A Closer Look at Oil Futures
Posted by nate hagens on September 4, 2006 - 5:52pm
[editor's note, by Super G] From the contributor formerly known as thelastsasquatch.
Fossil fuels comprise the largest commodity markets on the planet. In a world facing an upcoming date when it will have used 50% of its oil (and natural gas), interest in energy futures will continue to increase. And, as energy becomes more precious vis-à-vis dollars, the activity in the futures markets, particularly for crude oil and natural gas, will have increasing impacts on society. Indeed, the amount of finite oil that can be financially controlled by a near infinite amount of money is enormous. The following is a basic primer on energy futures and will be one of several foundational posts linked to a longer upcoming story, "Peak Oil, Investments, and Diversification". I will outline the basics of an oil futures contract, and discuss the risks and rewards of investing in energy futures. The post will conclude with a discussion of the growing paradox between money and energy.
There have been numerous posts on The Oil Drum referencing crude oil futures markets (Peak Oil Contango?, Predicting Future Oil Prices). If Peak Oil is factual (which I completely believe it to be), then at some point the mainstream public will gravitate towards investments that benefit from long term higher oil prices. Crude oil futures may not be the simplest but are the most direct way to invest in this theme(if dollars are your goal)
INVESTING IN FUTURES
Before we get to the specifics of an oil futures contract, lets explain exactly what a generic futures contract is, and how one invests/speculates in one.
First, the difference between investment, speculation and gambling should be mentioned. Investment is a long term allocation of funds to something with a (perceived) positive rate of return. Speculation usually refers to a short term investment with a (perceived) positive rate of return. Gambling is allocating capital to something with a zero-sum or negative expected return. To spend capital on something that gets you a negative return implies there are other reasons for the decision (primarily maladaptive) which is a subject for another post.
Here is an excellent introduction to futures and forwards. Essentially, when one buys a futures contract on an exchange, one is entering into a legally binding contract to control the financial upside (and downside) of a product at a certain price and time. Futures markets are attractive to many because they offer often uncorrelated returns to conventional stocks and bonds and because the margin requirements are very low compared to traditional equity markets. Many commodities require 5% or less initial margin to enter into a futures position. (Crude oil is currently 6.7% margin ($4,725) for contracts expiring in 2006 and 4.8% margin ($3,850) for contracts expiring 2007-2012). With 5% margin a 10% move (in the right direction) will result not in a 10% return but in a 200% return on money invested. (Leveraged return =(100/Margin rate) x Nominal return). Of course, this leverage is a double edged sword as a move in the wrong direction results in sharp losses and a move below maintenance margin will result in a call from the broker representing the clearinghouse. If subsequent margin is not posted on a losing position, the clearing member can legally liquidate the position without the investors permission. The vast majority of players in the futures markets never take delivery of the product, but participate in the financial movement of the commodity until they close out their contract prior to expiration.
So, after one buys (or sells) a futures contract, it will eventually result in one of three outcomes:
- the buyer will sell it at some point prior to expiration at a gain or a loss
- if a margin call occurs and the client doesn't post required margin, the brokerage firm will liquidate the position, irrespective of profit or loss.
- the contract will expire, and the buyer (seller) will take (make) delivery of the specified commodity.
CRUDE OIL FUTURES
(The grey box quotes are directly from the NYMEX website)
Crude oil is the world's most actively traded commodity, and the NYMEX Division light, sweet crude oil futures contract is the world's most liquid forum for crude oil trading, as well as the world's largest-volume futures contract trading on a physical commodity. Because of its excellent liquidity and price transparency, the contract is used as a principal international pricing benchmark.
The contract trades in units of 1,000 barrels, and the delivery point is Cushing, Oklahoma, which is also accessible to the international spot markets via pipelines. The contract provides for delivery of several grades of domestic and internationally traded foreign crudes, and serves the diverse needs of the physical market.
Light, sweet crudes are preferred by refiners because of their low sulfur content and relatively high yields of high-value products such as gasoline, diesel fuel, heating oil, and jet fuel.
Specific domestic crudes with 0.42% sulfur by weight or less, not less than 37° API gravity nor more than 42° API gravity. The following domestic crude streams are deliverable: West Texas Intermediate, Low Sweet Mix, New Mexican Sweet, North Texas Sweet, Oklahoma Sweet, South Texas Sweet.
Specific foreign crudes of not less than 34° API nor more than 42° API. The following foreign streams are deliverable: U.K. Brent and Forties, for which the seller shall receive a 30 cent per barrel discount below the final settlement price; Norwegian Oseberg Blend is delivered at a 55¢-per-barrel discount; Nigerian Bonny Light, Qua Iboe, and Colombian Cusiana are delivered at 15¢ premiums.
The contract is listed for 72 months.
As of Wednesday there was open interest of 1,130,596 contracts on the entire oil futures strip from Oct 2006 thru Dec 2012. At 1,000 barrels per contract this represents 1.1 billion barrels of notional oil, only about 12% of annual use for the US. (I admit a lack in html graphics ability, especially compared to The Oil Drum master)
As of this writing, front month oil is $69.19. The strip prices peak in Dec 2007 at $74.44 gradually declining to $66.30 in 2012.
INVESTING IN CRUDE OIL FUTURES
These are some of the more prominent reasons to invest in oil futures (in a Peak Oil world):
- Oil, unlike other futures choices, is actually embedded in ALL commodities. It doesn't take sugar to deliver cocoa or frozen orange juice to plant soybeans. The pervasivness and non-substitutability (easily) of oil will eventually result in outsized price increases
- The market does not recognize a)net energy, b)the important differences between (short term) flow and (long term) reserves or c)net exports. As these concepts permeate the investing public, it will result in new higher price floors.
- Oil price spikes will likely be negatively correlated, or at least uncorrelated with other asset classes, so provide beneficial diversification.
- All renewable sources of energy (wind, solar, biomass refining, etc) require oil to transport their goods and employees. Even if we seamlessly transition from a world of fossil fuels to one of renewables, we cant make windmills from wind or solar panels from sun. Oil will continue to increase in value.
- We still are firmly entrenched in a neo-classical system that believes in perfect substitutes so 'hoarding' behavior is not yet being seen. Hoarding could occur at local, regional and national levels and once the concept of finiteness of oil is more widely understood, the hoarding aspect will represent another permanent increase in demand.
