Oil and the alternatives to Black Gold

Brasil is the world's biggest producer of plant alcohol as fuel. They are the largest grower of sugar-cane. The Americans use corn to produce alternatives for oil. However, despite our good meanings there is a lot of criticism on bio- or eco-energy.

To execute the final heating processes to distillate the by-products from the products take extremely much energy. Some processes even take more energy then they provide. There is still a long way to go to create environmental friendly energy products in a profitable way and on a large scale.

Around the world more and more processes are developed to create substitutes for oil. Although these processes take years to mature and are still insufficient to meet the growing demand for energy, it all supports the need to transform our way of living, thinking and handling.

Coal as oil

Coal for instance can be transformed into oil. Since coal is much cheaper than oil, this sounds interesting. Years ago South Africans found a procedure to this transformation. Big buckets of coal were set on fire and battered with a mixture of steam and oxygen under high pressure.

Coal is burned and this produces large quantities of gasses which are rich of hydrogen and carbon (the most important components of oil). For oil -compared to coal- has twice as many hydrogen atoms as carbon atoms, hydrogen must be added to the coal gas. This is what the steam is used for.

The burning coal supplies enough heat (energy) to separate the water molecules in the steam into hydrogen and oxygen atoms. This hydrogen assures that the gas will consist of the right amount of hydrogen and carbon.

This gas must be mixed (washed) with methanol to remove sulphur and cyanide. After this process, the gas is transferred to reactors where the final product by means of a chemistry process is optimized. In these reactors fuel, LNG and oil can be produced, but also wax, alcohol and aldehydes. Unfortunately, these processes are rather costly.

Secondly, what's in it for you? Why am I referring to this technical background? Simply because you need to have general knowledge of the background of commodities, otherwise you can never make a good decision of the valuation of these products.

Price correlations

Because of the possibilities for substitution, the prices of different commodities (i.e. gas, oil, coal) are correlated. To trade futures you have to be aware of this.

You can also use these price-relations to offset your risk by hedging through another product than the exposure reflects. This is called cross-hedging. Usually margins are also (at least partially) offset.

The reason for hedging with a 'proxy' can be the cost of hedging or the liquidity of the specific markets.

Even within a market you can set up cross related positions. In the oil markets crack spreads are often used. Prices of fuel oil, gasoline, jet-fuel, and crude are highly correlated. Sometimes price moves in certain products face a delay. Try to profit from these situations!

Buy undervalued products and sell short at the same time the overvalued products. These opposite positions are not exposed to the direction of the market as a whole (up-trending or falling).

Regardless of the market you try profit from the price discrepancy and wait for prices to return to the ratio you expect. Then turn around your position and cash out!