Do exchange traded futures matter when there are also swaps and forwards?

In a word: yes. I wanted to post a follow up to a comment to my recent post “2015 Futures.” That comment argued, contrary to my own position, that the availability of crude oil futures out to 2015 didn’t substantially improve the ability of oil producers to ensure profitability of “expensive” oil ventures. Here it is:

Producers could fix their revenues out 5 yrs well before this listing. 1st, most large hedgers are likely to use calendar averaging swaps, not futures (which impose onerous variance margins, ie ongoing cashflow swings .) Swaps are cash settled against an index (typically NYMEX but often Platts) and are secured by an ISDA agreement and the balance sheets of the contarcting parties. Margin isn't assessed day to day so often it amounts to a long term loan.

The interbank market has quoted long dated swaps in these tenors for some time. Morgan Stanley and J. Aron are two of the larger market makers, but any highly rated investment bank would likely quote something out that far.

It is certainly true that swaps exist, and so do bilateral forward contracts for delivery which are arguably more important in this regard. The reason that exchange traded futures—negotiable instruments—are critical is that they alone most accurately fix the market price that is the basis of swaps and forwards. Any two parties can enter into a contract for delivery of oil at any point and for any point in the future. You can enter a binding contract to deliver oil for $10 a barrel in the year 2099 if you want. The value of an exchange-traded, negotiable instrument is that there is great volume, liquidity, and transparency (here on the NYMEX crude oil pit), and this sets the effective price. The comment above essentially concedes this point in stating that swaps are settled against an index, such as NYMEX. The ultimate point is that the availability of futures out to 2015 (8 years out) is significant because it acts to more effectively fix a value on oil at that distant time, and therefore makes any instrument to “lock in” that price—whether that is a future, swap, forward, etc.—more accurately to the extent that it can index against the value of the NYMEX future.

I should also point out that my choice of “Canadian Tar Sands” as an example was poor, as it is already being produced in significant quantities. I think that the 2015 futures remove one obstacle from producing more expensive tar sands reserves, but the far better example is Colorado oil shale. The oil shale deposits on the Western Slope of the Rockies have been, with some hyperbole, said to be the “Saudi Arabia of Oil Shale.” Well, with the NYMEX December 2015 crude oil contract currently trading at $80.92/barrel (on 619 contracts volume), where are the Colorado oil shale projects??

Well, in a timely enough manner, CNN has an article out yesterday claiming that "Oil Shale May Finally Have its Moment." They claim that Shell is nearing the ability to use a secret new technology to produce oil from kerogen in an economical manner. The article suggests that Shell has been working on this technology for years, and that they may be profitable at $30/barrel oil. Critically, they don't mention when that $30/barrel profitability estimate was made. Princeton Professor and peak oil scholar Kenneth Deffeyes commented in "Beyond Oil: A View from Hubbert's Peak" that "When oil was $3 per barrel, many people said that if oil ever reached $8 per barrel, Green River oil shale would have its revenge on Spindletop and shut down the oil industry." Hmmm... sounds like there may be a sliding scale at work here. Why? Well, the crux of Shell's "secret" technology is to insert probes into the kerogen and heat it over a long period of time, and to surround those heater probes with freezer probes that trap the liquefied kerogen within an ice shield. Sounds energy intensive, doesn't it? If it was an energy-positive process at $8 a barrel when the energy used cost $3 a barrel, and it was energy positive at $30 a barrel when the energy used cost $15 a barrel, it doesn't sound too promising to me. Surely Shell has made improvements, but even IF they get the EROEI of the process all the way up to 1:1, or even 3:1, that is nowhere near the EROEI of our current, depleting sources of energy.

Technology under development in a laboratory is great. Show me the projects.

