The mark of great writing is encapsulating the essence of a complicated idea in a memorable and accessible way. It’s more than a little humbling that this scene from Landman in a little over 20 seconds does a better job than our previous 90 blog posts and 8 whitepapers in explaining futures markets, economic risk and (with some poetic license) our approach to portfolio construction and CTAs (Managed Futures). In the show, Tommy Norris is a Texas oil fixer and explains oil pricing like this:

“You want oil to live above 60 but below 90. And don’t get me wrong, we’re still printing money at 90, but… gas gets up over $3.50 a gallon, it starts to pinch. It hits a hundred, every product in America has to readjust its price. $78 a barrel, that’s about perfect. You know, brings enough profit to keep exploring, but it don’t sting as much at the pump.”

CTA strategies live and breathe this, in oil and many other commercial markets, participating on the upside through long positions as prices rise, and on the downside through shorts as they fall. The start of 2007 saw oil prices right around $60 a barrel, by the end of the year they were north of Norris’s $90 line in the sand, by mid-2008 they were $140. The GFC had a lot of causes, but it sure wasn’t helped by gas prices squeezing household finances. A few months before Lehman failed and things went really off the rails, FOMC meetings were dominated by inflation and oil fears, the ECB even hiked rates. As the world fell apart through late 2008 and into 2009 oil collapsed, falling some 75% to $35 a barrel, well below the $60 marker.

Fast forward a few years into 2014, prices had recovered and were floating around $90, until they dropped out of the golden range pretty abruptly and averaged $45 for 2015-2016. To paraphrase Norris, $45 isn’t enough profit to keep exploring. US oil and gas extraction jobs dropped by a third.

What’s that got to do with futures markets, CTAs and portfolio construction? Eventually these things self-correct. The best medium-term cure for high prices is high prices, same in reverse. Futures markets facilitate that price discovery — pricing and incentivizing demand reduction in the near term, shifting inventory into the present through the forward curve, and allowing producers to lock in longer-term higher prices as the long-dated curve shifts higher. Locking in the higher prices gives producers certainty on project revenue to expand into production that was uneconomic at lower prices. This hedging risk premium is a two-sided market, the market needs participants on both the long and the short side. In the mid-1980s we created the MLM Index to capture this risk premium and made the case portfolios need exposure to it as a diversifier.

Right now, traditional diversifiers aren’t helping much. Bonds are dropping. Gold is behaving like a risk asset and the new toy, bitcoin, is near the lows. Investors should have some exposure to the CTA premium as it is typically uncorrelated to traditional stocks and bonds and historically in crisis periods it has been decently negatively correlated. As we look at oil prices in the current environment, we see this playing out again. The equity and bond markets moving in lockstep with the oil price, as the multiple contracts and yields shift upwards as oil moves (incidentally, these dynamics are a textbook example of a VaR shock we recently wrote about here).

Our approach is designed to generate maximal skew when the futures risk premium is expanding as that is when you need it most in equity portfolios. This helps match the equity market’s volatility in periods of stress. Oil volatility has recently jumped. Some CTA approaches reduce positions into that volatility. We stick with it. We wrote more about that in this piece. We have no idea how this plays out, but it is a great test case.