Peak Cheap Oil - Spread trade long Contango article - Comments?

The following article was published by financialsense. I'm particularly keen to hear iTulipers' feedback, criticisms, and of course Jtabeb's declarations of stupidity... :p

My primary contentions are that you can't afford to wait to get exposure to long-dated oil futures, because eventually the world will wake up and smell the roses, and the looming threat of PCO will cause crude oil contangos to expand. But because the economy is likely (very likely IMHO) to get worse before it gets better, oil prices are likely to go down before they go up. I therefore propose to speculate on contango rather than price for now, while planning to convert the trade to a price speculation at a perceived low point in the future.

All comments and feedback welcome, even from Jtabeb!

xPat
---------------
FSN Link: http://www.financialsense.com/editor...2010/0507.html

Full text:

ffice:smarttags" name="country-region">ffice:smarttags" name="State">ffice:smarttags" name="City">ffice:smarttags" name="place"> The Speculative Peak Cheap Oil Trade – Part I

By Erik Townsend ∙ May 7, 2010
Executive Summary

• Peak Cheap Oil will result in much higher long-term crude oil prices.
• Before that happens, oil prices are likely to move much lower if a double-dip recession occurs, which now seems likely.
• Waiting for lower prices before entering a peak cheap oil trade risks paying a much higher contango for long-dated futures after PCO awareness increases.
• A calendar spread can be used to lock in exposure to today’s very low contango while hedging downside price risk.
• A repeat of 2008’s contango blowout would make the calendar spread extremely profitable.
• Potential contract months for such a trade are evaluated and discussed.
• The mechanics of putting on such a trade are reviewed.
• Speculating on peak cheap oil could also be achieved using options rather than futures.

Goals of the Peak Cheap Oil Trade

This is a follow-on to my last article, Why Peak Oil will never lead to $500/bbl crude oil. If you haven’t already, please read that article first. No trading strategy ever makes sense unless the rationale and objectives around which it was designed are first understood. The previous article details my perspective on Peak Cheap Oil, then explains how my views differ from some other investors, and makes a few suggestions in the last paragraph about how a trading strategy might be formed. The feedback I got from readers is that they enjoyed the first article, but wanted much more detail on specific trading strategies. This article will describe the trading strategy I’m using for my own Peak Cheap oil trade in much more detail.

This information is presented for entertainment and educational purposes only. This information should not be construed as investment advice or a solicitation to purchase or sell securities. Always consult a licensed investment professional for advice before making investment decisions. Now that the legal disclaimer is out of the way, I still have more to say: I really mean it! This article talks about complex multi-legged trades using futures contracts, which are arguably one of the most dangerous investment vehicles in existence. Please read this article only for the sake of understanding how a hedged futures trade works. If you’re inclined to enter this trade yourself, please get help from a professional investment advisor who really knows their stuff!

To recap some major points from the first article:

• Peak Cheap Oil (hereafter, PCO) will result in much higher production costs from new sources of crude oil and a declining supply from conventional sources.
• PCO means that oil prices are almost certain to go way up in the long run.
• However, in the short run, I expect crude oil prices to go way down if the U.S. enters a double-dip recession, which I think is likely.
• Based on the U.S. DoE chart presented in the previous article, a reasonable estimate would be that PCO starts to “hit the economy” around 2012.
• PCO may begin to enter a “severe crisis stage”, meaning government intervention in the free market system should be expected, as early as 2015.
• Because of these factors, I advocate focusing on price appreciation in crude oil between now and what I call the early crisis window, i.e. 2012-2015.
• Equity plays are certainly possible, but for reasons explained in the previous article I prefer to focus on the price of crude oil itself.
• Peak Oil Awareness seems to be “going mainstream”, and I expect this will start to be reflected in long-dated oil futures pricing within the next year.

So we have an obvious problem: two competing goals and a reason we can’t afford to wait and do nothing:

• I expect crude oil prices to skyrocket as a result of PCO, which would seem to indicate going long. But…
• There’s a strong chance longs would get killed in a double-dip recession. That makes it seem better to wait to go long, but…
• As PCO awareness goes mainstream, the long term prices are likely to increase even if the short term prices don’t. What a conundrum!