2015 Futures

I don't remember seeing any press release on this, but for several months now it has been possible to buy December 2015 futures on NYMEX. That's a full 8 years out. Prior to this it was only possible to buy futures 5 years out (CLZ12). Why is that significant? Conventional wisdom is that it takes about 5 years from discovery to commercial production in an oil development, so when you could only accurately price and fix your revenue five years out, you really couldn't hedge against a price drop. Even with oil at $90 a barrel, it was still risky (essentially a peak oil bet) to produce oil that would cost you $50, $60 or more a barrel. Now that it is possible to sell futures 8 years out (currently the CLZ15 is trading at $77/barrel), it becomes a much more conservative financial move to start a project with a projected cost/barrel to produce of $50. On the flip side, this distant future allows fuel consumers to better hedge against future fuel costs.

So, if there are alternatives or expensive-to-produce oil reserves out there, there seems to be less of an excuse than ever. Lots of alternatives claim to be profitable at $50/barrel oil (though I have my doubts based on simultaneously rising metal prices, etc.). If this is true, the ability to sell 2015 futures means there are no more valid excuses to getting those into production today. I've heard people talk about Canadian tar sands, or Colorado oil shale. If these really are profitable at $50/barrel oil, why aren't we seeing more projects starting up? Where are they? Have these people realized that the ability to produce Colorado oil shale at less than $50/barrel is in part predicated on $30/barrel oil as an input (hence a constantly sliding 40% differential on the value above oil that oil shale is profitable)?? Maybe I'm just being pessimistic, but show me the projects!

Thoughts on Oil

Oil hits $86.

I was discussing the reasoning behind invading Iraq with a friend. I suggested that there seems to have been a mix of reasons, but that preserving the petrodollar system and some naive notions that there actually was a terrorist threat from Iraq that we would somehow neutralize by removing the government of Iraq from power were probably two core reasons. He suggested that lots of the pressure came from the oil companies. This is really a no brainer, but I thought his rationale was interesting, and certainly not the standard oil-rothschild-skull and bones-conspiracy stuff. He pointed out that, for the second half of the 20th Century, the western oil majors had a simple business model: discover reserves and produce them. With the onset of the peak oil plateau, this model became invalid. The western oil majors were only discovering a fraction of their own production, and were increasingly forced into mythical write-ups of their reserves to maintain the validity of this business model. A new business model was possible, but it would require a geopolitical smokescreen to disguise the geological peaking of oil production. This new business model: increase the value of existing reserves faster than you produce those reserves, allowing the value of your company to continue to grow despite production out pacing discovery. Interesting thought--along the lines of intentional instability. I still think that oil companies are a terrible investment as it seems likely that their costs will continue to rise and that demand destruction will eventually invalidate this new model. But interesting, none the less...

Another thing driving up oil prices today: geopolitical tensions between the Kurds and Turkey. The bottom line is this: will the PKK attack the Baku-Tbilisi-Ceyhan pipeline? I've been arguing for some time now that targeting of energy infrastructure is the way of the future in asymmetrical conflicts. This seems to be playing out in Mexico, and the Kurds are certainly aware of its effectiveness as it is the attack of choice in Iraq. That said, the BTC pipeline doesn't pass through much ethnically Kurdish territory (it seems to clip the corner of Turkey's Kurdish region just southwest of Erzurum (Map 1 showing pipeline, Map 2 showing Kurdish region). Not that it would be that difficult for the PKK to attack this long and largely undefended pipeline outside of their home region, but it makes it arguably "less easy."

Also, take a look at this excellent article at The Oil Drum on the peaking of various minerals...

