Not Reinventing the Wheel

“I’ve Never Made A Play Up. You Just Steal From Other Coaches. Brad Stevens Draws Up Great Stuff. Dave Joerger Runs Really Good Stuff Too.” - Steve Kerr, Golden State Warriors head coach 

The internet is a great equalizer.  Institutions used to have a huge information advantage back in the old days.  And most of the information is free, and people willingly give away valuation information, which is sort of their way of doing philanthropy.  I know there are many traders that don't like to reveal how they make money, or give out their investment ideas, thinking that letting others know will dilute their edge, or make it go away if too many people trade it.  But even if you give people a profitable trade idea or strategy, most of them will figure out a way to make it much less profitable or even unprofitable. 

My experience from talking to other investors, who trade their own money, most of them who are just dabbling part time, is that they have pretty big egos, and often don't follow recommendations, or if they do, only partially.  People like to do their own thing, and think they are usually right.  That's why investors like to hold on to losers, not just because they don't want to admit defeat, but its because they think they are right, even when the market is telling them they aren't.  I actually fall into that trap myself.  Although I've gradually improved at admitting defeat and taking the loss.

A few months ago, I spoke to an acquaintance, a novice investor.  He asked me what he thought were a good investment, and I mentioned a few oil and gas stocks.  I gave him my reasoning, and he bought a couple of them, but then promptly took a profit a month later, saying that they went up quickly and he thought they were short term overbought.  I told him I was still long, but he clearly didn't have the same view. In fact, he actually shorted an oil ETF after the Russian invasion, when WTI was around 110, because the chart looked overbought, despite my pleas to not short oil.  Last time I spoke with him, he was still short.  

This gets back to information that you find on the internet.  There is a lot of bad or irrelevant information out there, so its hard to separate signal from noise.  But what I've noticed is that you would be surprised how often widely available information is actually not fully priced into the market.  

Investing is not reinventing the wheel, a lot of its looking around, finding other people's good ideas, doing some due diligence, and making an investment.  Not much creativity or direct hands on research is involved, a lot of it is just stealing other people's stock ideas.  But that's the tricky part, because you have to pick the right people to follow, a lot of people are just talking their book, and not being rigorous or objective about the investment prospects of a stock.  There's a lot of misinformation, bad research out there.  Honestly, I'm much better at picking and choosing who to follow, figuring out what is good research than I am at actually doing good research myself. 

This brings me to the commodities market.  The underperformance of commodities vs US equity indexes since 2008 have biased people's views and asset allocation.  Despite the overtly bullish fundamental supply/demand situation that's developed over the past few months, there doesn't seem to be a huge rush of capital flowing to the energy sector.  I think most of the recent strength has not been from eager new buyers, but from corporate buybacks and those already invested less willing to sell at current prices.  

At first, I was also skeptical about a new up cycle in commodities, in particular oil, after the big drop in 2020 because I was expecting OPEC+ to cheat, and boost production much more quickly than they did, keeping inventories high.  They were actually quite disciplined in staying under their quotas, a change from past behavior, which went a long way towards eating away at the inventory surplus that had built up in the the first half of 2020.  By late 2021, global oil demand had basically come back to pre Covid levels, even without much international travel to Asia and even some parts of Europe, so I knew the inventories were going to have a hard time building back up. 

All the research reports and articles from informed sources in the energy space were coming to the same conclusion: supply was not able to keep up with demand.  Capital investment in future production was low and not growing, even as prices were going higher, and demand was going up much faster than expected in the emerging markets.  Perhaps it was due to the big drops in oil prices from late 2014 to early 2016, in late 2018, and in spring 2020 that gave pause to oil company CEOs from spending more money on investment and exploration, and they stayed conservative and disciplined.  

 

Due to the natural decline of oil wells, especially shale oil, you need continuous capital investment to maintain production, and that's not happening.  In the above chart, you can see the drop in capital expenditures from 2014 to 2021 is steep for 3 large oil producers.  Whether its scars from oil bear markets, peak oil demand concerns or ESG compliance, oil & gas companies have dramatically reduced capital spending in the past few years.  That's not a good sign for oil supply.  Most oil projects that are not shale require a few years to ramp up production, and its safe to say that most of the easy pickings have been drilled, so the stuff that's left over is going to take longer and require more investment.  

There is lots of other research that have confirmed both less capital investment, higher than expected demand in emerging markets, and relatively inelastic demand in developed economies to higher gas prices (much higher than implied by crude oil prices, due to extremely high crack spreads).  And that's not even mentioning the ridiculous energy policies in Europe and America, that have focused on renewables and have shut down nuclear power plants, slowing the growth of power generation capacity, increasing demand for natural gas, even to the point that natural gas was twice as expensive as oil in Europe, prompting power companies to switch from gas to oil.   

From everything I read, from reviewing the data, from the price action in oil, natural gas, and coal, it all points to a super tight market for energy.  An energy shortage looks to be inevitable, its a perfect storm where the market can only be balanced in the short term by demand destruction.  And energy demand is much less elastic than people think.  People in America complain about $5-6/gallon gas, but that would be considered an absolute bargain in Europe.   Its going to take a big sustained increase in energy prices to get the required demand destruction to balance this market.  It won't be able lean on SPR releases, or count on China regularly locking down and keeping a zero Covid policy forever.

The plan is to hedge my energy longs with shorts in NDX and overpriced tech (ARKK, TSLA, etc.) after the CPI on Friday.  Still giving the bulls more room to roam, I have a feeling that they'll get excited and bullish after the CPI report this Friday.  Also you tend to get that upward drift into the FOMC meeting in the days ahead of it.  Plus VIX expiration, which will close out a lot of VIX call options, more than puts of course, which should help to suppress vol next week.