Invest Like the Best with Patrick O'Shaughnessy
· John Arnold
[00:00:00] S1: I was always entrepreneurial. I always wanted to make a dollar. As a 13, 14, 15-year-old kid, you have limited options, and I didn't really want to work retail because you weren’t going to make very much money doing that. I was in high school in the late 80s, early 90s, and this baseball card boom was happening. I remember, even in middle school, first getting started and introduced to baseball cards. It was when it was really starting to take off around '87. It became clear to me – I guess in retrospect, this is a really interesting kind of financial instrument that’s very volatile, that information on pricing is not very uniform across the market, and there were a lot of geographic price differences that were happening. I managed to talk myself onto this bulletin board of baseball card dealers back in the late '80s, and you had to get some references, and I’m like 14 or 15 years old, and I somehow finagle myself to be on this bulletin board, which is when internet commerce was just getting going, and they just had this wholesale system that was real-time pricing, in effect. You'd have people in New York trying to buy hockey cards, and people in Texas were trying to sell their hockey cards because there wasn't much demand for them. There were these arbitrage opportunities that got created. I know this from this bulletin board, people in Montreal or New York or Buffalo were willing to pay X, and I can buy these at Y and make that money. So I started doing that. The sports card business started to boom, so there was more and more money coming into it, more and more cards. A lot of the dealers in and around Texas weren’t caught up on day-to-day, week-to-week price changes. Oftentimes they had cards that were more valuable on the west coast or east coast or in the north. So I would just run around every weekend to a bunch of card shows. I was living in Dallas at the time, but would travel to Houston, Louisiana, Oklahoma. I started getting on planes when I was 16 and going to big card shows around the nation. I just always had this sense of value, of what something was worth at the time. It turns out there were a lot of similarities between doing that and the trading. I was, in a way, doing market making in sports cards. I was taking advantage of arbitrage opportunities in sports cards.
· John Arnold, Patrick O'Shaughnessy
Knowing what every product is worth at every moment stuck with me. And that was my mantra when I was trading gas, is that I knew what every month was worth, better than I think anybody else did, and I would do that – I knew that every moment of the day. To do that, it takes focus. Just sitting there and staring at the screen and listening to every trade that happens in the market. All day long, every day. It takes that work and intensity. [00:00:00] S0: Can you describe the actual instruments that you were trading? When you were trying to put positions on and take them off, what were those positions? What were they in, on average? I want to get into some of the nitty gritty details to give people a sense of how far you had to go to get an edge in this world, as an analogy for how far you have to go to get an edge in anything. This was the thing you enjoyed, and I want to come back to why you were so passionate about it in the first place. But what were you literally trading in those days?
· Patrick O'Shaughnessy, John Arnold
[00:00:00] S0: Can you describe the actual instruments that you were trading? When you were trying to put positions on and take them off, what were those positions? What were they in, on average? I want to get into some of the nitty gritty details to give people a sense of how far you had to go to get an edge in this world, as an analogy for how far you have to go to get an edge in anything. This was the thing you enjoyed, and I want to come back to why you were so passionate about it in the first place. But what were you literally trading in those days? [00:00:00] S1: It was primarily futures, and swaps that were a look-alike to the futures. I traded natural gas. The hub for natural gas trading was Henry Hub in Louisiana. There would be price differentials between what gas was worth in Louisiana versus gas in Pennsylvania, or in West Texas or Colorado, for instance. That's basis. I did that for a small part of my career, those price differentials between one point and the hub in Louisiana. But most of my career in trading was trading what we call the fixed price of natural gas. This is, if you're watching CNBC and on the ticker, it has a gas price. That's what I was trading. [00:00:00] S0: In a given day, how much volume and activity would there be? How many key decisions would you make in a given day?
· Patrick O'Shaughnessy, John Arnold
[00:00:00] S0: In a given day, how much volume and activity would there be? How many key decisions would you make in a given day? [00:00:00] S1: It changed over time. I was, for a long time, the largest market maker in the business. Which I did both because it was profitable, as well as – maybe more importantly – it allowed the ability to put on and off positions with lower slippage and with fewer people knowing what my position was. It also gave me insight into who was doing what in the market, so I could start to build the psychology of the market. I could see certain traders positioning certain ways and try to reverse engineer what their thinking was, which helped me in trying to figure out how I wanted to be positioned. [00:00:00] S0: Maybe for those that are less initiated in the act of market making, just describe what it does, how you’re provisioning liquidity for the market. Also why you were able to sort of cover some of your tracks by being that player in the market.
· John Arnold
[00:00:00] S1: A healthy financial market exists for a reason. And that reason is that there are commercial players – in this case, producers or end users, who have exposure to the commodity, that are willing to pay something to have somebody else reduce their risk to the commodity price. They will pay something to the market for that risk management. And if that exists – so if you think about a producer of natural gas whose revenue is almost entirely based upon what the price of natural gas is for a given month, or even day-by-day. There's these huge boom-busts that can happen, because commodities naturally have this boom-bust cycle. So businesses then, if you're exposed just to the spot price, or today's price – those businesses also go through a boom-bust cycle. So many businesses will choose to hedge out or fix some of their forward revenue and reduce their exposure to short-term swings in the market. That's the demand for hedging. If there's demand, there has to be a supply. There has to be somebody who's willing to take the other side of that trade. Somebody has to warehouse that risk, price the risk, and manage the risk. In aggregate, that's what the traders as a whole have to do. And then there are also speculators that come in. The people who are warehousing that risk often have to price that risk, so they become experts in the pricing and how to hedge it. There's often speculation that happens on top of that. As well as, there can be speculators who are not actively market making, but just have a view on natural gas or oil, or gold, or anything, and come in and want to put on a position. Again, they need liquidity. Somebody gets paid to provide that liquidity.
· Patrick O'Shaughnessy, John Arnold
[00:00:00] S0: It strikes me, as someone that looks at a lot of young companies, that it is exciting. Energy is exciting again. Maybe it's just because of data centers and AI and the new demand that's coming onstream for power. Does it feel that way to you? I mean, I know you've looked at tons of companies. I'm sure you're incredibly on top of energy markets today. Do you feel like it's a good time if you're interested in this field, like you were, to go into it relative to 10 years ago, when it seemed a little bit quieter? [00:00:00] S1: I think it's more on the asset side today. But I think there's an enormous amount of innovation that's happening in energy assets. Whether that is in new technologies like in batteries or geothermal, or advanced nuclear. I think also, all the data center development and the amount of money and capital in those fields, and so the need for innovation – that if you can make things even a little bit more efficient, there's enormous value that is created that a new company or a new individual can take advantage of. One of the characteristics of the energy industry broadly is that it is enormous. If you can have a little edge in a niche of the energy industry, there can be tremendous gains to be had. Certainly, this mad scramble to build data centers and to power those data centers is creating enormous opportunities for new entrants to the market.