The Iranian Gambit Opening

Chess analogies are overdone, but chess is a good way to explain the narrative fallacy--the tendency of humans to be able to explain things in hindsight much better than understand them as they unfold. So I'll explain in hindsight how two current events led to our bombing Iran:

Trying to invade and hold Iran is a fool's errand. OK, so was bombing Iran, but it seems that the we didn't understand that at the time. Rather, we opted for a strategy of bombing key sites, and holding and occupying a few other key areas (Khuzestan, Bandar-e-Abbas, etc.), without attempting to occupy the entire country. In order to do that, we needed to address a force problem: all of our ground forces were tied up on the ground in Iraq. Specifically, the US Marines, the force most capable of larger expeditionary actions, was spread thin in a counter insurgency and peacekeeping role. We needed to make a significant chunk of Marine Corps manpower available for use against Iran. The problem was that the American people (before that rather effective PR blitz and those statements by Hillary) were quite opposed to attacking Iran. We couldn't just pull back an entire expeditionary force into a staging area in some Gulf Emirate airbase without raising several red flags. And anything originating out of the Vice President's office would look suspect, as well. BUT, if we got the Commandant of the Marine Corps to say that the Marines are meant to operate in an expeditionary role, and that they should leave Iraq and go to Afghanistan, that would have exactly the same effect, but seem quite legitimate. Suddenly, the Marines would be nicely staged for aerial redeployment within theater when they would be unexpectedly re-tasked (from their trans-shipment point conveniently near Bandar-e-Abbas) before they were actually spread thin on the ground in Afghanistan. It's easy to explain these kind of set-up moves on the chess board eight moves later, but understanding how today's move is intended to set up an attack eight moves down the road is much more difficult.

Of course, we needed more than just ready-to-deploy Marines. There was that sticky issue of American public opinion that was, at the time, against attacking Iran. Discussions of their nuclear ambitions were too speculative after the WMD debacle, we needed something more tangible. We had been issuing press releases to everyone who would listen that Iran was supplying the weaponry used by Shi'a insurgents against our forces in Iraq for months, but it really hadn't galvanized American behind attacking Iran. However, sometimes your enemy is your friend. The insurgency in Iraq had been operating under a model of open-source innovation for quite some time. They had tried many indirect fire attacks against US bases with mortars and rockets, and on occasion had minor success. It was natural to expect them to learn and improve over time. But this time, their tactical improvements (combined with a re-entry of certain Shi'a militias into a more active role) allowed us to point the finger at Iran. Beginning with the relatively minor but accurate attack on Camp Victory that killed 2 and injured 40, and escalating into the string of more deadly attacks that followed, we were able to spin this increase in accuracy to point the finger not at the expected improvements of an open-source enemy, but as a result of training and improved guidance systems and munitions provided directly by Iran. It was surprising, even to the most cynical among us, how quickly the American people rallied around the flag.

The rest, as the saying goes, is history...

Future Planning: Hedging the Solution Space

NOTICE: The following is not financial advice, and is solely my opinion. If you follow the plan laid out below you will probably lose money. In fact, by following this plan, I hope to lose money. By the end of this post, hopefully, you will understand why.

______________________________

I tend to think that we are on the verge of a global economic and societal collapse driven by diminishing marginal returns on civilization’s investment in complexity—especially by the declining availability of surplus energy. I don’t think that this will result in a single, catastrophic collapse event, but rather in a slow, grinding decline that is masked by epiphenomena and the confusion of symptoms and causes, effectively negating our ability, as a society, to muster the will to take effective mitigation measures. I also think that there is a reasonably high probability that I am dead wrong. I don’t have a crystal ball—all I can do is attempt to project trends into the future, and guess at the outcomes of our massively non-linear planetary-societal system. Humans tend to have a very poor track record at predicting the long-term future—why should I not be subject to the same limitations? After all, conventional wisdom says that things will keep on much as they always have, that we will find a way to overcome. Here’s the grand challenge: if individual or societal plans for the future focus only on collapse, or only on continuation of the status quo, then the high probability that the alternative occurs will be catastrophic. Further complicating matters, there are certainly more than two possible future scenarios. How does one hedge against the multi-dimensional future solution space?