These are some of the more prominent risks associated with oil futures (in a Peak Oil world):
- Since oil is priced at the marginal unit, demand destruction, even in the face of less future reserves, will result in price drops. Large exogenous shocks to the system, like bird flu or some other natural (or man-made) disaster could cause oil prices to drop precipitously.
- Since oil is only storable to a point by end-users, a situation like the one above would preclude end users (that are aware of long term scarcity issues) from `hoarding' at the margin and prices could stay low until the economy recovered.
- If oil prices go high enough, there is the risk of nationalization of the resources, rationing, windfall profits taxes on oil companies, all of which change the dynamics of the oil pricing market.
- In a real collapse (New Orleans on a national scale due to a shortfall in production below the level needed to make the system work), money in futures in a brokerage account might be meaningless.
LABOR AND ENERGY
Since it is Labor Day weekend, it might be instructive to remind ourselves how much `labor power' fossil fuels in general and crude oil in specific provide for us. Here are some quick facts about US oil consumption and production. A closer look shows the US currently uses about 7.6 billion barrels per year. Given our current population of 300,000,000, this equates to over 25 barrels per person per year. Each barrel of oil has 5,800,000 BTUs. An average man working for 1 hour generates between 240-500 BTUS (this range assumes computer operators blended with construction workers). So one barrel of oil provides the latent energy of up to 25,000 hours of human labor, or 12.5 years working 40 hour weeks.
Using this estimate (and this is unadjusted for energy 'quality', e.g. it would be hard to get enough persons to push a semi-truck full of steel from Chicago to Denver.) So annually each American has at its disposal 300+ high quality oil slaves (and that's just the oil -if we include the natural gas and coal we're up to 57 boe which is 700+ energy slaves). We are receiving a massive labor subsidy due to fossil fuels.
One barrel of oil costs $70 and generates the energy of 12.5 years of human work. The average American wage is about $20 per hour so a business can pay someone for 3.5 hours of work for the same amount of money. In effect, we are printing money to buy the good stuff from countries that haven't yet expended their `energy armies'. (How long the world will continue to accept an abstraction for something finite and powerful is an open question, but something here seems awry. I humbly opine that this paradox between energy, labor and value will necessitate that neoclassical economics be replaced by a better model.)
ENERGY AND POPULATION
I believe there are 3 different definitions of Peak Oil and they will come in succession.
- The point when we have used half of the oil that will ever be extracted.
- The point when we reach maximum sustained production (given that we use high technology like horizontal drilling and water and nitrogen injection, we are likely borrowing from the second half of what was normally a bell shaped curve so this point will come later).
- The point when the meme of finite energy resources takes hold in society.
Lets assume that the 1 trillion barrels nets out to 650 billion barrels to non-energy society. (Yes I chose this number specifically). Given our current world population, that equates to 100 barrels of net oil remaining for every person on the planet, (and leaves none for our children, grandchildren or subsequent generations). Any Tom, Dick or Rainwater for $4,000 can financially control 1000 barrels of oil in the futures markets, or 10 times his or her all time planetary allotment. Once Peak Oil version #3 is realized, there will be many investors clamoring to financially (or physically) control their 100 barrels, let alone 10,000 or 1,000,000 barrels. Can the futures markets absorb this? Will this make the Hunt Brothers cornering of the silver market seem like childsplay? The world uses 85 million barrels per day - and for a mere $340 million in margin, this entire amount can be controlled via the futures markets. Consider this in contrast to the $7+ Trillion invested or saved annually, and the nearly $100 trillion in stock and bond market assets. Will the market send the right signals? What smart angles will hedge funds take on this?
CONCLUDING THOUGHTS
Global society runs on a just-in-time inventory system. It cares about the current flow of products and assumes that shortages will trigger price increases which will in turn spur development of substitute products. Paradoxically, an awareness of future oil scarcity coupled with higher current flows would result in lower prices. Imagine if OPEC issued a press release that admitted their proven reserves were overstated but simultaneously announced that they had developed a new siphoning technology that would immediately bring 120 million barrels per day online. Would futures go up or down?? They would plummet as there would be more supply at the margin than people could use or store. Similarly, if OPEC announced a new trillion barrel oil find, but simultaneously initiated a reduction of the current flow rate to 50 million bpd, oil prices would spike even in the face of long term abundance.
What if Exxon announced they believed oil was going to $200+ per barrel and therefore had adopted a policy to shut down production and lay off workers so as to keep the oil in the ground until 2020 when it will be worth more? Their market capitalization would be decimated, as investors care about current quarterly and yearly earnings, which would now be near zero.
The market cares about the marginal barrel and immediate results. And that fact, in the opinion of this writer, is the achilles heel of modern society. Oil and natural gas are products that are largely non-discretionary in our world economy. They are unlike any other product in history in the % of human society that revolves around them. Long lead times are needed to create alternatives and restructure society around more local energy sources and smaller energy footprints. The high futures prices caused by production shortages or excessive financial ingress into commodities will slow economic activity, which will then reduce demand for oil and prices will plummet and overshoot on the downside. Then, when the economy next recovers, we will be further along the curve of depletion and prices will make new highs. This cycle of volatility will hamstring policymakers (and investors) as we will get mixed signals every 12-18 months until we are well past Peak when we will have permanently high oil prices.
The invisible hand moves from mouth to feed trough and back again, like a machine. Without market regulation, the hand will gorge its corpulent body, unaware that the upstream feedtrough appears to be narrowing. True to its origins, it will only react when its hungry, and as the Hirsch/Bezdek report pointed out, society needs 10-20 years to effectively prepare for a change in diet.
In conclusion, many are saying that the era of cheap energy is over but in the ways that count it is still here. At some point in the future, when net tradable global production is too small to quench societies thirst, $70 oil and $3 gasoline will be viewed as incredibly cheap.
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It is clear that oil futures markets do not see real shortages post 2010. Hedge funds don't make long term assumptions, they mostly look for and ride trends. However, many investors in US E&P's are quite aware of po theory, and many of these, including myself, are investing on this basis. THe problem with futures is you can be right in the long term and get crushed short term.
