Buy oil producers, sell crude futures

Trade Unit:
short: 1 Jan NYMEX crude
long: $80,000 of a pure producer like APC or DVN, or.....
$120,000 of an integrated major like XOM or COP

The key to this trade short term is that WTI crude futures have about a $1.40 front month to second month carry. This type of carry has held for over six months. I believe it is due to the huge amount of outside money that has come into the commodities markets. This new money is long only, and it plans on sticking around. In fact, since much of the money has gone into closed end vehicles like EFTs, there is no way for it to exit. This money is going to be rolling every month, and that should keep the carry large. Note that $1.40 a month is equivalent to about 27% a year!

OTOH, I don't want to be short crude after a 25% or so fall. The long term is just too bullish, and you can never tell what kind of political risk will pop up. So I hedge the trade by going long oil equities. Note that long term, this has been a fantastic trade since you also get the long run return on the stock market. But I'm thinking shorter term here. If oil goes up, oil stocks will also. If oil goes down, oil stocks will fall with them. However declining oil prices tend to be very good for the overall stock market, so there is a natural cushion. And of course there's that 27% carry you get just for holding on.

The problem in the trade is deciding what the hedge ratios should be. My statistical work shows that the beta of pure producers (Anadarco, Devon and such) is slightly over 1.00 on a day to day basis. That would imply equal dollar amounts in crude and equities. However, if you look longer term, the betas go down substantially. This makes sense: over the long term these companies costs go up with oil prices. However this means there is no way to hedge yourself for the duration of the trade (I'll hope to be in this for six to nine months) without accepting significant short-term volatility. So keep the leverage down!