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An insightful piece from Seeking Alpha prompted this post, as I’ve noticed deficiencies in the use of certain types of ETF’s:

  1. “USO” – which tracks the spot price of Crude Oil
  2. Any of the Proshares Leveraged ETF’s (short or long – SKF, UYG, SDS, SSO, DXD, DDM…)

I am certainly late to the party of pointing out the leveraged ETF’s, but nonetheless have a few things to say.

First, the explanation on USO from Seeking Alpha:

Here are the current prices for oil contracts with expirations in the next six months. Notice how every contract is more expensive than the one that preceded it. USO follows a simple strategy of buying the current contract and then rolling into the next contract before the current one expires.

March 2009 $40.42
April 2009 $46.22
May 2009 $48.88
June 2009 $50.45
July 2009 $51.28
August 2009 $52.70
Source: NYMEX. Data as of 2/9/08.

Until last Friday, USO owned the March 2009 contract. Specifically, it owned 84,378 March contracts, entitling it to 84.4 million barrels of oil.

But on Friday, it sold all those contracts and bought the April contract instead. But because the April contract cost $6/barrel more than the March contract, it couldn’t afford as many contracts. In fact, if you exclude new inflows into the fund, it could only buy 73,444 April contracts.

Whammo presto, the holders of USO lost 13.4% of their exposure to crude oil. They now control less oil. If the spot price stays near $40/barrel, the value of those April contracts will decay back to $40/barrel over the next month and investors will lose their shirts. If the price of oil jumps 15% in the next month—before USO rolls again into the May contract—investors will only break even.

Basically, because the price of Oil is upward sloping, the parent fund has to cost average-up at the beginning of every month – they have to reinvest all of the money from expiring contracts at a higher price – meaning there is less firepower behind the investment.

(The author makes reference to “contango,” which may sound complicated but isn’t…it’s just when the Oil futures price is above the spot (current) price).

The Leveraged ETF’s, on the other hand, aren’t flawed per se; it is our perception of how they should work which is flawed.

This concept was well covered by the Wall Street Journal, and by Jim Cramer, who through the powers of cognitive dissonance decided that the Ultrashort Financials ETF (SKF) brought down the bank stocks in January (The author of the Proshares article from thestreet.com provides analysis on how this is somewhat true).

Here’s the WSJ excerpt:

The issue is that these funds are designed to double the index’s return — or double the inverse of that return — on a daily basis. The compounding of those daily moves can result in longer-term returns that have a very different relationship to the longer-term returns of the underlying index.

For example, take a double-leveraged fund with a net asset value of $100. It tracks an index that starts at 100 and that goes up 5% one day and then falls 10% the next day. Over that two-day period, the index falls 5.5% (climbing to 105, and then falling to 94.5). While an investor might expect the fund to fall by twice as much, or 11%, over that two-day period, it actually falls further — 12%.

Here’s why: On the first day, doubling the index’s 5% gain pushes the fund’s NAV to $110. Then, the next day, when the index falls 10%, the fund NAV drops 20%, to $88.

The funds themselves are tricky, but if you understand that making 10% is different than losing 10%, then this should make perfect sense.

End Lesson: These are instruments made for day traders, not long term investors.

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After a move from $40 to $50, it looked like oil may have bottomed. We now stand at $38, even after production cuts from OPEC.

Oil extended yesterday’s 8.1 percent decline after OPEC agreed the group’s 11 members with quotas will trim current production by 2.46 million barrels a day to 24.845 million barrels a day. U.S. fuel consumption in November declined 7.4 percent from a year earlier to the lowest for the month since 1998, the American Petroleum Institute said yesterday.

The media describes this as “traders thinking the cuts won’t be enough to eliminate a supply glut.” I don’t necessarily agree with that since it isn’t plausible to say that cutting aggregate output from 87.5 million barrels a day to 81.5 wouldn’t affect the price…there lies the issue. It’s not that the action won’t be enough to boost prices, its that OPEC can’t afford to/doesn’t have the discipline to cut output that drastically since they are having a credit crisis of their own, and oil is the only thing the middle east exports (How else will they finance all of these underground malls?)

