The other day a friend of mine, let's call him Reza Shiraz, asked me of my opinion of oil stocks with the intention of getting into the market. Unfortunately I didn't't have much to offer - as I see it, the risk/reward in oil stocks is pretty much even in the short term.
But Reza was really insistent as he wants to capitalize on any potential disruptions in the Strait of Hormuz, but at the same time feared a potential calamity from Europe. So I thought a pairs trade might do the trick: long one and short another, once it becomes clear in which direction oil is headed, close the inverse position and keep the other open.
Running correlations on several stocks didn't get me anywhere since there is a huge difference between correlation and actual causation!
The Perfect Pair
Petrobank Energy and Resources Limited (OTCPK:PBEGF) trades on the TSX as PBG and is a heavy oil producer in western Canada. Petrobakken Energy Limited (PBN) is listed on the TSX and is a light oil producer in the Bakken region of Saskatchewan (as well as the Cardium formation in Alberta, Canada).
As the table below illustrates, correlation runs high at 98.75% (using January 4, 2011- January 24, 2012 closing prices):
If PBN declines in value, PBG will decline in value since its investment in PBN declined, and vice versa. As the table above clearly shows correlation between the stocks is strong and that is due to the fact that PBG owns about 59% of PBN, which clearly reflects a cause-effect relationship.
Why Short PBG and buy PBN?
In this pairs trade, you want to buy the independent and short the dependent. Since the value of PBN impacts PBG through its 59% stake, PBN is clearly the independent in this case.
PBN is a producer of light crude, which sells at the spot price and is cheaper to extract than heavy oil. This combination provides a safety cushion if oil prices decline.
On the other hand, PBG is a heavy oil producer, which sells at a discount to the spot price since it's harder to refine and more expensive to extract. As you can imagine, for these reasons heavy oil producers are hit harder than light crude producers if oil prices turn south.
In addition, PBN provides a yield (currently 5.8%), paid monthly, which in this environment is very desirable. PBG does not pay a dividend and therefore, shorting it has no consequence in that sense (hate paying dividends, love receiving them).
Putting Theory to the Test
Using two scenarios, in negative and positive conditions, I have used price/dividend data to put the theory outlined here to the test.
When market conditions are poor, oil prices decline, or expectations are not met, we can expect both stocks to decline as was the case in much of 2011. In fact, from January 4, 2011, to September 29, 2011, both stocks suffered more than a 70% decline!
Even though the pair declined significantly in value, the pair trade was profitable, as the table below illustrates:
*Note: PBG can be shorted for 30% margin
So when conditions are bad, the stock that pays the dividend declines less, well da!
But is the pair profitable when market conditions are positive, oil prices increase and expectations are met?
From September 29, 2011, to January 24, 2012, both stocks climbed more than 120%!
It seems the trade is even more profitable in positive market conditions, as the table below shows:
The "Obvious" Risk
Every trade entails risks, some we can pinpoint and some are just obscure until they actually appear (black swans, so to speak).
With this trade the primary risk is PBN's juicy dividend. What if PBN cuts its dividend?
This is why causation is vital in a pairs trade. If PBN were to cut its dividend, the stock would likely plummet; however, it would also take PBG with it for the following very simple reasons:
- PBG owns about 59% of PBN and will therefore have to mark to market its investment causing it to decline in value.
- In the quarter ending September 30, 2011, PBG generated $192.332M in cash flow and dividend income from PBN. Were the dividend to be cut, PBG would lose more than 23% of that cash, which it needs to operate and grow its heavy oil operations.