Anna Nikolayevsky on Lower Oil Forever: Capitalize For Kids Conference

We're posting up notes from the Capitalize For Kids conference 2016.  Next up is Anna Nikolayevsky of Axel Capital who made a presentation about lower oil forever.


Anna Nikolayevsky's Presentation at Capitalize For Kids 2016

•    Current consensus is that current prices (which are in contango) are not sustainable and will increase in 2017, 2018 and 2019. More of these estimates are driven by marginal cost curve and well depletion analysis. However, nobody predicted the fall therefore why should any give value to analyst expectations?

•    Overall, the industry is much more productive now (US shale technology advancement). Anna believes $50 is the current ceiling.

•    Most forecasters focus on supply, but demand is much more important. Over 50% of oil demand is due to transportation. A few things can impact demand: Higher fuel efficiency (since 2007, fuel efficiency has increased by 22%), sharing economy is also a major risk (better it gets, the fewer cars we’ll need on the road), electric cars are also a serious threat.

•    Tesla, has been gaining market share relative to comparable car models.

•    Leading car companies and governments are looking to embrace electric or hybrid models. In fact, large car companies are setting high standards to have meaningful percentage of their overall fleet to be electric vehicles in the mid-2020s.

•    Regarding cost, combustible engines are becoming more expensive in terms of compliance/ regulatory standards while electric ones are only getting cheaper.

•    Interestingly Saudi Arabia is looking to diversify away from oil with long term clean energy targets and announcing it is selling Saudi Aramco.


Be sure to check out the rest of the presentations from Capitalize For Kids/Sohn Canada Conference. 

Andy Hall's Outlook For Oil: Invest For Kids Chicago Presentation

We're posting up notes from the Invest For Kids Chicago conference 2015.  Next up is Andy Hall of Astenbeck Capital who talked about his outlook for oil.


Andy Hall's Invest For Kids Chicago Presentation

•    Presentation is the outlook for oil.
•    Rarely consensus view for oil has been this pessimistic.
•    Saudi Arabia/Worries over China – murky long term outlook for oil and fossil fuels. Running out of storage perhaps. Cash costs production avg $20 per barrel.
•    Perception is worse than reality. Q3 stock build at 500K BPD vs estimate of 1.6MM BPD.
•    Q2 estimated surplus revised lower by 900 KBPD.
•    No super contango means no distressed surplus of oil in contrast to 09 and 86.
•    Global oil demand growing at 2MM BPD so far in FY15, double the rate predicted at beginning of the year.
 •    Chinese demand growing at 7% YoY, led by gasoline and jet fuel.
•    Demand response to lower prices has already reduced surplus. Current oversupply is not just crude oil but also NGLs.
•    Overall surplus will continue to shrink and become a growing deficit in h2 2016.
•    In 1986 OPEC spare capacity was almost 20% of global product, today OPEC spare capacity is less than 2%.
•    Cuts in industry capex will prove excessive – industry cut capex by 25% in FY15. Further cuts expected in fy16, only second time in 30 years capex cut in consecutive years. Believes capex reductions will prove excessive – not 1986.
•    Significant lag between laying down rigs and production rolling over. Production peaked in June and has since dropped by 500 kbpd. USA shale/tight oil production overs over first.
•    Us production to continue to fall – EIA has reduced USA oil production forecast for FY16 from growth of 200 kbpd to a decline of 400 kbpd.
•    Rig productivity has plateaued.
•    Iran will add 300k to 400k barrels per day. Iraq will decline due to budgetary constraints.
•    Nigeria, Venezuela and Algeria at risk.
•    High geopolitical risks throughout oil producing regions.
•    Stop growth – supply declines by 8.6% per annum at existing production. 1.3MM bpd per annum has been the average or 1.4% growth in demand.
•    Thinks $70 per barrel is where it needs to be. Shale co’s said $40 break even yet they haven’t been able to generate FCF since FY10. Their supplier costs will likely rise as well particularly after consolidation.
•    2/3 E&P have negative cash flow and may be heading to bankruptcy. PXD says they need $70, EOG needs $80.

Check out the rest of the presentations from Invest For Kids Chicago 2015.

Passport Capital's John Burbank: 2012 is a Stockpicker's Market

John Burbank of $4 billion hedge fund Passport Capital recently sat down with Bloomberg TV to discuss his outlook on the markets and oil, among other things.


On Why This is a Stockpicker's Market

The founder touched on his fund's strategy for those looking for more insight into his ways:

"We’re stock pickers. In fact, this is a great year to be long and short individual securities. In 2008, everything went down. In 2009, everything went up. In 2010, everything moved together and eventually ended up. Last year, things started separating. Our strategy is to be picking individual securities, companies that are not depending on economic growth.”

You can see Passport Capital's latest equity holdings in the brand new issue of our Hedge Fund Wisdom newsletter that was just released.


On Healthcare & Biotech

He also went on to say that, “Biotech and healthcare is one of those sectors. There hasn't been an obesity drug approved in over 30 years and we thought QNEXA would have a good chance of being approved…We were one of I think four big holders in the stock. We think it can double again because we think a large pharma would probably like to own the company at some point."

QNEXA is the drug made by VIVUS (VVUS). In addition to Passport, large holders of the stock at the end of Q4 were Caxton Associates, Citadel Advisors, D.E. Shaw & Co, and SAC Capital.


On Oil

Burbank also addressed some macro topics like oil. "[Oil] is up 16%, more than any of the indices. It's a big problem for the rest of the world - central bank easing and liquidity providing presents a lot of problems for the average consumer here but also for emerging markets around the world.”

Burbank also mentioned where he has allocated a sizable portion of his capital:

“The one market it really helps is the Saudi market. We have 15% of our capital in the Saudi market - only about 1% is held by foreigners. It should be opening up this year. So we think unfortunately QE3, which is now being pursued in Europe and Japan, essentially in the U.S. with other programs, has negative feedback loops. And oil we think is the one. Gold goes up 10%, 20%, 50%, it doesn't cause any problems with people the way banking is done these days, but oil does… I don't think oil is going to stop until the economy breaks which is a real risk."

Embedded below is the video of John Burbank's interview with Bloomberg TV:

Strategist Saut: Accumulate Stocks With Favorable Risk/Reward

Raymond James market strategist Jeff Saut is out with his latest weekly missive and it's quite clear he's bullish in the intermediate term. However, he does think a consolidation could still happen in the near-term.

In particular, Saut points to oil:

"Indeed, over the past few weeks oil has become almost as extended above its 200 day moving average as it was in July 2008, and we all know how that ended. Not that I am predicting a similar collapse in the price of Texas Tea, but rather that a consolidation/pullback period is likely, which could provide the backdrop for another 'leg up' in stocks (even the energy stocks)."

Overall, Saut thinks any pullback in the S&P 500 will be around the 1315-1320 area. Saut was buying stocks during the February/March decline and it seems he has a 'buy the dips' mentality.

So what stocks does he like? Saut prefers favorable risk/reward setups and offers up Hospira (HSP) as a name with a lowered risk profile. He also continues to like Williams Companies (WMB). We just noted that Dan Loeb's hedge fund Third Point LLC likes WMB as well. You can read an in-depth analysis of Williams Companies in the most recent issue of our newsletter.

In other energy names, the market strategist also likes EV Energy Partners (EVEP), LINN Energy (LINE), and Clayton Williams Energy (CWEI).

Embedded below is Jeff Saut's latest market commentary:

Jeff-Saut-Market-Commentary


You can download a .pdf copy here.

