Long-term bullish factors for oil

The headline on Marketwatch blared that the BP spill may lead to higher oil prices. Indeed, Jeff Rubin has expressed similar sentiments about how the Deepwater Horizon disaster is likely to affect the supply situation for oil (see examples here and here).

I agree wholeheartedly. My latest monthly comment for Qwest Investment Management details these same supply concerns. I would also add the possibility of higher heating demand from a global cooling cycle.

There is a controversial view that solar cycles are responsible for the warming and cooling cycles on earth. The English astronomer William Herschel noted a relationship between sunspot cycles and wheat prices and that link has been confirmed by other researchers.

Right now, the sun is undergoing an extraordinarily quiet period and tracking previous periods of global cooling. If the climate were to cool, which would raise heating demand, and oil supplies fall because of higher operating and environmental standards – look out!

Come and read it all here.

Global cooling: Profitable contrarian investing?

I have penned a new monthly newsletter for the folks at Qwest Investment Management entitled Global cooling: Profitable contrarian investing?

Here is the abstract:

While it is critical that we take serious our collective responsibility for the health of our global community, scientists today are debating the real cause of global warming and most recently the cooling trends. Prudent investors should monitor these debates as they may have an impact on their portfolios. For example, if scientists conclude we are now going through a global cooling phase, this would certainly impact pricing and/or demand for certain agricultural and energy commodities and subsequently affect portfolios.

This is a controversial topic. For those readers who would label me a denier, I would reply that I stand in the same camp as Phil Jones of the CRU when he stated in a BBC interview that:

It would be supposition on my behalf to know whether all scientists who say the debate is over are saying that for the same reason. I don't believe the vast majority of climate scientists think this. This is not my view. There is still much that needs to be undertaken to reduce uncertainties, not just for the future, but for the instrumental (and especially the palaeoclimatic) past as well.

Notwithstanding Al Gore's latest op-ed in the New York Times, I remain agnostic about whether the Earth is warming or cooling, or what the possible causes of any warming trend is. As an investor, however, we have to be aware that the consensus may be shifting and the big money can be made by correctly going against the crowd, especially when the crowd turns in your direction.

Consensus shifts ahead of Copenhagen

There are many crowded trades in life and in finance. One crowded trade that I am comfortable with is “the earth is spherical” trade. If the consensus was to shift off that paradigm, analysts would, after the fact, label that view a “bubble” and the market fallout from such a change would be extremely ugly.

After the hacker break-in at CRU, I speculated on what the possibilities might be should the consensus change. Today, as the world looks forward to the Copenhagen summit, the market consensus seems to be starting to shift as a result of the CRU incident. Avner Mandelman recently voiced his skepticism about climate change thesis and the issue of researchers either fudging data or denying others access to data:

Say that a pharmaceutical company's researchers were caught fudging their tests to make their drug look effective; then, when found out, conveniently lost the non-fudged data. If a doctor prescribed for your child the fraudsters' drug, would you let her take it? If you said yes, would we not be justified in saying you are acting irrationally?

If you missed the controvery, the issue isn't about just how a researcher might have used some "trick" to fudge data so that it would agree his model, but the distressing lack of discipline in the scientific method. Judith Curry, an American climate scientist and no skeptic of the climate change thesis, was appalled [emphasis mine]:

What has been noticeably absent so far in the ClimateGate discussion is a public reaffirmation by climate researchers of our basic research values: the rigors of the scientific method (including reproducibility), research integrity and ethics, open minds, and critical thinking. Under no circumstances should we sacrifice any of these values; the CRU emails, however, appear to violate them...

If climate science is to uphold core research values and be credible to public, we need to respond to any critique of data or methodology that emerges from analysis by other scientists. Ignoring skeptics coming from outside the field is inappropriate; Einstein did not start his research career at Princeton, but rather at a post office. I’m not implying that climate researchers need to keep defending against the same arguments over and over again. Scientists claim that they would never get any research done if they had to continuously respond to skeptics. The counter to that argument is to make all of your data, metadata, and code openly available. Doing this will minimize the time spent responding to skeptics; try it! If anyone identifies an actual error in your data or methodology, acknowledge it and fix the problem.

Meanwhile, the financial market consensus appears to be starting to shift. Donald Coxe, former Global Portfolio Strategist at BMO Capital Markets, also indicated his doubts about the global warming thesis. In reporting on Coxe, a reporter commented:

My purpose here is not to weigh in on Mr. Coxe's theory of climate change (which mostly has to do with sunspots) or those of the scientists who disagree with him. But he is worth listening to in this respect: The big money is always, always made by those willing to bet against a deeply held consensus. So if, five or 10 years from now, new evidence has thrown theories of global warming into doubt, enormous profits will be made by those putting their cash on that outcome now.

Quantitative finance = science
While I have my own personal opinions about climate change, I have learned to be flexible and open-minded about my beliefs as an investment and quantitative analyst.

Quantitative finance is much like science. We observe, we form our hypothesis, we test our hypothesis and we try to apply them. If the evidence changes, our models have to change too.

I have observed situations in the past where people have been dogmatic about models and investment processes despite evidence to the contrary. In the short term, these people may be successful in the short term. In the long term, the market will punish them for their views if they are wrong. Some of these models were built by analysts with incredible stature. Not only do some of these people have Ph.D.s from top universities, published in leading peer-reviewed journals, a few are even Nobel laureates.

In fact, why don’t we start a hedge fund with some Nobel laureates, we’ll call it Long Term Capital Management….

