment choice.

For the month of September, I have spent $108.78 on gas. Assuming I don't spend anymore on gas for the month, I'm going to log into my DRIP account at Equiserve and request an electronic transfer to purchase $171.22 of Exxon stock.


Historical Performance Simulation
Since I haven't actually tried this strategy yet I thought I would look at some historical data to tell me hypothetically how well it would have performed in the past year.

Lets assume I had been following this strategy for one year. Well first lets see what my Budgeted Energy Spend would have been:


Sep-03

Oct-03

Nov-03

Dec-03

Jan-04

Feb-04

$ 85.42

$ 79.74

$ 95.95

$ 50.28

$ 59.69

$ 105.22


Mar-04

Apr-04

May-04

Jun-04

Jul-04

Aug-04

$ 59.55

$ 125.05

$ 113.14

$ 50.04

$ 120.43

$ 97.54



Average Monthly Gas Spend = $86.84
Budgeted Energy Spend = ~(3 * $86.84)
Budgeted Energy Spend = $261


So with a Budgeted Energy Spend of $261/mo, the last 12 mos would have resulted in the following:

Sept 2004-Aug 2005 Improved Energy Hedge Strategy

Sep-04

Oct-04

Nov-04

Dec-04

Jan-05

Feb-05

Monthly Gas Spend

$ 76.16

$ 121.31

$ 61.33

$ 48.03

$ 92.25

$ 97.04

Remainder for Invest

$ 184.84

$ 139.69

$ 199.67

$ 212.97

$ 168.75

$ 163.96

Exxon Stock Price

$ 46.42

$ 48.84

$ 49.68

$ 49.41

$ 50.32

$ 55.55

Shares Added

3.982

2.860

4.019

4.310

3.354

2.952


Mar-05

Apr-05

May-05

Jun-05

Jul-05

Aug-05

Monthly Gas Spend

$ 254.88

$

$ 189.76

$ 185.00

$ 239.63

$ 80.06

Remainder for Invest

$ 6.12

$ 46.05

$ 71.24

$ 76.00

$ 21.37

$ 180.94

Exxon Stock Price

$ 60.44

$ 55.63

$ 53.44

$ 58.10

$ 59.11

$ 61.05

Shares Added

0.101

0.828

1.333

1.308

0.362

2.964


Number of Shares Purchased: 28.372
Total Amount Invested: $1471.60
Avg Share Price: $51.87

Now lets compare these results to a hypothetical dollar cost averaging strategy for the past year. To keep the comparison fair, we'll assume the dollar cost averaging strategy will invest approximately the same total amount of $1470 or $122.50/mo.

Sept 2004-Aug 2005 Dollar Cost Average Strategy Simulation

Sep-04

Oct-04

Nov-04

Dec-04

Jan-05

Feb-05

Exxon Stock Price

$ 46.42

$ 48.84

$ 49.68

$ 49.41

$ 50.32

$ 55.55

Shares Added

2.639

2.508

2.466

2.479

2.434

2.205


Mar-05

Apr-05

May-05

Jun-05

Jul-05

Aug-05

Exxon Stock Price

$ 60.44

$ 55.63

$ 53.44

$ 58.10

$ 59.11

$ 61.05

Shares Added

2.027

2.202

2.292

2.108

2.072

2.007


Number of Shares Purchased: 27.440
Total Amount Invested: $1470.00
Avg Share Price: $53.57


Results
The net gain over the dollar cost averaging strategy was an extra 0.932 shares and the averaged share price was reduced from $53.57 to $51.87, an improvement of 3.28%. I'll take it - I like the potential here. Keep in mind this is the additional benefit from this strategy as compared to dollar cost averaging.

I think in practice the difference between dollar cost averaging and this improved energy hedging strategy will actually be greater because in this simulation we already knew how much we would spend over the course of the year and used that amount in the dollar cost averaging strategy.


Other Pros/Cons of this Improved Energy Hedging strategy
Pros
-Combines 2 techniques to give you a more amplified hedge against energy prices
-all the benefits of dollar cost averaging
-makes budgeting for gas easier by smoothing the monthly spend on gas
-hedges against energy prices increases
-can all be done electronically by tracking gas spend in pf software and then making a monthly electronic purchase of stock using DRIP account

Cons
-Requires a little more work to do the monthly calculations

I like some of the benefits this strategy could offer me to hedge against energy prices and improving my ability to budget my gas expenses. I plan to give it a try for the next year and see how I make out.

8 Comments:

  • Dude,
    You have entirely too much time on your hands. Why not spend your time doing something useful, like helping your brother and sister in law with their home repairs?!?!?

    By Anonymous Anonymous, at 8:19 PM  

  • Amen-just buy xle and go help your brother!

    By Blogger Steve Mertz, at 6:50 PM  

  • Touche! Family first...

    By Blogger 2million, at 6:55 PM  

  • Interesting analysis, if exceedingly thorough. However, you don't include home heating costs in your analysis. Up here in the Northeast, that's a huge bite out of monthly budget in the cold months.

    Down in NC, I'd imagine your air conditioning bills are the same issue in the summer months.

    By Anonymous kpny, at 8:40 AM  

  • Seems like an awful lot of effort to figure out precisely how to hedge against rising oil prices.

    We know oil prices are going up. Global consumption is on the upswing, new oil sources aren't being found and oil production has peaked.

    How about just trying to make some money with this knowledge and not just as a hedge against rising gas bills?

    this post talks a bit more about it.
    http://moneyshaker.blogspot.com/2006/01/commodities-update-book-recommendation.html

    By Blogger Empty Spaces Inc., at 12:26 AM  

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