This could be the most important column I write all year – and I wanted to write it when the ‘free view’ period was done and only those who had paid their hard earned money had access. I’m about to give you what I think is the best investment I see right now, one that strikes me as having the best risk/reward and available to any subscriber, given just a little work.
You need to be long contracts in the far back of the crude oil curve, with a holding period of at least 18 months.
Yes, it’s a long-term investment and yes, it has margin responsibilities that other equities and ETF’s don’t. But it also takes advantage of a consistent and important mispricing I see in the oil market that delivers a most tasty risk/reward opportunity.
First, buying contracts in the futures market a year and a half or more from delivery takes fantastic advantage of the current shape of the crude curve – a steep backwardation. That means that the pricing of crude contracts as you move further out into the future cost less and less. How much less? Well, with prompt crude for October of 2013 trading at $108 or so, prices for March of 2015 are pricing at slightly under $90 and for December of 2015 at $87. That’s a $20 discount for crude prices less than two years from now.
I consider that $20 to be a true buffer that you can rely upon, helping to greatly increase the risk/reward profile in your favor.
A major reason you can buy back month crude so cheaply is because the vast majority of trading in futures contracts is done in front months. That means equally that the vast majority of what you might call “speculative premium”, the subject of my book on the oil markets, “Oil’s Endless Bid”, resides almost entirely in those front months. Only slowly, with the passage of time, does that premium get transferred into the back end of the curve as these months travel towards the front.
And what about the arguments for a higher price of oil in the future, even 18 months out? We could list the growing nature of demand from emerging markets, the continued geopolitical risks all around the globe and the increasing costs of finding and developing new sources of crude from ever more difficult and dangerous places. Whatever your theories on oil, the long-term chart on crude oil prices is incredibly steady. Since 2008 and the great collapse of the energy markets, every year has seen a higher low, if not a higher high – and the market has never delivered so deep a discount into the back months that are trading than they are now. Unless you are predicting or expecting another financial crisis like the one we weathered in 2008, back month oil money strikes me as a fantastic opportunity – maybe the best I’ve ever seen.
This is a complete patience trade. You will experience ups and downs and the lion’s share of the profits won’t be seen until the last 3 months before delivery date approaches and most likely in the last several weeks.
Every six months or so, you need to replenish longs further out on the curve, so as contracts come due for delivery, you’re reinitiating positions 18 or 24 months back out on the curve. And this plan requires 3 to 5 years of consistent monitoring.
Back tested, this system has worked well, but particularly now, with the state of the curve, it should work far better. It’s not for the faint of heart or those investors afraid of the futures market, but for a small piece of a portfolio, it’s something I strongly recommend.
I don’t think this is a great trade for the year, I think it could be the best trade you’ll see this decade.