Crude Oil Market Outlook
Welcome to the inaugural issue of The Peak Oil Investor, a newsletter intended to share my thoughts on the Peak Oil trade with other investors.
The idea for this newsletter came from my friend Kirby Daley, then with NewEdge (SocGen’s PB arm), who has since moved on to a senior position on the buy side. I was debating whether or not to launch a Peak Oil hedge fund, and Kirby’s advice was to begin by writing something similar to a typical hedge fund’s quarterly letter, both to document my own investment outlook and performance, and also just for the sake of getting a taste of how hedge funds communicate with their clients.
At this juncture, nothing is on offer, and this is not a solicitation of any kind. I’m sharing my trading strategies (for free), to promote my own name recognition, just in case I ever decide to get into the business of running OPM. More on that at the end of this issue.
If you want to receive future copies of this letter via e-mail, please go to my website, www.eriktownsend.com, and “Join” the site, giving me your e-mail in the process. I’ll be sending future newsletters to anyone who has “joined”. I will not sell or give your e-mail to anyone else ever.
In this issue…
- Crude oil market outlook
- Performance review of trades recommended in my Peak Oil investing videos
- The WTIC-Brent spread
- Looking ahead (trading strategies from here forward)
- The risks to the trade are regulatory
- Update on my OPM aspirations
- My round-the-world “peak oil tour”
Crude Oil Market Outlook
In January of this year, I released two free videos about Peak Oil investing. This newsletter is intended as an update to the ideas and predictions contained in those videos, so if you’ve not already seen them, please start there. You can find them at www.eriktownsend.com/peakoil.
In the videos, then again in my presentations at the ASPO conference and before Walloon Parliament (those talks are also available in free online videos – google my name and ASPO to find them), I set forth a general thesis which can be summarized as:
- The bullish case for higher crude oil prices over the long run could not be stronger!
- However, I predicted a major sell-off due to economic weakness before peak oil actually “hits the tape”.
I remain convinced of this view, and the sell-off I predicted is now under way, having begun on May 5th. The big correction came about a month earlier than I had predicted. So far, it has not been quite as deep as I expected, suggesting the bull case may be taking hold in the market sooner than I first anticipated. Whether prices have much farther to fall depends entirely (in my opinion) on U.S. monetary policy. A full-on announcement of QE3 at the upcoming Sept. 20th FOMC meeting would certainly change my view (I would then conclude that the rout is over and I’ll regret not having covered my hedges when the December’11 contract briefly dropped below $80 on August 9th.)
But my expectation is that the rout is not over yet. The trouble in Europe just keeps getting worse, China’s tightening seems to have put a dent in the inflation that nation has experienced, but the tightening could also cripple China’s economy and bloated housing market. Meanwhile, the U.S. economic story continues to rely entirely on an unsustainable policy of stimulus, under the theory that the problem of too much debt can somehow be solved by adding more debt to fuel an unsustainable system with “stimulus”.
While the weakening economy portends lower energy prices, we’re finally starting to see a few mainstream analysts waking up to the realities of Peak Oil. And therein lies the conundrum: My economic outlook is bearish (suggesting lower oil prices), but I think that bullish factors discussed at length in the videos are going to trump the economy and the big upside move in oil prices may come even in the face of an economic slowdown. If that happens, high energy costs will certainly exacerbate that slowdown markedly, making oil prices a very hot political issue.
My advice to retail investors and others not able to trade futures spreads – both in the videos and at ASPO – was to wait. I felt pretty certain that crude oil prices would move lower before moving much higher, and that’s exactly what has happened. But the time to stop waiting and start acting is fast approaching.
Have we reached the bottom, and is now the time for new longs in energy? My guess is that we still have a little ways left to go to the downside (in terms of spot price of crude oil), but market timing is never smart business. While I don’t think we’ve seen the bottom yet, the risk of “missing the chance” to get in at current prices is about equal to the risk of “not waiting for a lower bottom”. The best advice I know for investors new to the Peak Oil trade is to start averaging into long exposure to both crude oil and energy stocks. I have no idea whether we’ve seen a bottom yet, but I’m pretty sure the bottom will occur before March, barring unforeseen new information. Another big upset in the MENA region could rocket prices to the upside overnight.