Anyway, if you believe oil will sustain these lower price levels for the immediate future, there is no explanation for oil related companies to sustain the rallys they had when oil seemed to have bottomed at $40. The drillers (Schlumberger, Transocean, Haliburton) are still depressed, but the conglomerate companies like Exxon and Chevron are quite high.

xom-cvx-uso1

“USO” is an ETF which tracks the price of crude, “XOM” is Exxon, and “CVX” is Chevron (a company which does the same thing as Exxon). Notice that during the sell off in October, both of these companies dropped at faster rates than crude oil. We see the divergence since then,  however during the sell off in November, we saw the same behavior as the October sell off – the oil companies falling harder than oil itself. Given this increasingly large gap in the past month, I don’t think it’s unreasonable to conclude that Exxon and Chevron will be hit rather hard during the next sell off in the new year.

Therefore if you think this rally will end in January, consider buying “DUG” a 200% short ETF which targets oil companies like Chevron and Exxon, or “EEV” which shorts the MSCI emerging markets index. Emerging market economies rely heavily on oil prices, however the Obama infrastructure plan ignited a rally amongst the Iron-ore companies (iron-ore is the chief ingredient in making steel), which caused this ETF to go down substantially.

Or if you don’t like financials either, there is “SDS” which is the inverse of the S&P 500. Since the S&P is a weighted-average index, moves in Exxon and Chevron (in addition to financials) typically dictate how the S&P will close (since they have the most weight from their share price multiplied by outstanding shares – or market caps).

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While I find much of our financial and economic news inspiring, It is not very often that I find something that really resonates with me from a moral perspective.

While it is bothersome on many levels that [Bear Stearns, Fannie & Freddie, Indy Mac, and probably Lehman Brothers/Washington Mutual/AIG] have failed in our free market system, the thought of people giving money to “experts” to invest in these companies and the broader market is far more unpalatable.

Barron’s published an article in this weekend’s edition which deals with this very issue. I think this installment is worth reading if only to illustrate that it’s not safe to be invested in most equities in this environment. Typical recessions of the past have lasted 2-3 years, but they did not witness the evaporation of billions of dollars in write downs, and perhaps up to 1 trillion in taxpayer support for our Government Sponsored Enterprises. The main point which is continually disregarded by the media, is that many of our market’s participants are not Hedge funds and Proprietary trading desks. There are REAL people who think now is a good time to buy certain stocks like Warren Buffet would…We cannot rely on the media pointing this out, because that is not their job. We cannot rely on a source when they have an ulterior motive; in their case, it’s getting viewers.

  1. we are in year 1 of a recession; one in which there is unanimous agreement that it is unlike anything anyone has ever seen. What good will come out of entering right now? You will not miss anything until bank stocks are in single digits…
  2. Unfortunately, this one is not restricted to the equity markets (like the tech bubble of 2000-2003) in which investors felt the most pain. Our American consumer, one which has been indestructible in the past, is now faced with asset deflation (houses, cars, and would not rule out dollars as a deflationary asset just yet) and commodity inflation (while gasoline has come back from $4 a gallon, it is no longer $2, and food still costs more than last year). Because these notions are so negative (believe me, I feel pain when I see peoples’ reactions to this cynicism) we have been trained to brush it off and say “we’ve gotten through this before. It’s part of the business cycle” This is certainly true. Maybe I just haven’t thought enough about this, but I can’t remember a time where 70% of our GDP (consumer spending) was weakening, while we underwent credit, mortgage, and energy crises simultaneously.
  3. Honestly, what is there to lose by keeping mostly in cash, and if one must invest, can it be in companies which have A LOT of cash, and pay big dividends? An individual is not flaunting his/her financial performance like a Mutual Fund or a Hedge Fund, one which would be ecstatic to say “I only lost 8% in this market when the S&P lost 20%…That makes me better than the average!” Money managers try to manipulate statistics and mask the reality of relativity: is losing 8% really good? A checking account would have made you 2.5%…that sounds better than the mutual fund’s rate of annualized return…

Finally and most importantly, If you wonder how some of CNBC’s programs can be so optimistic in an “intermediate horizon”, maybe its because their parent company is General Electric. They would rather have your money in stocks than savings accounts, because the run-of-the mill investor is unlikely to short the market. But can we trust our source of information? is this advice founded on objective analysis of the market, or are they more concerned about their GE stock options? (CNBC is actually very neutral when it comes to talking about their parent company, though).