For more insight from market strategists, head to our recent coverage of Don Coxe, who says the risk of a stagflationary bond bear has arrived.

Hedge Fund T2 Partners: Updated Long & Short Positions, In-Depth Analysis of BP

Whitney Tilson and Glenn Tongue's hedge fund T2 Partners recently released their June letter to investors. In it, we get an update on their performance but more notably, we see some of their long and short positions. Additionally, they've attached an in-depth analysis of BP plc (BP). As you know, we've previously outlined Tilson's reasons for buying BP. The extension included in the letter further elaborates on the analytical rationale behind owning shares of the oil spill giant.

Performance wise, T2 had a very impressive month of June, up 4.2% net of fees compared to the S&P 500 which was down 5.2%. T2 sits up 9.8% for the year net of fees, handily outperforming the S&P again. Since inception, T2 has returned 189.9% net of fees compared to only a 2.6% return for the index over the same timeframe.

Here are some of T2's current longs (in no particular order):

Berkshire Hathaway (BRK.A/B)
Iridium (IRDM)
Liberty Acquisition Corp warrants
BP plc (BP)
Winn Dixie (WINN)
Microsoft (MSFT)
Echostar (SATS)
dELIA*s (DLIA)
General Growth Properties (GGP)

Of their longs, we've noted numerous times how hedge funds are finding value in large cap names and Microsoft (MSFT) is the perfect example of this. While some argue they face tough challenges ahead, there's no denying its cheap valuation by historical metrics. For another value large cap play, we also highlight T2 Partners' position in Anheuser-Busch InBev (BUD) as we presented their analysis of BUD from the Value Investing Congress.

In terms of other longs, we first covered when Tilson bought BP and the basic gist of this play is that there's a reasonable chance the oil could stop flowing sooner than people expect and that clean-up costs will be less than imagined a year from now. In the letter below you can read his full assessment of the oil spill situation, company balance sheet, and more.

And here are some of the hedge fund's short positions that they've revealed:

Pacific Capital Bancorp (PCBC)
Homebuilders via the Homebuilder ETF (XHB)
For-profit education companies (no specific names mentioned, most likely a basket)
Barnes & Noble (BKS)
Boyd Gaming (BYD)
MBIA (MBI)
InterOil (IOC) puts

While we've known some of these stakes from when we previously looked at T2's short positions, the disclosure of their Pacific Capital Bancorp short is new. This ties into one-half of the long moneycenter/short regional bank trade that many hedge funds have on. Additionally, Boyd Gaming (BYD) is another new short we're seeing for the first time from Tilson and Tongue.

Embedded below is T2 Partners' June 2010 letter to investors:



You can download a .pdf copy here.

For more investment ideas from Tilson and Tongue, they'll be speaking at the upcoming Value Investing Congress in New York City in October along with many other prominent hedge fund managers including David Einhorn, Lee Ainslie, John Burbank and more. Market Folly readers can receive an exclusive discount to the event here.

Crude Oil & Gold Trading Ranges: Key Levels to Watch

MarketClub recently analyzed two of everyone's most favorite commodities: crude oil and gold. Adam just took a technical look at crude oil and wondered if it has topped out for the year. He draws a fibonacci retracement from the peak during oil's epic rise down to the trough and notes that the commodity is currently trading right around the 38.2% retracement level. In his oil video, Adam concludes that it is currently stuck in a trading range and could be for some time. But he does note that after trading ranges often come explosive moves. He highlights that the $72 level as an absolutely key level for support. If crude oil breaks that level to the downside, then he thinks it sets new lows for the year. One thing their analysis does not take into consideration, however, are the seasonal factors at play with crude. Typically, summer months command higher prices in oil so we'll have to see what happens there. Click below to watch Adam's video:



MarketClub also cranked out a technical analysis video on gold where they wonder whether or not gold is setting up for its next big move. Obviously, the longer term trend has been up and they illustrate how the metal continues to make a large move higher and then consolidate and trade sideways for a while to digest the move. It has repeated this pattern on a large scale numerous times over the past few years as you can see in their gold video. So, similar to crude oil, Adam feels there's really no trend right now and it will continue to trade sideways. He outlines $1,165 as the key level for the metal as it won't be able to start any move higher until it breaches that level to the upside. You can check out their technical look at gold below:

Regulators Seek To Throw Light On Hedge Fund Impact In Energy Trading

The following is a guest post from Darrell Delamaide for OilPrice.com:



Do hedge funds have an impact on energy trading?

While the answer might seem intuitive, the debate as to whether they actually do has come to resemble the medieval theological dispute about how many angels can dance on the head of the pin.

Because, like angels, many trades in energy futures are invisible, and it is often not possible to pinpoint where they take place.

And yet, for most of us, including lawmakers on Capitol Hill, it seems obvious that when hedge funds buy and sell billions of dollars worth of oil and gas futures, it must be having an impact on energy prices. While hedge funds and other speculative traders would never dream of taking delivery of a barrel of oil, their trading activity affects the prices for actual consumers of oil and gas and their downstream customers – or so it would seem.

When Gary Gensler, a former Goldman Sachs banker and Treasury Department official, was nominated last year as chairman of the Commodity Futures and Trading Commission – the chief regulator for energy futures trading – he reversed the CFTC party line that speculators don’t have an impact on energy trading.

“I believe that excessive speculation in commodity futures can cause sudden or unreasonable fluctuations or unwarranted changes in commodity prices,” Gensler said in a written response to lawmakers’ questions ahead of his nomination hearing.

Gensler went on to pledge that if confirmed, he would have the CFTC guard against such speculation.

While he stopped short of saying that excessive speculation had taken place in the run-up of energy prices in 2008, he did express the opinion that the rapid growth of commodity index funds and increased hedge fund allocation to commodity assets contributed to the “bubble in commodities prices that peaked in mid-2008.”

He noted that non-commercial investors sometimes account for up to 90% of open interest in a contract. (Open interest is a calculation of the number of active trades for a particular market, and is used as an indicator whether trading is becoming more or less active.)

Gensler’s answer, enshrined in draft legislation currently before Congress, is to make trades more visible by requiring all over-the-counter derivatives to trade through an approved clearing house. While the thrust of new legislation is to get a better handle on financial derivatives such as credit default swaps, it will give regulators a better picture of all derivatives trading, including energy contracts.

At the same time, the CFTC and the Securities and Exchange Commission both are beefing up their ability to monitor hedge fund activity. The SEC for the first time will require hedge funds to register as investment advisors, and Gensler has pledged closer oversight of the funds that it supervises as commodity pool operators.

The industry, predictably, is pushing back. In congressional testimony on the new legislation, the Chicago Mercantile Exchange, the largest futures exchange in the world, and other exchange operators presented studies based on CFTC data to show that large positions held by index funds and other managed money were not “routinely detrimental” to the commodity markets in the period January 2005 to June 2008.

“All of the trader groups displayed instances of non-optimal behavior (including small traders), but none were consistently harmful to the studied markets,” they said. A task force of the International Organization of Securities Regulators (IOSCO) released a report last March that came to a similar conclusion.

“While reports reviewed by the task force concluded that fundamentals rather than speculative activity was the plausible explanation for price changes, the task force has made a number of recommendations to improve the transparency and supervision of these markets,” IOSCO said.

These included suggestions regarding information about the underlying commodities, access to and sharing of information about trading positions, beefing up enforcement powers, and improving global coordination.