What I expect from here is pretty simple: Oil prices should continue to suffer with continued economic weakness, until the myth of Saudi spare capacity is exposed, unrest erupts in MENA, or some other catalyst sparks the first big move to the upside. When that happens, I think it could be really big (as in $200+/bbl by end of 2012), but I also see a very real risk that continuing global economic weakness could dampen the rise, or even delay the onset of a big upside move by as much as a year if the economic stress turns out to be worse than even I expect. But assuming that QE3 happens in some form (as most investors seem to expect), I think the U.S. economy will once again experience the illusion of “recovery”, and oil prices should go through the roof.
The big wildcard is election year politics. I predict that the Obama administration will do everything it can to keep equity markets and the general economy propped up with printed money, right through the election in November. I am convinced that the reason QE3 has not begun yet (and why I think it will come later than many expect), is that I think the Obama administration wants to be able to “stimulate balls-to-the-wall, without stopping, right through the election”. If they started now, they would blow up global commodity markets well before the election, leading to massive unrest. So they have to wait a bit longer before starting the next major monetary stimulus campaign, else risk having to take the proverbial foot off the pedal at the worst possible time, just a month or two before the election.
I am convinced that their strategy is to hold off as long as possible, and then begin a massive money printing campaign as soon as they believe it can be sustained through the election. I don’t give much credence to the notion that the Fed is supposedly independent, and therefore not influenced by the administration. It seems obvious to me that the Obama administration has been able to influence the Fed in the past, and will continue to be able to do so going forward.
So put yourself in the U.S. Government’s shoes. They want to stimulate like there’s no tomorrow right through the November 2012 elections. The artificial upside for equity markets from QE only helps the campaign. But $200 oil by November would spell a guaranteed loss for Obama. These people may be reckless, and they may be willing to sell out future generations’ prosperity for their own personal immediate gain, but they’re not stupid. They will do everything they possibly can to contain oil prices until the 2012 election has passed, and this will likely include both margin hikes and other “offensive tactics” designed to “punish speculators”. More thoughts on that subject later in this issue, under The risks to the trade are regulatory.
2011 Performance Review
Coming into the new year, I was debating whether or not to launch a Peak Oil hedge fund. For the sake of documenting my own trading performance, I set up a $1mm seed account in which to implement my peak oil trading ideas (from the videos). I should acknowledge up front that I consciously chose a very aggressive (leveraged) trading strategy, because I wanted to see how my performance looked in contrast to hedge funds managed around a speculative strategy with a reasonably aggressive risk appetite and volatility tolerance. At +165% year to date, I’m quite satisfied with the performance of the trades thus far, but I also feel obliged to acknowledge that these returns were made possible by designing the trade with up to a -30% loss before I would have been stopped out had I been dead wrong about everything. A more conservative investor (including myself had I not been trying to prove I could produce big returns if I set out to do so) would have taken on less risk and only seen a “measly” return in the 80% - 100% range YTD trading the same strategies. The remainder of this section will detail the trades I made year to date.
I began the year focusing primarily on the strategy described in the videos as long-dated crude futures hedged by puts on shorter-dated contracts. More specifically, I was swing-trading to accumulate both Dec’15 WTIC futures (CLZ5) and puts against the Dec’11 contract to hedge market risk. The puts were struck just below the market, and my strategy was to buy a few more long CLZ5’s on each dip, and a few more puts against CLZ1 on each (short-term) overbought indication.
In a sense, the trade is a synthetic long call on 2015 crude oil futures, except that by assuming the downside risk is concentrated in the early phase (prior to 2012), the cost of the synthetic call was much lower than a real call, because of the shorter duration of the put component. Stated more simply, the idea was to get as much long exposure to CLZ5 as I dared, hedging market risk with much cheaper insurance that’s only good thru 2011, after which I don’t expect to need insurance.
That strategy was working very nicely in the first few weeks of January, but then when the MENA unrest started to break out, my already-bullish outlook gained conviction. I continued to accumulate puts against the CLZ1 contract, but also took on a naked long position in the June’11 WTIC contract, protected only by stops. That position was later rolled forward into the Sept’11 contract. I should acknowledge that the CLM1 long was not really a Peak Oil play per se, but rather an additional speculative play on MENA unrest.