Finally, One has to approach investing as a risk manager; what can I win? What am I likely to lose? If the trend is down for 2 years, and sideways for another 3 years, is it smart to invest in broad based indexes with no dividends?

All of this is not to say that all investment opportunities have vanished forever, it is just that we will not miss the bus for a while, and it is very foolish to lie below a falling knife.

I promise not to write about anything this negative again, I just felt the need to offer a concession, and the hope that this post could stop someone from watching a 10% loss grow to a 30% loss in lieu of what is coming our way.

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Via TheBigPicture:

Abreas_20080720205615

Seeing as I haven’t posted anything about actual equity ideas in a while, there are a couple of good ETF’s out there if you believe in this trend, or in the idea that this is just a pull back in oil.

The XLE SPDR would normally be a little boring for my taste, (because Chevron and Exxon make up 28% of the fund) , but big oil companies have been beaten up for the sake of recession, lately.

APACHE CP APA 3.15
CHEVRON CORP CVX 11.65
CONOCOPHILLIPS COP 8.35
DEVON ENERGY CP (OK) DVN 3.44
EXXON MOBIL CP XOM 16.7
HESS CP HES 3
NATL OILWELL VARCO NOV 2.99
OCCIDENTAL PET OXY 4.74
SCHLUMBERGER LTD SLB 4.74
TRANSOCEAN INC RIG 3.3

I think the better play is OIH, which includes only Oil Service stocks – the guys who find the oil, and the guys who drill for it. Here’s the ETF’s top 10 holdings:

 

BAKER HUGHES INTL BHI 8.7
DIAMOND OFFSHORE DRL DO 7.11
HALLIBURTON CO HAL 9.94
NABORS INDS INC NEW NBR 4.74
NATL OILWELL VARCO NOV 7.48
NOBLE CORP NE 6.52
SCHLUMBERGER LTD SLB 10.37
SMITH INTL INC SII 5.87
TRANSOCEAN INC RIG 16.07
WEATHERFORD INTL NEW WFT 7.6

You pick up a lot of good exposure, while diversifying your risk. This sector hasn’t been as nicked up as the XLE, probably because they’re not involved in buying/refining crude oil. That makes me a little less comfortable taking on a short term position, because I’m not sure any sector is “recession proof”. As the old adage goes: “all  boats fall with the tide”

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There are several applications of the Law of Diminishing returns, most commonly used in reference to marginal production of labor (which I could not find a good chart of), but in this case we also have an example of optimal power use.

There are also practical applications of this law to the markets, and stocks themselves. Companies are first bought for their growth prospects, and inevitably they mature; Citi, GE, or any company in the Dow Jones Industrial Average.

Citi and GE are examples of companies which have simply grown to be too large (Citi has a balance sheet of $2.2 trillion, and GE has a market cap of $283 billion). Its not that they are not competitive in their respective industries, its only that they have limited upside due to lack of further growth (As you can see in the chart above, 1 share of GE is practically worth the same nominal amount after 5 years) . For example’s sake, lets say Berkshire Hathaway acquired a small cap materials company which doubled its returns one year after the acquisition; those profits would be negligible on Berkshire’s balance sheet.

This has been an inconvenience to investors in the United States for a while, as we are maturing as a nation. The addition of billions of dollars to our GDP amounts to a very small amount regarding the total (its been near 1%-2% per year), hence the diminishing returns. No wonder hedge funds/Investment banks are levered 25 to 1…25 times 2% turns into a good return, but it comes with consequences when abused, as we have seen.

Finally, the question; what does this mean for the future of the US? we have had some bad recessions including the tech bubble, but this one is being lead by financial instruments which got out of hand, and driven further by bad bets (This is not reminiscent of old fashioned value investing).

Perhaps this is why we have witnessed a shift to stocks which have natural growth prospects, ones which have exposure to demand driven markets: Rio Tinto, Vale, Southern Copper, Monsanto, Potash, US Steel, XTO, Apache, and Petrobras.

Materials and Energy are emerging as secular themes in global markets, and this may be the beginning of a trend which leaves the US in the dust as a global importer of raw materials…after all, we’re only a nation of 340 million people, where as China and India make up close to 3 billion combined (or half of the world).