The spectacular collapse of the Amaranth Advisors hedge fund in 2006 when it lost $6 billion on natural gas futures did pull back the veil on hedge fund activity in energy markets. Amaranth built up its huge position in natural gas futures through OTC contracts that exactly mirrored the contracts on the New York Mercantile Exchange but remained hidden from regulators, who were unable to enforce position limits designed to rein in speculative trading.

In hearings about Amaranth before various House and Senate committees as well as at the CFTC itself, it became clear, at least to many lawmakers, that contracts on unregulated trading venues can influence prices.

The case was so straightforward that it prompted the Federal Energy Regulatory Commission to flex its new post-Enron mandate to stop manipulation of energy prices by pursuing disciplinary action against Amaranth.

This led to a turf war with the CFTC, which claimed exclusive jurisdiction over futures trading and argued that FERC’s mandate extended only to spot trading. FERC countered that when activity in the futures market affected spot prices, it was authorized to act.

Those proceedings ended in a joint settlement last August, before either CFTC or FERC held their administrative hearings and before an appellate court could decide the jurisdictional issue.

But the Amaranth case remains as a reminder of what a hedge fund can do in energy markets if these trades are not more transparent. Legislation bringing more visibility to the market and strengthening the hand of regulators will ensure that hedge fund activity in the energy markets will be more closely monitored and limited.

This article was written by Darrell Delamaide for OilPrice.com who focus on Fossil Fuels, Alternative Energy, Metals, Oil Prices and Geopolitics. To find out more visit their website at: http://www.oilprice.com.

Hedge Fund BlueGold's Investor Letter (November)

This is the first time we've covered BlueGold Capital Management so here's their background: Founded by Pierre Andurand and Dennis Crema, BlueGold is a London based hedge fund that trades in commodities markets, primarily in oil derivatives. Before founding the firm, they were both senior oil traders at Vitol S.A. and they seek absolute returns "through discretionary fundamental trades, directional and relative-value." They were up a whopping 209.4% for 2008, a year in which many other hedge funds struggled. Year to date for 2009, BlueGold is up 59.8%. Given that BlueGold primarily trades crude oil, we'd be remiss if we didn't include a technical look at crude oil for reference.

Their November investor letter provides some interesting commentary on the economy on a macro level. Specifically, their macroeconomic thoughts are pinpointed in a few main talking points. Firstly, Stephen Jen (the author of this section of the letter) feels that the world will gradually recover and should continue on this course at least until next summer. He feels recent risks such as Dubai's crisis are more-so a temporary distraction rather than a fundamental problem that will begin a wave of sovereign defaults.

This is interesting because it is in stark contrast to thoughts of fellow hedge fund manager Kyle Bass of Hayman Advisors. We've previously covered Bass' prediction of massive sovereign defaults. So we'll have to see who ends up right in this regard, Bass or Jen. Keep in mind that as far as we know, Jen doesn't have any positions on in the sovereign arena, while Bass has been betting on sovereign defaults in his hedge fund.

There are a few more bullet points worth highlighting in BlueGold's commentary as we see that Jen feels that global economic data has been and will continue to be broadly constructive. He also believes that the Fed will not use interest rates to keep asset prices in check. Overall, a much less pessimistic view than what we have seen from other hedge funds. Check out Stephen Jen & BlueGold Capital Management's in-depth macro thoughts via their November investor letter below:

*Update: The document has been removed per the request of representatives from BlueGold. Sorry for any inconvenience.


We'll continue to cover intriguing hedge fund portfolio movements and investor letters. In the mean time, we've just recently outlined hedge fund Woodbine Capital's thoughts on gold and highly recommend reading it given all the buzz around the precious metal lately.

Taking A Look At Gold, the US Dollar, & Crude Oil

The guys over at MarketClub just put out three interesting videos covering three hot topics: gold, the US dollar, and crude oil. Let's first start with their coverage of crude oil since it's trading near a crucial level.

Crude Oil

Firstly, Adam checks out the crude oil market and right off the bat he highlights that while crude has been in an overall uptrend since March of this year, the recent decline could be worrisome. He specifically notes the $67 level as crucial seeing how that was the most recent level of major support back in late September. While crude initially traded higher from thos levels, it has since spiraled down and is getting close to testing support. If it takes out $67 to the downside, Adam notes that you should exit the market as support will have broken. You should also note that Adam previously identified a pattern in crude oil where it is sold off every 75 days or so and then was bought right back up again. We're in the midst of one of those downtrend areas right now and buying needs to come in for this pattern to remain in tact. If crude heads lower, it will have breached a support level and nullified this patterned uptrend as well, a definite sign to exit the commodity. Click the chart below to watch the crude oil analysis.




Gold

Secondly, you can see their technical analysis on gold here. Adam feels that it's best for you to just stay out of the precious metal for now if you're not already in it because of what he calls "silly season." He's referring to the period from December 15th until the new year where many traders and money managers simply take off for the holidays. As such, volume in markets decreases and it only takes a little bit of money to really whipsaw things around. Not to mention, they are seeing conflicting indicators on their screen as the weekly trend is going down but their daily indicators are pointing up. These divergences combined with the lack of market participants over the holidays means it's best to sit on your hands they say.

US dollar

Lastly, you can see their analysis of the US dollar here. The dollar has been in a definitive downtrend over the past few months and their monthly indicators have been bearish since May of this year. Their weekly signals on the other hand, have turned up as the dollar has been rallying as of late. While some may interpret this as bullish, they note that trading against the primary trend (which is still down) is not advisable. We'd tend to disagree with him on this point as illustrated in the chart below you can see that the dollar has clearly broken out of its downtrend (green line) from the past few months. Not to mention, it is now trading above its 50 day moving average (blue line) and both the RSI and MACD are heading higher.



To his credit, Adam highlights the potential divergence in the MACD as its been slowly building higher since June. This means that the dollar is definitely something to keep an eye on in his view, but until the primary trend reverses, he thinks it's best to sit on the sidelines. We're obviously starting to see a common theme here in staying on the sidelines. It's typically not worth the risk of playing around in the anemic holiday markets. Conflicting signals and lack of true trading participants going into the holidays means you should probably avoid getting whipsawed around. Overall, Adam took at a look at some hotly traded assets but conceded that maybe it's best to just not trade them at all until the new year and we can't argue there.

Technical Analysis On Crude Oil & Apple (AAPL)

The team over at MarketClub just released two new technical analysis videos. You can check out the video on crude oil here and then the video on Apple (AAPL) here. Starting with crude oil first, Adam has identified a pattern where oil actually pulls back every 70-80 days or so. The gap of time between the last three lows is 70 days, 84 days, and 76 days. The current time elapsed since the last low is around 65 days. So, Adam has hypothesized that in 10 days or so, we'll see the next low in oil before it heads higher. After all, the gradual trend in crude since March has been up and all large dips have been buying opportunities Click the chart below to watch the crude oil video.




Secondly, they also look at the popular stock Apple (AAPL). And, things aren't looking all that rosy for this name. Many have pointed to Goldman Sachs (GS) to show the relative weakness compared to the market as it could be a warning sign. Apple could now be exhibiting similar signs as it could possibly have seen a double top and be headed lower. Normally, every big pullback in AAPL has been met with buying. While that still could potentially happen, their signals currently have them out of AAPL as they are worried it could head lower. So, if you're looking for possible 'tells' in the market, watch the action in some of the industry leaders of Goldman Sachs (GS) and Apple (AAPL). You can see how the guys at MarketClub have been trading AAPL throughout the year in their video.