My own preference, shared by many, is to invest in small US E&P's with low cost, growing reserves and earnings. These are companies that, by my definition (which counts reserves equally with earnings), are not yet fully valued in the marketplace. As such, they are usually bought at some point by larger companies having difficulty increasing their reserves; four of my former picks were bought last year. My current favorites are ard and gpor because, in addition to having the highest rating based on my own formula, analysts are projecting record earnings to continue at least through 07 based on oil prices somewhat lower than today's.
I avoid companies with foreign assets. Revenues are generally stable while price is steady because the host country needs expertise and capital that they don't have. However, when price jumps, the host country thinks foreigners are making too much from the national treasure, and accordingly reneges on the contract, raises taxes (often retroactively), or both. Russia, Venezuela and Bolivia are recent cases in point. So, the investor may (or may not) retain his investment, but does not share in the price increase. And, it is anticipation of price increases that attracts po believers to oil and gas investments in the first place.
Regarding gas, the current NA overhang caused by last year's warm winter has held storage at record levels, and the record looks to continue through the first week of Nov, usually the last week that gas is added, and maybe througout the winter unless significantly colder than usual. As a futures contract moves towards the front, it comes face to face with real supply and demand vis a vis the spot market, at which point it has, for months now, crumbled. Futures players are still thinking that gas and oil are bound by their traditional relationship based on heat value. However, the record storage, combined with the ongoing departure from the US of fertilizer and plastics precursor manufacturers, is causing a rolling crash of gas prices. There may be a crash in NA production in a few years, but profits will be under high stress for several quarters. Meanwhile, long investors in gas futures contracts have been losing money quite steadily since the first of the year, and imo this will continue for some time.
- There will not be a windfall profits tax while bush is president. After he leaves, there may be a change in taxes, but with US reserves running out, no tax will focus on e&p's looking to develop old fields or find new ones. Of course there will be market wide sell offs - thre have been three since I began investing in e&p's eighteen months ago, the shoulder seasons are dangerous. That is what volatility means - however, as long as the long-term direction of oil prices is up, these companies will continue increasing profits; I simply stay in because timing is too tough. Regarding US vs foreign - the last 1% from the old fields might fetch as much as the first 99%, and represent more profits to boot, which is the main point, and meanwhile there is no risk of nationalization. The majors have no choice - they produce so much that they must replace their older, labor-intensive US fields with foreign ones. However, the majors are not as profitable as the small e&p's (I measure this as net/production), and, equally important, are not growing reserves as are a few small ones.
- Policymakers aren't doing much one way or the other anyway, the question is, what are investors, or e&p's for that matter, to do while gas price remains soft? Some investors will move away (like me), some will hold, few new investors will buy into gas right now, so shares will ease back and become a buy at some point in the future as we get closer to where prices reverse to the upside, maybe sharply (my moving away from gas is timing, not my strong point, will see if I get it right this time). E&P's will carry on in a more difficult environment because they have expenses to pay, maybe not contracting for quite so many rigs (85% of us rigs are looking for gas), freeing up some rigs to look for oil.
Hurricanes did not take that much gas off production, we still entered last winter with a very comfortable storage, higher than the five-year avg. THere was never a time when storage justified last winter's record prices... this was a case of market irrationality, maybe hedge funds pushing too hard. There is no chance we will not have a record amount in storage, my guess is we will add at least the avg of the past ten years thru the first week of nov, usually the last week that storage is added, meaning storage will climb from the current 2905 to 3725. I see the front month dropping to around 6/mcf every month through next summer... and, even at these lower prices, fertilizer and plastics precursor manufacturers cannot compete with foreign suppliers closer to cheap cas, not least qatar, so the us is quickly shedding around 20% of gas demand as we move to import more of our energy needs.example 1) ethanol is said to give a 25% return over inputs. But 25% would be an outstanding return for a financial investment
example 2) people spend $20,000 on rooftop solar to save $400 annually on electricity bills. That's a return of 2% yet the claimed energy payback period of 7 years implies a yield of 14%.
Hotelling theory in economics and maybe ergodic theory from physics suggest that physical and financial yields must converge. I dunno, it's all too hard.
Two points here. First, I dont believe the return from corn ethanol is really 25% if we count ALL the inputs (including environmental impacts) in energy terms. Secondly, you are correct, a 25% return is excellent, but not when one is used to a 1000% return from crude oil. In this case we have care about what society has been built around and what we are replacing more than the absolute return.
Consider the obvious example of pumping oil out of the ground. Sure, there may be even a 2,000% energy return on investment (20 barrels of oil extracted for each barrel of oil equivalent in energy expended) but the overall return on investment will be much lower, perhaps even negative. Suppose, for example, you spent $10,000,000 to find the oil and to set up all the equipment needed to pump it out. Great, now you've got yourself a money machine - put $1 worth of energy in and you get $20 out. But that's not the only cost. If the machine doesn't work fast enough you may be paying $20 in wages over the time it takes to get that $20 worth of oil out, in which case obviously you're losing money. Even if your net return on a barrel of oil is positive you may still have a very bad investment, because you just can't pump the oil fast enough to cover the opportunity cost of that $10,000,000. If that money were borrowed at 5%/year then you need to make $500,000 per year just to cover your borrowing costs.
As for the solar energy payback example - hey, that doesn't make sense to me either!
As we labored over Ethanol (or RR did, anyway) lately, I was trying to put into words another input, which is TIME.. as in 'time is money' When your energy return takes a long growing season and subsequent processing to arrive (Ethanol), or takes a regulatory process and long-term development to initiate (ANWR drilling, Nuclear), or finally, takes a lot of time to repay you for the investment (Solar Electric/Heat).. how does the wait affect the economics, as opposed to oil, which by most measures is fast in, fast out..
* Aircraft don't do well on extension cords, and it is unlikely batteries or fuel cells will ever be even remotely close to light enough to power non-trivial-size aircraft.
Just you wait - I've got a coal powered plane out in the barn I've just about perfected!! :)
In simplest terms, individually and nationally, the question that food and energy consumers have to ask is what thing of value do they have to offer the food and energy producers, in exchange for food and energy.
It's possible that the US government may offer not to use nuclear weapons on oil exporters, in order to keep the oil coming.
I doubt we're at peak food yet, since we can always redirect energy to food. However, the price increases for food are likely to cause some real havoc, and "demand destruction" WRT food is not a pretty picture.