The strategy of being levered up long through the Arab spring worked fabulously, and I first hit the +100% mark on account equity in mid February. By then I had also adjusted my stops and hedging ratios, so that my worst-case would be a break-even (as opposed to -30%, the original loss limit designed into the trading strategy).
Everyone knows the old adage about pigs getting slaughtered. I didn’t quite get slaughtered, but I definitely learned a lesson about taking profits in stages. I knew the big upside move had to end, and I even said as much publicly in my lecture as the ASPO conference in Brussels just a week before it did end. But I thought it had a little farther to go. I was targeting June 1st or $117 on the September WTIC contract as my exit point for the unhedged portion of the portfolio. The profits were fantastic, and I came within two dollars a barrel of hitting my limit order to close the naked long in CLU1 at $117.
Then came May 5th. I knew immediately that the reversal I had long anticipated was upon us that day, albeit about a month earlier than I anticipated. I immediately switched gears and put on the ACH Calendar Spread trade described in the videos, hedging ALL of my Dec’15 longs with shorts against Dec’11, which I sold around $105, or about $10 below their price only a day earlier.
Re-learning a lesson you already knew always hurts, but it was hard to complain too much, with the trade still up +30% YTD even after the carnage on May 5th. Obviously, I’d have done much better if I’d been a little earlier reversing my short-term outlook, and I did see the reversal coming. But I’d also made a conscious decision to “bet my P&L”, and risk giving back all the gains in order to stay exposed to the upside. May 5th was definitely a setback, but I’ve since made back everything lost in May and quite a lot more.
When I converted to the calendar spread trade, I kept the puts, as a speculation that there was a rout in commodity prices coming as a result of the cessation of QE2. That’s exactly what has happened, and the trade has been very profitable.
In hindsight, I should have started covering the Dec’11 shorts when they briefly dipped below $80 on Aug. 9th. Unless Sept. 20th brings more stimulus than the market has already discounted, I’m reasonably confident we’ll see CLZ1 drop into the $70s again, and that’s where I’ll cover both the CLZ1 shorts and the puts.
Does that mean I think $75 will be the bottom? No, absolutely not. I think that short-term, the prices could drop much lower if we see a really bad economic slump for the rest of 2011. But the whole point of my trading strategy (described in the 2nd video) was to make enough on the hedge to be able to ride out any (future) vol in the naked 2015 and 2016 longs. I put the hedge on at $105, so if I’m able to cover at $75, that’s a neat $30 profit. For the overall trade to go into the red, my CLZ5s and CLZ6s would have to lose another $30 from here, i.e. down to $65. I just don’t see that happening, because of the price floor effect created by the incremental cost of producing non-conventional crude (see the videos).
So my strategy is to wait for a little more softness in the economy and short-term prices, then cover my shorts and puts, and then just ride the naked longs from there, knowing I have enough built-in profit to tolerate any realistic amount of vol in the long-dated contracts that might occur between now and the “aha moment”, where mainstream investors wake up to the realities of supply and demand, and when peak oil really hits the tape.
I have no idea how much longer the weakness in oil markets will last, but I think the announcement of QE3 will be the most likely catalyst to end the rout. If we see further weakness, I’ll start to really lever up the trade by buying out of the money calls on Dec’15 and Dec’16 crude oil futures. There is always the risk of a very deep recession delaying the onset of Peak Oil beyond those dates, but the money spent on (very high leverage) calls will come from profits already banked from the trade, and I view them as lottery tickets.
I don’t invest in individual stocks myself, so I don’t have much advice for equity investors, other than to say that I expect the bottom in energy stocks to come after the bottom in oil prices. For retail investors who seek to just make a simple investment in energy ETFs or individual stocks, my thought would be to design a dollar cost averaging program to start buying now, and make the final purchase around the end of the calendar year. Nobody knows (or can know) exactly when a bottom will come in any market, but my sense is that the bottom will most likely come between now and March 2012, if it didn’t already happen on August 9th. A disciplined averaging-in program is the way to go.
The WTIC-Brent Spread
An unprecedented condition now exists where Brent Crude (the benchmark in Europe) is trading at a considerable premium to West Texas Intermediate Crude (the U.S. benchmark). The reason this is so unusual is that WTIC is actually a higher grade of crude, which has historically traded at a small premium to Brent.
