Don’t be hasty

1. Xivvie has prone true to form and is up about 400% since I sold my entire position at around $8 last year, proving once again stop losses are the devil’s work and have no place in anyone’s strategy. Whoops.

XIV 1 year

On the flipside, the world has proven remarkably good at knocking down risk markets, so there’ll almost certainly be another chance to pile back in, though if we have a few years like 2003-2006 (likely) I’ll probably have to watch one of my favourite plays quadruple again from the sidelines.

Typically the lack of market volatility over the past year is the exact opposite of what (dare I say) everyone was predicting a year ago. Even lil Kim hasn’t been able to shake things around. The commentators gleefully stating that the Korean markets are at ‘four month lows’ completely miss the point: big picture there’s barely been a ripple.

10 year KOSPI

(Kospi, Korea’s market index)

Fortunately, having watching XIV and it’s ETF cousins for some time now (of particular interest ZIV – it’s like a smoother version using futures further down the curve that inherently jump around less than the front end) and actually read their legal docs, at least I now have a firm strategy and some level of confidence to put on a position that, in my weak defence, I just didn’t have this time last year.

2. While I’d prefer it didn’t, that sort of opportunity may come relatively soon. There’s hints of the now-typical mid year slow-down in the US, Eurozone statistics are somehow managing to worsen, and there are signs wherever you look that market exposure is at extremes. This all suggests the annual Sell in May and Go Away collapse might happen once again, for what must be something like the fourth year in a row now.

Eurozone unemployment:

Eurozone unemployment 2013

3. Meanwhile the broad road-map has been playing out according to plan. The Eurozone hasn’t collapsed as the pundits predicted, and it will take far more than economic statistics to shake it now. Meanwhile the shale story played out more or less as expected, and while this hasn’t resulted in the fall in crude I was expecting, I think downward pressure is a relatively safe bet over the next few years.

Pressure on commodity prices will likely be the theme of the next couple of years, and you don’t need to be an expert to guess what impact the wave of supply will have on commodities like iron ore.

The second and third order impacts are harder and more interesting to ascertain. Most likely prices will stay low (as will inflation statistics) and those who need cheap fuel and cheap raw materials will benefit. Perhaps steel makers will finally have their time in the sun, and some of the pressure on airlines, shipping and transport companies will be alleviated.

4. To be honest though, considering the run so far, to be long in this market is not a clever move. Better to be patient and wait for a real opportunity. If you were set at much lower levels last year, or better yet, at any point in the four years preceding, that’s a different story, but this bandwagon is not for jumping.

Enough with the boring recap.

Next post: Anarchy and Bubblecrap


Shale on.

The world’s best investment bank Squid just issued an excellent note on shale gas. I posted on this a while ago and the story is certainly filling out.

A few points stood out: 1. Natural gas prices, in both absolute term and relative to oil, have tanked. I often hear people assuming they will go up. If something drops dramatically, the first thing people seem to think is that it will go back up, and now it a buying opportunity. That is true if it’s a cyclical case. If it’s secular, i.e. driven by factors that aren’t cyclical, then there is no reason for something that has gone down, to go back up. Similarly, something that has gone up, won’t necessarily go back down if the story has changed. You probably won’t be able to buy Apple for $100 ever again, for example.


2. There are some big winners. US, Australia, China and Argentina stand out.


3. US energy imports are falling drastically as expected, but fortunately China is there to pick up the slack or prices would fall. Actually this is quite unfortunate as we all would benefit from lower energy prices, while only a handful of violent sexist extremist hoarders Western allies in the Middle East benefit when prices are high.


So how to play it? There are obviously some simple ways.. buying shale producers. But the easy money is certainly already made there.. not that you won’t still get decent returns on capital. The cost of sucking otu shale gas is so much cheaper than conventional drilling that the whole industry is likely to perform well.

My favourite pick? Buy US fertiliser producers. Natural gas is much lower in the US than elsewhere – one of the real anomalies in global finance right now. Natural gas is a key input, so US producers will have a huge advantage for a long time. And they are relatively cheap. Daniel Shand picked CF Industries, and I’m going to back him on this one.

Very volatile so a good candidate for selling puts, if current price seems a bit high.

Whilst on topic, has anyone noticed this? Doesn’t seem particularly bullish. Perhaps you could balance a long shale producers / short copper trade for a commodity neutral trade on this theme.


Oil Bear

The price of oil is going down.

The resilience of oil prices in the face of an onslaught of grim economic and political developments around the world implies supply is currently quite tight. But don’t be fooled by oil over $100: The energy market is about to be turned on its head, and it’s all about shale.