WT, your quote at Kunstler's website includes, "Through June, 2006, I estimate that the net exports from the top 10 net oil exporters are falling at an annual rate of 9.2%, since December, 2005." Any guess why that isn't showing up more strongly in the futures pricing?
I think that we are going to see a series of bidding cycles for declining net oil exports. Right now, I think that the only substantial reduction in consumption is in poorer areas like Africa.
Of course, a recession here would cause demand, or at least the rate of increase in demand, to fall here in the US.
IMO, the big difference between now and prior cycles is that we are not going to see a (higher) production response from higher prices. I think that we are just going to see a series of auctions for declining available oil.
I wonder if they're expecting a significant enough recession to slowly lower demand and keep prices fairly constant (but high). That would fit both your expectations and their prices. Otherwise the prices just seem too low.
I suggested this to my financial manager and this person thought it was the craziest idea she had heard and said that I should buy gold futures through her company, but that is still paper, not tha actual metal.
100% of our current 'investment' system is based on financial capital. Even commodity investments in foodstuffs and energy are denominated by digits in the bank. Investing something greater than 0% of your assets in non-financial capital will be a wise diversification strategy. I plan to write extensively on this.
If your money is in an IRA or 401K, one possibility is to invest part of it in gold coins. I understand some money managers will allow this - they hold the coins and charge a fee for doing so.
I have some of my 401K invested in TIPS - Treasury Inflation-Protected Securities. While not great, TIPS seem to have some possiblity of holding partial value if the government decides to print money.
Another possibility is to take money out of your IRA or 401K, if you have good alternative uses for the money. You might do this, even if you have to pay penalties and taxes, if you think the alternative is to lose it all.
Besides gold (or silver)coins, you might also buy the empty lot next door to have an additional place to grow food. You might also build a cistern for a water supply. You might add a screened in porch, to make your home more liveable if you can't use air conditioning.
Some have suggested buying things that would be good to trade if times get tough - liquor, medicines, small tools, razor blades, shampoo, etc. Also, some have also suggested "buying ahead" things you may need - non-perishable foods, additional clothing, a bicycle.
I would be interested in hearing thoughts of others on this topic.
Second, you can move your IRA or start a new one at another investment firm that allows for investments in one of the above, or at one of the trust banks that specialize in precious metals IRAs. The two I know of are Sterling Financial and American Church Trust. These two allow you to buy actual metal and have it stored at a vault for an annual fee. Starting a new IRA takes only a little paperwork, but moving an IRA takes a good amount of paperwork. If you handle the transaction right, not hard to do, there are no tax implications, since you are just transferring an IRA to another agent.
Note that under all of these scenarios, you do not have access to the actual goods. For it to be an IRA, you can't have any access. If you want to have something around for "emergencies", you might want to consider Professor Deffeyes' advice and buy gold coins in small denominations.
As for barter items, it occurred to me recently that canning jar lids might not be a bad thing to stock, along with bike parts. Canning lids can't be reused, they're vital for home canning, they're cheap (now) and easy to store. Having just put away a bushel of our peaches, I can testify to their usefulness!
There is a lesson in here somewhere, but at the moment, not a positive one since it appears that the hybrid vehicle may someday be as rare as the gold-on-platinum coin.
Gail,
No one can predict the future. Everyone wants to find the holy grail, put all their marbles in that basket, and then cash out a huge sum and live like a Saudi Prince. That's great, but what if you guess wrong?
Smart investing is about DIVERSIFICATION.
I'll say it again:
Smart investing is about DIVERSIFICATION.
A little bullion in the home safe or buried in the backyard is a great hedge on a systemic collapse.
TIPS might be ok.
A few well chosen technology companies might have good returns.
A few well chose biotech firms might have good returns.
A mix of large, medium, and small cap energy plays might turn out good.
Some PM mining company stock might be good.
Owning 5-10 acres of land might pay dividends. (Wood for your wood stove? Acreage to farm?)
The old adage "Everything in Moderation" is so true.
Live within your means. Live a diversified life. If you don't "need" much to live a happy life, then the threat of collapse needn't be a huge worry.
Lastly - be wary of the stock options market. It's a big game, and not only don't you know all the rules, you don't know when they'll change them on you. The large brokerage houses ARE the market. Read "Liar's Poker" if you don't know what I mean by that. Options and margin are easy ways to get fleeced when someone decides to run the stops.
Also, you took a tax hit cashing in that 401k, right? Did you consider moving it into a rollover IRA where you could have changed the investments?
Couple of questions.... First, if you buy a contract, the price falls and you pony up enough money to maintain your position but later the prices rises past your original price, does the broker refund the extra money you had invested?
Also, when the Chicago Board of Trade introduced ethanol contracts, the price was very low (about $1.38 a gallon) and I was very tempted to get into it, but the volume of trade on these contracts was quite low, ten, maybe 15 contracts per day. That's hardly any contracts compared to other commodities. CBOT ethanol still trades in underwhelming volumes. Does low volume make any difference?
Never mind the first question. I actually read the article you linked to and the answer is that margins are settled daily, so if the price rises, you get your money re-depositied into your margin account.
My sense is that the next big near-term trend may be a combination of lower oil prices (maybe in the $50 - $60 area) and increasing public acceptance of the idea that there is actually no long term oil problem. I think we'll hear more acceptance of the cornucopian arguments combined with a build up in public confidenced that the "bump" to $75 oil was a temporary phenomenon caused by Katrina, Iraq, and Nigeria and that increasing production spurred by the big jump from $30 oil will eliminate any supply issue for "a long time".
I also suspect that this counter-trend will occur while all the factors that will truly cause a supply issue (rapid decline in elephant fields, increasing use of oil by exporters for their own domestic purposes) at some point prior to 2010 are building. In other words, we may see one more orgy of Hummers being bought just before the general public recognition that the peak has already occured. That will be the time to own futures contracts on oil. Look for a Time Magazine cover story on the "hoax of Peak Oil". Then buy oil futures.
Perhaps I am reading you wrong, but as I understand your statement, you seem to believe that the "public", on balance, believe today that there is a long term oil problem.
Nothing could be further from the truth. The vast majority of individuals in North America have no idea what energy challenges may (possibly) face us. The vast majority are completely oblivious to the discussions that we partake in here.
All they know is oil is expensive, relative to several years ago, and few understand any of the reasons why.
