Shift Investments to Oil? Part 3

In Part 1, I talked about the various leveraged commodity ETNs and their potential gains. It looked like the ETN for Oil, symbol DXO, had the greatest potential, since oil has moved by a larger amount than the other commodities. Going forward, it seems to me that this will continue. For example, it seems easier or more likely for the price of oil to double from $60 to $120, than for, say, the price of gold to double from $720 to $1440. While both may move up, it seems that the potential for oil to move up more is greater.

In Part 2, I talked about the argument for the price of oil going up, and why oil was such a great investment in the long run.

In Part 3, the last post on this, I'm only going to talk about DXO and its risk/reward to help determine if it is a good investment.

I put together a chart showing some observed values of DXO at certain prices of Crude Oil.




One thing that is interesting is that the DXO line is a curve, not a straight line that follows "y = 2x + c". After reading up on how the ETN gain is calculated (which appears to be monthly), it seems this effect is due to compounding over time. For example, say the price of oil keeps going up 10% each month, compounding, for 7 months. This ends up being a 95% gain (1.10^7 - 1)*100%. You might expect the 2x ETN to gain double that, or 190%. However, if the 2x ETN goes up double the amount that the price of oil went up each month -- that is, 20% each month -- for 7 months, this works out to (1.20^7 - 1)*100%, or a 258% gain in the end. Notice this ends up being over 2.5x the oil price's percentage gain over the same 7 month period. Because the compounding effect varies a lot depending on whether the commodity is trending or whipsawing back and forth a lot over the year, we can't totally rely on the chart above for a prediction of the ETN price based on what the price of oil is, but it should give us a rough idea.

Reward:

Looking at the chart, we see we can make HUGE gains if oil goes up even a small amount. For example, with oil at $64/barrel right now, DXO is around $5. If oil reaches $88/barrel, DXO should be around $10. That is a 100% gain. If oil reaches $105/barrel, DXO should be around $15. That's a 200% gain, or an increase of 3x in your investment! And imagine if you were to get into DXO at a price below $5? How long until oil is over $88/barrel again?

Risk:
The bad news is that a small drop in oil price is a huge drop in DXO. Extrapolating the price data, if oil were to go down from its current $65/barrel to $50/barrel, DXO could drop to around $2.70 -- you'd lose almost 50% of your investment right there. If oil were to go down to $30/barrel, DXO could be around $0.80 -- meaning you've lost... well, most of your investment. So you will lose a lot with any drop in the oil price.

The good news is that oil is not like the stock of some company, where the company could go bankrupt and the price goes to zero. Oil cannot go to zero. We know oil is going to be in demand for a while yet, and as pointed out in the last post, all signs point to an increased oil price in the long term. So as long as you're willing to hold on, the risk of losing any money in this investment seems extremely low, as oil will eventually rise above its current price.

So, can you handle losing 50% or more of your investment for a few months... a few years, in the unlikely event it takes that long?

I guess one other risk I should mention is the risk that the ETN could shut down if the price gets too low, and you'd end up losing most of your money. I read somewhere that this happened to some ETFs (I'm too lazy to find the links for this).


The question for me is really just how low will oil go in the short term? While it's hard to imagine oil at $20 again, you only have to go back to 2003 to see oil in the $20's. That's scary to me. Losing 50% of an investment with a small drop in oil is scary to me. So what's a good entry point? Should I really care, especially if I believe that oil is guaranteed to go over $100 at some point in the future? Imagine what will happen when we see some of the production numbers and decline rates from the big reserves a year from now?

Another random thought: What effect is the election result going to have tomorrow?

I don't really know how to summarize this post. DXO's risk/reward ratio looks great if you're planning 5 years out from now, but in the short-term the risk is quite high. But again, the type of risk is mainly that you'd lose money on paper, and only temporarily too, and as long as you hold on you'd be virtually guaranteed making money on the investment. There is still some risk of you actually losing money; this would happen if the ETN shuts down while at a low price, or if you are forced to sell due to some other personal financial situation. So I wouldn't put your life savings in something like this, but the risk/reward ratio is too good to pass up not investing in this.

So what am I going to do? I'll strongly consider selling some of my Sprott funds and buying DXO at $4, meaning oil has to touch below $60 again, which I think it could do this week. If it doesn't look like that will happen, I may buy at $5. If oil drops even further to $50 (and thus DXO goes under $3), then I'd probably actually borrow some funds and buy a whole lot more, as crazy as that may sound.