The Initial Trade – Do you dance the Contango?

We need to figure out a trade strategy that profits when the price goes way up in the long run, but which doesn’t loose money if the price drops in the short run, and which locks in that future price appreciation opportunity now, before the masses figure out what PCO is really going to mean. That might sound like a daunting challenge, but it’s actually pretty easy to achieve with something called a calendar spread. But before getting into the nitty-gritty of the trade, let’s define some terminology.

In the commodities markets, unlike stocks, there’s another dimension beyond price, and that’s time. To say that you can buy a crude oil contract (which represents 1,000 barrels of crude oil) for $80 is an incomplete statement unless you also specify when the contract settles. The price for crude oil being delivered next month is different than the price for crude oil being delivered five years from now. In the normal case where expectations of normal inflation exist, the market is said to be in contango, meaning that next year’s price is higher than today’s price. The opposite situation is also possible, and is called backwardation. The word contango is also used to describe the amount by which price increases with time. So in market parlance, if the price for a futures contract securing delivery of crude oil in June 2012 is $90 per barrel but today’s price is only $85/barrel, one would say that there is a five dollar contango between the spot price and the June 2012 contract.

My contention is that at this point in the Peak Cheap Oil cycle, the most prudent bet to make is on contango, not absolute price. At first, it might seem logical to buy long-dated futures or options contracts; in other words, to go long on crude oil for delivery in the 2012 – 2015 early crisis window that I wrote about in the previous article. But who the heck knows where the price of oil is headed from here? I thought it was headed much higher because of the mounting disaster in the Gulf, but it turned out that the currency crisis that has embroiled Greece and is about to spread across southern Europe led to a big sell-off. Sure, growing awareness of PCO could lead to a big run-up in long-dated oil prices. But in the 2008 economic downturn, crude oil futures sold off from $147 to the low $30’s! A long investor in crude oil futures would get killed in a double-dip recession that repeats the 2008 sell-off. That’s why we need a hedged trade.

A calendar spread (sometimes called a contango spread) is a 2-legged derivative trade. But it’s not a bet on absolute price. It’s a bet on contango, or the difference between prices. The rationale for applying this kind of trade to PCO is that I am certain that as the reality of PCO comes into the awareness of the mainstream market, long-dated crude oil futures will cost much more comparatively than short-term contracts. I have no idea what the prices are going to be. Long-dated crude oil in the early crisis window (2012 – 2015) is priced by the futures market at $89 - $92/bbl as I type this. But when I began writing this article, the prices were in the high $90s! The news from Greece on May 6th pulled the price down by more than $5 in 24 hours! Clearly, betting on the price could be dangerous business. Betting on the contango is much safer.

During the 2008 sell-off, the market experienced an all-time record high in crude oil contango. At one point the immediate delivery month was just over $30/barrel, while the 2012 price was more than double that amount at upwards of $70/barrel! I think a repeatof the 2008 contango blowout is very possible and in fact very likely if we experience a double-dip recession. All these factors add up to one conclusion: I have no idea where oil prices will be in 6 – 12 months, but I think it’s a good bet that the contango between late 2010 prices and 2012-2015 prices is likely to increase considerably. If we get a repeat of 2008, that could mean another gigantic blowout to $30+ contangos.

The time will come when it makes more sense to bet directly on increasing prices of long-dated crude oil contracts. But the risk of a double-dip recession is just too high to enter that trade now. Waiting and doing nothing would be a mistake in my opinion, because there’s too much chance that the world will wake up to peak oil and the low contango in today’s market will leave never to return. So for now, the trade I’m putting on is the calendar spread, long contango. When the time comes to “take the hedge off” and convert this trade to a pure long play, that will be the subject of Part II – the next article I plan to write on this subject.
When’s a good time to enter a trade on Contango?