Should the public en masse suddenly be awaken to any notion of a longer term crisis which will affect their daily lives in profound ways, we'll see panic, hording, and significant downside in financial markets.
Then a rally. Disbelief.
Then more downside. ;-)
oilaholic, you said,
"Look for a Time Magazine cover story on the "hoax of Peak Oil". Then buy oil futures."
EXACTLY. Be ready to run counter to the popular sentiment. Over history it has been the best leading indicator in history. Be suspicious of everything. And don't get single sourced. People talk as if it's crude oil you buy at the convience store. Look at the finished product and be as diversified as possible., and play the seasonal spreads. What we are looking for is a way to play the retail futures soon. It's coming. The customer gets a prepaid card, and "locks in" a price and prepays for it. I would happily lock in today a price at anything below $3.50 or even up to $4.00 for the rest of my life. Even though gasoline is now at $2.48 in our area. Any of the above prices are still a marginal cost in my life compared to other costs of living.
People say, "hey, in the future $3.00 gas will seem cheap!" Duh! Well, yeah. The inflation factor alone assures higher prices, and the fact that we got a gasoline deflation for almost 2 decades through the 80's and 90's is always completely ignored....why is that by the way? For two decades crude oil and gasoline/Diesel prices ran at below the historical mean line. Why does no one mention what an abberation this HAD to cause in the outlying years (which of course would be NOW!
Everyone on all sides seems to be able to prove any case they want simply by picking carefully their starting dates. It renders most all coverage of the "rational" energy price useless.
By the way, unless a person is sure, DAMMED SURE, they are right on not only the fact of the events they predict, but also the timing, selling the IRA and the 401K could be a catastrophic move. If you guess wrong, at retirement time, you would have rather faced peak oil (I say this not owning either one of them, but that is for other reasons....)
Roger Conner known to you as ThatsItImout
I can't stay long, but in what way do you mean?
If you mean that everyone is expecting bad news, I sure haven't seen that.
The other day I did a satirical post showing how "scared the Germans were of "peak oil", referring in particular to German industry, and the Speigel article linked here on TOD....they are introducing 500 horsepower $100,000 dollar cars that are artpieces, and have more on the way!
The Japanese are no different. While they have been the pioneers of hybrids, their performance models are nothing short of stunning, with 400 and 500 horsepower supercars being built, and the prototypes on the show stands intended for a market 4 years away are astounding in their performance.
I hold in fromt of me road tests of the car that is the cover car on every auto related magazine this month, the Ford Shelby GT500, $41,000 price 12.7 quarter mile time, 157 mile per hour top speed, 0-60 mph in 4.5 seconds, 18.4 miles per gallon (actually, not a bad number given that insane level of performance)
It shares the cover with a BMW M6 (one of the cars in the 500 horsepower club when optioned with the V-10 engine (yes, that's right, a V-10 in a Bimmer), and the Mazda CX-7, and a 390 horsepower turbo RX-8.
Wedged between all this is the new Buick equiped with their highest performance engine, and it actually seems like a modest piker, a 275 horsepower Northstar V-8, it somehow looks modest, understated and quint in this company....I will leave aside the ads for the condos in Vegas, the vacation trips at discount prices....all that's for the rich, right?
A friend I work with recently visisted family in coastal North Carolina, and while there, talked himself into picking off a beach front condo.....he doesn't have to make the first payment for 90 days, and aims to "flip it" for about a 50% hit in the meantime, and he says, if I can't flip, I can afford it, I really hate to turn it loose.....I thought ya' you've hung yourself out...but he has already had about 6 people calling wanting to talk his terms.....
I swear, this believing in doom and gloom and missing some of these deals are STARTIN' to wear me down....I have taken the conservative "don't take any chances and get hung out idea, and it's cost me dearly! :-( If I had hit on some I thought about, I could have bought more Diesel for my old junk Benz than I could have used until retirement. There isa penelty for playing it safe!
Roger Conner known to you as ThatsItImout
hey, and like a bone head I missed that! :-) (blush), and me, so fond of the old joke on Garrison Keillors radio show "all the kids are above average" :-)
Roger Conner known to you as ThatsItImout
and
HOLY CRAP! That means that each American is only supposed to use oil for another 4 years!
This is a sobering statistic.
Here in New Zealand we are slightly better off with 8 years of oil burning allowed.
Unless we a) reduce consumption or b) find new energy sources commensurate with our needs or c) some of both, the 100 barrel per person of net oil allocation will eventually lead to vast social inequities that will make even the rich have declines in quality of life. Either that or wars over resources.
"What if Exxon announced they believed oil was going to $200+ per barrel and therefore had adopted a policy to shut down production and lay off workers so as to keep the oil in the ground until 2020 when it will be worth more? Their market capitalization would be decimated, as investors care about current quarterly and yearly earnings, which would now be near zero."
Markest respond to changes in quarterly and yearly earnings because they give them a view on what will happen to long-term earnings, which is where the value lies in most companies, and particulary growth companies. In a discounted cash flow valuation, the vast majority of value usually lies in terminal value, which lies beyond the forecast period.
Plenty of companies have huge enormous price to earnings ratios, or high value despite no earnings. This is because the market values the long-term earning power of companies and stocks. The market also rewards capital investment, although this is taking money now and creating earnings that may not occur for years.
If Exxon said that they thought oil would go to $200, so they were converting the company into an oil trust, what would happen to the value of Exxon? It is hard to say, but if people believed oil would go that high, and if Exxon had an enforceable claim on the assets, I expect the price (and market capitalization) would rise, despite the fact that earnings drop to nothing.
Unless all oil companies adopted similar strategies to XOMs in this example, investor capital would seek out companies with current earnings (and then assume they would use those earnings to obtain more reserves, etc).
This example was meant to be a thought experiment - I am not sure what would happen in this unlikely circumstance, but unless the rest of the market took their lead from XOM, their price would likely dramatically drop because institutions would collectively believe they were smarter than Lee Raymond.
In any case, this scenario is implausible - before they would do anything so draconian, they would split up the company, which would be better for shareholders.
Firms such as UBS, Merrill Lynch, etc. have very senior and skilled analysts covering Exxon since it is such a giant company. They know the firm extremely well. It is naive to assume that they are only using a PE and would mindlessly apply the same one to a vastly changed company.
I know this is not your main point and do not want to divert an important and education thread.
