Hedging Gasoline

Spring Break is upon us, with Memorial Day after that. Then comes July 4, Labor Day, and a few hurricanes in the Gulf. What will that lead to? Higher gas prices, that’s what! How’d you like to lock in the low price of gas today and insulate yourself against price increases in the future? Before you hit the road, I’ll show you how…

Gas prices in my area averaged $2.08/gal exactly one year ago and average $2.36/gal today. That’s an increase of 13.5%. How could I have locked in that $2.08/gal price for a year’s time? Large barrels of fuel in my garage or a late-night love affair with a gas station attendant? No…

One year gas price chart for Nashville via gasbuddy.com

There is a much safer and more discreet way – the United States Gas Fund, LP (NYSEARCA:UGA), an ETF that specifically targets the wholesale price of gasoline using futures contracts and derivatives.

One year chart for the price of UHA via Google Finance

Look back one year you’ll see the stock price of UGA has increased 16.29%, roughly tracking the 13.5% increase of the price of gasoline in my area.

How to Hedge

My car averages 30mpg and I drive about 10,000 miles per year. My first step in determining my gasoline hedge will be determining how many gallons of gas I need to plan for. It looks like I need to cover 333 gallons per year, which is 10,000/30 if I plan for a 1 year hedge. Now… what in the heck is a hedge?

In simple language, a hedge is a risk management technique used to reduce any substantial losses suffered by an individual or an organization. A hedge is an investment that protects your finances from a risky situation. Hedging is done to minimize or offset the chance that your assets will lose value. It also limits your loss to a known amount if the asset does lose value.

Knowing I need to hedge 333 gallons of gas I can look at UGA currently trading at $31.05/share with gas selling for $2.36/gal today. Math says $31.05/$2.36 = 13.157 meaning 1 share of UGA hedges 13.2 gallons of gas. That means I need to buy 333/13.2 = 25 shares of UGA to hedge my gas costs for the year and lock in today’s price @ $2.36/gal.

How Does Hedging Work?

Let’s predict we see gas up to $3/gal by this time next year, a 27% increase. I don’t think anyone would think you’re crazy to predict that, right? Hell, $3 gas was a bargain in the not too distant past.

If that happens, it’s safe to predict I’ll be able to sell my shares of UGA at around $39.50 this time next year as well – capturing that same 27% rise in gasoline prices. Boom – that’s a profit of $8.45/share x 25 shares = $211.25 profit. Nice, right?

It just so happens that 333 gallons of gas @ $3/gal is $999. That means gas will cost me $213 more than 333 gallons of gas at today’s price of $2.36/gal which would equal $786. You see what I did there? My $211.25 profit in UGA essentially covers my increase in fuel cost as I see gas prices go from $2.36/gal to $3.00/gal.

Obviously you can hedge out as far as your cash will take you. My cash outlay here is $776.25 to buy 25 shares of UGA @ $31.05, locking in my price @ $2.36/gal for one year. You could multiply 333 gallons times 10, divide UGA’s share price by the price of gas today, and buy enough shares to hedge out a decade’s worth of gas if you wanted to. Maybe this is a good plan the next time you see gas @ $1.90/gal?

Gas Prices Drop?

What if the price of gas goes down? Excellent question! Remember, with this hedge I am essentially agreeing upfront to buy a year’s worth of gas @ $2.36/gal. Let’s pretend downward price pressure strikes the gas market and the price drops to $2.00. I will enjoy a bargain at the pump but I’ll be selling my UGA shares at loss.

If gas drops 16% that means UGA is probably selling at $26.10 (16% down from my $31.05 purchase price) meaning my 25 shares are now worth $652.50, a loss of $123.75 on my $776.25 investment. No bueno…

At the same time, 333 gallons of gas at $2/gal is $666. I’ll need to add that cost of gas to my $124 loss on UGA and it equals $790. Checking the math again, $790/333 gallons is pretty dang close to $2.36/gallon – that’s the price I agreed to pay with my hedge today… Magic!

Caveats

Be mindful of the opportunity cost of money you use to hedge as you won’t be able to invest it elsewhere while it is invested in UGA. You’ll need consider tracking error of the index that swings as much as +/- 2%, and the expense ratio of 0.75%, though you will catch a 1.45% yield. Run this trade in a Robinhood account to eliminate trading costs or in an IRA to eliminate capital gains taxes – both of those will eat into your hedge a bit.

Conclusion, The Important Part…

Is this a viable trade? Absolutely. Worth the time and effort? That will be for you to decide. What I like about the trade is that it gets you thinking about hedging and it introduces you to tactics you can employ to get the system of capitalism working in your favor.

Instead of just lining up at the pump and complaining about rising gas prices this summer like all the other rubes, you can consider a strategy to combat the inevitable attack on your budget.

I’d encourage you to think it through and apply the tactic to other costs you incur on a regular basis. Can you hedge interest rates on your mortgage, natural gas prices to heat your home, the strength/weakness of the dollar against the Euro on your trip abroad, or maybe just the cost of coffee on your 3x daily Starbucks runs?

You don’t have to be a full-price retail sucka shuffling money out of your wallet hand-over-fist. We live in the greatest capitalistic society in the universe. Put the beautiful system of capitalism to work for you! Think like a winner and use your money to your advantage. Remember, it is not illegal to save money and to prosper!

Get on the move, resting easy in the fact you won’t have to worry about the rising cost of gasoline eating away at your budget – cheers, and thanks for reading!

note – this is not a recommendation to buy or sell any security. Any investment should follow your own due diligence. Consult a tax professional and a competent fee-based investment professional as needed.

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