We seem to have these talks about every year
you are right. we are on the same page on peak oil. it's just different ways of playing the same game. i don't believe there is only one "right" way to play it. it all depends on a person's risk tolerances and objectives.
still, even if different people have different risk tolerances, they can agree that the more risk you take, the more reward you should get, and the less reward you are after, the less risk you should be taking. also, obviously, each investor should try to maximize his reward at any given risk level. as i will explain below, i think people can overestimate the benefits of extreme risk-taking and underestimate the benefits of more moderate risk-asset weightings.
my own perception of risk is colored by my experiences in the tech bubble and its aftermath. i made my bankroll in the tech bubble, and managed to hold onto most of it, but i saw a lot of people get wiped out. an entire lifetime's worth of savings wiped out in a few months.
i would not be at all surprised if the sharp corrections we had in the energy sector from last August through this January wiped out many leveraged players who had substantial nest eggs in six, seven, and eight figures--sums that would be difficult or impossible to replace through conventional savings. and of course, there was Amaranth, losing $6 billion of a $9 billion portfolio in one week. (apparently the "star" trader, Brian Hunter, is opening a new hedge fund. heatherwilliams.wordpress.com )
there WILL be more such wipeouts in the energy sector in the years ahead, even if every one of Matt Simmons peak oil fantasies proves true. more people will go back to their day jobs, or perhaps become "gurus" and try to sell their wisdom on the internet.
in 2001-2002 i spent a lot of time reading about portfolio theory. i decided i couldn't have the kind of gunslinging approach i'd had earlier on in tech stocks, when i was 100% options and routinely experienced fluctuations of 20% up or down on a daily basis. i no longer felt like i was playing with "house money" that i could lose. i knew that this money was irreplaceable by traditional savings methods and i'd seen people lose that kind of money before.
that's why i decided the most important thing in investing is not to blow up. plenty of wiser, more experienced investors than myself have made this observation. Richard Russell, who's about as Ancient Mariner as they come nowadays, always says something like "Whatever you do, don't take the big hit". Taleb wrote a book on the subject (actually, two). Niederhoffer lost hundreds of millions because he blew up. what business does a centimillionaire have taking risks that could wipe him out? sounds crazy, but it can and does happen, and the easiest way to let it happen is to use too much leverage. gladwell.com
anyway, back to Modern Portfolio Theory. MPT looks at the universe of combinations of risk and reward--think of it as an x-y graph with risk on one axis and reward on the other. generally, things that are risky and have a lot of reward; and things that are safe have less reward. but sometimes there are relatively safe investments that provide a lot of reward, and relatively risky investments that provide little reward. and combining assets with differing covariances can result in portfolio behavior that provides more stability, and more performance "bang" per increment of risk "buck".
MPT seeks to define the combination of assets at each degree of risk that will provide the maximum prospective reward for that risk level. the entire curve of these combinations, at each risk point, is called the efficient frontier. if you want to read about it you could do worse than buy Bill Bernstein's excellent The Intelligent Asset Allocator and check out his excellent free quarterly at efficientfrontier.com (do read the back issues).
it is easy to poke holes in MPT--the way risk is defined, the fact that the efficient frontier can only be know definitively in retrospect, the existence Warren Buffett, and so on. but those weren't my biggest problems with it. when i looked at the real world i saw a world that was mostly overpriced assets. while passive and indexed funds recommended by MPT may outperform most investors over a long enough period, if the indexes themselves are overpriced, what's the point of buying them? the market itself is mispriced, and that's a big problem if you want to invest in indexes.
that's why i decided to focus on particular sectors. i was into gold and obscure foreign stocks earlier on, but then i got into the whole peak oil thing in early 2003. i figured after a 20-plus-year bear market, energy was a sector that had a high likelihood of outperforming.
so, that's how i got into energy. but i have kept some vestiges of what i learned from MPT. the most important thing is the equity/fixed income split: what percentage of the portfolio is in risk assets? i typically set this at 50/50 since i am simple-minded and in a chaotic universe, you have to make up the rules as you go along :).
i do like the flexibility that 50% "dry powder" provides. i don't believe the 50% risk-asset PF underperforms a 100% risk-asset PF or a leveraged PF by nearly as much as the risk-asset percentage might suggest. "A 50% mix captures about 12.5/15.6%, or 80% of annual equity returns with only 7.5/14.3%, or 52% of the risk as defined by standard deviation." evansonasset.com
i think people overestimate the benefit they will get from leverage (or even full investment) and underestimate how hard it will be on the downside even if they don't blow up completely. and, like i said, with energy in particular, i think it's easy to forget how much leverage the unhedged names have to the commodity.
I still believe you are overstating the downside:
i erroneously wrote "June 08" when i meant to write June 07. what i described was what would happen to somebody buying the June 07 contract last August. for June 08, the experience was a little less volatile but nevertheless gutwrenching.
I guess just about anything is possible but you are assuming that someone is going to make no return on the $83,000 of gain from $67 - $150 and at the same time keep all of their initial 25k tied up.
to begin with, the money you can earn on interest from your margin surplus is nothing compared to what COS dividends will be if oil goes up to $150. believe me, by leaving out the dividends and the cash return i am understating the case for COS relative to the futures if you want to talk about total return.
it goes without saying that there is a theoretical amount of leverage which would provide better returns in futures than an unleveraged holder would receive in COS. but i took your own suggested margin of 25 points, providing 2.7x leverage, and compared that prospective return to the COS prospective return. the futures holder does not outperform.
this suggests that the futures buyer would require MORE leverage to outperform.
more leverage means more risk, which increases the chance of blowing up.
the main thing i don't like about leverage (other than the free opportunity to lose all my money) is that it encourages momentum investing. when energy prices are high and one should be turning defensive, one has more rope to hang oneself with. once energy prices decline rapidly and it would be profitable to put on more positions, the leveraged trader has no excess capital and has to defend his positions by liquidating other assets (selling into weakness).
you describe a situation where you have 573K of equity backing around $3 million of CL contracts. that's a little over 5.2x leverage (almost twice the leverage you suggested by talking of 25 points safety margin), so if CL goes to 150 it's not surprising that this will provide a huge gain on equity. but with only about 9 points of drawdown, you obviously could get a margin call. yes, you may cover that call by moving cash from another account, and then if push comes to shove drawing down a million in margin from the Ameritrade acct. but the Ameritrade acct is tied up in energy equities, right? if CL does tank into the 40s, those collateral equities are likely to tank as well. so you might be selling into weakness to raise capital.
Many people are going to become incredibly rich by investing in oil over the next few years. I intend to be one of them.
i hope that works out for you. if it does, my plays should turn out OK, too. |