At first this might seem like a really bad time to be entering a new bet on higher oil prices. Oil prices are already quite high, and until the big market dislocation on May 6^th, they were at multi-month highs. But counter-intuitively, an investor entering this sort of spread trade shouldn’t even care what price they are paying for oil futures or options. What matters is what you are actually betting on: the difference in price, or contango. Just as a value investor buying a stock wants to get the lowest possible price, a calendar spread trader wants to get the lowest possible contango, because the trade is designed to profit as contango increases. The absolute price of either leg of the trade is irrelevant; what counts is the difference between them.

Longer-dated contracts tend to be less volatile, and shorter dated contracts tend to be more volatile. What this means is that contango often reaches its lowest points during steep up-moves in price. For example, back in October of 2009, the contango between December 2010 and December 2014 oil futures was running at about $8/bbl. I’ve been waiting for a lower contango spread to enter this trade for several months. The Deepwater Horizon disaster in the Gulf created the opportunity, because more volatile short-dated contracts moved up in price faster than the longer-dated contracts. By May 4^th, the Dec10 – Dec14 contango was down to $3 from $8 several months earlier.
Understanding the Calendar Spread

I’ll go into more detail later on about contract selection, but just to illustrate the concept, let’s use the example of a spread between December 2010 and December 2014 crude oil futures. Here’s what a quote screen might show you:

Contract	Bid	Ask
CL DEC 10	84.77	84.80
CL DEC 14	87.71	88.04

For now, let’s assume positions are entered simultaneously at the bid or ask price. To place a bet that profits from an increase in contango, the spread trade consists of two positions:

Position	Contract	Entry Price
LONG	CL DEC 14	88.04 (paying the ask)
SHORT	CL DEC 10	84.77 (accepting the bid)
	Contango:	3.27

By entering the position, the investor is betting that the contango will increase from its entry-point value of $3.27. Whether the spot price of oil goes down to $40 or up to $150 will have no bearing on the profitability of the overall position. All that matters is the difference between prices. If there is a repeat of 2008, when crude oil contangos exploded into the $30s for spreads of similar time differential, this trade will be a “ten-bagger”.
What can go wrong?

There’s no such thing as a risk-free trade, and the downside is not limited to the $3.27/bbl entry price. It’s rare but entirely possible for the crude oil market to go into backwardation, meaning that near term prices are higher than long-term prices. For example, an event like a small military conflict in the middle-east could cause markets to assume that crude oil prices will be higher during the conflict, but return to “normal levels” after it concludes. A terrorist incident affecting the supply chain could also increase prices in the short term, but markets might assume that the problem would be resolved in the longer term. In any case, the point is that there’s no free lunch. The premise for my PCO strategy is that awareness of PCO should eventually create large upward pressure on contango. However, as with any speculative trading strategy, there’s always room to be wrong.
Engineering the Peak Cheap Oil spread trade

To summarize what’s been covered so far, the outcome we want to bet on is an increase in contango. The question then becomes, contango between which specific contracts? That’s a critical question, because the profitability of the trade will be heavily dependent on which contracts are chosen, and a number of factors ranging from seasonality to the approximate timing of a potential double-dip recession come into play. I’ll address the long and short sides of the spread separately. But first, we need to know our choices. The following table (a snapshot from early on the morning of May 7^th) shows the available futures contracts for West Texas crude oil (CL symbol series) through 2016:

[Ed: For some reason I can't get the graphic to appear - see the FSN article or just trust me that the figures to be quoted below came from a list of CL series futures contracts]

[IMG]file:///E:/DOCUME%7E1/ERIKTO%7E1/LOCALS%7E1/Temp/msohtml1/08/clip_image002.jpg[/IMG]
Choosing the Long side of the PCO spread trade

Let’s start by recalling what we’re ultimately speculating on: an anticipated move upward in crude oil prices during the 2012-2015 early crisis window discussed in the previous article. So we need to choose one or more specific contracts in that timeframe. Should we aim toward the beginning, middle or end of that period? There are pros and cons to each possibility. Our PCO outlook (from the last article) suggests that prices should be highest later in the cycle. But those contracts are also a little more pricey (in terms of contango). Furthermore, the bid-ask spread gets wider the further out you go, reducing trading efficiency and profits. On the other hand, if we just bet on the 2012 price, the onset of PCO might not have been felt by the economy by that date. So, in my opinion, a basket of several contracts across the early crisis window works best.

