As the broader market took a downward turn this week, largely due to geopolitical and macroeconomic factors, I wanted to explore the correlation between Oil, Natural Gas and BioFuels, as well as the correlation between all fuels and the Nasdaq and broader US S&P 500 index. Understanding these correlations can help investors develop hedging strategies, and understand market sector risk to a greater degree.
Part one of my analysis was determining market proxies. For the SP500, I used the SPY etf. For the Nasdaq, I used QQQ. For the biofuels index, I used my equal-weighted BioIndex, which incorporates publicly traded cellulosic ethanol producers, biorefining catalyst firms, biodiesel, Ethanol producers, biocrude, and isobutanol producers (see disclosure in graph for list of firms). For oil, I used the United States Oil Fund (USO), and for Natural Gas, I used the United States Natural Gas Fund (UNG). I believe that these proxies were reasonable enough approximations of the US natural gas and oil markets.
I wanted to see how these sectors performed over 2012 in a graph, where trends would be more easily revealed. I used USO’s January 3rd starting price as a base, and adjusted the price of SPY, QQQ, BioIndex and UNG to USO’s price, so that they started at the same point. In doing this, I could review all segments in a similar price band, to more clearly reveal trends. The result is below:
Laying out the BioIndex, UNG, and USO equities against one another revealed an interesting trend between USO and the BioIndex. This begged for more quantification via a true correlation matrix. The green arrows show that the local relative minimum of the USO correlated closely with the local relative maximum of the bioindex. This suggested a negative correlation.
Interesting Findings
In laying this out graphically, I quickly noticed that the peak in the BioIndex followed the low in the USO over the period. This seemed counter intuitive, but I believed there may be an explanation. Biofuels benefit as a substitute fuel to petroleum products, as they become more economical as oil prices rise. Rising oil should increase the demand for biofuels. Yet, as biofuel prices rise, particularly ethanol, which is currently used as a drop-in additive to gasoline, it becomes less economical to add ethanol to gasoline, which should stem demand. I can see there being a negative correlation.
It is clear that there is some negative correlation between USO and the BioIndex. The final phase of the analysis was quantifying correlations by producing a correlation coefficient matrix.
Conclusion
There appears to be potential for correlation trading between the BioIndex and USO, as well as with UNG and the QQQ and SPY.
I am going to investigate the potential to hedge BioIndex exposure via investment into USO, or other broad oil indices in a subsequent post. Such a move would limit risk exposure to the segment during this year of apparent high volatility in the biofuel sector.
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