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This is a particularly interesting issue if we consider the long-term future of refiners. I, for one, am a buyer of peak oil. It seems as though no one can verify the amount of oil the Saudis claim to have (maybe this is why their relief efforts have provided NO RELIEF in crude futures market), and the only new discoveries in recent years have come off shore in deep waters, which by definition are harder to come by because of their deep locations.

Petrobras seems to discover these types of oil fields all the time; there was the monumental oilfield back in november (which will cost them an estimated 240 billion dollars to retrieve), and one in the Campos Basin more recently. Despite these discoveries, crude has shrugged off this data, and continued its seemingly unstoppable ascent.

There have been many theses as to why Oil is going up, so lets briefly depict the most viable ones, without subjectivity….yet. These will be cookie-cutter, CNBC talking head explanations (or recaps for the least common denominator…ha!) Full Disclosure: I cannot stand Maria Bartiromo.

Back to the fundamentals…

  • Supply & Demand issues: India and China have displayed booming economies, despite a stagnant US, and appear to be able to cover our decreased demand on their own.
  • Weak Dollar: There isn’t much for the background on this one…the Federal Funds Target is still at 2%, primarily to bail out banks with bad paper. Many analysts speculate that Bernanke will raise rates by 25 bps at August’s FOMC meeting. Bottom Line: when the greenback decreases in value, a dollar denominated commodity will increase in value (because we need more dollars to buy the same quantity).
  • SPECULATORS & Hedging Strategies: In order to hedge a depreciating dollar, investors (mutual funds, pension funds, hedge funds) have gone long oil because of the former two points.

Now that the framework is in place, we can finally delve into the probability of a sustainable pull back in oil.

Lets face it: the true driving factor of the oil run has been a booming economy in China, exacerbated by the fact that their Government has subsidized prices at the pump to the point which they have felt only an 18% increase year to date (compared to our outlandish 50%-60% change).

The only sign of a pullback occurred last Thursday, when China announced a decrease in their gasoline subsidy, resulting in an increase of 17%-18% for gasoline. This is an example of curbing demand. However what if there were an event which caused a natural decrease in demand…like a recession, or even a correction? This is an interesting prospect considering that the Beijing Olympics will end in August, and the potential mark of an end to their renaissance…could this be the chief reason driving Royal Bank of Scotland’s call for a global crash in 3 months?

Forgetting China for a moment, we can extrapolate a more certain outcome. I know we have never really had a strong dollar, only strong dollar policyat best. However Ben Bernanke was smart enough to figure out we had a Financial Crisis at hand, and that wasn’t so obvious to many. When we relieve ourselves of that wretched “core-inflation” statistic (or ex-food and energy), it is quite clear that average household income is being eaten alive. If Ben Bernanke is half the Fed Chairman he has been hyped up to be recently, he will increase rates rather aggressively in the coming months. This will result in a stronger dollar and should (key word) result in a noticeable pullback in oil…

If either of these outcomes seem remotely plausible, then you may be thinking of a way to play a fall in oil prices. One of the more obvious routes is by going long refiners. Two come to mind, primarily because they have been smoked YTD: Valero (-38% YTD) and Tesoro (-57% YTD).

Note: Tesoro is down by a greater amount for good reason. Their refineries are constructed to handle the more accessible “light sweet crude” which will be more scarce going forward. They have experienced far greater losses due to poor hedges. Valero has a competitive advantage, in that they have the capability to refine both the muck which Venezuela sends us, and the lower grade which Brazil will be sending the US for years to come.

Both companies have been victims to pinched margins.  They buy crude (spot or future) and sell it for the fixed price at the pump. As the article says, they will continue to lose money until one input corrects; crude needs to drop, or gas prices need to rise. The fundamentals seem to point to one of these happening, at least for a little while.

Therfore on an intermediate basis,  Valero should be a great trade (its around 42.80 as I write this). My price target is $52.oo, but would begin to scale out around $48.oo. I think it could go as high as $55.oo, but that may be a reach. If all goes to plan, this is a near 25% return on a 3-4 month time frame. Normally, I would talk about fundamentals/option strategies, but this post is already too long.

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