Description

Nothing in this post should be construed as recommendation to purchase any investments and nothing should be interpreted as investment advice of any kind.  Additionally, no representation or warranty is made or can be given with respect to the accuracy or completeness of the information.

This is meant to be a thought piece. Most of you will hate it and rank it with a zero. I’d almost be offended if you didn’t…

Anyway, here goes…

I believe many things about oil:

• I believe that peak oil demand is decades into the future, not 2025 or 2030 or some other random number dreamt up by some global acronym agency
• I believe that the marginal cost of the 103 million barrels per day (MMB/D) that the world currently needs and the 105 MMB/D that it will need this time next year is around $70 per barrel (bbl) and that the world needs at least $80 bbl to incentivize production growth from high-cost areas like shale
• I believe that there’s now been almost a decade of insufficient investment in long-cycle oil projects as shale took share and the catch-up phase will take time, if it ever even gets off the ground
• I believe that shale’s production growth has finally topped out with most US basins in terminal decline and the Permian likely to enter decline within the next few years.
• I believe that US shale has effectively been the only real growth in global oil production for almost a decade as growth in some countries has been offset by declines in others
• I believe that oilfield services (OFS) inflation will continue at a rate that is in excess of the rate of inflation, as OFS pricing recovers from nearly a decade-long depression in pricing, while much of the world experiences continued and structural inflation that runs in the mid to high single digits. Meanwhile, more technically challenging basins will cost more to extract
• I believe that the confluence of these factors mentioned above, along with a higher cost of capital due to current interest rates, has deterred investment in oil
• I believe we’re on the cusp of an energy crisis, regardless of if the world has a recession or not

In summary, I believe that the price of oil is going higher, much higher.

On May 23 of 2021, I wrote about Valaris (VAL – USA). At the time it was trading for $21. On Friday, it closed at $75. The IRR has been pretty decent over the two and a half years since I wrote about it. I think Valaris is going MUCH higher. However, I’m not here to write about Valaris. I’m here to write about an oil asset that has barely appreciated since then. I’m here to write about oil itself. (On May 23, 2021, front-month WTI was $63.58 and today the December 2026 contract is $70 or only 10% higher)

Here’s a chart of the WTI curve. Why is it backwardated?? I’m completely baffled. Clearly, most investors do not believe the things that I believe to be true, as noted above. To me, that spells opportunity.

In my mind, the curve should roughly take the marginal cost of production, and add in annual OFS inflation, leading to a 5-10% annual contango. Instead, there is extreme backwardation. Effectively, I think the curve is simply mis-priced.

Here’s the trade, you buy a future like the December 2026 at $70 and you earn a ~5% or better yield on the T-Bills in your account that fund the futures + a roll-up of $21 to current pricing of $91 + the annual rate of OFS inflation. While these last two factors are somewhat abstract, they’re real-world costs. If they weren’t, oil production globally would be expanding as rapidly as demand is, except production isn’t growing as rapidly, because it’s only marginally economic to produce the stuff currently and if you do produce it, you cannot hedge profitably as the curve is backwardated.

Bear with me a bit just in a theoretical sense. There’s 3 years left on this contract, or about $7 a year in roll-up and then at an estimated 10% OFS inflation, you get another $9 a year (10% on $91) + you’re still earning your $3.50 (5% on $70) in money market accounts. So, call it a nice $19.50 on $70 or 27.9% a year potential return on those December 2026 futures currently at $70.

Yes, I know this is super abstract. Yes, I know this return may be super choppy over the next 4 years. Yes, I know this is all super theoretical and somewhat nonsensical, but honestly, why is this not directionally correct?? Why isn’t this a really attractive low-risk rate of return at 27.9% a year?? Oil can always go below $70, but it really cannot stay there long because production collapses at that level and OPEC cuts more. You have a floor there. Maybe it’s a very tenuous floor, but it’s a floor and you can always roll out another year if you get unlucky and it’s a global crisis as this part of the curve becomes less than one year deferred and trades more in-line with spot.   

OK, so this is probably shaping up to be the worst VIC posting ever. I can live with that as I’ve posted enough winners. I told you go give me a zero. But, with the view that we always invert in finance, why not look at the calls instead.

So, let’s spice this up a bit. The December 2026 $100 call is $3.50. That works out to an implied volatility of 17.6%. Excluding the period when oil went negative and the period when Russia invaded Ukraine, WTI has been rangebound between 30 and 60 IV. In 2025, with a year left to these calls, using the lower bound of 30 IV, those calls are worth $1.94 and at a more conservative upper bound of 50 IV, they’re worth $6.62 and the midpoint is $4.28. Effectively, as the option comes closer to maturity, the IV should increase and the option should actually appreciate (all else held constant), at least until the decay accelerates as it matures beyond 1 year of duration. (please pity me as I’m not a quant and some of your quanty friends can probably optimize for when to

roll this out a few years) 

Said differently, you basically have a 2-year look at what happens with these calls and it’s somewhat low risk, in fact, you may actually make some money on this call option, even if oil does not appreciate. Of course, this is all before you get the oil price rolling up the curve organically. This is all before you get your OFS inflation. This is all before the curve adjusts to price in some contango in deferred years. This is all before you earn some interest on this piece of paper as futures options earn you yield on the cash that backs them. At 5% a year, you’ll take roughly 10% off the purchase price in interest income over two years.

There’s no such thing as a free look in finance, but the OTM calls on oil are pretty damn close to a free look at inflation, oil, volatility and a bunch of other things I tend to want to be long. At the 1-year mark, you can just roll them forward again and get another multi-year look.

I own a bunch of pieces of paper along the curve. Some are OTM and some are now ITM. I intend to keep adding and rolling over time, it's all the same trade to me and the individual strikes aren't as important as the conceptual idea that this oil curve is mispriced and the OTM call options along the curve are even more mispriced. I chose to highlight one so that the math was available.

So, gimme that zero rating that I deserve on this terrible writeup.

In the end, I spend a lot of time trying to think about how to get longer-dated inflation protection that really doesn’t cost me much and may even pay me something. I don’t think there are many products better than this, as energy = inflation.

Catalyst

Time passes

Oil goes higher