Another consideration is that of which contracts are easily tradable. Referring to the table above, notice the disparity in open interest (the number of contracts presently open), particularly in the contracts several years out. We want to choose contracts with more open interest, because these contracts have more liquidity and therefore narrower bid-ask spreads. Note that each contract represents 1,000 barrels of crude oil. The prices quoted are per barrel. As a practical matter, long-dated oil futures tend to be traded predominantly in the December contract. So for our purposes, the choice is pretty easy: December 2012, December 2013, December 2014, and December 2015. The decision about proportion of each contract is very subjective. For my own PCO trade, I settled on the following ratios:

Contract	Position
December 2012	20% long
December 2013	40% long
December 2014	40% long
December 2015	20% long

My rationale for these choices was pretty simple. The 2013 and 2014 contracts are my favorites, because I expect PCO to be widely understood and reflected in market prices by then, but I think the risk of government interference is the free market system in that timeframe is relatively low. The 2015 contract offers more “bang for the buck” at higher cost and higher intervention risk, while the 2012 contract comes at lower cost but with the risk that the market won’t be fully pricing in PCO when the contract expires. So I went for twice as much exposure to my admittedly subjective favorite contract picks and half as much exposure in my second-choice contracts.
Choosing the Short side of the PCO spread trade

Picking contracts for the long side of the trade was pretty straightforward: get exposure to the early crisis window discussed in the previous article. Choosing the short side of the spread is much more involved, because it’s more subjective and requires more guesswork. The process starts the same way, by taking inventory of the available choices. Open interest is still a consideration, but for nearer-term oil futures, pretty much any March, June, September or December contract will have plenty of open interest and liquidity. The other months are candidates too, with the caveat that open interest and the bid-ask spread become more important in the less frequently traded months. For the short leg contract selection, I’m looking primarily at the prices (and therefore the contango to the chosen long contracts) to evaluate their suitability.

It might seem tempting to just use the most immediate (June 2010) contract for the short side of the spread. But look at the difference in price (contango) between the June 2010 and December 2010 contracts. There’s a $7 difference! Remember, the “entry price” of this trade is the contango between the short and long sides. The contango from December 2010 ($84.71 bid) to December 2012 ($88.85 ask) is only $4.14. If you instead used the June 2010 ($77.68 bid) contract for the short side of the trade, the contango entering the trade would be a whopping $11.17! Remember, if the contango between the chosen contracts falls below the entry price, the trade loses money. On a historical basis, a $4 contango for a multi-year spread is pretty darned good. Although the market could go into backwardation, that’s unlikely in my opinion (barring a major unexpected event affecting short-term but not long-term oil prices). On the other hand, an $11 contango is no bargain. It could easily contract by several dollars, creating a significant loss in the trade.

But more importantly, we need to think about what might cause the contango to increase greatly over time, because that would be the most opportune time to close out the hedge (short leg of the trade) and convert to a pure long play on crude futures in the early crisis window. The best thing that could possibly happen to this trade would be a repeat of 2008, when spot prices for crude oil sold off from $147 to $30 and contangos blew out to record levels as the sell-off in longer-dated contracts was far more moderate. A double-dip recession could result in exactly that outcome. When might that happen? With the European sovereign debt crisis starting to mushroom out of control, it’s looking more and more likely that a pronounced economic downturn may already have started. But I think the U.S. government will do everything it possibly can to “extend and pretend” until the November mid-term congressional elections. So my guess is that the earliest we might possibly see a good exit opportunity on the short side of this trade would be after the election.

