When I add a position, my first question is always the same; is there a way to hedge this? To most people, a hedge means buying puts or shorting an index, both of which have carrying costs and a certain drag on performance. Furthermore, you often learn that it didn’t quite hedge things the way you thought it would. I have lost track of how many times I have tried shorting the Russell 2000 against a concentrated basket of small cap equities and lost my mind as the two positions diverged. There is nothing more frustrating than having your portfolio tread water or decline, while your short hedge goes parabolic.
A good hedge is something that offsets the risks to a position in your portfolio, yet will go up on its own accord (shorts make terrible hedges). There’s a reason that Risk Parity has done so well in a deflationary environment—treasuries usually offset equity drawdowns, while marching towards the zero bound over time. However, I tend to invest in individual esoteric equities or make sector bets. Treasuries have no correlation to what I’m doing, positively or negatively. Instead, I try to think creatively about my portfolio, my exposures and what can kill a thesis. Often, I cannot find the right hedge, but sometimes I do. Sometimes, it’s so perfect that I realize I can just max out both positions because it’s almost risk free.
Take my oversized tanker position; what is the only way the thesis gets hurt? If oil producers cut back more than demand drops and we don’t top the tanks. I had already been eyeing natural gas as byproduct liquid production was pulling back, potentially letting gas prices rise. As soon as COVID-19 quarantines started in America, I realized that wells would ultimately have to be shut in and drilling would cease. Will they fill the storage tanks before oil hits equilibrium? If they don’t, it’s only because the US and Canada cut back more rapidly than expected. In that case, gas supply will plummet.
In the days after I wrote about natural gas, people doubted that gas pricing could ever recover. Now, with the gas strip elevating, I see many people echoing my thesis. As you can imagine, many of the near-dead natural gas equities have rallied dramatically. While the fully solvent ones have doubled, some of the more fringe ones are up five-fold or more. The ‘Kuppy Maxim’ states that “The most money in investing comes from when a situation goes from hopelessly fucked to sort of shitty.” This has proven itself true once again.
I never set out to be a natural gas investor. It’s a terrible business with endless capital destruction. The management teams are terrible and there is always more capital available for someone to drill wells at a negative IRR and destroy everyone’s economics. If gas prices rally too far, competing energy sources encroach. This means that cycles are short and sharp. That said, there are brief moments where it works and I think that 2020 will be one of those. I also wonder how much of this recovery is already priced in. While the share prices are only fractions of what they were a few years back, on an Enterprise Value (EV) basis, nothing has really changed. If anything, the EV is higher due to increased debt. While I had planned to own these natural gas positions for longer as I suspect that they go higher, I also recognize that the easy money on many of them has already been made. It’s hard to ignore multi-baggers in six weeks.
Now, with the oil prices a few months out kissing up on $30, I’m wondering how many guys actually go through with their announced shut-ins. Oil guys are in the oil producing business (even if it is at a loss), they’re not in the shutting-in business. They are itching to waste shareholder capital drilling. Oil supply builds have slowed, they haven’t stopped. Everyone is modelling more shut-ins and lower production. I’m wondering if this is a giant head-fake as supply keeps coming.
As production declines became consensus, I booked the majority of my natural gas exposure this week. I’ve kept my Sandridge (SD –USA) because it’s stunningly cheap (I’m also the ultimate bag-holder there), along with one other dry gas producer and a basket of puts I wrote. I’ve used the proceeds to average down on my floating steel mainly by writing puts at insane volatility levels. Last week, with tankers at their highs and implied volatility screaming, I wrote enough calls to earn a mid-single-digit percentage return on my tanker book. I never thought an equity could swing so wildly that I’d be able to also write put legs a few days later. You guys trading these tankers are silly. Stop, deep breath, think a bit.
Most of these tankers trade at historically high discounts to NAV at a time when they have record earnings. I remain convinced that charter rates stay unusually elevated for a very long time due to storage demand. The contango will fluctuate wildly, charter rates will swing around. Please stop emailing me about what to do. I’m not your personal financial advisor. The oil glut keeps building and it needs to go somewhere. The contango is just a way to measure the price of storage at a moment in time. Stop asking what I’m doing with my portfolio. Unless you’re an investor in my fund, it’s none of your business. Stop freaking out when rates jump around. VLCCs mainly transport OPEC oil. Do you think the cartel focused on fixing the price of oil ignores the cost to transport it? They play games. They withhold cargoes. The members of OPEC may hate each other, but they hate high charter rates more.
Please, look at the chart from 2002 to 2009. Look at what rates did. They bounced around a LOT. They had spikes, they had crashes. All that mattered was the underlying fundamentals. The market is tight and will get tighter every time a vessel is loaded for storage. I look out my window and there are more cars today than last month, but it’s nowhere near normal. No one is flying. A bunch of countries are still locked down. Go back to my original thesis. 50 days at 20 million barrels of oversupply, then 100 days at 10 million barrels. It seems like the 50-day period likely averaged a bit over 20 million barrels and the question is; what happens over the next 100 days? It seems as though we’ll be building less than 10 million a day over that time, but we’ll certainly get past 1.5 billion of surplus and probably a few hundred million beyond that. A LOT of tankers are getting tied up in storage deals. My expectation was that it would be the crude tankers that bore the brunt of the storage demand, instead, it seems as though the product tankers are where the storage crisis is most acute. There’s a reason I run a diversified tanker book. I want exposure to the nuance.
Over the next few weeks, I think the narrative swings away from the shut-ins and shrinking oil supply and moves towards the steadily building glut. Even if we were to hit peak storage tomorrow and start drawing down, what’s the right price for an equity at less than half of NAV at a time when charter rates are at all time highs due to storage tying up vessels? It’s not like we’re going to work down this glut anytime soon as I don’t see how global demand gets past the low 90s before year-end.
In any case, this isn’t a tanker article. You all know where I stand. If the thesis changes, I’ll say something. Rather, this is a victory lap on natural gas. I got schooled last year, but I got it all back and then some. Most importantly, these gas positions perfectly hedged my tanker exposure.
Every position out there has a perfect hedge. I don’t think investors think deeply enough about offsetting positions. Look through your book and think creatively. The best portfolios are those that are able to withstand any event as the various positions offset each other with multi-bagger potential.
Disclosure: Funds that I control are long a basket of tankers, short puts and calls on various tankers, long SD and have various other natural gas equity and option exposures.
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