Engineering the optimal Peak Oil trade

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Erik T.'s picture
Erik T.
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Engineering the optimal Peak Oil trade

I posted the following on iTulip.com, which is a more investment-centric web site. But since CM.com has such a strong awareness of Peak Oil and several very experienced investors, I thought I'd cross-post it here in case it interests anyone.

-Erik

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EJ and anyone else inclined to comment:

As a speculator in the futures market, I've been pondering how to engineer the optimal Peak Cheap Oil trade. I'll share my thoughts thus far in hopes they will inspire EJ and others to chime in with suggestions and ideas to help refine my own thinking.

Premise and Assumptions:

The way I see it:

  • Peak Cheap Oil is real and much higher crude oil prices are a future certainty in real terms and a near-certainty in nominal terms. This is as close to a "sure thing" as ever exists in the investment world.
  • Before Crude prices move much higher, there is a distinct possibility (I might go so far as to say likelihood) that they'll go lower first as a result of a double-dip recession, stock market correction or crash, etc.

Trading Challenges:

The obvious opportunity is to take advantage of recently-collapsed contangos and buy long-dated crude futures. I personally favor the December 2014 contract, because the contango is reasonable (got as low as $4 earlier this month, presently $8.50 or so) and 2014 seems to be a year by which the consensus of experts agree Peak Cheap Oil will either be upon us or at least recognized as impending by the markets.

But because of the risk of a considerable downward move before the big Peak Cheap Oil spike, I've hesitated. And hesitated. And hesitated. When I started debating this trade, the spot market was at $65. Now, $20 later I'm still hemming and hawing because I think the risk of a large economic correction is very high. In 2008 when the front month sold off to $32, the Dec14 futures (CLZ4) bottomed out in the low $60s, which is far enough below their present $92 level to annihilate the trade, especially in a leveraged instrument like futures.

My strategy had been to wait for a reality check to hit the equity markets (and drag CL down with it) before going long crude futures. But I'm sick of watching what could be the trade of a lifetime slip away as markets refuse to acknowledge reality and the Fed and US Gov't continue to doctor their data under the Extend & Pretend mantra.

An economic hedge is needed:

So the obvious solution is a hedged trade. Lever up the long the Dec14 position against a hedge that protects the trade from the economically obvious (there is no recovery) becoming apparent to the masses.

The big question: What's the best hedge?

A calendar spread?

My first thought was a "calendar spread". Long CLZ4 (Dec. '14) against an equal position short CLM0 (June '10) or CLZ0 (Dec. '10). This is effectively a trade on the contango, with the intent to take the hedge off if and when the short side sells off to a greater extent in a big economic downturn. When the front month sold off to $32 in 2008, contangos went thru the roof to record levels. I would expect similar on the next economic downturn.

The good news is that the contango has come way down. CLZ4-CLK0 (May) got as low as $4 around the beginning of this month, and is presently around $8.50. Contrast with $20 contangos at the bottom of the 2008 sell-off in near-month futures.

But as I researched this I was surprised to learn that the crude market actually went into deep backwardation during the big run-up to $147 in early 2008, which many people attributed to peak oil speculation. That doesn't seem to make sense - one would think a peak oil expectation would lead to a steeper contango curve. But that's what happened.

Another big question about the calendar spread is which contract to use as the short leg. The contango between the December '10 and December '14 contract is only $2.70 presently and has traded below $1.50 in the last two weeks. But that's basically a bet that the world will not figure out how real Peak Cheap Oil is until after December 2010. The more conservative hedge of the front-month (May '10) almost doubles the contango, and then you have to deal with rolling the position every month.

Another general economic hedge?

Another obvious idea is to hedge the long crude position with a short against another commodity such as Copper, which is often viewed as a proxy for the health of the general economy. But my problem with that is that I think China has wised up to the reality of natural resource scarcity, and will probably buy into any weakness both to accumulate industrial surplus and to diversify their USD holdings.

