I MESSED UP
An Oil Market Rant
The following article is comprised of a twitter thread I wrote on July 22, 2022 reflecting on the crude selloff during the summer. Minor edits have been made. I plan to write a follow-up article soon, further reflecting on price action since then and specifically the increase in Kurtosis in the crude complex. Thanks for reading my first Substack article!
I MESSED UP - An Oil Market Rant
Well it’s been a wild few weeks, and I my portfolio is certainly down more than I’d like it to be from the early June peaks. My biggest weakness in investing…I tend to have very high conviction in my calls. This clouds my ability is properly assess tail risks and market dynamics/macro factors outside of the fundamentals I typically base my calls off of. So, I’ve been doing a lot of thinking about what has occurred specifically in O&G and how I could have better managed my risk. But, rather than dumping all my holdings and calling it a year since I’m still up vs the S&P by 100% ytd, I decide instead to obsessively comb every inch of #EFT for any info and articles on what is happening while recalibrating my expectations for the rest of the year. Buckle up, because based on what I’m seeing we’re in for a ride that only the strongest stomachs will survive. We’re at an interesting crossroads where sentiment has arguably not been lower since March/April ‘20…. Yet we’re at ~$95/bbl $8.3/mmbtu and the physical market is screaming that we’re as short supply as we’ve ever been. Square that peg… cause I can’t. Now, I absolutely expected a pullback in equites but if anyone says they saw a +30% drop in a two-week liquidation of energy stocks coming they are lying… (3rd biggest drop in 30 plus years as I’m sure most of y’all know). Rather than boring y’all with more “state of the O&G market and why the selloff doesn’t make sense from a fundamental and physical market perspective”… (we’re still short supply, demand looks good considering what product prices got to…there done). What I’m going to touch on some here is more the mechanical/cyclical nature of the paper market/equites.
Which brings me to my first major point. The market is ALWAYS right. Not accepting that the market is right is a great way to double down on stupid and blow up your account. Now, that being said…. The market may come to a very different conclusion tomorrow….and it’ll be right then too. So, what is going on, how do we prepare ourselves for what the market might conclude tomorrow and how do we calibrate our risk tolerance to that…??? Here’s how I’m thinking about it and hopefully I can untangle the jumbled mess in my brain effectively, so you get something from it.
What follows is an overview of multiple articles and podcasts.
The main points involve the inherent tension in Malthusian bull markets @Haymaker_0 , the area under the curve as it applies to energy prices @LynAldenContact , and the low liquidity currently in the market causing a volatility trap @ArjunNMurti
Starting with Malthusian bull market mechanics. Malthusian markets operate on fear. With the long-term structural bull market for O&G in place and western leaders constraining supply… The Fear is that there won’t be enough O&G/Energy supply to go around.
The Inherent Tension In Malthusian Bull Markets (Guest Haymaker - Louis-Vincent Gave)In The Ring - July 1st, 2022https://haymaker.substack.com/p/the-inherent-tension-in-malthusian?r=qyq6a&utm_medium=ios
But, even though the long term bull is in place, if it’s fear that rules the day, then any downward corrections can and will be mind-bending in its velocity and depth. As seen in the most recent sell off as the fear of an ever-deepening global recession has taken hold.
I’m not going to really touch on the fundamentals of a recession as they apply to O&G but considering during the GFC oil demand went down ~1Mbpd (‘09 avg vs ‘08). And we are drawing ~1Mbpd globally with China still reopening and a coordinated SPR release over 1Mbpd…. ??
It’s important to understand here too the fear (of missing out) played a roll in the O&G equites rug pull as well. Based on what I’ve seen, many believe major market participants were positioned in energy equites to offset their tech losses, piling on in a momentum trade.
This was likely expressed though margin positions as well. So, while funds are attempting to raise cash the fear of recession hit plus the big June CPI print, 75bps Fed raise…. and all headed into a monster options expiry week…the rush to the door ended up being truly biblical.
This triggered numerous others to offload their positions as margins calls came and others piled on to ride the short wave that was quickly snowballing. And that’s how Exxon goes down 20% in 14 days while making the most amount of $/day in the history of the company.
Other things to consider. Obviously high energy prices are contributing to inflation concerns and therefore recession concerns as the fed tries to reel everything in. I believe their efforts will amount to holding a beach ball under water.