The Future of Energy: New Technologies, New Opportunities & Crude Oil's Role

While we normally don't cover these topics since our time is consumed by hedge fund activity, we welcome a guest post courtesy of MoneyMorning. Since energy will undoubtedly be a big talking point now and into the future, it makes sense to start to examine things.

---

Renowned Oil Expert Dr. Kent Moors details shortages of oil, the impact of higher prices, the promise of new technologies and the opportunities for investors. Dr. Kent Moors is one of the world’s foremost experts on oil, energy policy, finance, risk management and new technologies. Moors advises the leaders of six oil-producing countries, including the United States, as well as global corporations and banks operating in 25 countries.

Moors is the founder and director of the Energy Policy Research Group, which conducts analyses and makes recommendations on a range of energy-related issues. He is also the president of ASIDA Inc., a worldwide advisor on the oil-and-natural-gas markets.

In an interview with Money Morning Executive Editor William Patalon III this week, Dr. Moors detailed the top current energy challenges in the global economy, and also provided investors with a look at some of the looming new technologies, as well as a future in which China is a dominant global energy player.

Some of these issues are already at work. Although oil prices remain well below the all-time record of $147 a barrel set in July 2008, crude prices have been on the march of late. Just yesterday (Wednesday), in fact, supply concerns pushed oil futures up above $81 a barrel, their highest level in more than a year.

“If you think the run up to July 2008 was a wild ride, you haven’t seen anything yet,” Dr. Moors told Money Morning. “In the next five years, investors who focus on medium- to small-sized producers and oil-field-service companies having a well-developed specialty niche will outperform the overall energy sector.”

Money Morning (Q): In an earlier discussion, you said that the successful energy investor of the future wouldn’t be a person who just goes out and invests in ExxonMobil Corp. (NYSE: XOM). Can you explain?

Dr. Kent Moors: We are entering a period of rising prices. There is still some play left in the large verticals (vertically integrated oil companies or VIOCs) such as ExxonMobil, but the primary profits will be made with smaller, leaner exploration-and-production (E&P) outfits, field-service companies and specialized producers (unconventional gas producers – shale gas, coal bed methane, tight gas, hydrates – heavy oil and biodiesel).

(MM): How will investors have to play this future? What types of companies should they be looking for, and where should they look?

Moors: The market rapidly approaching will be more volatile with valuation often more difficult to determine than in the past, even with prices increasing. How much of the increases result from actual product margins and how much results from oil becoming a financial asset rather than just a commodity is a major concern. It requires some careful homework. The types of categories mentioned above – smaller producers, new developments in field services and technology (especially those providing ways to decrease wellhead and operational costs, increase productivity, use associated gas, treat and utilize produced water, increase efficiency per barrel … there is a long list here) as well as the specialized producers and providers of their technical needs are the main targets.

(MM): When we look at the U.S. economy, you said that investors would be stunned to discover how much of our oil is produced by small players. In that discussion, in fact, you even described the type of firm that could be the “savior” of the U.S. energy sector, and perhaps even the economy. Could you take a moment to describe that situation and explain what that means for the economy?

Moors: The United States remains one of the top five producers of crude and will shortly ramp up production of natural gas (once the current glut has moved through the system). Sixty percent of crude produced in the U.S. market is at stripper wells providing less than 10 barrels of crude a day, but more than 20 barrels of water, a major byproduct. As America enters an accelerating field maturity curve (and an intensifying decline in well debit – well production), the efficiency of production declines. Therein lies a significant area for innovation and leaner companies. And that spells greater profitability at lower entry prices. Some offshore and Alaskan National Wildlife Refuge (ANWR) production will be done at scale, but that is not where the future of U.S. production will be. It will be the result of greater profitability at existing depleting wells with the new technology rolled out (on the oil side) and unconventional gas production.

(MM): Let’s take a look at the global markets, too. China’s global shopping spree has been well chronicled. As China locks up suppliers and supplies of oil and natural gas, what are the chances there could end up being what’s almost a two-tiered market, where China has access to oil and natural gas at lower prices levels, creating a shortage of non-captive supplies and leading to Western countries having to pay much higher prices?

Moors: Price rises for Westerners will occur anyway, and not just because of China (where a rising energy bubble resulting from the recent acquisitions is a concern). The competition for available energy sources will usually result in those regions prepared to pay more, increasing the overall aggregate price for most others. China, India, a resurgent East Asia, Japan and even regions such as West Africa will occupy important positions moving forward in this regard. Also, rising demand will center in places other than OECD countries. The new oil market emerging can hardly discount the developed countries, but the primary demand spikes are going to come from elsewhere.

(MM): After some significant turmoil in recent years, you said that Russia is finally opening up to foreign investment. Will that last, and what effect will that have on global energy prices?

Moors: To offset a more rapidly declining traditional production base (primarily Western Siberia), Russia must move north of the Arctic Circle, into Eastern Siberia and out on the continental shelf. These moves are technologically sensitive and very expensive. Moscow needs the outside investment and that will remain. However, projects must be carefully structured. Foreigners cannot own 50% of “strategic fields” under new laws or anything on the shelf. This means watch out for the smaller, focused operators and oilfield service companies. They will include companies currently trading on the Alternative Investment Market (AIM) in London: The AIM and London Stock Exchange (LSE) are the sources of the new external investment phase in Russia.

(MM): From a global perspective, which markets show promise? And which ones – either because of overly restrictive investment policies, or because of the risk of nationalization – are markets to be avoided?

Moors: Many markets show promise or telegraph restraint. Let’s look at some of the more noticeably promising markets, organized by energy category:

• Conventional Oil: Sub-Saharan Africa, Brazil, Kazakhstan, Russian Eastern Siberian and Far East smaller fields.

• Conventional Natural Gas: Turkmenistan (if recent government overtures to outside investment remain genuine), Uzbekistan, Northwestern Australia (region of the Gorgon project) and New Guinea.

• Unconventional Oil: Tatarstan (Russia) for bitumen and heavy oil, Alberta for oil sands (assuming an average and multi-year sustainable crude price of $72 [USD] a barrel or above).

• Unconventional Gas: The United States for shale (especially Marcellus Shale) and coal bed methane (Powder River Basin, Wyoming, also basin into Montana – if that state reduces regulations), Poland, Turkey and Germany for shale, south central Russia and Ukraine for coal bed methane. If Baghdad and Erbil can finalize central Iraqi and regional Kurdish oil legislation – and if security is maintained – Iraq will become a major play in both oil and gas.

• TO BE AVOIDED: Iran (sanctions and buyback contract frustrations), Mexico (collapsing infrastructure and nationalization), Venezuela (significant technical shortcomings, concerns over productivity assessments, and absence of Western operators).

(MM): If an investor were to divide the energy market into short/intermediate/and long-term segments, what will be the dominant energy plays (oil, natural gas, solar, coal-bed methane, for example) in each of those three time segments? What time periods would you tack onto the short-term, intermediate-term, and long-term segments? And which energy plays will be the real winners?

Moors: To make this easier to see, let’s divide this into short-term, intermediate and long-term segments and look at the key players, issues and technologies in each category.

• Short-Term (five years out): Here we’ll see an increasing efficiency at existing oil wells; Marcellus Shale natural gas; an extension of large fields into known deeper production layers – for example, BP-led (NYSE ADR: BP) multinational plays such as the Azeri-Chyrag-Guneshli and Shah Deniz deposits offshore Azerbaijan. Other developments to watch are the huge Chevron-led (NYSE: CVX) Tengiz field in Western Kazakhstan, initiatives in the central Gulf of Mexico and all satellite fields operated by other companies.