Short S&P is another potential hedge, but given how well they've managed to keep the index propped up against a mountain of bad fundamentals already, I'm skeptical about whether the index will serve as an effective proxy for general economic condition. As Marc Faber has suggested, I think that significant weakness on the S&P would be met with a new round of QE, but that should theoretically bode well for the long (crude) side of the trade.

What about Deflation?

I tend to think inflation is going to take over eventually, but deflation is clearly winning the day at present. The long leg of the trade (crude oil several years in the future) is a cinch in real terms, but if really strong deflation took hold, it could be a loser in nominal terms. So the hedge needs to pay off in spades in the (very unlikely, IMHO) scenario that Deflation wins out and Peak Cheap Oil doesn't result in markedly higher nominal crude prices.

My Conclusions:

I think I've waited too long already to get into a long position in what will probably be a basket of crude futures in 2013, 2014 and 2015. The contangos have finally collapsed to a small fraction of what they were in 2008, so now seems like a smart time to take action.

The big question is what to use as a hedge against short- to intermediate-term price vulnerability. I'd love to hear others' ideas, both on what I have suggested above and other potential hedges.

Thanks in advance to anyone who cares to offer an opinion...

Dogs_In_A_Pile's picture
Dogs_In_A_Pile
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Re: Engineering the optimal Peak Oil trade
Erik T. wrote:

The big question is what to use as a hedge against short- to intermediate-term price vulnerability. I'd love to hear others' ideas, both on what I have suggested above and other potential hedges.

Thanks in advance to anyone who cares to offer an opinion...

Erik - for your consideration....

Can you buy Call LEAPs on the futures basket as you have it constructed?

If you can, sell covered call contracts equal to or less than the LEAP contract inventory as the price begins backing up - then close the position by buying them back at a lower price as the price drop starts to wind down.  Eventually you squeeze all of the value out of the LEAPs on the way down, you preserve your capital by printing money out of each of the price drops.   At the end of the day you don't care about what the LEAP contract price is since you have taken the money out on the way down.

And if the stars are aligned for you, after insulating your futures basket against the ups and downs, the LEAPs have gone up in value - just sell them and throw a party.

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Lemonyellowschwin
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Re: Engineering the optimal Peak Oil trade

Thanks Erik.  There are some very thoughtful and smart people who frequent that site.  I'd be interested to know if you get any other ideas after seeing their responses.

idoctor's picture
idoctor
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Re: Engineering the optimal Peak Oil trade

Great thread thanks Eric. Hope we see some good ideas come out of this.

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Re: Engineering the optimal Peak Oil trade

Hi Erik

I'm more inclined towards equity investment than futures. By which I mean shares in oil explorerers and producers as opposed to the integrated majors, i.e in companies that are actually managing to replace/grow their reserves. Many of these are still trading at or below NAV, esp if you believe current oil prices are sustainable.

I agree that oil prices will trend higher over the coming years but always bear in mind there will be an upper limit above which the Global economy cannot tolerate. History suggests this is around 6-8% Global gdp which would give a price today of not much more than $100. OK we got to $147 in 2008 but that was a short spike rather than a sustained level and gambling on spikes is a tricky business. So at todays price and with the contango still present in the futures I reckon there is as much downside as upside.

If you decide, like me, to go with equities then pick companies of sufficient critical mass to survive a further downturn and those without excessive debt levels. And diversify across a basket of them cos they will all have stock-specific risks.

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Re: Engineering the optimal Peak Oil trade

Erik,

I'm more inclined towards equity investment than futures. By which I mean shares in oil explorerers and producers as opposed to the integrated majors, i.e in companies that are actually managing to replace/grow their reserves. Many of these are still trading at or below NAV, esp if you believe current oil prices are sustainable.

I agree that oil prices will trend higher over the coming years but always bear in mind there will be an upper limit above which the Global economy cannot tolerate. History suggests this is around 6-8% Global gdp which would give a price today of not much more than $100. OK we got to $147 in 2008 but that was a short spike rather than a sustained level and gambling on spikes is a tricky business. So at todays price and with the contango still present in the futures I reckon there is as much downside as upside.