I do have two main concerns that this brought up:
- Yes, markets have their problems. But broadly, it has been extremely difficult for anyone to beat the stock market over a long period of time. While I agree with your overall investment analysis, I would not blindly advise people to follow it. Those that do should be willing to spend time following their investments and be willing to suffer losses. I think individual tend to overestimate, rather than underestimate, their ability to beat experts at their own game. It is fun to critize the market and brag when we win. But it is a tough game and the reason you don't hear from the losers is not because they don't exist, it's because they shut up. If all TOD investors followed a uniform results reporting system I am sure the results would be more balanced than just reading those self report.
- The short-termism of the market has become accepted as fact. However quantitative studies do not seem to support this claim. Clearly short-term measurements do affect decision-making in listed and unlisted firms. But if people are acting inefficiently to cater to a group of naive investors, a more sophisticated group would be glad to swoop in and take the other side of the deal. I noted above several cases where the market values long-term decision-making and why it is that earnings short falls impacts share prices. I don't think it is useful to perpetuate the lack of understanding on this issue.
Nate, generally, I think you are giving a very useful and balanced view of investing in the energy sector. However, giving investment advice, especially without taking into account the individual investor, is fraught with difficulties. I do think that you have the background and skills to walk this line. The fact that you are uncompensated is also a plus. I have, however, been appalled to see some others in the peak oil field, with far less investment expertise than you have, charge money for energy investment advice. This, to my mind, comes very close to fleecing widows and orphans.I don't think it can be stated too often that investing with the objective of beating the market is very risky and speculative. It is a big boys (and girls game). Don't risk what you can't afford to lose. Futures and options aren't government bonds, you know.
I get very concerned when I hear people implying that markets, brokers and funds may be stupid and some one without a whole lot of knowledge can consistently beat them without risk.
There is no free money and a lot of people get burned on what they were convinced was a sure thing.
I share your disdain for newsletters, salespeople, etc that cater to the human drive for excess return. I would never give someone direct advice unless I knew their precise situation and objectives.
Energy futures are one way to play the financial side of things, and I wouldnt recommend it to anyone who doesnt understand the risks. The main nugget of this post was to point out that $4,000 can control roughly 10 times ones all time allocation of crude oil. The fact that this is even possible is what impressed me, irrespecive if one does it or not.
My strong, and in my view, justified reaction, comes from the fact that much investment advice is thrown around on TOD. Many people hail their success and promote ideas to others. But I have been close enough to the investment game to be able to see behind the curtains - to know that people brag when they win and keep quiet when they lose, that they boost ideas to others that they may not be in themselves, and that people loose everything on what seems like a sure thing.
If it appears that I was lumping you into that camp, I apologize and take this opportunity to state that is not my view.
A lot of people here at TOD think they are smarter than the sheeple, the MSM and the markets. But lots of people have thought they were smarter than the market and only a few of them got rich.
Good post Jack!
I said it in another post, but will say it again: If for example you are fortunate enough to be involved in a 401K or IRA or other matched or tax deferred investment, I would be VERY cautious about giving up that stake. Sure, if your cautious, re-allocate the assets, but some are talking about the complete collapse of American paper money (???)
Compared to what? Do we assume the Euro is FUNDAMENTALLY any better? Is it that peak oil will not affect Europe? I want to see proof of that.
Japan, or Russia? Give me a break....Japan has ZERO home resorces of crude oil OR natural gas, and Russia is so eaten up with corruption and gangsterism signing a contract there is about as valid as a drunken handshake...
I do not mention them as a game of "last man standing" but purely to indicate that unless you presume an immediate and total collapse of world society, then U.S. currency and the U.S. economy is no more "abstract" than anyone else's, probably less so....there are Chinese buying life insurance policies and annuities from U.S companies for pete's sake.....think about the abstraction involved there! :-)
Remember, when speculating futures (and that is what it is, even the pros are considered the "brass balls" folks of the investment crowd), your timing has to be perfect as well as your called direction of movement.
Again, let's play with that for a sec'...the recent Spiegel article for examply had a horrifying graph...
http://service.spiegel.de/cache/international/spiegel/0,1518,grossbild-669253-426728,00.html
But let's look at it for a second....note that the Campbell projection never gets to 85 mbd (million barrel per day)...yet current production has already been given in a window of 85 mbd (million barrel per day, or some 10 mbd higher than the highest number before the beginning of the collapse. (!!!)
So what was predicted in 2002 by Campbell as something that could never be done is already being done, and we are within a couple of mbd of the top given by the Shell projection in 1995 (around 90mbd) that could be reached by 2025!!
This is without CTL, the anticipated expansion of NGL (condensate natural gas liquids) natural gas or LPG substitution, or possible (only possible, but still there) expansions such as Khurais in Saudi Arabia, other onshore Persian Gulf fields, and offshore Persian Gulf, as well as further recovery possible for nat gas shut in at Gulf of Mexico fields, and Qatar's natural gas expansion), we are still above where Campbell projected we would ever be, and almost at Shell's dark scenario projection out to 2025. Recall some optimists such as the EIA are projecting 125mbd by 2025 (a number that many of us greatly doubt can be done....but we cannot know that...and given possible technical advance such as advanced batteries and PHEV, will it even be needed by then...that's 18 years away, and remember, it's your retirement money your betting.)
Does this invalidate the Peak idea, and mean we should all become Cornucopians? ANYTHING BUT. Any scenario you can easily come up with means an uphill fight all the way, and if we get by to the Hirsch style mitagation, it will be by the skin of our azz, and we should be starting NOW....and the big shoe to fall would be the "peak all liquids" catagory, almost impossible to call but Laharrere gives at around 2020. Even CERA starts going over the "undulating plateau" idea about then. Over the long haul, betting on higher energy price is a damm good bet.
But, and this is BIG, dumping you IRA or 401K, and trying to out bet the people who have access to more information and connections than you could ever dream of would be an game a financial Russian roulette.
Trying the time "peak" or crisis in the energy industry is lke trying to "time" the next San Fransisco earthquake....I mean, the evidence shows it WILL happen, but when? Would you bet your retirement money on it? Would you move, divorce your wife who doesn't agree, begin to hoard gold coins and canned food and toothpaste and liquor to trade in the celler?