So is that December 2010 contract a good choice? Maybe, but it’s less than ideal. The problem is that the “December contract” means that if you were making physical delivery of the oil, that’s when it would have to be delivered. But for speculators, the deadline to close the contract is generally in the prior month. In the case of this contract, the last trading date is November 19^th. That’s only two weeks after the election, barely long enough for any post-election economic downturn to take hold. For that reason my initial instinct was to pass on this contract and choose a later one. The March 2011 contract could be purchased with a lower entry contango (a good thing), and the close-out deadline of February 22^nd seems like a much more likely time for a post-election downturn in the economy to have taken effect and been reflected in prices. So my first pick is the March 2011 contract for the short leg of the trade. But after seeing the news from Greece on May 6^th, I concluded that the economic downturn might not wait for the elections, extend-and-pretend policies notwithstanding. So I decided to break the short leg up into a basket of both December 2010 and March 2011 contracts. Here’s what I ended up settling on for the short side of the trade:

Contract	Position
December 2010	30% short
March 2011	70% short

Why not keep more options open by choosing a later-dated contract, such as June or September 2011? Going back to 2008, when prices sold way off, the steepest contango was found in the first 2 or 3 months. Covering part or all of the short leg just before the contract expires would therefore be much more profitable if similar conditions occur again. Furthermore, if February 22^nd comes and it seems best to keep the hedge in place, the March shorts can be rolled over to June, presumably capturing more contango and effectively reducing the entry price in the process. Again, this is inherently guesswork to a large degree, and my goal here is merely to give you an idea of what some of the considerations are.
Not for beginners: Trading out Contango

Normally, a spread trade would be put on by entering all positions simultaneously, i.e. a total of 6 positions (4 long and 2 short) using the contract choices I’ve outlined above. As I pondered this trade over the weekend of May 1-2, I saw the potential for an even greater opportunity, which I call trading out the contango. A market with a strong and established directional trend creates the opportunity is to take a little market risk and use a bracket trading technique to reduce the contango even further from the spread revealed by comparing the various prices at any given time. Rather than entering both legs of the spread trade simultaneously, it’s possible to trade out some of the contango by taking on some market risk and using disciplined risk management techniques to limit the downside aspect of that risk. This is best explained with an example.

By May 2^nd, I was convinced by the weekend’s news about the Deepwater Horizon disaster escalating from 1,000 bbl/day spillage to 5,000 bbl/day that oil prices were likely to rise for several days. Of course it turned out that I would be dead wrong in that prediction, as the bad news from Greece ended up pushing prices much lower by May 6th. But that actually makes this story all the more interesting. On Monday morning May 3^rd, I started putting on the long side of the trade. I started with half the number of contracts I ultimately intended. I didn’t care about the entry price because it would (eventually) be fully hedged by the short leg of the trade. At the time, the contango was extremely tight thanks to the run-up in prices from earlier news from the Gulf of Mexico pushing the near-term contracts up more than the less volatile long-dated contracts. The contango from December 2010 to December 2013 was just over $3 and from March 2011 to December 2015 was just over $4. But the market was moving up swiftly, so rather than entering the short leg at the market, I used a bracket order, hoping to delay my entry until the market had moved high enough to reduce the net contango to only $1 - $2 between long and short contracts. I knew it would be unlikely for the spread to move below those low contangos, so if I could build some profit in now, I’d have a trade that would be very likely to stay in the black even as the market fluctuated. To protect myself from an unexpected market reversal, I set a stop to enter the short leg $1 below the market at the time I entered the long side of the spread. So worst case, I’d end up with a still-respectable $4 to $5 contango in the spread.

One of the advantages of being based in Hong Kong is that I was already awake for Monday’s open in Asia, which occurs 12 hours before New York and Chicago open for business. Setting up the first half of the trade and watching the market move up swiftly, it was a pleasure to watch my effective net contango getting smaller every step of the way. My target price was almost $3 above the market when I entered the order, but by late in the afternoon (Hong Kong time), my limit price was fast approaching. I’d already “traded out” over $2 of the entry contango, and was well on my way to having a very tight spread with a built-in initial profit. Then all hell broke loose. News from Greece trumped the Deepwater Horizon story, and everything started selling off. In a matter of a few hours it was clear that not only was I going to miss my target, but that I’d likely be stopped out by the defensive side of my bracket orders.