If you decide, like me, to go with equities then pick companies of sufficient critical mass to survive a further downturn and those without excessive debt levels. And diversify across a basket of them cos they will all have stock-specific risks.

 

piquod12

I share your thoughts on the equity side.  After thinking very long and hard on this, I feel US royalty trusts and Canadian trusts are the best way to play this.  Large cap producers (majors) have too many refineries and chemical plants that will be closed in the near future.  They also pursue large fields that ulitimately will carry marginal EROEI values.  Trusts drill in low risk fields that will never yield a large find.  However, higher EROEI (not scientific - just my gut feeling).  Two more important points - large dividends and tiny managerial compensation (and pension liabilities). 

Nate

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Erik T.
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Re: Engineering the optimal Peak Oil trade

The main reason I shy away from equity investment in energy is that I think Peak Oil is going to be a really, really big deal when it is finally understood. And that means nationalization. I fear that oil exporation and production companies could crap out after a few nationalizations steal all their assets.

I suppose a corollary to that is that government price controls could cap the upside of a straight commodity trade, but I still like the odds better.

But in any case, a large equity investment in energy at this juncture clearly needs a hedge for the same reasons the commodity trade does.

Erik

 

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piquod12
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Re: Engineering the optimal Peak Oil trade

Hi Erik

Outright nationalisation makes little economic sense when you have an efficient industry generating maximum revenue from operations. Simply put govmnts aren't going to be able to run the O&G E&P's any better than the private sector. More likely are increased taxes (rates and windfall) putting a cap on shareholder returns. But this will have to be balanced against incetives to carry on E&Ping which is in the interests of both govmnts and private corporations.

Investment post-peak may come down to where is the least worst place to put your money rather than the best. If everyone is effectively getting poorer, i.e. the whole gdp pie is shrinking, then mainaining wealth will be more important than growing it. In such a scenario even the more heavily taxed profits of E&P's may look good next to investment in other industries (airlines anyone?), assets or even cash.

In some ways it's a shame it's not as easy to store a decent amount of oil in a safe as it is for gold. Buying physical commodities has not been a good play during the last 200 years whilst they have been relatively abundent but that could change going forwards. Maybe we should all club together and buy a large tank of diesel!

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land2341
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Re: Engineering the optimal Peak Oil trade

Look at PBF,  where they came from, who funded them and why they bought the Valero Delaware City Refinery (Oops asset sale sorry it isn't running)  and why the Blackstone group and O;malley are involved in the purchase and expansion of the Bahamian terminal and storage.  After you're done rethink your position on nationalization.  Then ask yourself do they know something we don't or do we know something they refuse to believe?  Or both?

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Nate
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Re: Engineering the optimal Peak Oil trade

Erik and P12,

Both excellent points.  Nationalization or best investment in the current climate.  Thinking outside the box (and off topic a little), I thought of what my local community really needs to function without external inputs.  Energy is at the top of the list (San Jouquin valley has more food than we could possibly need).  Last week I made my first batch of biodiesel using only local materials.  Maybe we should think about investing in our local communities to circumvent peak oil issues.  Small scale energy projects will not attract the attention of the authorities.  Thoughts?

Nate

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piquod12
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Re: Engineering the optimal Peak Oil trade

Hi Nate

Maybe we should think about investing in our local communities to circumvent peak oil issues.  Small scale energy projects will not attract the attention of the authorities.  Thoughts?

Definitely. I'm lucky enough to live in a town in Scotland that has just kicked off a transition movement which is all about community and within which energy is a major part. The biggest changes will hopefully come from conservation, insulation and generally using less. But micro-generation is also very much on the agenda. The movement actually does have the support of the local authorities so no need even to hide :-)

I was toying with using some savings to invest in solar panels but now I don't need to because the UK govmnt are going to stump up most of the cost for me. Basically they've introduced a subsidy (feed-in tariff) that means anyone with an appropriate S-facing roof can install solar panels courtesy of the tax-payer. It's potentially a massive transfer of wealth from the poor to the middle-classes but if you have a house with a suitable roof then you'd be a mug not to take up the offer. About which I shall feel terribly guilty of course ;-)

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