This is exactly what I talked about in other posts, these are stories people are telling ...check out
http://www.peakoilblues.com/
Folks, we may need to get a grip on reality here, to a sensble person, this whole thing is starting to slide right over into the "Twilight Zone". The wierdness is fun though! :-)
Roger Conner known to you as ThatsItImout
P.S.
http://news.yahoo.com/s/nm/20060905/bs_nm/energy_chevron_dc_2
They make it hard to bet my retirement nest egg against um....:-)
If so, this is not only unconvincing for the reason cited by Jack, but also because Exxon does not face a choice between two such extreme positions. If they, with their inside knowledge and expertise, thought that oil was going to be much more valuable in the future, they should first of all tell everyone that at the top of their lungs. And then, they should reduce their production, while still producing enough to pay their staff and keep things running. That way they will still be in business five or ten or twenty years hence, and they will still have the skilled and experienced employees as well as the capital equipment necessary to develop and produce that far-more-valuable future oil.
The fact that no oil company is following this strategy suggests that they, the consummate insiders, do not believe in Peak Oil. And oil market investors, people who have devoted their entire professional lives to analyzing every detail of the oil business, apparently share their skepticism.
And the Exxon example was just that - I dont know what they believe - but if they or any other oil major DID choose to delay production, their share price would drop vis-a-vis their peers., unless the market changed the way it evaluated oil companies (which would be a good thing!)
We had a very good discussion at the original oil drum site, over a year ago I guess, on the economics of hoarding versus producing in an environment of rising prices.
My conclusion is that the discount rate applied to oil sitting in foreign locations over which the company has little control would be higher than any mainstream expectation of price increases.
If the oil were sitting in tanks in front of Exxon's front office, the situation would be different.
If Exxon had announced six years ago that they would pump all of their production into a giant reservior to hold in anticipation of price increases, the market probably would have been thought they were nuts and would have been wrong. But it is much easier to identify market errors in retrospect than in advance.
Given the increasingly short-sighted attitude of American business, I have no problem at all believing that a major American oil company would rather run full-bore right now so as to maximize profits for the next two or three quarters than to reap much larger profits some unknown number of years from now.
High revenues in the present are real and do wonders for the current CEO's contingent compensation package. Higher profits at some undetermined point in the future is an abstraction, and one more likely to benefit the next generation of management, something not likely to overly concern the present management.
No, the fact that the major oil companies are not hoarding oil or cutting back production is hardly a refutation of peak oil, but rather a confirmation of the short time-horizon upon which American business functions.
It's not just CEO's.
When do you get rewarded, or praised, or thanked at your current job?
When you put in place systems that will benefit the company 5 years from now? 10, 20?
Or is it when you put out some fire, or release a system that works NOW?
Everywhere I've ever been it's always the second. In a capitalistic market, things change FAST. Fix today's problem. Get a handle on tommorow's problem.
It's not that people don't care about the future, but the uncertainty surrounding said future makes it nearly impossible to do any sort of cost benefit analysis.
Exactly. Unless you have personally sat in on a Board meeting of a medium-to-large corporate business, it is hard to get a grip on how those short-term Excel spreadsheets drive everything.
What is our cash flow situation next month? Over the next 3 months? Get me more cash now. I need it now! We'll worry about long range problems later.
You have again hit the nail on the head. I have yet to encounter a good refutation of this argument by any peak oil theoretician. Of course, your point will probably be treated with 'dynamic silence', i.e. ignored.
Perhaps one should ask oneself the inverse of the Ur-American question:
If they're so dumb, why aren't they poor?
They're NOT stupid.
As soon as they admit to peak oil, the rules of the game are going to change.
Right now - with the current rules - these executives are literally printing money. They are making millions upon millions of dollars. They don't want the gravy train to stop. I really can't say I blame them.
If the Main Stream Media starts sounding the bugle horns about Peak Oil, the game is up. Congress will be calling these CEO's in for congressional hearings. Oil will be rationed. Windfall profit taxes will be levied and distributed to alternative energy companies. Oil stocks will tank.
That's how the game works. Big Oil is fighting like hell to keep that from happening.
Big Oil even profits from a little horn sounding (as long as it's not too loud), as it keeps the prices high ..
<quote>The fact that no oil company is following this strategy suggests that they, the consummate insiders, do not believe in Peak Oil. And oil market investors, people who have devoted their entire professional lives to analyzing every detail of the oil business, apparently share their skepticism.</quote>
There's a major agency problem; executives of major oil companies personally benefit the most by pumping now, guaranteeing high bonuses, and then banking those huge profits. Their pay is set by formulae which no doubt depend on maintaining and improving the current cash flow.
There is no reservoir large enough to keep securely many years of production, except to leave it in the ground in its unproduced state.
But in foreign nations, they gain nothing by leaving in the ground under soverign ownership by somebody else. The royalty-seeking foreign government will terminate their rights and replace them by another oil company.
It would be interesting to see the personal investing accounts of major oil company executives.
How do we know that they aren't buying long-dated oil futures or calls?
More likely they also invest in smaller companies which they feel are good buyout targets, knowing the dynamics of the industry.
If some billionare corporate raider takes a company private, then you might see some radically different strategies.
Backwardation is a market condition where spot prices exceed forward prices. Contango is the opposite condition, where forward prices exceed spot prices. The terms are most commonly used in oil markets but are also applied in certain commodities and energies markets. In oil markets, the prevailing condition may reflect immediate supply and demand. If crude oil is contango, it may indicate immediately available supply. Backwardation can indicate an immediate shortage. Anything that threatens the steady flow of oil around the world, such as imminent war, tends to drive the oil market into backwardation.
This is an excellent article. I have thought a lot about investing in long-term oil call/buy options. However, I came to a similar conclusion to that made in the article - if you appear about to make a killing, the rules will be changed. I guess the trick is to get your cash out while it is accessible and worth something. They changed the rules for the Hunts and the silver market was tiny compared to this. Recently, the rules for nickel were changed temporarily on the London Metal Exchange.
In view of this, I have spent a lot of time thinking about Dmitry Orlov's articles. Very distressing but compelling.
For those of you who are still hung up about your IRA or 401K accounts, forget it. I have been through two financial crashes already - Egypt 1962 and Iran 1979. My wife went through one - Russia 1998. Anglo-Saxon economies cannot defy gravity indefinitely.