• Intermediate-Term (five to 15 years out): All U.S. and Canadian shale plays, Wyoming, Montana, New Mexico and Russian coal bed methane, selected wind power Western U.S. and Baltic Sea region (Denmark, Germany, Poland).

• Long-Term (20 years or more): All alternative and renewable energy (by this point, crude oil will be too volatile with supply problems and natural gas from whatever source will be the main power source both for conventional applications and for new technologies – fuel cells will obtain most of their price-sensitive hydrogen from natural gas).

Moors: Here’s the bottom line. Looking forward, successful energy investors will be those who: (1) weigh volatility as well as opportunities; (2) understand the rapidly changing supply/demand balance; (3) hedge within a focused time-frame; (4) watch the development of new technology to improve production, processing or transport; and (5) have a flexible approach to the market.

(MM): Spotlighting and providing detail and in-depth analysis of the specific winners would require a much-more-detailed category breakdown than we have here. But stay tuned: Dr. Moors will delve into these topics in future issues of Money Morning.

---

Thanks to MM for the guest post on what surely will be a hot topic going forward.

Seasonality Of Crude Oil

The guys over at MarketClub came out with a new video on crude oil yesterday that examines how seasonality typically effects the price of oil. And, their findings are interesting in that crude oil seasonally heads a bit lower this time of year, yet the market seems to want to head higher. The chart on crude oil has been pretty similar to that of the stock market in that it made lows in February/March and has trended higher. The main difference is that while the overall stock market has continued to head higher, crude oil has kind of traded sideways in a consolidation pattern since June.

There is a clear area of resistance around $75 a barrel and a nice triangle-like formation is setting up so that you can easily draw the lines to identify a breakout to the upside or a breakdown to the downside and trade it either way. Since the market just jumped up on the $75 level for the first time in over a year, it definitely seems like it wants to breakout to the upside as it has setup in a similar pattern to what gold was in before breaking out to above $1000. Also, if you run fibonacci retracements on crude oil from the highs in July of last year to the lows in February of this year, the retracements identify $83 a barrel and $95 a barrel as potential upside targets. You can check out their technical analysis video here.

Crude Oil Breaks Trendline (Technical Analysis)

We haven't looked at crude oil in a while from a technical perspective so we figured it'd be worth a look as the guys at MarketClub analyze it in this crude oil video. They highlight a trendline in crude from the lows in March until September. They note a trend break here just recently which signals crude could trade lower in the near-term.

They also pull up a fibonacci retracement on crude oil from the lows of March until the highs in August and notice that the 50% retracement could be a pivot point for crude as it has already acted as support for the commodity once before back in July. Check out their analysis here. And if you're unfamiliar with fibonacci, learn about it in this video as it's a useful technical analysis tool).

Crude Oil & Gold: Both Bounce Off Fibonacci Retracements

Wanted to link up a few different technical analysis videos we've seen recently for those who may be interested. These are a bit more educational in nature since they were filmed a few days back, so just a head's up on that. They're always a great resource for those looking to fine-tune this analysis within your investing or trading arsenal. And specifically, these videos focus on Fibonacci retracements, a tool that many technical analysis gurus swear by.

Firstly, the guys over at MarketClub are back looking at a video of both Crude Oil and Gold. And, they noted a similarity between the two: both recently bounced off Fibonacci retracements. In a previous video we highlighted, they thought Gold would retrace to around $924 or so and that's exactly what happened. They are now targeting $980 to the upside before the metal encounters more resistance. And, of course, $1000 is the key level for gold on the upside in order to breakout and really start running. Adam suggests putting on a trade with a stop around $950 and you can see the other key technical levels he's identified in this separate gold video. Oil on the other hand reversed off the $63 level which coincides right with a Fibonacci retracement as well. They said they were looking for crude to run into more resistance there around $74 in the near-term. You can watch the video showcasing these two very recent Fibonacci retracements here.

If you're unfamiliar with Fibonacci retracements, we highly suggest learning about them and there is a great educational video on Fibonacci's here. And of course, if you're new to technical analysis altogether, we'd suggest checking out our recommended reading list on the subject.

Crude Oil - Interview With CME Group's Joseph Ria

The guys over at MarketClub have sat down and interviewed Joseph Ria of the CME Group regarding crude oil and energy. They aimed at putting out some educational and trading material regarding crude oil since it is such a hot topic & commodity these days. Here's a transcript of part of the first interview,

"Crude Oil & Energy Update - Interview with the CME Group's Joseph Ria

When you hear the news reporters talk about the price of
crude oil in the marketplace, they're generally talking about
WTI, which is West Texas Intermediate crude oil. It's a very
light, sweet crude oil and the highest grade that's out there.
Crude oil is based on and priced on the amount of sulfur that's
in the oil. It makes it easier or harder to refine base on the
amount of sulfur. WTI being the lightest and sweetest, is the
highest priced crude oil in the marketplace.

It is a benchmark delivered in Cushing, Oklahoma.

In benchmarks for crude oil and global pricing of crude oil, WTI
probably prices about 50% of the global pricing of crude oil.
Brent being basically the other pricing benchmark. There's two
out there, Brent being a little of a mixture of three different
grades of crude oil; BF&O, Brent 40 and Ossenberg. They're
all produced in the North Sea.

---

That's the first part of the work transcribed and you can view the rest of the stream here. Keep in mind you'll have to do a free sign-up with them to see the material. We like to focus on educational content every once in a while seeing how we have a diverse reader base on the site. And, after all, everyone is a beginner at some point and you can never cease learning. You can check out their video series here.

We also wanted to point out that we have numerous other resources on the topic of crude oil. Some of the most popular articles on Market Folly in the past have been 2 crude oil related pieces by author Tradefast. Firstly, he examined How Contango Affects Crude Oil ETFs. Then, in a follow-up piece, he also examined How to Play Crude Oil via ETFs & ETNs in an article that examines the various crude oil investment vehicles. We highly recommend these pieces as they have received much praise due to their in-depth analytical nature.

Also, for those of you more concerned about where crude oil is heading in the near-term, check out the recent crude oil technical analysis video.

Crude Oil Chart: Technical Analysis Video

So, what's up with crude oil lately? In the span of a year, this commodity has been all over the map and we've been a bit astonished at what we've witnessed. We saw it ramp way up to $140+ last summer. This summer, where's it headed? Very recently, it's dropped from $70 to $60. The guys at Market Club just put out a great crude oil technical analysis video, so check it out if you want to know if crude will keep dropping.

Crude Oil Technical Analysis Video

The guys at MarketClub are back with another great video and this time they're talking about crude oil, which has had a heck of a year so far. They take a look at the chart using technical analysis and talk about the current trend and where it is headed next. So, check out their excellent video on crude oil.

Also, if you missed them, they've done some great analysis on the best inflation indicator and then separately on gold as well. These guys give great technical analysis commentary and we highly recommend checking the videos out.

How to Play Crude Oil Using ETFs & ETNs: A Comparison of USO, DBO, & OIL

The following is a Guest post on MarketFolly.com.

'tradefast' is the nickname of an independent equity trader who has more than 20 years of market experience at a major financial institution and 2 hedge funds. He now trades for a private investment fund, using a combination of both fundamentals and technicals. (He's our kinda guy).