But why? And what is the effect of higher prices on demand? This is where the area under the curve comes in. It’s not only how high prices go it’s how long they stay there. Impact to the consumer must be considered as a function of price plus time.
Energy: The Area Under the CurvePublished: July 2022 There’s a ton of focus in financial media about how high energy prices will go, or how low they will fall. However, I think a lesser-understood aspect of this current energy and i…https://www.lynalden.com/the-area-under-the-curve/
Now a few items with this consideration, we arguably tested the current upper limits of prices in June with % of global gpd spent on energy hitting ~8%, where end user demand grinds to a halt (gasoline and diesel were pushing ~$180/bbl, extrapolate FX effects to other nations means it was even worse), prices don’t have to keep going up for O&G equities to do very well, very higher prices still haven’t triggered a new wave of investment.
And here lies the major issues. The current energy crisis will not be solved until capital returns to the industry and a new capex cycle is entered. Period….
It is highly likely we are in the midst of a new round of price discovery necessary to bring about the needed capex and new supply required to meet demand. The effect of monetary policy and inflation cannot be understated here.
With the amount of money pumped into the system the currency debasement vs crude prices (you can’t print commodities) could result in a stepwise and permanent change in the new normal for oil prices. This would be very similar to the 70s when we went from $5 to $20/bbl avg
This price discovery will absolutely involve highs/lows as the market tries to establish the upper/lower bands, weighing demand destruction vs capex increase + demand growth.
We are likely in a period where the market is trying to determine where that lower band is.
This is critical to form a new higher base case for equites from which analysts can work from and will ultimately lead to the next stage of the bull market in the O&G equites.
One of the mental traps I certainly fall into, that goes hand in hand with assessment of tail risk, is thinking too linearly about my returns. Applying linear logic to nonlinear systems can get you upside down trading in a hurry.
I must continually remind myself that if I believe a O&G stock is going to generate X% returns over the next decade (price appreciation, dividends, buybacks include) that path to those returns will much more resemble a sine wave rather than a straight line.
With this in mind how do we create a new base case for prices and how should be think about investing in O&G equites around that? This is something I like to do and what I failed to reevaluate in June.
It’s a risk skew based on a simplified probabilistic scenario analysis. Here’s what I’m now thinking the probability we see (or stay around) the following crude prices over the next 12months is…
$60 (10%) $80 (10%) $100 (40% - this represents the current $90-$110 band) $120 (20%) $150 (20%) The average of these sets the baseline at $108/bbl with the risk skew in the other direction if your above or below that point. This is where I messed up, in early June with prices at $120/bbl the risk skew was glaringly to the downside even under this decidedly bullish scenario.
At the very least I should have hedged a percentage of my call option positions that has ballooned to a considerable % of my portfolio (hedging is preferable to selling for me in this case due to tax considerations)
Now coming full circle…. Back to volatility. I want to make it very clear that high volatility is going nowhere. So, the amplitude of that sine wave on our journey to big returns is going to make for a wild ride of highs and lows.
The big moves in O&G prices recently can be attributed to the dearth of liquidity/ low OI given price levels from a managed money/CTA perspective. This can create higher levels of volatility due to a recursive feedback loop of tightening margin requirements leading to even higher volatility as managed money has to lower their exposure to meet their VAR limits.
I recently listened to a podcast that covered this topic, putting some real numbers behind Oil price volatility. The amplitude of our sine wave we can think of as std deviation moves in prices from our baseline.
Currently a 1 std deviation moves in crude oil price is ~$20/bbl….. that’s obviously a lot. Here’s the kicker. To get on this ride you need to be comfortable with at least 1.5-2 std deviation moves and more like 2-3.
I think it goes without saying a $40-$60/bbl move down in crude prices will absolutely destroy O&G equity prices. But, that’s what could happen under a recessionary flash crash whether it’s fundamentally justified or not. The good news is that likely nothing structurally will have change with respect to the supply side constraints and the market will “quickly” (6-12 months) move back into a shortage of supply with equites rapidly recovering along with crude and gas prices.
So bottom line….
Set a baseline and reevaluate the scenarios based on the most up to date info you have, don’t focus on picking the highs and lows.
Hedge big positions, especially options.
Have dry powder for the dips.
Last, Set your exit strategy and know when to get out. For this cycle, return of capital and a massive O&G capex boom will give you the signal we are entering late cycle and the end of the bull run, until then Get Long and Buckle Up.