I am beginning this discussion with the assumption that none of us know what the future holds. We can, however, identify possible future scenarios. Not all of them, of course. Rather, I am proposing a “future solution space” methodology that uses current trends or indicators as dimensions. Then, based on my belief that risk is mispriced (based largely on continued reliance on variations of the Gaussian-derived Sharpe Ratio for portfolio risk management and Black-Scholes method of option pricing) and that returns for options on extreme price movements are highly scalable, it should be possible to hedge against movement in any vector in the future solution space simultaneously. Let me offer a simplified illustration:

Oil/Dollar/Dow solution space:

Here is a solution space with three dimensions: dimension 1: NYMEX Crude Oil rise/fall, dimension 2: US Dollar rise/fall, dimension 3: Dow Jones Industrial Average rise/fall.

These three dimensions are an extreme simplification of the possible sets of future scenarios, but are useful as an example and because it is relatively simple to hedge against extreme movements in any direction from the status quo through out of the money options on established futures exchanges. In fact, I think that a multi-dimensional hedge can effectively address this solution space with only 3 options: crude oil call option (betting on extreme rise in price), dollar put option (betting on extreme loss of value), and DJIA put option (betting on extreme loss of value). As a hedge, this set seems to address most of the risk scenarios where a “conventional” investment in a career and home won’t pay off. Can you describe a scenario where one of these three options doesn’t pay, but the economic status quo doesn’t continue? This simplification isn’t meant to address sudden collapse scenarios where the markets simply cease functioning (an identified weakness, which we can also hedge against). But I have a difficult time explaining in advance how the economy could collapse while none of the following—spike in crude oil, drop in the dollar, OR drop in the Dow—occurs. Under most scenarios, at least one, probably two of the options pays off (e.g. Dollar drops causing a spike in the price of dollar-denominated oil but a rise in the numerical value of the Dow).

Example:

Sudden Peak: Oil prices will spike. IF they spike sufficient to cause enough demand destruction to actually fall, that will cause the Dow to collapse. It will likely be accompanies by either high inflation (dollar collapses) or deflation. While deflation is also possible, that would cause the numerical value of the Dow to collapse. Not perfect, but nothing is…

Now expand this multi-dimensional hedge beyond purely financial market considerations. Accept for a moment that the above hedge system is a perfect hedge against any movements in the financial markets (it is not). What could still cause it to fail? Two thoughts immediately come to mind: 1) collapse/conflict is so sudden that markets shut down completely, or 2) popularist laws are enacted that negate the hedge, say by penalizing people who “exploited” the dramatic market swings through options. Under scenario 1, the classic survivalist advice along the lines of “beans, bullets, and gold” may suddenly prove extremely valuable. Under scenario 2, hedges that operate outside the purview of established exchanges may suffice—again, perhaps gold or silver coins. Moving beyond the fixed game-rules of financial markets makes defining and addressing the future solution-space far more difficult, but no less necessary.

Of course, these are intended as hedges AGAINST the continuation of the status quo. You still need a viable plan if things continue as conventional wisdom suggests they will. So, here is a potential outline of a “complete” future plan. It also happens to be what I am presently doing. It is certainly imperfect, but its imperfections should be illustrative:

1. Job for the Status Quo: invest in/prepare for a job that will pay well under the status quo. Personally, I’m studying law, even though I already have a “good job.” I find it fascinating and actually enjoy the area that I hope to be working in—litigation/appellate work with a subject matter focus on energy law. That said, law is probably a terrible choice for most people, but I have been very fortunate thus far in that things are working out according to my master plan:) —as general advice nursing or engineering seem the most prudent. I already have an engineering degree, but I want to be involved at the nexus of anthropology, politics, and the future of energy (an odd combination, isn’t it?), so I have chosen law.

2. Plan for a resilient and flexible “End Game”: I hope to continue to practice law in a capacity that I enjoy for the rest of my life, but I certainly want to be in the position that this is a choice, not a requirement. Therefore I plan to invest some of my income in creating a flexible and resilient “end game”—for me, this is a sustainable, self-sufficient home for my family that will excel in future roles as disparate as a vacation home, retirement location, or a survival retreat. This will be my principal investment, as I think that it will most effectively hedge against the vast majority of scenarios for which there is no effective market hedge.