Last week, he sat down to explain how contango affects the crude oil ETF's and ETN's that many investors and traders usually play, including USO, OIL, & DBO. This next piece is a follow-up post to that topic. So, before beginning, make sure you check out: How Contango Affects Crude Oil ETFs & ETNs.

Next, he takes a look at how to play crude oil using those same ETFs & ETNs. He writes,

Objective

This article provides some straightforward insight as to how a retail trader/investor can implement a directional play on the price of crude oil. Included is a discussion of the manner in which the forward market for crude oil can cause crude oil ETF returns to deviate from spot market returns. This article is not intended to be authoritative, comprehensive, or highly technical. It is simply a compilation of previous discussions on the topic (with some added elbow grease and my version of common sense). Readers should be aware that much of the material in this article has been discussed previously here and here. Certain elements of this article are pulled directly from these sources.

Note

When I first wrote about the effects of forward curves on crude oil ETFs, the crude market was in steep contango and the discussion attracted widespread attention. More recently, the crude curve has flattened somewhat and it may appear to some individuals that the curve shape has become less of an issue to retail speculators. I have a different view. I believe that sharp volatility in the shape of the curve makes it imperative that retail crude speculators understand how curve adjustments can affect their positions. This topic is not dying, but rather garnering added importance.

Introduction - Retail Investors Cannot Trade Spot Crude Oil

I have a friend with fairly extensive stock trading experience who generates most of his technical market analysis using the S&P 500 futures contract. When it comes time to transact, however, he will swing over to the cash market and trade an ETF such as SPY (S&P 500) or a leveraged ETF such as SSO (2x the S&P 500) or SDS (2x the inverse of the S&P 500 - a double short). Although he and I share the same trading objectives (to capture a directional movement in the S&P 500), I choose to generate my technical analysis using the precise instrument which I expect to trade. In my case, SPY (or SSO or SDS if I desire leverage). I am confident in my approach because I know the instrument I am trading exhibits an extremely tight relationship to movement in the S&P 500 cash market. Simply put, I trade SPY because is a highly dependable proxy for replicating the spot market of the S&P 500.

Unfortunately, traders or investors wishing to implement a directional play on crude oil lack access to a tradeable instrument which tracks spot crude oil in the same manner that SPY tracks the S&P 500. Instead, we must choose from an array of instruments which are structured with the intent of tracking crude prices, but with flaws relating to the fact that crude oil (unlike the S&P 500) is a physical commodity for which spot trading is limited to those who can transport, store, or produce crude oil.

Crude Oil Futures – The Curve

Fortunately, despite our lack of access to the crude oil spot market, there is a highly liquid market for futures contracts which reference crude oil. And, the price of these contracts exhibits volatility which generally resembles the movements in the spot market. Many traders transact directly in crude oil futures contracts, electronically or in the futures pit. These traders rely on the fact that they will never have to physically handle the commodity itself. They can simply close out their futures positions prior to expiration and net out the difference between their entry and exit price.

The fact is that trading in crude oil futures (which expire monthly) is spread out over several months, even years. And, the price of crude for delivery at future expiration often varies substantially from month to month. At times, prices in future delivery months are progressively higher than in the nearest delivery month (contango). And, more often than not, the opposite is true (backwardation). Many futures traders have specialized knowledge of the day-to-day shifts in supply and demand fundamentals and they are comfortable projecting price movements at specific points along the forward curve. The typical retail investors probably lacks the skill-set needed to profitably exploit forward curves in a sophisticated manner.

Introducing Crude Oil ETFs/ETNs

For the retail crude oil speculator who is incapable of trading crude oil futures, there are tradeable ETFs (Exchange Traded Funds) and ETNs (Exchange Traded Notes) which employ futures contracts in pursuit of the general objective of “tracking the price of crude oil”. A typical crude oil ETF will hold long positions in WTI (West Texas Intermediate) crude oil futures contracts. As with most futures traders, these funds employ leverage, putting up a small portion of the capital to buy the contracts. The rest of the fund’s assets are invested in money market instruments which generate a modest amount of interest income for the fund.

ETFs – The Roll

In theory, the existence of crude oil ETFs enable individuals to implement a single equity trade to express a view that crude oil prices will either rise or fall in the future. Unfortunately, this objective is compromised by the existence of a forward curve in the crude oil futures market.

Because of the forward Curve, any ETF referencing crude oil cannot simply rely on ownership of the existing front month (closest to expiration) futures contract. To remain invested at all times, it must periodically sell its existing futures holdings and roll its exposure to a futures contract expiring in a more distant month.

ETFs – Return Components

With crude oil ETFs, the technical result of utilizing crude oil futures for the NAV (net asset value) return is dependent on three variables: 1) changes in the spot price of crude oil, 2) interest earned on un-invested cash, and 3) the ‘roll yield’ – which is a function of the spread between the price of the contract being sold and the price of the contract being entered. In contango markets, the roll yield will be negative because the fund must pay up to enter the more distant contract, and the opposite is true in backwardated markets. Furthermore, the precise timing of the forward roll can have a material impact due to the propensity of the expiring contract to experience high volatility in the days immediately prior to expiration.

Roll Yield – ETF Return Illustration

Let us consider the case of a hypothetical crude oil ETF which provides exposure to the front month crude oil futures contract, with the exposures rolled forward as expiration approaches.

To illustrate the concept of the roll yield, assume that the 2009 spot return on crude oil is +20%. But, assume that persistent contango in the market results in a cumulative roll yield of -15 %. In these circumstances, the combined return of a crude oil based ETF might be in the ballpark of +5%, a far cry from the +20% return generated in the crude oil spot market.

As illustrated, contango in the crude oil market may cause ETF returns to lag spot market returns. Not surprisingly, a flat/stable forward curve would result in a minimal roll effect. On the other hand, a backwardated curve may cause the ETF to outperform the spot market.

Roll Yields – A Source of Tracking Error

The variability of roll yields coupled with the shifting slope of the forward curve should dispel any notion that the return on crude oil ETFs will track the spot market of crude oil in a predictable manner. The managers of the crude oil ETFs and ETNs are fully aware of this issue and they make no claims regarding their ability to replicate spot crude returns. They merely claim to attempt to track a return benchmark that is comprised of crude oil futures contracts, thereby providing traders/investors with some ability to participate in directional movements in the price of crude oil. (Note: This situation is analogous to an issue which exists with certain leveraged (non-oil) ETFs which have proven to be extremely deficient in terms of tracking their benchmark indices in volatile markets. These instruments have strictly adhered to their stated strategies and objectives, but have failed to achieve the imaginary objectives of many careless traders.)

ETFs/ETNs – Examining the Fine Print

Included below is some language directly out of the prospectuses of some of the more popular crude oil ETFs and ETNs. Notice that the managers willingly acknowledge the issues related to forward curvature and the roll yield impacts on returns. This segment of analysis will focus on the three most popular crude oil instruments in existence today: an ETN (OIL) and two ETFs (USO & DBO). Many of the issues raised herein are applicable to all crude oil ETFs and ETNs, although leveraged ETNs (such as DXO) involve complications which are not analyzed here.