Fortunately, I was monitoring the trade closely, and when the significance of the news from Greece became clear, I knew better than to wait for the stop price. I cancelled my bracket order and immediately sold the short side of the spread at the market. But not just the first half – all of it. I reversed my strategy, now taking advantage of the downward-moving market. By entering all of the short but holding off to enter the rest of the long side, I was using the same trading technique in reverse. Again, I set up a bracket to limit the risk of another market reversal. But this time I was more ambitious and chose much lower entry targets for the remaining half of the long position. That paid off in spades on May 6^th, when oil futures sold off sharply. Long before the big stock market event happened later in the afternoon, I was fully into my spread at an average contango (on the overall trade) of $1.50 and a nice built-in profit. As the market continued to sell off, market contangos widened by $1, adding even more profit to the trade.
What’s Next?

So where does this trade go from here? For now, my feeling is hurry up and wait. I have no idea where oil prices are headed from here, but I feel very comfortable holding the spread. There’s enough profit built in to the trade already to make me comfortable that the odds of the trade going into the red are pretty small. The chance of a double-dip recession leading to a repeat of 2008 (where market contango blows at great profit to the spread) is much higher. The bottom line is, watch the market, pay close attention, and take action when there’s reason to. Until then sit back, relax, and enjoy the ride.

Something has to be done by November 19^th, since that’s when the December 2010 portion of the short leg needs to be either rolled over or closed out. Unless we see a huge sell-off in crude prices, it will most likely be rolled over. But anything is possible, and market fundamentals can always change. The fiasco in the Gulf of Mexico alone has the potential to change everything. I plan to write Part II of this article by early November, or sooner if changing conditions warrant an earlier change of strategy.
The other option: Options

This article has focused on how a speculative PCO trade could be structured using futures contracts. Another way to approach the trade – potentially at lower risk but with higher cost – would be to use options on futures rather than actual futures contracts. Call spreads on the same crude oil futures discussed here could be used to affect a similar speculative position. Because I primarily trade futures myself, I’ve focused the discussion on a futures-centric approach. If you’re an experienced options trader you should be able to translate the basic investment thesis presented here to an equivalent option trading strategy.
Conclusions

In summary, the strategy at this point is to gain exposure to the upside potential in long-dated crude prices while hedging downside risk using a calendar spread. The calendar spread is not the right long-term play for PCO, but I believe it’s the best way to gain exposure while keeping risk minimal. At some point it will make sense to increase both risk and potential reward by removing part of the hedge leg of the spread, but for now safer is better. By the time of the U.S. mid-term elections, I think it will be much clearer where the U.S. economy is headed. That will be the time to re-evaluate the trade.

I cannot stress this strongly enough: Do not attempt to put this trade on yourself unless you are a very experienced professional futures trader! The reason Hedge Fund managers get away with charging such exorbitant fees for putting on this sort of trade is that it can very easily blow up in your face if you make even the slightest mistake. For example, a margin call causing your broker to liquidate one side of the spread (but not the other) could suddenly put you at extreme risk! Even a small price change in the unhedged position could wipe out your entire account equity. This information is presented for educational and information purposes only. If you feel inclined to speculate in the crude oil market with this sort of trade yourself, please enlist the services of a competent investment professional who is well versed in spread trading with futures.



Erik Townsend is a private investor based in Hong Kong.

Full disclosure: Long the crude oil futures calendar spread discussed in this article, short (unhedged) crude oil futures short-term.
© 2010, Erik Townsend, www.eriktownsend.com

[xPat]

Re: Peak Cheap Oil - Spread trade long Contango article - Comments?

Sorry guys, all those smiley faces didn't show up in the preview. I have no idea what happened. If this is too annoying to read, I suggest following the link to the same article on FSN.

xPat

[Ben]

Re: Peak Cheap Oil - Spread trade long Contango article - Comments?

Maybe you should start a fund and let us invest in it? hehe

I've taken the simpler approach of buying a 3-years futures ETF. It's the longest dated I could find. The downside is about 25%, which is fine for me, since it's unleveraged. I'm planning to buy more if it drops below $80.

My 2 cents on the situation is that a fall back to 2008 levels in real terms in unlikely until EJ's "next recession" around 2013. And that is only if CPO doesn't arrive before 2013. The worst we will get on the way - for long-dated futures - are 10-15% corrections, like we are maybe seeing now.

[xPat]

Re: Peak Cheap Oil - Spread trade long Contango article - Comments?