3. Financial hedge: If the economic status quo continues, the home described above will become my version of a 401(k). If not, my financial hedges are intended to ensure that I can still complete that plan. I plan to follow a variant of the oil-dollar-dow hedge described above—at least until I can think of a better system. I currently have long-term call options on oil and short term puts on the dollar. I think that an investment of roughly 5% of my income will be able to effectively hedge against most financial catastrophe.**

4. The Black Swan: While I think that this future plan effectively hedges against many possible future scenarios, and will increase the probability that I achieve my goals under a variety of scenarios, it is important to recognize that there is always the possibility of something totally unexpected happening that will derail all of these plans. That probability is likely much greater than most people anticipate. Some investment in stored food and water, gold, etc. is probably a prudent way to hedge against at least some unanticipated dimensions of the future solution space. Like a far out of the money option, investment in a few gold or siver coins or a shotgun is a small price, probably won’t be necessary, but has a highly scalable value in certain possible futures. A broad base of knowledge, fitness, and health may be even more valuable.

My intent here is not to slide into self-help or prophecy. Rather it is to suggest that, if you think you know exactly what the future holds, you are probably deluding yourself. If you are not preparing for multiple contradictory future scenarios, then you are not preparing but gambling. What is the optimal hedge—the simplest, cheapest, and most complete coverage against radical departures from the status quo? I’ve proposed the following set: crude call options, dollar put options, Dow put options, 30 days food and water and a shotgun. Call it a future first-aid kit. My proposal is only a starting point, and certainly imperfect. How can it be improved?

It is also worth pointing out that such a hedge is only viable if it helps to achieve a future end-game vision that functions under both the status quo and collapse. In some Mad Max future, 30 days of food and a shotgun is a start, a broad base of knowledge is even better, but the point of the hedge is to get ensure existing plans come to fruition. Taking out a loan now to create that end-game vision in the near future, and then hedging against scenarios that would make you unable to repay that loan over the long term might be (contrary to “conventional wisdom”) more prudent than saving to get there some day…

**This financial hedge is, unfortunately, a bit more complex than simply buying one of each of these three options. For now I’m not going to delve into the intricacies of coordinating the strike prices and expiration dates of multiple options necessary to create a smooth hedge against risk through time. The general advice, though trite, is that if you don’t understand how to invest in options, you shouldn’t invest in options.

Parting question: I think this is a viable methodology for creating an individual plan of action. Can it be extended to a broader, societal plan? Financial hedges tend to be zero-sum in nature, so can't serve as the basis for a societal hedge--would any societal hedges necessarily pay "fair value" for risk, and therefore make hedging against multiple, contradictory future scenarios impracticable??

Visions of a Biofuel Future

Indentured servitude, a workforce confined to the borders of the plantation by armed guards, being "paid" by being allowed to live in unlit huts and drink water from the pig trough. Violations punished by summary execution and burial in an unmarked pit.

This sounds like a historical account of life on a colonial plantation of the 18th century, but is actually the description of the sugar industry, today, in the Dominican Republic. The new film "The Price of Sugar," about the abuses of Hatian migrant workers on a Dominican sugar plantation, tells the story of a Catholic priest trying to organize the workers. (IMDB, NPR story)

Of course, the larger issue here is that biofuel production is dependent on exactly this industry. As long as biofuels are an over-subsidized boondoggle, then industrially raised corn is fine. Well paid farmers driving their John Deere tractors don't present a human rights problem. But as EROEIs decline and we increasingly turn to human labor for biofuels, classical plantation problems will likely resurface in force.

It may be quite some time before Americans are enslaved in the production of fuel for other Americans' cars, but are we so racist/nationalist/blind to accept the enslavement of others to these ends?