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When you are betting on the oil price, timing is all-important

JUST how high can the oil price go? It broke through $80 last week, and in the past few days Barclays Capital analysts said that they think that oil has now made the transition into a higher trading band and a sustained improvement in demand should continue eating into excess inventories.

The chances of oil hovering around the $80 mark – and going even higher – are good. That said, in the near-term excess supply should cap the upward momentum that has driven the price of oil. Indeed, it has so far struggled to consolidate above $80. Weekly inventories data released yesterday showed an increase in crude oil inventories, only serving to push oil futures even lower. But BarCap sees the price of West Texas Intermediate (WTI) crude only hitting $90 in the fourth quarter of next year. But by 2011, we could see oil above $100 per barrel, believes Bank of America-Merrill Lynch.

With these forecasts being bandied about, private investors might be tempted to take a punt on where they think the price of crude oil will go to. While institutions and professional traders will use futures and options to speculate on and hedge against changes in the oil price, private investors cannot access these instruments easily. Covered warrants are therefore ideal – they not only allow you to gain greater exposure to the underlying than you would if you were directly involved in the oil markets, but they also give you the right, but not the obligation, to buy or sell at a predetermined price (the strike price) on a predetermined date (the expiry). So, for example, if you think that crude oil will reach at least $90 by this time next year then you could take out a call covered warrant with a strike price of $85 and an expiry date of either December 2011 or December 2012.

But one of the biggest problems with oil covered warrants is that they are normally denominated in US dollars and therefore British investors are also exposed to currency fluctuations as well as changes in the oil price. A strong sterling can erode profits made in dollar-denominated assets. You could look to hedge your position by looking to go long on sterling either using call covered warrants on sterling-US dollar or by trading in the forex markets directly.

Another way of avoiding the loss of profits that can be caused by currency fluctuations is to use what are known as quanto call and put warrants. These are set at a fixed rate of exchange, and so shelter investors from currency risk, says RBS’s Ben Board. RBS, an issuer of covered warrants, offers quanto covered warrants on Brent crude oil futures and more should be issued soon. However, while these products can offset the problems associated with currency fluctuations, they are expensive for the end-user and it is for this reason that the other big UK provider, Societe Generale, doesn’t offer quanto covered warrants.

Covered warrants’ flexibility and breadth means that you can always take a view on the future price of oil.