ETF versus ETN – Counterparty Risk

No discussion of crude oil ETFs would be complete without some mention of the important difference between an ETF (Exchange Traded Fund) and an ETN (Exchange Traded Note). With an ETF, holders are secured by the assets of the fund, so the credit worthiness of the fund manager firm is not a relevant consideration. If the manager collapsed into insolvency, the ETF would be unaffected, except for the possibility of a change in management (which is not an important consideration in the case of a fund which is passively managed to match a specific benchmark). In contrast, owners of an ETN are unsecured creditors who receive a mere ‘promise to pay’ equivalent to the value of the underlying assets. Let's simplify this distinction: If a given ETF and a given ETN have the same exact net asset value (NAV), it is conceivable that the ETN could be worth less than the ETF if the manager of the ETN asset pool experienced a level of financial distress which resulted in a material downgrade of the credit quality of the manager’s bonds. Given that most ETN managers are financial institutions with challenging balance sheets, this risk is worthy of consideration.

In a worst case scenario, the ETN manager could face an abrupt insolvency and default on the ETN. This risk, often referred to as counter party risk, is similar to the risk that credit default swap (CDS) holders faced when Lehman Brothers and AIG encountered insolvency. We, as rational individuals, do not buy insurance from high risk insurers. And, as such, we should think similarly about owning ETNs issued by high risk managers.

US Oil Fund (USO)

USO is a standard crude oil tracking ETF that utilizes a strategy resembling the hypothetical ETF analyzed earlier in this article. Accordingly, USO entails all of the risk factors related to the use of crude oil futures as a tracking mechanism for crude oil prices. As with all ETFs, the objectives, the portfolio structure, and the major risk factors are clearly disclosed in the prospectus.

From the ‘risk factors’ section of the USO prospectus,

"in the event of a crude oil futures market where near month contracts trade at a lower price than next month contracts, a situation described as ‘‘contango’’ in the futures market, then absent the impact of the overall movement in crude oil prices the value of the benchmark contract would tend to decline as it approaches expiration. As a result the total return of the Benchmark Oil Futures Contract would tend to track lower. When compared to total return of other price indices, such as the spot price of crude oil, the impact of backwardation and contango may lead the total return of USOF’s NAV to vary significantly. In the event of a prolonged period of contango, and absent the impact of rising or falling oil prices, this could have a significant negative impact on USOF’s NAV and total return."

Notice how they warn that USO may experience a negative roll yield which may cause the NAV of USO to deviate significantly from the spot price of crude oil. Is there historical precedence for USO deviating from spot oil by a material amount? As it turns out, the answer is ‘yes.'

"During the past two years, including 2006, these markets have experienced contango. This has impacted the total return on an investment in USOF units during the past year relative to a hypothetical direct investment in crude oil. For example an investment made in USOF units on April 10 and held to December 31, 2006 decreased, based upon the changes in the closing market prices for USOF units on those days, by 23.03%, while the spot price of crude oil for immediate delivery during the same period decreased 11.18%."

The only logical conclusion is that USO is not a direct play on the spot price of crude oil. It is, instead, a play on the spot price, forward prices, and the relationship between spot and forward (or, the slope of the futures curve).

Power Shares DB Oil Fund (DBO)

DBO is different from USO in that its managers utilize specialized strategies intended to mitigate the effect of roll yields on returns. As with USO, the prospectus for DBO directly addresses the issue of roll risk. In the case of DBO, however, the manager is not passive about accepting a negative roll yield in a contango market. In the words of the manager,

"Rather than select a new futures contract based on a predetermined schedule (e.g., monthly), each Index Commodity rolls to the futures contract which generates the best possible ‘implied roll yield.’... [The manager] is able to potentially maximize the roll benefits in backwardated markets and minimize the losses from rolling in contangoed markets."

I think it is fair to point out that the active approach being utilized by DBO presents both opportunities and risks in relation to the more passive rule-based approach used by USO. It is certainly conceivable that, by employing their optimization model, DBO will exhibit improved roll yields and better returns than USO. But, as with all things financial, the DBO model may backfire due to faultiness of imbedded assumptions. If DBO’s approach were full-proof, it is probably fair to conclude that an arbitrage opportunity might exist whereby profits could be generated by pairing a long position in DBO with a short position in USO. At this juncture, I am extremely hesitant to advocate such a strategy. Advanced readers wishing to gain a better understanding of DBO’s optimization approach may benefit from this link.

IPath S&P GSCI Crude Total Return ETN (OIL)

OIL is structured as an ETN issued as an uncollateralized obligation by Barclays Bank PLC. It is a financial institution that can be regarded as vulnerable to rising default risk in the current environment. As with USO and DBO, OIL is managed with the objective of tracking WTI crude oil prices by trading in crude oil futures (rather than the physical commodity).

OIL uses a specific benchmark to guide its futures trading activity: a crude oil index devised by Goldman Sachs. As with most index funds, OIL’s objective is to minimize the performance tracking error in relation to the index. OIL is not intended to perform better or worse than the index. The composition of the index, by design, can include any of the crude oil futures contracts which expire within three months. At present, however, the only contract used to calculate the index is the front month contract (which expires three business days prior to the 25^th of the next calendar month).

OIL’s roll strategy is formulated and it is unique from that of DBO and USO. But, the differences in relation to USO probably do not have a material economic effect. In particular, holdings of the front month futures contract are rolled over a five day period commencing on the fifth business day of the month. Essentially, this means that OIL will have completed its roll approximately two weeks before front month expiration. (Note: USO rolls two weeks prior to expiration).

In essence, OIL is more similar to USO because the roll strategy is formulaic, and not intended to minimize the effects of negative carry in a contango futures market (or maximize the benefits of backwardation). But, this similarity is also offset by the fact that OIL carries material counterparty risk since it is an ETN, while USO and DBO do not (since they are ETFs).

USO Versus DBO Versus OIL - Expenses and Liquidity

The volatility of these instruments is so high that expenses have a relatively minimal impact. But, for frugal and/or longer term investors, the following information may be relevant:

Annualized expense ratios:

• USO 0.86%

• DBO 0.54%
  

• OIL 0.75%
  

Empirical Data – Historical Price Returns

It is unwise to draw any specific conclusions from this information, but a quick examination of the recent market returns of USO, DBO, and OIL reveal the following facts:

Year-to-date price returns (thru 1/24/09):

• USO -2.9%

• DBO +1.1%
  

• OIL – 7.9%

Although inconclusive, the material disparity between the return of USO and OIL is potentially due to the fact that OIL is an ETN issued by Barclays – a Bank that has suffered from extensive credit quality impairment in recent days.

Returns, 2008 peak to current:

• USO -72%

• DBO -65%
  

• OIL -75%

Further assessment of the relative returns of these instruments can be found here.

Conclusion

Considering the following factors:

1. Counterparty risk
2. Futures roll strategy (and roll yield)
3. Liquidity and expenses

USO has no counterparty risk and no active management risk. DBO has no counterparty risk but has inherent risks and opportunity related to the active management of the roll. Lastly, OIL has material counterparty risk. I currently favor USO as the instrument to express my directional views on crude oil over the other two instruments DBO and OIL.

Thanks to 'tradefast' for the excellent in-depth overview of crude oil ETFs & ETNs. We think he has highlighted some excellent points that any trader or investor should know before using these vehicles to speculate on crude oil. If you haven't already, make sure you check out: How Contango Affects Crude Oil ETFs & ETNs. For additional coverage on crude oil, check out the recent slide presentation: Cheap Oil = Over. Also, we've commented on cheap oil, and have covered energy trader Eric Bolling's latest oil trades and thoughts here.

Lastly, you can follow tradefast on Twitter, and catch his thoughts on his blog.

