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Tuesday, March 17, 2009

Energy and Materials Performance Following Steep Yield Curves

Recently, the major U.S. banks disclosed that they have been profitable on an operating basis, during January and February. Many commentators have attributed this to the steep yield curve where the banks are borrowing at low rates and lending at much higher rates. Researchers at Bespoke Investment Group have looked at the performance of various sectors one year before and one year after a peak in the yield curve (yield on ten-year treasury minus yield on three month treasury) going back to 1962. The current yield curve maxed out on November 13, 2008.

What they found was energy sector was up 78% of the time for an average of 10.7% one year before and 89% of the time for an average of 16.1% one year after the peak in the yield curve. Materials sector was up 67% of the time for an average of 9.7% one year before and 78% of the time for an average of 11% one year after the peak in the yield curve.

Sunday, March 15, 2009

Provocative Research: Downgrade Integrated Oil

Credit Suisee downgraded integrated oils to 20% underweight recently, citing:

1. Price outperformance of about 30%;
2. Rich valuation with (a) P/Es close to the top of the historical range relative to the market ex-financials and (b) stock prices reflecting $60 per barrel oil, 31% above the current levels.
3. Oil Price: There is a good chance of demand disappointing and the prices staying low for longer. (a) at current prices, most other commodities have around 10% to 30% of production operating at a cash loss, compared to virtually none of oil production - yet, cartel and depletion rates are similar to other commodities (indeed, only around 10% of oil production is operating below berakeven, compared to 54% for steel and 17% for copper); (b) oil demand is likely to disappoint. The IEA expects a mere 1.2% decline in oil demand this year; yet, half of demand comes from developed countries, all of which are going through a severe recession (only 8% of demand comes from China). In the last major US consumer recession in the early 80s, US oil demand fell by 22% (compared to 7% so far). Miles driven in the US are still falling, down 4% yoy in December, despite gasoline prices halving. If demand disappoints, then OPEC discipline may crack (with OPEC spare capacity now at 6.5% of global demand); (c) bear markets in oil historically last 11 to 27 years. Investors appear to have too much faith in depletion rates and OPEC to protect against downside risk.
4. Big oil consistently appear as overweight in analyst recommendation;
5. High dividends of integrateds are inconsistent with low leverage of these companies.

Tuesday, March 10, 2009


No one knows when the stock market will enter a sustained bull phase again. I like generating income with a hedged investment style, while waiting for the markets to turn. I am buying XEG.TO, iShares S&P/TSX Energy ETF, and selling XOP, SPDR Oil & Gas Exploration & Production ETF. XEG has a yield of 5%, whereas XOP's yield is 1.4%. Our studies show that the correlation between these two securities is about 95% and a hedge ratio of 42% is appropriate (e.g. buy 100 shares of XEG and short 42 shares of XOP). The economics of the trade would be as follows, if the trade is held for a year (all prices are as of March 10, 2009; no commissions):

Buy 100 shares of XEG and pay $(985.85) {
$(1,267) Cdn.}
Sell 42 shares of XOP and receive $ 1,050.42
Borrow/Interest Costs @2% are $21.05
Net Investment $ (43.53) {positive cash flow}
Net Dividends Received $ 37.73


In trading this pair, one has to keep in mind that one is exposed to basis risk and he will have to monitor the position for a change in the relationship between the two ETFs. The price ratio of XOP to XEG averages around 2.3. However, it has been as high as 3 and as low as 1.9 in the last 3 years. In the same period, the difference in the two prices have been as high as 44 and as low as 12, with a mean of 24. That metric stands at 14, currently. In a bullish and speculative environment, XOP is likely to outperform XEG. The US market is much larger and XEG is not known to most individual US investors. Also, XEG contains lower beta income trusts and pipelines.

Other factors to watch would be the additions and deletions to each ETF and the dividend rates over time.