Emil van Essen has been involved in the managed futures world for 25 years. He has run successful brokerage operations, hedging programs, commodity trading advisors and commodity pools. Van Essen has a passion for finding new sources of alpha. Perhaps it is because he came to the world of managed futures late in the game when the trend following space was crowded.
Instead of looking to build a better trend-following strategy, he listened to all the allocators who were looking for something new. In 2006, he delivered a unique strategy that took advantage of the massive dislocations in commodity spreads due to the expansion of long-only commodity funds. It was unique as van Essen was not simply placing bear spreads in front of the Goldman Sachs Commodity Index (now S&P GSCI) roll — as many traders had been doing — but trading in front of the massive number of traders and volumes that were attempting to take advantage of the roll. In essence, he was front running the front runners. The strategy has produced a compound annual return of 13.99%.
It was part of van Essen’s approach of finding alpha in different places. “What I like is looking for things that have changed, or things that other people aren’t looking at in the same way,” van Essen says. “We tried to get into roll arb when nobody was looking at roll arb in a comprehensive total commodity way. And then we started looking at other things; we are always trying to stay away from mainstream strategies that everybody is doing to try and find ways where there was alpha that other people weren’t looking at.”
It is not simply a desire to be different. Van Essen says he assumes that, “if everybody is on the same trade, then that is probably going to end soon.”
Perhaps this is a reason van Essen is always researching markets and strategies, and he has just launched a new program that is a unique mix of equities and managed futures.
Van Essen has been studying and listening to oil producers for several years, as energy is a major driver of his Spread Trading Program (STP). Seeing the technological improvements in drilling and shale in recent years, he knew there was an opportunity for significant growth in the energy services sector. “They are going to be doing amazingly well and the infrastructure guys are paying ridiculous [margins]; they are very underpriced and are paying huge distributions and they are growing,” van Essen says. So much so that he was investing his own money in the sector before devising a broader investment strategy. It showed promising returns despite extremely low crude oil prices at the time.
He saw two reasons for this. “One was because a lot of them were master limited partnerships (MLP) and a lot of people don’t want to deal with the tax filing issues; and two, with all of the volatility in the last few years in crude oil, people looked at the infrastructure companies as a risky play, but they are not,” he says. “I realized that you could make a phenomenal return if you just buy these companies and hedge out the external risk (mainly the price of crude oil), and you get this amazingly steady return.”
While that is a great trade, and the basis for van Essen’s newest product — the EvE MLP Yield Capture Program — it was not yet a completed strategy. For that, van Essen decided to combine his MLP investment idea with his existing managed futures program, the Eve Multi-Strategy Prgram (MSP), which itself is a combination of van Essen’s STP and the EvE Long-Short Commodity Program (LSCP), which is a short- to medium-term systematic futures program. STP has evolved over the years to encompass multiple commodity spreading opportunities instead of simply capturing roll yield.
“The benefit is that multi-strat is only using 5% margin, which allows us to lever up the MLP side with that unused margin and then hedge out the external risk, which then makes it a lot less volatile and you can get something that yields 20%+ returns,” van Essen says (see “Sum of its parts,” below). “We buy the companies, and these companies have steady distributions (dividends) that they pay out and you can get 9% to 11% distributions and it is growing; that is the key.”
Van Essen points out that the technological breakthroughs in shale oil have allowed the cost to producers to come down from $60 to $70, to $30 to $40 [per barrel]. “They have literally tens of thousands of drilling locations, so there is no question that production is going to expand over the next several years. Even OPEC says we expect most of the slack to be taken up by the shale drilling,” he says. “All these companies are predicting double-digit growth over the next five years.”
What that creates is a massive demand for infrastructure. “Whether it be for fracking, whether it be water systems, whether it be cement, whether it be compression for pipeline shipping, the demand is huge,” van Essen says. “Halliburton had its call and said, ‘for fracking, we are sold out because there are not enough frackers out there to meet the demand.’ These guys are paying 10% distribution and they have a runway to grow probably to 6% a year for the next five years.”