Here’s another idea. Let’s take some of these models of mortgages and apply them to how we package mortgage backed securities. We’ll slice up the mortgages into different tranches, from senior to junior and…

Oh, I remember how that turned out.

Good quantitative modelers observe, form hypotheses, test and apply them. So do good scientists.

We all need to thimk and watch out for errors in our data set and assumptions.

Global cooling?

I woke up on Saturday to see the New York Times headline Hacked E-Mail Is New Fodder for Climate Dispute. The New York Times headline editor was restrained while others were far more outraged. As an example, Mish’s blog stated the story as:

It's now official. Much of the hype about global warming is nothing but a complete scam.

Thanks to hackers (or an insider) who broke into The University of East Anglia's Climatic Research Unit (CRU) and downloaded 156 megaybytes of data including extremely damaging emails, we now know that data supporting the global warming thesis was completely fabricated.

He went on to detail some of the incriminating emails in his blog post about the alleged conspiracy to fudge the data. You can also see the emails here.


Sunspots and global cooling
Before the news of this hacker break-in, there had already been skepticism about the global warming thesis. I had previously speculated on this topic in a post:

What I am writing here may be sacrilege to some people. The popular consensus about Global Warming is that the Earth is undergoing a warming period caused by the effects of industrialization. However, there is another view that global warming is caused by solar activity – sunspots and solar winds.

Currently, the forecast for the latest solar cycle is that it’s late. Such extended cycles have been associated with cooling periods such as the Little Ice Age experienced a few hundred years ago. Indeed, there have been reports that there is more ice in the Arctic (yes – it’s only one data point) and there has been some hand wringing among the scientists about the timing of the solar cycle.

Is this theory about solar activity correct? I have no idea. I do have allow for the possibility that it is a valid one and should the Earth enter a cooling period, this would be bullish for energy demand and result in higher energy prices.

There are links between solar activity, climate and commodity prices. In 1823, William Herschel reported finding a correlation between sunspot activity and wheat prices. In June 2009, NASA announced that a Dalton Minimum is possible, which implies that world could undergo a period of cooling.

I am not investing based on global cooling as my base case, but what happens if Mr. Market decides to price in the possibility of global cooling?

What do you think that would do to energy demand if the Earth were to undergo a period of global cooling?

What are the possible effects on food production and commodity prices?

Just thinking out loud...

More constructive on crude oil

In retrospect it was easy to call the top in oil. When cartoons like this appeared it was clear that high oil prices had penetrated the public consciousness – a contrarian sell signal.

Now that the oil price has descended about $30 from its peak and other commodities have also been hammered, it’s time to become more constructive on crude. While downside risks remain (e.g. cyclical US slowdown affecting commodity prices, China slowing, US$ in rally mode, etc.), I would like to review the bull case for oil prices and detail the reasons why I remain a long-term oil bull.


Peak Oil
I could go on and on about Peak Oil but I refer you to the site Oil Drum and Matt Simmons’ speeches for more detail. It isn’t about the world running out of oil but more about world oil consumption running into extraction limits. Robert Hirsch wrote an important report for the US Department of Energy back in 2005 discussing these concepts and how to mitigate their effects.

Peak Oil Concepts

Peak Oil mitigation: 9 women can’t have a baby in 1 month
Hirsch’s conclusion was that the US needs to invest in alternative technologies now, because mitigation technologies take time. Put it another way: nine women can’t have a baby in one month – no matter how hard they tried.

If we are indeed facing Peak Oil in the immediate future then the secular trend for energy prices is up and will continue to rise until a combination of alternative energy and conservation measures kick in. This bull would have a long way to go.


Global cooling?
What I am writing here may be sacrilege to some people. The popular consensus about Global Warming is that the Earth is undergoing a warming period caused by the effects of industrialization. However, there is another view that global warming is caused by solar activity – sunspots and solar winds.

Currently, the forecast for the latest solar cycle is that it’s late. Such extended cycles have been associated with cooling periods such as the Little Ice Age experienced a few hundred years ago. Indeed, there have been reports that there is more ice in the Arctic (yes – it’s only one data point) and there has been some hand wringing among the scientists about the timing of the solar cycle.

Is this theory about solar activity correct? I have no idea. I do have allow for the possibility that it is a valid one and should the Earth enter a cooling period, this would be bullish for energy demand and result in higher energy prices.

Heebner still bullish on Energy
In s post back in early June comparing Bill Miller and Ken Heebner, I noted that Ken Heebner had a hot hand largely because of his overweight position in resources and underweight position in Financials. Moreover, Heebner does not hesitate to turn over his portfolio if he thinks that it is positioned improperly.

The chart below shows the Heebner’s latest imputed position in the Energy sector. Despite the recent rally in Financials and the air pocket hit by Energy, Heebner may have trimmed back some of his Energy overweight and is now adding back to his position.



You have to respect Heebner's views given his record.


Investor sentiment is bearish
Finally, in the short term, investor sentiment on crude has retreated to levels that warrants taking a less bearish stance. While oil prices may not rocket up from these levels, these readings do suggest a period of stabilization or consolidation in price.

A nervous bull on oil
Given that oil prices have retreated about $30 from their peak, I believe that the near-term upside and downside price risks are far more balanced and would be inclined to be more constructive on the oil price. Does that mean that it can’t go down any more? Of course not, there remain substantial risks to buying here. However, if you are playing the odds then the probabilities are now tilting more in favor of the bulls.

Addendum: The chart estimating the CGM Focus position in Energy has been corrected as the previous x-axis was incorrect. Apologies for any inconvenience.