As for Exxon, I have worked for them in their IT finance area, please don't think that they are masters of the universe. They are simple employees with an overwhelming urge not to rock the boat - they have mortgages too. I would guess that if any senior manager of Exxon were to mention peak oil at work, that would be the end of his chances of getting promoted. They are no different from anyone else - they want a gentle and secure life without nasty surprises.
At the recent taping of a Peak Oil debate to be shown on PBS in some markets (still trying to find out which ones), while talking to the ExxonMobil guy before the taping I could not even get him to admit that Cantarell was declining. Talk about "See no evil; hear no evil; speak no evil."
In regard to the oil markets, Deffeyes estimated that we crossed the 50% of conventional crude + condensate mark in December. At current rates of consumption, in the next four years we will use 10% of all remaining conventional crude + condensate reserves.
If the oil price falls a long oil commodity position is in doodooland. For some relative safety invest in commodities using options or use much less margin (increase your cash in).
Or consider using an exchange traded fund: U.S. OIL FUND (USO).
Exxon doesn't believe in PO or they are not telling. Top management's compensation is tied to share price, their salary just a starting point. They are not going to say anything to rock the boat, ever.
Is investing different this time? Maybe not. First rule in making money is Don't Loose Money. Second is Diversify, spread your risk amongst multiple investments. Third rule (or is it first?) is Timing Is Everything. Look at this record for expansions and recessions:
Average Returns during Expansions and Recessions
Stocks Bonds Commodities
Expansion +13.29% +6.74% +11.84%
Recession +0.51% +12.59% +1.05%
Source: NBER, Working Paper 10595
http://www.investorsinsight.com/otb_va_print.aspx?EditionID=362
So where are we? I don't know. Brighter bulbs may care to tell us. The yield curve has been forecasting recession for awhile now though.
Novice investors should realize you are not going to make an investment killing unless you already are one of the big boys/girls, an insider or just lucky.
Speaking of diversifying you might consider Dmitry Orlov's suggestions:
If PO isn't confounding enough...
Bad news from PIMCO's Bill Gross on the mass of retiring boomers and investments.
A hedger is someone engaged in the business who expects to buy or sell the commoditiy (or some closely-related product) in the future, and buys a forward contract today to lock in their future price. This was actually the original purpose of the commodities markets - they don't just exist for people to bet on future prices! Commodities can be seen as a way for hedgers to transfer risk to speculators, in a similar way to how people transfer risk to insurance companies when they buy insurance.
Today I read this article in the Los Angeles Times about the role of hedging in the airline business:
http://www.latimes.com/business/la-fi-fuelhedging5sep05,1,369246.story?ctrack=1&cset=true
It's well known that Southwest Airlines has engaged in massive hedging for years, buying futures contracts in oil and related products so they could lock in prices. As we know, this turned out to be a prescient strategy and as a result Southwest has paid only a fraction of other airlines for its jet fuel, the past couple of years.
But what to do now? Does it make sense to hedge today? A Peak Oiler would say yes, absolutely: today's $70 prices will look positively cheap a few years from now. An airline that locks in $70 oil through 2010 will have enormous cost advantages vs its competitors. However the conventional wisdom would probably say the opposite. Many commentators have been quoted expecting oil to fall to $60 or even $50 over the next year or two. Locking in $70 today would be an enormous and even potentially fatal blunder if these predictions come true.
So this is a great test of how much Peak Oil theory is having an influence on people and companies whose livelihood and financial survival will depend on getting things right. Especially for those who see conspiracies everywhere, who are convinced that insiders know about Peak Oil but are suppressing the truth to prevent panic while they line their own pockets, this provides a chance to see what insiders will do, not just what they say.
According to the article, airlines are in fact beginning to get back into the hedging business. They are locking in $70 oil for the next few years. Apparently they had stopped their hedging for a while in the recent run-up, no doubt hoping it would be a short term phenomenon, but now it seems that they are resigned to the reality of high oil prices for the foreseeable future. And given the uncertainties involved, they would rather have to pay for known $70 oil than possible $80 or $100 oil. They are even willing to risk $50 oil, which would hurt them badly once they execute this strategy.
Now, not all the airlines are doing this, just apparently Southwest and one or two others. I'm not sure how the reporter knows this - I wouldn't expect companies to divulge much information about this kind of strategy. But it does appear that at least a few airlines are acting as if they are beginning to believe in Peak Oil.
If this is true and if the effect continues, the result will be that relatively far out (more than 1 year away) futures contracts will be driven up in price. As Nate pointed out, the actual volume of oil contracts is not all that large, and the markets get even thinner as you go out a few years. Actions like these, and possible similar hedges by other oil consumers (i.e. virtually every business in the world!) could easily have a strong upward effect on future oil prices.
This would put us into a true "contango" situation. What people call contango today is not; prices only go up as we go out a year or two, but then they fall until they are lower than today. True contango would have oil prices in 2008 higher than 2007, 2009 higher than 2008, and so on, all the way out (to 2012, currently). That price structure of true contango will be evidence that market investors and insiders really do accept and believe in Peak Oil. Until we see that, my reading is that the market rejects Peak Oil theory.
Also, right now they are basically locking in today's prices or even a little lower. What happens if and when the far forward futures start being substantially higher than today (contango)? Then it's not such an attractive deal. It's one thing if you can lock in to pay $70 in 2010, it's quite another if your only choice were to lock in $80 or $90. Once futures prices become substantially higher than today's prices it will be a lot more tempting to gamble on the spot market.
Then there is the question of who is going to take the other side of these contracts. I've often wondered why oil companies don't step up to the plate. So often we see credible reports that oil companies are still using prices of like $40/bbl to estimate profitability of new projects. Why not instead lock in $60-70 for the next few years in the futures market, that way they'd be able to justify a lot more investment.
"Not enough liquidity" doesn't really explain it when there seem to be significant opportunities for hedgers on both sides to protect themselves from the extreme volatility and even more extreme unknown future in this market.
We still are firmly entrenched in a neo-classical system that believes in perfect substitutes so 'hoarding' behavior is not yet being seen
That hits the nail right on the head. Speaking of these "perfect" substitutes:
Re: 5.8 million BTUs
I hope people see that you are talking about
I see from your bio that you went to The University of Chicago, my alma mater -- and lived to tell about it.