Hi Ben,

Actually, I've given serious thought to the idea of starting a hedge fund, not only for peak oil but for the rest of my investment strategy. But frankly, I think I'm happier just being a private investor. Having invested in hedge funds in the past, I'm not sure I want to be part of that industry.

At Jim Puplava's request, I rushed to get that article done in time to be published Friday before this weekend's show which includes a lot of peak oil content. In retrospect, I wish I'd taken a bit longer since I don't think I did a very good job of explaining the full rationale for the trading strategy.

I agree with you that the long-dated futures will not likely suffer much more than mild corrections. But I do work with leverage, and even a 15% correction (unhedged) is an unacceptable risk to me. The contango play is ripe because on the occasions that the more volatile shorter-dated contracts have moved up dramatically (as happened at the beginning of the Deepwater Horizon fiasco), the contango has collapsed to almost nothing - low enough to make trading it down to zero plausible.

Here's the "macro argument" I'd really love to hear critical feedback on from iTulipers: My contention is that with PCO on the horizon, persistent long-lasting backwardation in oil futures should be next to impossible. Sure, there could be some terrorist event or situation or sudden unexpected short-term demand spike that temporarily throws the market into backwardation. But short of discovering 10 new Saudi Arabias, I can't imagine a situation that could lead to persistent backwardation. There would have to be a reason to believe that oil is either going to be much easier to come by in the future, or that it will no longer be needed. I just can't fathom either of those scenarios. But frankly, that's the whole reason I wrote the article - to throw these ideas in front of smart people and see who can think of risks I might have missed.

If I am correct that backwardation threat exists only in the form of passing, short-term events, then it would seem reasonable to use a fair amount of leverage on the contango trade. Eventually that next recession will happen, and I believe that regardless of PCO, short-dated oil futures will sell off purely on short-term demand destruction, just like 2008. That's where the contango trade becomes a ten-bagger. Ten-baggers that are relatively safe to lever up are my kind of trade.

xPat

[Ben]

Re: Peak Cheap Oil - Spread trade long Contango article - Comments?

It sounds exciting. Unfortunately I don't have any prospect of a ten-bagger. Maybe EJ and his gang of hedge fund managers can get something similar together.

Nevertheless, it was very interesting to read about your trade, especially as someone who has only recently started to learn about the futures market. Thanks for explaining it to us. It came through clearer this time that it was a trade on contango. I think a low chance of persistent backwardation seems like a good bet, and since you have bought in at almost zero contango, there's little downside.

I suppose my worry is, what happens if there is no short-dated futures sell off before people get really worried about PCO? What happens if stimulus keeps the economy nominally growing or sparks the inflationary solution, and both short and long term futures work upwards, by the time we get the next recession, PCO or high inflation is upon us? I think what I mean is that maybe the contango won't get that large, even if oil goes up a lot. How well will your trade perform if oil simply goes up but contango stays in the $5-20 region?

[dummass]

Re: Peak Cheap Oil - Spread trade long Contango article - Comments?

Maybe you should start a fund and let us invest in it? hehe

I've taken the simpler approach of buying a 3-years futures ETF. It's the longest dated I could find. The downside is about 25%, which is fine for me, since it's unleveraged. I'm planning to buy more if it drops below $80.

My 2 cents on the situation is that a fall back to 2008 levels in real terms in unlikely until EJ's "next recession" around 2013. And that is only if CPO doesn't arrive before 2013. The worst we will get on the way - for long-dated futures - are 10-15% corrections, like we are maybe seeing now.

Hey Ben, You mind me asking what the ticker symbol is for the 3 yr oil future ETF you chose?

[xPat]

Re: Peak Cheap Oil - Spread trade long Contango article - Comments?

I suppose my worry is, what happens if there is no short-dated futures sell off before people get really worried about PCO? What happens if stimulus keeps the economy nominally growing or sparks the inflationary solution, and both short and long term futures work upwards, by the time we get the next recession, PCO or high inflation is upon us? I think what I mean is that maybe the contango won't get that large, even if oil goes up a lot. How well will your trade perform if oil simply goes up but contango stays in the $5-20 region?