There are lots of theories for why this anomaly has persisted so long (all year), and I’m not going to bother describing my own thoughts on that subject because I don’t think they’re particularly important. What matters is that this abnormal spread exists now, but will almost certainly go away some day, since the physical distance between delivery points alone simply isn’t enough to explain a price disparity that has remained above $10/bbl for most of the year.
I focused my Peak Oil longs on the WTIC contract alone because of this unprecedented spread. I figured the spread had to close eventually, so I could effectively buy Brent at a $10 discount by buying WTIC now and then rolling over to Brent when the spread closes. But this anomaly has lasted longer than most of us predicted, and that’s an important signal. It changed my thinking.
As we come into a U.S. election year, the Obama administration has very strong impetus to do anything it possibly can to contain a rise in WTIC, but has far less motivation to concern itself with Brent prices. Could some sinister government price containment (i.e. market manipulation) scheme be behind the unprecedented spread? I don’t know, and frankly I don’t find it useful to speculate about such things. All I know is that to whatever extent the U.S. government is able to, they will focus their efforts on keeping WTIC prices down thru the 2012 elections. The conclusion should be obvious – my decision to focus the Peak Oil trade on longs in the WTIC market, expecting the spread to have closed by now, was probably a mistake. I’m watching the spread, and plan to convert at least half of my existing WTIC longs to Brent on a good dip. Likewise, any new longs will be on the Brent contract, and any new short hedges or puts will be against WTIC contracts, on the theory that any U.S. government efforts to contain oil prices are likely to focus on the WTIC contracts.
The real story is not the rout in commodity prices now underway, but rather the extraordinary upside I see over the next few years as the reality of Peak Oil can no longer be denied, and the myth of Saudi spare capacity is finally disproven for once and for all.
If you followed my advice in the videos and used the ACH Calendar Spread strategy, you already have enough profit built in to weather any further downside on your longs. I think the time to cover the hedges and go naked long is approaching rapidly, but then again the perils of unhedged, levered positions are considerable. Out of the money puts (struck around $40 to $50 as a disaster hedge) are a cheap way to mitigate that risk.
For speculative traders willing to risk losing everything they put into the trade, out of the money calls (but not too far out – in the $100 to $125 strike range) on CLZ5 and CLZ6 are starting to look awfully attractive. The problem is that there’s almost no liquidity in those markets, so you’re going to over-pay for implied vol. Speculating with out-of-the-money calls is always dangerous business, but so long as the investor can tolerate the risk, I think the upside could be incredible. I think I’d wait for even more weakness before really backing the leverage truck up to the door, however. This sell-off could be over already, or it could be just starting. Nobody but Ben Bernanke really knows, so you have to consider a wide range of outcomes.
The Risks to the trade are Regulatory!
The Peak Oil trade is starting to look like the ripest investment opportunity I’ve ever seen or heard of in my entire life. But nothing is ever that simple, and there’s no free lunch. There’s alwaysrisk, and sometimes it’s hidden in less than obvious places.
I think the biggest risk to the speculative peak oil trade is quite simply that it’s speculative. In case you haven’t noticed, “speculators” are the politicians’ favorite scapegoats for their own reckless policy decisions, and we would be foolish to expect anything other than to be targeted once again as the cause of all evils afflicting the world.
We’ve already seen margin hikes on crude oil futures that don’t appear to be warranted by actual price volatility. I think the “margin hike = government manipulation” mindset found in some parts of the blogosphere is overblown, but there is some merit to it.
What worries me much more is the possibility of commodities futures markets simply being shut down entirely, or being restricted exclusively to commercial traders who can “prove they are not speculators”. Of course the big and well connected players will find a way to work around such changes, but the rest of us will be unable to.
I know the notion of futures markets being shut down probably sounds absurd. But stop and think about it. The world runs on oil. It really is that simple. All the fundamentals are lining up for $200+ crude oil by end of 2012, and the bitter truth is that the global economy simply cannot tolerate energy prices that high without falling into depression.