The only thing that could alter that is a collapse in crude oil prices, which is why they hedge out much of that risk.
They hedge 40% of the value of the MLPs in the crude oil market, which reduces 50% of the risk in MLPs based on their backtests, and there are additional benefits. “When you hedge short in crude oil —because WTI typically is in contango — over the years you tend to make several percent extra a year by doing the hedge,” Van Essen says. “If you look at the alpha drivers, you’ve got the returns of the MLPs leveraged up, the returns of the managed futures leveraged up, and the whole point price appreciation of the MLPs as that sector grows; then your hedging of crude tends to grow over years.”
They also can lend the MLPs out as many of them have a high borrow cost.
“The only thing that can create a problem is a dramatic drop in crude oil prices, but that is the point,” van Essen says. “If we hedge it here at $60 [the MLPs] can keep expanding production to 15 years not five years, so there is going to be tremendous infrastructure demand. If crude goes to $50, which it might, we will be fine — production still will increase, just not as much.”
This begs the question, what if crude goes back to $30? Even that scenario won’t be a disaster.
“MLPs tend to trail drilling by about nine months, so if the price collapses, it takes about three to six months for drilling to slow down and then about another nine months for volume to slow down because there are these big projects in progress and they still go through,” he says. “So it takes over a year after a price collapse for MLPs to feel it, and by then the price has already rebounded. If you look at the years with big price collapses in crude oil since the shale boom, MLPs tended to increase their distribution. If crude goes to $30 to $35 the price of MLPs will be killed, but because of that, their yield goes up.”
The strategy makes some of that up because they are hedged and the hedge can results in additional returns if crude is in contango. The program will also increase their stakes in some MLPs when their price drops.
“My original thesis was that when it went down to $30 to $35, you cover the hedge; but then when I backtested it I realized that in that kind of a price environment you get such a strong contango that the short hedge in crude oil earns a tremendous amount of money,” van Essen says. “It probably earns 10% a year on the crude hedge. At $30 a barrel the front contracts are going to be a dollar in contango, so every time you roll you collect $1 every month, and that’s $12 a year. Even if it is 60¢ to 70¢, that’s $7.20 a year on a price of crude that is $35, that’s 20%. You make a tremendous return just on the hedge and the MLPs are still generating cash flow.”
Van Essen uses Knot Offshore Partners LP (KNOP) as an example. “All their revenue comes from long-term contracts from the largest oil companies in the world, like Petrobas, BP, Shell, etc. And, by the way, if they don’t get paid, they don’t shuttle the oil, and if they don’t shuttle the oil the company stops making money; so they have to get paid,” he says. “Most of these companies don’t have a contract coming due for years, so their yield is not going to change one iota.”
The bottom line is that the strategy can still make money even if the price of crude collapses. The MLPs are relatively resilient to short-term price movements. “In a couple of years, things would flatten out, but when the price of oil collapse the producers get hammered, but the MLPs tend to do fine because it is a volume game for them. Their growth trajectory would stop, but they will continue to make money,” van Essen says.
Van Essen is a master of finding alpha drivers and has designed a strategy that has numerous drivers. “If the price of crude goes up we will make money, if the price of crude goes down we will hedge, if the price of crude stays the same these guys are going to be growing by double-digits for years to come and earn dividends along the way.”
Van Essen has always been weary of strategies that are beta dependent. “If you’re capturing beta, how long is that going to last? It is all about finding things that are adding real alpha. [Finding] different non-correlated alpha generators is key to everything. In this new program the MLP is a totally separate alpha generator than the futures, and the managed futures part of the program [has] two non-correlated alpha drivers, and then within the MLP side we try and strip out the beta of crude oil and just leverage up the alpha generation.”
One of van Essen’s philosophies is to reduce risk by stripping out the beta so you get your trading down to just the alpha generators. In creating another unique strategy, he has appeared to have done that.