Hi Ben,

Hmm. Sounds like I definitely could have done a better job of first explaining the big picture strategy then laying out why the contango trade fits in as the first step.

For the reasons you describe, I don't think the contango trade is likely to pay off very well by itself. The exception would be another 2008-like selloff of near-dated futures, which would cause a big profit. But I think the more likely scenario, as you describe, is that PCO awareness causes prices in general to creep up both long and short, with relatively little contango expansion.

What I meant to convey is that this will be an evolving strategy, hence the "Part I" title and promise to follow up when market conditions warrant a change. The intended point of the article was "It's not time to make the real play yet, but you don't want to be complacent and take the risk that contango could blow out if you do nothing. So secure the contango risk with the relatively low risk calendar spread for now. That contains the "risk of waiting to act", and allows you to be patient and wait to take more aggressive action until the entry opportunity is ripe.

There are several ways the trade might change with time. The most obvious is to wait for a big sell-off (a double-dip would do it), then cover the short leg and keep the long exposure to futures in the crisis window. But that involves unhedging the trade, and if you have it on with leverage, that's a little scary. There's another scenario I'm doing analysis on now that maintains a hedged trade. I already have a very healthy profit (~$500k) on the trade I put on last week thanks to contango expansion that has already occurred. Taking some profits early and using the money to add a third leg - protective puts on the long leg - would double-hedge the trade and allow the hedge leg to be covered at a low point (possibly coming soon if the sovereign debt contagion continues to push oil prices lower). In other words, cover the time decay cost of put protection with existing profits, and make an early conversion to a long speculation rather than a contango spread. But I don't think it's time for that yet. If we see prices move higher without contango contraction, I'll use some of the profits to start accumulating puts on the long leg, but I don't think it's time yet.

Anyway, the point of the article was supposed to be that the contango spread is a first step that protects the one big risk of waiting (contango expansion), and allows the investor to react to the market and look for the right opportunity to increase the long bias.

I should have known better than to blow this out in a day for the sake of getting it on FSN in time for Jim's peak oil show. As I read the comments here and elsewhere I realize I didn't do a great job of expressing the high-level strategy.

xPat

[Ben]

Re: Peak Cheap Oil - Spread trade long Contango article - Comments?

On the LSE: OSW3
Provided by ETFS. Maybe there is a US version?

[BlackVoid]

Re: Peak Cheap Oil - Spread trade long Contango article - Comments?

I think this investment strategy is way too complicated. I think (real!!!) PMs are a better investment for Peak Oil than anything else. Forget any kind of paper.
If you can buy a large tank and store oil there, than its a different story. Paper denominated by paper is not safe today.

[Bearster]

Re: Peak Cheap Oil - Spread trade long Contango article - Comments?

What is the historical contango in oil, per year?

Even without PCO, this strikes me as a statistical play, like buying VIX a few weeks ago when it was at multiyear lows. Sure it could go lower (in the case of VIX there's a hard lower bound, obviously) but if one has time one has a virtually certainty of making money.

With oil contango if the average is $10 a year, and jitter sometimes give you an opportunity to get in at $3 (or $1.50!!!) take it and wait. Then the only decision is where to take profits.

[jtabeb]

Re: Peak Cheap Oil - Spread trade long Contango article - Comments?

less than 10 years ;) (remember that question I asked you?) less than 10 years!!! How does your strategy play on that time line?

[jtabeb]

Re: Peak Cheap Oil - Spread trade long Contango article - Comments?

Do you really think that any strategy is likely to pay off given the environment that we are in? I mean crap look at this last week. I guess what I'm trying to say is that I honestly question playing in the casino for two reasons. First, I have to trust that the casino operators are honest, will not cheat me, and will pay me my dues if I win. Second, I have to believe that the vehicle I'm getting compensated in is going to be worth something.

Call me skeptical on both counts, I guess. For what it's worth.

There was this guy named Don Harold who thought he could make a ton of money shorting the SURE thing (based on fundamentals) called financial stocks. I know people make money in the casino, I'm just not sure everyone realizes who is doing the winning.