So I think the big wildcard lies in the uncertainty about how, specifically, speculators like myself will be [wrongly] blamed for rising oil prices, and what actions governments will take to “punish” us. Let’s face it: the governments of the West have screwed up really, really badly. They are going to need scapegoats whom people love to hate, and we speculators are their favorite targets. Anything they do to “punish” us will be politically popular. And that’s where I think the greatest risks to this trade lie: in the unknowns of position limits, price controls, windfall profits taxes, or even outright closure of futures markets to speculators. I suggest having an equity-based backup strategy ready for any conceivable outcome.
My OPM Aspirations
Several of my friends in the business have observed that I’m already doing most of the work of a hedge fund manager (in support of my own trading), and have suggested that I launch a Peak Oil hedge fund. But other friends (veterans of the industry) have shared war stories about the hazards of dealing with HF investors and their emotions.
The notion of being compensated for the value I am presently giving away free (by sharing my proprietary trading strategies openly) is certainly appealing, and I have researched the mechanics and legalities of launching a Cayman Islands-based peak oil hedge fund.
But quite frankly (and I hope this won’t offend readers), my opinion is that the hedge fund industry exists primarily to dupe high net worth individuals into taking risks they usually do not understand and probably should not take. Although running a hedge fund would be extremely lucrative, getting into the rat race of an industry whose ethics I find dubious simply doesn’t appeal to me at this stage in life. So I have decided not to launch a hedge fund this year, and probably not ever.
What I am interested in is talking to a small number of family offices and/or HNWI’s about running the peak oil trade for them in managed accounts.
I’m not interested in managing anyone’s money unless they are willing to invest the time and energy necessary to really understand what I am doing for them and where all the risks are. I hope to form strategic relationships with private wealth managers who are willing and interested in really learning what I do and how I do it, and who are willing to give feedback on my trading strategies and also share their own outlook vis a vis other markets. Rich guys who like my returns but don’t really understand what they are signing up for need not apply.
The Peak Oil Tour
I am quite convinced that (as Jeff Rubin so aptly put it), our world is about to get a whole lot smaller. Peak Oil will change the airline industry radically, and I predict that the days of being able to fly anywhere around the globe, usually on a non-stop flight, for at most a few thousand dollars per ticket, are coming to an end.
So I decided to embark on an around-the-world “peak oil tour” with my girlfriend. We left my home in the U.S. on Sept. 1st, and will be on the road for a full year. We’re taking a boots-on-the-ground approach to evaluating countries we might like to live in some day (for all or part of the year). We’re visiting these countries now, while getting there is still cheap, so we can evaluate how each nation and its economy will fare in a world of rapid inflation of both energy prices and most raw materials. I’m writing this letter from Buenos Aries, Argentina, and our travel plans include Chile, Panama, Mexico, Thailand, Bali, Australia, Hawaii, Croatia, Spain, Germany, and several other countries. Some are serious “Would we ever want to live there?” considerations, while others are just places we wanted to visit on our round-the-world tour.
But I need to clear up a misunderstanding… Several people have jumped to an errant conclusion, and have publicly applauded what they believe I am doing, saying things like “Wow! That guy could have run a hedge fund, but instead he decided to go travel around the world, volunteering his time and energy to warn all the good people of the world about what’s coming when the reality of Peak Oil hits the global economy.”
Ahem. I have to admit that does sound pretty impressive, and if any part of it were true, I’d certainly feel proud of it. But the truth is simply that we think now is the time to travel the world, for the simple reason that we still can. The main purpose of the trip is for us to check out places we might enjoy living some day, should we ever move out of Hong Kong, my present legal residence.
I certainly like the idea of doing my part to share what I know about Peak Oil and what it will mean to the world, but I’m ashamed to admit I’ve not made any effort to organize a speaking tour. The folks at ASPO are extremely friendly, and their Australian representatives have tentatively invited me to speak at an event of theirs when we visit Melbourne in February 2012, but that’s the only speaking engagement on the radar at present. I would certainly welcome invitations to speak to other groups if they fit our travel plans. Please contact me through my website if you represent such a group.
Erik Townsend is not a Registered Investment Advisor, nor is he a Broker Dealer. He has no formal investment management qualifications whatsoever, and nothing in this letter should be construed as investment advice. This information is presented for entertainment and informational purposes only. Always consult a licensed investment professional before making important investment decisions.