Energy Trading – Background

There is so much attention on oil prices that it seems like CNBC has become the Energy Channel.  It is not surprising.  The energy "sector" is up over 20% on the year and also accounts for the largest segment of earnings growth.  The S&P uses the term "sector" as it is defined in Morgan Stanley Capital International’s Global Industry Classification Standard (GICS).

Many — perhaps most — of those in the parade of talking heads on CNBC, and online pundits as well, talk about energy in this same broad fashion.  Everyone wants to act informed, including those who paid little attention to energy stocks before this year.  The result is that nearly everyone says things like "You have to own energy," or "We like the energy names," or "We have been doing well in energy."

Our own sector definitions are much narrower, more like the sub-industries in the GICS system.  For trading purposes these definitions are much sharper.  Here’s why.

The broad energy sector as defined in the GICS system includes a wide range of companies including the following:

  • Companies that own oil reserves
  • Companies that explore for oil
  • Companies that build exploration equipment
  • Natural gas and pipeline companies
  • Refiners – who buy oil from others and sell a finished product
  • Shippers – who transport either crude or refined products
  • Large integrated oil companies who do most or all of these things

The S&P 500 includes 28 companies covering the gamut listed above.

These companies do not all benefit in the same way from changes in oil prices.  Those that have large reserves will benefit from higher long-term prices when they sell the reserves.  More important for stock valuation is the impact on earnings.  A spike in prices may be good for the integrated companies, but have no real implications for the drillers or oil services companies.

More later..

No Inflation???

Pundits on TV and websites express amazement that today’s CPI data show no change overall and only a .1% increase in the core rate.  Writers on Cramer’s site, experts on CNBC, and even Bill Gross all claim that government measures of inflation are silly and inaccurate.  To them, it is obvious that prices are much higher than reported.  Just look at medical care, gas prices, hamburger, or home prices.

That argument sure sounds good.  It is easy to understand, and most people do not think it through any more.  That means that for those willing to get a deeper understanding, there is real opportunity.

Let’s look at some evidence and then try to approach the problem with an open mind.

There are several government indicators of inflation, including the CPI, the PPI, the PCE (focused on wage related costs) and the GDP price deflator.  Greenspan favors the PCE, but the others all get some attention and each is a slightly different measure.  They all show inflation as running about 2 – 2.5%  This is not a bad reading.  It is consistent with a healthy economy.

Another way of looking at this is by turning to the market.  The Treasury now issues inflation-protected bonds.  You can look at the difference between the rate for TIPS and the rate for other government bonds and find the expected inflation.

The result is similar to the inflation readings for the next ten years.  This shows the verdict of one of the largest and most liquid markets — hardly the picture of stagflation that some expect.

So what is wrong with the anecdotal story?  Part II of this series will be the explanation.

Professors and Traders

Professors and traders are at opposite extremes of a continuum related to decision making.  Professors work very methodically and do a lot of careful research before publishing findings.  A lot of effort goes into their writing, so an article or book can take a long time.  Professors can lose reputation if they make mistakes, but they do not generally face immediate financial conequences.  Traders often make big decisions very quickly, with imperfect information, while using simplified analysis.  They usually do not write about it, even to record their reasons.

As someone who has worked in both worlds, I see the blog as my weapon of progress.  While I have the makings of a book — good thesis, nice fit with existing theory, lots of evidence, and some interesting examples — there are some problems in writing it.  First, I do not have a sabbatical year available.  Second, those interested in my work want the conclusions — preferably actionable conclusions–when they are still useful.  (They should also be interested in the theory, but alas they are not.  That discussion must wait for another time).

Conclusion:  I’ll start with some interesting trading topics and examples and sneak the theory in as we go along.  One of my themes will be what works and what doesn’t.  Investment returns that beat risk-adjusted market performance derive from finding market inefficiencies.  There are always people beating the market, but most of them (and their followers) have been Fooled by Randomness.

One type of inefficiency that may provide a lot of opportunity comes from mistaken analysis or information.  There is a bull market in that commodity!  Here is the process:

  1. Find a topic where there is a lot of posturing with little reasoning;
  2. Examine the analytic framework used, the evidence, and the conclusions;
  3. See if there is a way to trade on the opposite side.

Not every exercise will lead to a tradable conclusion.  Many winning investment decisions started with faulty analysis, but something lucky happened.  People can be "right" for the wrong reasons.  There may also be no catalyst, permitting a popular mistake to persist for a long time.

It is important to be very rigorous in this analytic approach.  One must be open and receptive to all ideas, especially those that do not fit one’s current position.  I will stick to issues where I think the evidence of error is very clear.  Comments are always welcome.

Using our three-step method I am drawn first to Energy stocks. I’ll include some of my recent trades as well as an idea that our team is checking out.

What’s it all about….

Why write any of this?  For the best reason:  It is in there and it wants to come out!  Some traders and investors just want to play the game.  Others, like the OldProf, are analyzing, asking why, and trying to figure out whether we were lucky or good.

Mostly I am writing this for myself — at least for the moment.  I have a number of ideas that fit a few specific themes.  There are some interesting notions that could be made better with some reaction and comment, and that is a good use for blogging.  Since I have had some happy consumers of my teaching over the years, maybe it will eventually produce something of more general interest.  For now, this is my workshop, but I open it to comments from anyone who shares the goals of understanding markets better and trading them effectively.

Like many other beginning bloggers I am using this as a way of quickly capturing thoughts during the working day or at odd hours.  I plan to identify some of the major themes right away, even though no particular proof is offered.  These are themes that represent conclusions I have reached — either tentative or firm.  I expect to offer persuasive argument, evidence, and examples as the occasion suits.

This is not a trading blog in the sense that I will describe most of my trades or my daily thoughts.  I will, however, identify some opportunities.  On other occasions I will present a situation that seems to be an opportunity and invite comment about how best to exploit it.