I have been lugging around a big long position of far dated crude oil contracts for quite some time now, so I am no Johnny-come -lately to the recent rally. Although most of my peers have been uniformly bearish on crude oil, I have refused to join their camp. The bears’ obsession with increased US production has completely ignored the fact that oil is a global commodity that trades based on worldwide supply and demand. The ameliorating US energy picture is going to be dwarfed by increased demand out of emerging markets and declining supply out of the rest of the traditional producers.
Over the last week crude oil has rallied to a new 2014 high on heightened geo-political tensions. Although my bullish position is not based on geo-political problems, I have been amazed at how insensitive all markets have been to the increasing geo-political strains throughout the globe. Whether it is China’s increasing aggressive actions in the surrounding waters, or the continuing civil war in Ukraine (which Russia is ready to jump back into in a heart beat) or the frightening developments in Iraq, the world has become a much riskier place during the past year. I like to keep my tourism limited to the macro variety, so I am going to limit my geo-political tourist comments, but I assert that markets are consistently underestimating the potential geo-political instability.
In case you are worried about the recent rise in crude oil being “too far, too fast,” I want to remind you of the price action during the mid 2000s. Do you remember what price crude oil traded for at the beginning of 2007? It was approximately $50. Then a year and a half later? $145! That’s right, crude oil almost tripled in the space of 18 months.
Crude Oil – Jan 2007 to July 2008</a> </div>
When you become concerned that the last $6 of the crude oil rally feels a little frantic, remember back to 2007…
To be a big crude oil bull I don’t think you need to be forecasting continuing deterioration in the geo-political situation, I think you need to simply remind yourself that even with the amazing US shale oil developments and the increased competition from solar and other alternative forms of energy, the supply of extra crude oil is still extremely tight. Have a look at this chart from the great TerraJoule:
OPEC’s spare capacity continues to shrink. The insatiable energy demand from emerging markets is going to gulp up any extra energy that is either found through new drilling technologies or saved from switching to alternative forms of energy.
We have not even discussed the insane money printing of the last half dozen years. If you share my view that eventually easy monetary policies will work their way into increased prices in things we need, then it is only a matter of time before crude oil enjoys another 2007 style rally. So far this call has been premature, but traditionally equity markets and crude oil have actually traded with a positive correlation:
S&P 500 (yellow line) vs Crude oil (white line)</a> </div>
You might argue that the 2007 crude oil rally was actually one of the big factors in triggering the ensuing credit crash (it forced Central Banks to raise rates), but you will notice that crude oil and equities have often traded right on top of one another. This relationship (like most relationships recently) has broken down. But this mad dash into financial assets like equities is not going to remain benign forever. Eventually this monetary madness is going to extend into real assets, and when that happens, crude oil is going to soar. The fact that my hedge fund brethren have all been bearish on crude oil for the past couple of years, all the while the prices have refused to collapse as predicted, only strengthens my resolve.
I continue to love owning the deferred contracts. The curve is experiencing a massive backwardation:
Crude Oil Curve</a> </div>
Buying crude oil at a big discount means I don’t even need to be right to make money – I simply have to not be wrong. A sideways move in spot oil during the coming years would be a great winning trade as these contracts decay upwards.
Over the past year, these far dated contracts have been trading heavy, but recently started trading with a much better tone:
Dec 2018 Crude Contract</a> </div>
During the past couple of months the far dated contracts have started to respond much more constructively. I expect that eventually sentiment will reverse to the point that participants are scared about future supply and paying a premium for far dated contracts. (don’t forget one of the greatest trade of all time where the crude oil curve was in a big contango)
I believe that this process has started. Don’t buy crude because of geo-political concerns – buy the far dated contracts because they are a great cheap risk reward long that is completely out of favour due to hedge funds’ myopic obsession with the American energy picture.
Even a blind squirrel finds an acorn every now and then…
Proving that even a blind squirrel finds an acorn every now and then, I was lucky enough to be somewhat early in climbing aboard the recent rise in GDXJ.
GDXJ – Junior Gold miners ETF</a> </div>
Since then GDXJ has continued to run like it stole something. I am not going to add to the position into this frantic scramble, but once it quiets down and goes sideways for a couple of days, I will double up on the junior gold miners. The ferocity of this recent rally is telling you that the next big move is going to be higher, not lower.