A rather lax regulatory regime (courtesy messrs Bush and Cheney) has led to rapid exploration, immense investment in technology and huge increases in estimates of US shale energy reserves. It is quite likely that in a matter of years the US will shift from being an oil importer to an exporter – with interesting consequences for the global economy and political ecosystem. The percentage of US oil that’s imported has dropped from 60% during Bush’s second term to under 45% now.

As a sign of how fast reserves are being discovered, in 2011 the US Energy Information Administration more than doubled its estimate of technically recoverable shale gas reserves to 827 trillion cubic feet (for a sense of scale, in 2010 the US consumed about 24 trillion cubic feet). This is not the sort of thing that would lead to an increase in global energy prices.

The consequences within the industry are no less dramatic. Currently most oil in the US is travels South from the oil sands in Canada – with a production cost of around $80 per barrel. The cost of producing a barrel of shale oil is around $60, with some fields potentially as low as $40 – Royal Dutch Shell announced it could produce in Colorado at $30 a barrel. The numbers themselves tell the story. Once these fields pumping at full capacity, higher cost producers are up the creek, so to speak. Since they’ll have already made huge fixed investments they will have to keep pumping, as even producing at a loss would be better than idling the wells and losing more. The result will be disaster for the weaker capitalised and vast profits for the shale producers.

The impact will be far more broadly felt than that. Cheap energy, the lifeblood of industry, is exactly what the world needs right now. Cash saved on petrol is cash left sitting in all of our wallets. Every industry relies on the price of energy, so lower prices would be a boon to all. Traditionally periods of low energy prices have corresponded with booms (think 1970s vs late 90s), while the mid-2008 oil spike is arguably the most under-estimated causes of the sharp recession that followed. Perhaps this could be the boost to growth that the global economy is lacking right now. Hope so.

A good way to play it would be on the futures curve. Selling 12-18 months forward would have better risk-reward – the price will respond less sharply to any positive oil shocks while a clever move would be to cover the position by selling long-term puts around $50-60, or higher, giving you a much wider range of profitable scenarios. I’ll post later on specific long-short equity plays that also make sense.

Now there are obviously darker consequences to cheaper energy, most obviously the effect higher consumption has on global warming. There are also concerns over the health, safety and environmental impact of harvesting shale. The process involves pumping oceans of water underground, which ominously appears to increase local seismic activity, while there are (perhaps a little hysterical) concerns gas could enter the water supply, with a video of tap water igniting recently going viral. These concerns, magnified by higher population densities, have left Europe years behind in developing the legal and technical structures to make use of their own vast reserves. Whether these fears play out and the US slams the break on shale development is impossible to discern, though a health disaster in the headlines would probably have more impact than simmering environmental concerns, valid though they may be. But with whole continents stagnating and no end yet in sight to the crisis, almost into its fifth year, it would be a foolish politician who wasted this potential windfall.

Spread that.

The WTI-Brent spread has gripped the attention of the financial world. Historically trading in a tight band the spread dramatically blew to as high as $28 intraday before plunging just as dramatically to around $9 where it is now – particularly odd considering the greater refining yields and lower sulfur content of WTI.

A bottleneck at the Cushing terminal in Oklahoma, where the Nymex WTI contract is settled, caused incremental Canadian oil to build with only expensive barges to transport the crude to refineries.

Exacerbating the problem was ConocoPhillip’s decision to keep the Seaway pipeline flowing towards Cushing. In doing so the company protected the profits of its Midwest refineries by keeping WTI crude artificially cheap, all at the expense of Canadian oil sand producers who were pushed to breakeven levels.

The sudden tightening of the spread occurred after the sale of Conoco’s 50% stake in the Seaway pipeline to Enbridge for $1.15 billion, which allowed the reversal to take place. Curiously, the spread began tightening as early as October when WTI entered backwardation, a clue that supply/demand story was tighter than thought.

An initial capacity of 150k barrels / day by 2Q12 is expected to expand to 400k barrels / day by early 2013. This will probably displace the use of the congested and expensive barge market from 2Q12-4Q12.

Whenever prices get this out of whack the gods of economics demand a physical respones. In this case rail capacity was immediately planned with the aim of circumventing Cushing, which may induce further tightening as Cushing prices rise to encourage more oil flow through the terminal.

How I’d recommend playing it: inventories at Cushing will likely build up in anticipation of the opening of the Seaway pipeline. The best risk reward is probably in longer dated Brent spreads, while perversely inventories at Cushing may actually build as oil is pumped there in anticipation of the opening of the pipeline. This would push down prices at the front end of the curve, while leaving the back end free to compress below $6.50 – which is the cost of transporting WTI to Brent.

On this theme, selling the March 2012 WTI-Brent spread and buying the March 2013 spread would benefit from a rotation of the curve – simultaneously profiting from any short term widening while betting that by March 2013 the excess inventories have cleared out. Quite a likely scenario.