How Contango Affects Crude Oil ETF's and ETN's (USO, OIL, DBO)

The following is a Guest post on MarketFolly.com. Note this is part of a 2 article series in which we also examine how best to play crude oil via the various ETFs/ETNs. Below, you'll find the article relating to how contango affects these investment vehicles. In a follow-up article, we compare the crude oil investment vehicles.

'tradefast' is the nickname of an independent equity trader who has more than 20 years of market experience at a major financial institution and 2 hedge funds. He now trades for a private investment fund, using a combination of both fundamentals and technicals. (That sounds like our kinda guy!)

He sat down to explain how contango affects the crude oil ETF's and ETN's many investors and traders usually play, including USO, OIL, & DBO. He writes,

"The US Oil Fund (Ticker: USO) holds long positions in West Texas Intermediate crude oil futures contracts, and rolls these contracts forward each month. Like most futures traders, USO buys futures with leverage, putting up a small portion of the money to buy the contracts. The rest of the money is invested in Treasuries, which generates interest income for the fund.

Three factors play a role in determining the performance of USO: 1) changes in the spot price of crude oil, 2) interest income on un-invested cash, and 3) the 'roll yield'. The first two factors are easily understood, but the third factor, 'roll yield' should be examined further in order to determine the extent, if any, to which traders of USO will be surprised by its performance in relation to spot crude oil.

First some background: Oil futures are available for each month of the year, so you can buy a futures contract right now which gives you the right to buy oil in February 2009, March 2009, April 2009, and so on. Currently, the price of oil in February 2009 is less than the price of oil in April 2009, a condition which is referred to as 'contango'. (If the opposite were true, the market for crude oil would be in backwardation.) Most commodity funds, including the US Oil Fund (USO) buy what is called the 'near month' contract and, because they do not want to take physical delivery of the commodity, they sell the current month's contract before it expires and buy into next month's contract. This process is called 'rolling forward', and it can result in the ETF paying up if the forward month contract is higher than the current month (contango), or cashing out if the opposition condition exists (backwardation).

To investigate the issue, I read through the 'risk factors' section of the USO prospectus. The following is relevant:

in the event of a crude oil futures market where near month contracts trade at a lower price than next month contracts, a situation described as ‘‘contango’’ in the futures market, then absent the impact of the overall movement in crude oil prices the value of the benchmark contract would tend to decline as it approaches expiration. As a result the total return of the Benchmark Oil Futures Contract would tend to track lower. When compared to total return of other price indices, such as the spot price of crude oil, the impact of backwardation and contango may lead the total return of USOF’s NAV to vary significantly. In the event of a prolonged period of contango, and absent the impact of rising or falling oil prices, this could have a significant negative impact on USOF’s NAV and total return.

In essence, the USO prospectus is warning traders that USO may experience a negative 'roll yield' which may cause the NAV of USO to deviate significantly from the spot price of crude. Is there historical precedence for USO deviating from spot oil by a material amount? As it turns out, the answer is 'yes'.

During the past two years, including 2006, these markets have experienced contango. This has impacted the total return on an investment in USOF units during the past year relative to a hypothetical direct investment in crude oil. For example an investment made in USOF units on April 10 and held to December 31, 2006 decreased, based upon the changes in the closing market prices for USOF units on those days, by 23.03%, while the spot price of crude oil for immediate delivery during the same period decreased 11.18%

The conclusion, at this stage of analysis, is that USO is not a direct play on the spot price of crude oil - it is, instead, a play on the spot price, forward prices, and the relationship between spot and forward (the slop of the futures curve).

For a trader who is long USO, my instinct is that maintenance or aggravation of the contango in crude oil will cause impairment of the value of USO in relation to spot crude - whereas, any mitigation of the contango situation (including a shift to a flatter curve or backwardation) will enhance the performance of USO.

I plan to study this issue more extensively. But, in the mean time, I will not consider USO to be a good proxy for the spot price of crude oil - and I will be particularly leery of participating in USO for anything other than a short term trade."


'Tradefast' highlights an issue that many have overlooked or just not taken the time to research. Many perceive that USO is the "best way to play oil" since it's the front-month contract. But, as he points out, there are some issues with this ETF, depending on how crude oil is trading in the front month and beyond. So, as always, read the prospectus of each fund you're trading or investing in. It's important to understand what exactly it is you're dealing with.

In the comments section of his original article, he goes on to address similar issues in other crude oil ETF's and ETN's. Regarding ticker OIL, he writes,

"Here is a link to the prospectus for OIL, the IPath crude Oil ETN.

The 'contango issue' is discussed on PS-10. Short answer: yes, a contango market in crude oil will result in negative roll yields - similar to USO.

Also, be aware that OIL is an ETN (exchange traded note), rather than an ETF (exchange traded fund). With ETNs, you are an unsecured creditor of Barclays (the issuer of the note), so you have credit risk overlaid on the risk of the commodity.

In a former life, I used to enter into total return swaps on various indices with Lehman as the counterparty. I halted this practice long before LEH became a troubled credit. My sense is that the popularity of ETNs have fallen in relation to ETFs, because of the credit risk.

I have no strong opinions regarding Barclay's default risk, but it might be worthwhile to consider that Barclays CDS widened by a meaningful 98 bps on Friday, and the stock declined 24%. Although the current CDS spread of 265 bps is not indicative of extremely high default risk, the level and direction are cause for some concern. (Barclays credit risk can be hedged with CDS, but this is a market for instititional investors - and shorting Barclays stock against a long position in OIL exposes the OIL holder to unacceptable basis risk. Ergo, I would prefer ETFs (such as USO) over this specific ETN (OIL)."

He also addresses the Powershares ETF: DBO, writing,

"I took a quick glance at DBO from PowerShares. In the prospectus, PowerShares notes the following:

Rather than select a new futures contract based on a predetermined schedule (e.g., monthly), each Index Commodity rolls to the futures contract which generates the best possible ‘implied roll yield.’ The futures contract with a delivery month within the next thirteen months which generates the best possible implied roll yield will be included in each Index. As a result, each Index Commodity is able to potentially maximize the roll benefits in backwardated markets and minimize the losses from rolling in contangoed markets.

My interpretation of this statement is that the manager of the ETF utilizes a certain amount of discretion with respect to the futures roll. If the forward curve were humped (i.e. backwarded to some point, and contango thereafter), a skillful manager might be able to take advantage. I do not claim expertise in this area, but my observation is that the current market in Crude Oil is in contango as far as the eye can see, and there does not appear to be any immediate advantage to having a selection of forward contracts with which to complete the roll. Also, keep in mind that with active management comes potential advantages (the manager may make a skillful maneuver) and potential risks (the manager may screw up and underperform the benchmark).

Currently, I am not commenting on the leverage associated with DBO, it is beyond the scope of this particular topic (contango effects on crude oil ETFs and ETNs)."

Great insight from tradefast. We definitely appreciate his effort to research and write about each of the various popular ways to play crude oil in equity markets. We feel this is an important topic that needed to be addressed, seeing how so many people trade or invest in these ETF's/ETN's without even blinking an eye. So, thanks again to tradefast for the guest post. Note that a follow-up article was also posted where we examine how to play crude oil via ETFs & ETNS as we compare the different vehicles such as DBO, USO, & OIL. You can view the article on how to play crude oil here.

For some of our coverage of crude oil, check out the recent slide presentation: Cheap Oil = Over. Additionally, we've commented on cheap oil ourselves, and have covered energy trader Eric Bolling's latest oil trades and thoughts.


You can follow tradefast on Twitter, and catch his thoughts on his blog.