Do Not Buy OIL; Sell OIL Instead; Or Put OIL Into A Pair Trade

| About: iPath S&P (OIL)

Summary

The OIL ETN is currently a mispriced asset.

There is thus no rationale for holding it.

Investors should consider selling OIL, replacing OIL with a similar asset that's not mispriced, or putting OIL into a pair trade with another asset that's not mispriced.

This is going to be a very short and clear thesis here. If you'll notice, today the iPath S&P GSCI Crude Oil TR ETN (NYSEARCA:OIL) is dropping a massive 15%, and this is happening even as crude itself is up 5%. Moreover, even something like the United States Oil ETF (NYSEARCA:USO) is up nearly 4%. Why is this, and why am I saying that you ought not to buy OIL?

The reason is very simple. OIL's intrinsic value/indicative value, which is akin to net asset value for an ETF, is way lower than where OIL is trading, even after this beating. Its intrinsic value sits at $3.94, whereas OIL even after all of this drop still sits at $4.69.

In effect, OIL is still trading at a significant 19% premium to its intrinsic value. Put another way, it still has to drop another 16% before its value is fair.

You can check OIL's intrinsic value at iPath's official page, though it shows the intrinsic value with a delay (it refers to the previous day's close).

You can also check it in real time by using the following Yahoo Finance link.

Knowing of this mispricing, an OIL noteholder would do well to at the very least replace such exposure with USO.

Possible Arbitrage

You can also possibly arbitrage the still existing mispricing by buying a proxy for crude like USO and selling short OIL on equal amounts. The mispricing is apparently recent.

However, it's a bit troublesome recommending this particular trade now because unfortunately I only got to know about this mispricing today, and obviously the mispricing was much, much larger yesterday, when OIL closed at $5.51 and its IV was just $3.70 (a massive 67.2% premium, requiring a ~33% drop, half of which is being eliminated today).

Furthermore, it seems that the massive premium started collapsing because Barclays called attention to it the day before. This reminder is no guarantee that the premium will close in short hand, it just means Barclays is declining responsibility for what happens next. The proper way for the premium to disappear altogether would be for Barclays to issue more notes.

Conclusion

There are three courses of action a rational investor can take here, due to the information presented:

  • Sell OIL
  • Sell OIL short and buy USO for a pair trade
  • Replace OIL with USO (sell OIL, buy USO). This is for someone already owning OIL and wanting to keep his exposure to crude, while exiting the mispriced asset.

This event is similar to what happened with iPath Bloomberg Natural Gas SubTR ETN (NYSEARCA:GAZ) a few years ago, and which I covered in my article titled "GAZ's 42% Premium: Sell This ETN Now". That trade was successful but stressful, as the ETN became very tight to borrow. The same could easily happen here and argues against taking the pair trade -- after all back then the premium was even larger than OIL displays right now.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.