Hedging Gas-Just For Fun.

Let's have a little fun with gas prices shall we. Currently the price of oil and by extension gasoline has collapsed. If you think this is a permanent event read no further......

......Now for the rest of us. Let's assume that you think gas prices could be a buck or two higher next summer. Then today you could do what Southwest Airlines {LUV} does and hedge your risk. Here's how it could be done.

Say you think the price of gasoline will be 1-2 dollars higher next summer during the peak driving season then guess or figure out how much you'll drive your vehicle(s) during that time. You could do this by using a miles per gallon figure and then estimate how many miles you'll put on cars between say May 1 and September 30. So for example 10,000 total miles at an average of 15 miles per gallon means that you'll use approximately 667 gallons of gas. At today's prices of $2.29 this would cost you $1,527.53. (this is what I currently pay in Chicago so it will vary with location)

But say you think gas will be between $3-4 by then. Hedge it with options on the USO. At $4 a Chicago area driver would spend an additional $1,141 on gas. You today could buy 1 option on the USO and hedge most of this risk away. Currently for example if my Chicago driver purchased one of the January 16, 2010 $40 USO contract you would as of this writing pay $11.80 for the privilege. That before any commission would be a cash outlay of $1,180 to you. Your break even on this transaction is likely around 62 a barrel oil and as a guess between 52 & 55 based on how the USO trades. Based on your 667 gallons of gas that contract costs you $1.76 per gallon. Here are some but not all of the possible outcomes:

The price of oil collapses say going to $25 by next summer. Then this contract is likely worthless. You have locked in a higher cost basis for your summer driving. However, any loss taken is a capital loss which does at the end of the day have tax consequences.

The price of oil stays more or less the same. In that case the time value associated with this contract will likely decline and you'll have some of the tax consequences associated with above.

The price of oil heads back towards that $3-4 dollar level. This equates to oil prices at least above $70 per barrel or again between 52 & 55 on our USO. $52 on the USO is our break even given the price of the option. After that we should make one dollar of profit for every one dollar of the USO's advance. $3-4 per gallon gasoline I estimate translates to 80-85 on the USO. Our profit then would be the 80-85 less our total cost of 52. Our profit using a midpoint of 82 as an example would be 30 points or roughly $3,000. Divided by our 667 gallons this works out to a per gallon profit of $4.49. $4.49-our 1.76 per gallon cost=$2.73 gain. Since you are currently hedging versus a 2.29 price that means anything over 1.71 (again using $4.00 gas) is a profit. Thus if it works out then you're going to have a profit of $680 which can be used anyway you want.

Now remember you could lose all of this if gas prices don't go back up next year and I'm not actually putting this trade on at this time. Also options carry certain other risks that we are not discussing here but you should know this risks exist. But it's fun to think about and it is a real world exercise on how ETFs are changing the way we can think about investments. Also its doubtful that any other investment manager is bringing this type of idea to you.