Oil Stock Investments vs. Commodities Futures Trading

I do not understand how regular commodities trading can be part of any sustainable wealth-building plan.

A futures contract is when you agree to buy or sell a commodity at a certain price at a certain future date. Let’s say oil is trading at $60 per barrel. Assume that you think a year from now, oil will trade at a higher price than that. So you enter into a futures contract to take delivery of 1,000 barrels of oil in November 2018. By August 2018, you appear to be right–the price of oil has increased to $75. You decide to close out your contract, and rather than taking delivery, you pass on the rights for the 1,000 barrels of oil onto someone else and you collect your $15,000 less any fees.

A lot of speculators are drawn to futures contracts because of the high leverage you are legally permitted to use. Most brokerage houses will only require you to deposit 10% of the value of the commodity at the time you enter into the contract.

If oil is trading at $60 per barrel, you are only required to put down $6,000 for the total value of the commodity. You then borrow the remaining $54,000 at the margin rate offered by your brokerage. If the borrowing costs are 8%, then you will need to make at least an $8,400 profit to breakeven.

When that oil contract is sold at $75, the transaction breakdown is $75,000 minus the $60,000 value minus the $8,400 interest cost for getting the leverage. The profit is $6,600, which is extreme when you consider that only $6,000 had to be put down. Therein lies the appeal.

However, the obvious drawback is that leverage works in reverse, too. Imagine if, in 2014, you entered into an oil futures contract when oil was trading at over $100 because you thought the price was going to go up. Instead, the price fell to $30 per barrel. Not only do you have to pay for that 70% loss in commodity value, but you also have to pay 8% on borrowed funds to the brokerage house for the privilege to speculate and lose 70%.

But really, my concerns about investors trying to build wealth through futures contracts are more pervasive than the risk of leverage and short-term fluctuations.

It remains a truism that the investor class cannot create more wealth, in aggregate, than the underlying asset over long periods of time.

From 1980 through 2015, the price of oil went from $37 to $41. All of the positive returns in those 35 years of can only come from a $4 positive price movement. The asset itself only moved from 0.29%. Even accepting that the 2015 period marked a low point for oil, the highest average price for oil was $91 in 2008 and 2013. Even assuming a 1980-2008 comparison–the most favorable you can find–the commodity only delivered compounded annual growth of 3.27% each year.

There is no rising tide here. There is no wealth tailwind. If you earned returns greater than 3.27%, it is because you were clever at one point in time and created wealth at someone else’s expense.

Meanwhile, the corporations that dig up, transport, and refine oil have an extreme advantage that acts as a multiplier compared to those that invest in the underlying commodity itself. That advantage is production growth.

Between 1980 and 2015, Exxon Mobil increased its production of oil from 800,000 barrels of oil per day in 1980 to over 4 million barrels per day in 2015. This growth enabled Exxon the ability to take profits and buy chemical divisions, repurchase stock, and pay dividends to shareholders. Participating in the growth of commerce, rather than the packaging of fixed assets, leads to a vast difference in total wealth created. From 1980 through 2015, every dollar invested into ExxonMobil became $98.15.

While someone with 1,000 barrels of oil at $37 in 1980 would only have 1,000 barrels of oil at $41 in 2015 for a profit growth of $37,000 into $41,000, the investor that put $37,000 into ExxonMobil stock back then would have grown into $3.6 million.

The long-term wealth created by Exxon Mobil, Chevron, and ConocoPhillips / Phillips 66 is so extreme compared to wealth that can be created trading the underlying commodities. The low point of commodities trading is that 70% decline plus 8% debt payments I talked about. What’s the low point for Chevron stock? Seeing it fall $50 per share and pay you the same $4.28 per share dividend for a few years in a row?

Meanwhile, there is a lot more room for everyone to be a winner when an extreme amount of wealth get created. When Exxon grows from $37,000 to $3.6 million in value, nearly everyone can be a winner because there are so many interval points where a seller can come out a higher point than he initially paid. With the underlying commodity, you spend decades operating in that narrow band of growth between $37,000 and $91,000 that tell the story of your 1,000 barrels of oil.

This is not a special insight. Warren Buffett has told a parable comparing an ounce of gold put in a safety deposit box in 1950 that remains nothing but an ounce of gold in 2015. Meanwhile, an acre of farmland can produce over half-a-century of crops that are created each year and sold for a profit that can be used to perpetually fund new investments.

The irony is that futures trading in commodities can be a very time-intensive and consuming process that requires lots of ongoing activity to eke out scraps of gains while taking on the risk of deep losses if the speculation reverses. Meanwhile, another option exists–the totally passive investors in Big Oil stocks that do nothing but pay annual taxes on their investment and let the dividends reinvest create wealth at an astonishing clip compared to the net returns of commodities trading. I would wager that less than a tenth of one percent of commodity traders will out-earn the performance of a totally passive investment involving the same starting capital put into ExxonMobil over the next three decades.

Originally posted 2017-01-28 22:20:59.

Like this general content? Join The Conservative Income Investor on Patreon for discussion of specific stocks!

Leave a Reply