Oil’s Well That Ends Well

March 20, 2015

The primary reason for our trades of 3/13-3/16 was to cut back on our oil short, DB Crude Oil Double Short ETN (DTO), which has performed very well in the Powerfund Portfolios, even without a collapse in either the global economy or the stock markets. We wanted to get out of utilities and floating rate junk bonds and also to use the recent major slide in the euro to get back into foreign bonds after a long hiatus. We rebalanced the portfolios a little, too. 

But first, oil.

Oil, like most commodities, was in a bubble from over-investment. It had almost nowhere to go but down, eventually - the key word being ‘eventually’.

We’ve been short commodities of one type or another in some of our portfolios for much of the last seven years, and this is our second triple-digit gainer (the first being DB Commodity Double Short ETN [DEE] for a 389% gain in the first leg of the commodity crash in 2008-09). Those who have been following the Aggressive portfolio for a while know we have been short oil for quite some time, waiting for this collapse. In fact, this position was added to after a post-purchase drop in 2011. 

You can’t predict when a boom or bubble will end and it’s very difficult to profit from the collapse. Some hedge funds went out of business in the late 1990s, shorting tech stocks too soon. Moreover, inverse ETFs and ETNs are an imperfect vehicle at best.  

Our entire DTO position, including the partial sale, is now up from the original purchase by about 70%, but the shares added along the way are up over 200%. The first 30 shares (these portfolios have been real money since 2010 - we trade at TD Ameritrade) were purchased on 9/19/2011 for $65.28 a share with commissions. On 08/15/2013, we essentially ‘doubled down’ and bought 70 shares for $31.61. We have just sold 60 shares for about $111 a share - a 250% gain on the new shares, a mere 70% gain on the original shares. On the total position in dollars, we’re up about 175% at the recent price of $120 a share (we still own 40 shares). Note that the performance on the website shows only the gain percentage since purchased, not any gains (or losses) from buying additional shares. (It is not an internal rate or return or IRR calculation - the performance online merely shows you the performance of a fund while we owned it from start date.)

We predict that, long term, oil will remain in the $30-40/bbl range, adjusting for inflation for the majority of the next 10 years. If we get another spike in oil as we did a few weeks ago - which took this ETF down briefly but substantially - we will consider buying more, if no better options for benefiting from economic collapse appear. 

The bottom line is that the oil bubble has largely gone. The usefulness of shorting oil as a hedge against a global recession remains.

In the meantime, we’re keeping some of the oil short, which has become increasingly volatile as short-term gamblers have entered the fray on both sides. Oil may keep falling as the commodity money leaves the table and goes into overpriced healthcare and tech stocks. The oil short also gives us an angle on a continuously rising U.S. dollar, which will hurt our latest addition to the portfolio, Barclays International Treasury Bond Fund (BWX).

Other Sells

We sold American Century Utility Income (BULIX), a long-term holding that has done well, considering  its lower-than-the-stock-market risk level. Ideally, we would have done this a few weeks ago, before performance for utilities lagged. Our rating on utility funds has been sliding for quite some time, as the category has become more popular. 

We dumped DoubleLine Floating Rate N (DLFRX), not because the fund has been a bad performer, but because our reasons for owning never materialized. In hindsight, we should have just owned more long-term investment grade bonds, but we already hold more of this category than almost anybody and wanted something with less interest rate exposure that wasn’t stocks. 

We thought it was possible that this popular but illiquid asset class of floating rate bank loans would go up in price with massive inflows by investors – particularly DLFRX on the success of DoubleLine’s other bond funds, which we owned during the golden years of asset growth and top performance. This never really happened, or not enough for big gains – roughly 5% over two years…Well, it’s better than cash, but not for the heightened risk. The secret is that these floating rate funds are really a type of junk bond fund and can collapse 15-30% in a recession. That’s too much risk - a risk many people are willing to take today (which is why it’s a bad risk).

The Buys

Our latest buy (SPDR® Barclays International Treasury Bond ETF [BWX]) is a pure foreign bond fund to capture the eventual rebound of the euro – which probably won’t happen anytime soon. In fact, while the euro is now at decade-plus lows, it's been even lower.  

Euros are currently not far from parity with the U.S. dollar; one can be had for a mere $1.06. A few years ago, during peak anti-U.S. economy and dollar insanity – a euro cost around  $1.60. But once they were as low as $0.80. At that time, we wrote about our optimism about the euro and soon loaded up the truck on foreign bond funds for our model portfolios  – both emerging and developed markets - and did quite well as the dollar collapsed and investors fled the U.S. We’ve been essentially foreign bond free (most regular bond funds own some but we have been out of pure foreign bond funds) for over seven years. Near perfect timing considering the U.S. dollar stopped falling around that time.

When the euro eventually climbs, euro-denominated bonds will rise. As there is even less yield abroad than in the U.S., this is not about yield. It’s about having a potential gainer that is cheap to own, is reasonably safe, and is not U.S. stocks or more U.S. bonds. It is entirely possible the euro will overshoot and we’ll get back to eighty-cent euros, in which case we will increase this stake significantly and wait. And wait. Someday, there will be a nice 10%-30% capital gain here, and even if it takes five years, that is still better than cash and short-term bonds these days. We probably won’t make the super money we made in the early 2000s, because the euro will not see $1.50+ for many years, and the current bonds in this portfolio don’t have 5% yields like the good old days. Some of the yields abroad are actually negative today.

We are sort of insulated from a further falling euro(which will hit this fund) by being short gold and oil. We may lose 10% here but will gain 25%-100% in the shorts (or vice-versa). And, for the record, a euro can’t go to twenty cents, because I and many others will buy a villa in Italy for $50,000, pushing the euro back up.

Somewhere along the way we may increase our stake in foreign stocks, especially in Germany and Japan, which, as major exporters of quality goods, benefit from low currencies.

The only reason not to be more optimistic about investing abroad – after essentially six years of foreign under-performance – is that investors at large have been recently, and are still, buying foreign stocks. We’d like to be the only bottom fisher. This is why we still have mostly U.S. stocks and bonds.

A Final Note On Commodities

Perhaps commodities collapsed because inflation never materialized. The real explanation is that over-investment leads to under-performance. This is especially true of commodities, which have no real long-term investment potential when you factor in the costs of hoarding commodities (either with actual physical product or futures market contract rolling), the fees of the funds themselves, and the lack of dividends or income to offset these costs. 

Moreover, I've yet to see the commodity that can grow in price faster than inflation for long periods of time in the face of massive investment in new production. In the short run, anything is possible. This, of course, does not bode well for gold, which we remain short, even though we have yet to make a bundle on the position like our oil short (we are up ~25%... but we’re looking for our third triple-digit commodity short gain here, folks…we can get 25% safely in normal funds). Gold peaked in 2011 at $1,920 and is now at $1,148. Unfortunately, that 40% slide has been slow, unlike oil, which fell from $100 to near $40 in a few months. The slide should quicken as gold goes back below $1,000 – the scare point for the gold hoarders.