The WSJ sparked The Prince’s interest with its story yesterday about sky high analyst projections for oil. The story reminded him of an arbitrage opportunity some of The Prince’s friends had brought to his attention. The trade was originally brought to his friends' attention by Gary Lucido at InvestingMinds a few months ago. Gary wrote about the arbitrage trade on seeking alpha and expanded on this trade with this post on his blog. He also expanded further with this post on how to hedge oil in the trade. Naked Shorts also commented on the ETFs contained in this trade. Since these bloggers covered this trade it has become even more attractive.
Here are the details of the trade. There are many oil ETFs that try to track the price of oil. Macroshares created two such securities, (UCR) & (DCR), which trade back and forth without using futures. Gary makes this clear when he writes that, "they [UCR and DCR] simply pass the price changes back and forth between the two funds so they don’t have to deal with contango and backwardation. But they do have to deal with a different problem - trading at a premium or a discount." The long oil security, UCR, tracks a barrel of light sweet crude on the NYSE. The “Net Asset Value” per share of UCR is the price of oil divided by three. DCR, on the other hand, is inherently short oil since it is structured so that DCR = $40 – UCR. The NAV right now of the DCR is $4.97, and the stock is trading at $10.25, which is a 106% premium. This means that investors are anticipating that the price of oil is going down.
We have to question why this security’s price is so far off the net asset value of its assets. ETFs trade off of their NAVs all the time, but not to this extent normally. These two linked ETFs, according to their prospectuses, only pay out net present asset value if oil closes above $111 on the NYSE for three consecutive days. If this happens, the security terminates, and Macroshares pays out the NAV at the close of the third day (approximately [$120 – (barrel of oil)/3]). This eventual termination triggering a payout is the only mechanism that keeps the NAV close to the price of the ETF’s shares. We are very close to that trigger currently (with light sweet crude closing at $105.50 on Friday).
So the play is to sell short DCR, with the thinking that the premium between the price of the ETF and its NAV will close. If oil continues to move towards $111, the premium should close in a manner that is similar to the increasing value of a stock option approaching the at-the-money point. Of course, to just short DCR or go long UCR you take on long exposure to the oil price, when all you really want is exposure to the spread between the NAV and the price of the ETF. Each share of DCR or UCR gives the buyer long exposure to 1/3rd of a barrel of oil. There are two ways to hedge this exposure. The cheapest option is to go short one month oil futures. An easier way to do this is to short USO (another ETF that tracks the price of oil much better).
In summary here is the trade:
Short DCR or Long UCR, each will give us exposure to 1/3rd barrel of oil long.
Hedge oil exposure by selling oil futures in the amount of:
DCR/UCR shares * 1/3 = Number of Barrels of Oil to Short
The payout if the spread closes is largest if you are able to short DCR, since the spread is larger compared to the spread on UCR. Some investors will have to settle for going long UCR since they will not be able to get available shares of UCR for short sale borrow. Some prime brokerage accounts should be able to short DCR.
Why does this inefficiency exist? It is worth noting that market cap of DCR and UCR combined is only approximately $85m. So most hedge funds/institutions cannot exploit this mis-pricing at scale without substantially moving the price. It is also worth noting that these two ETFs were created when oil was much cheaper and the thought of oil hitting the $111 termination price was an afterthought.
Here is an example of what this trade would look like with a $50,000 short position in DCR.
Short DCR with $50,000 at $10 per share which leaves the investor long 1666 barrels of oil. Sell futures on 1666 barrels of oil or short 2080 shares of USO. (Each share of USO longs approximately .795 barrels of oil). If the spread closed tomorrow, the investor would stand to make $5*5000 = $25000, or a 50% return on the long position. However, note that depending on the mechanics of the trade, the investor may get short proceeds back from the broker on the short position, which means the return on capital invested in the trade would be much higher.
Here is an example of a $10,000 long in UCR.
Long UCR with $10,000, which, at $30, makes the investor long 111 barrels of oil. Sell futures on 111 barrels of oil or short 141 shares of USO. If the spread closed tomorrow, the investor would stand to make $5*333 shares = $1667, or a 16.7% return on the long position.
The risk in this trade is that spread between the NAV and price on the ETF you decide to trade widens. If oil really shoots through the roof like some analysts in the WSJ article suggest, you may lose more money on the oil short than you gain on the spread closing.
Table 1: Sensitivity analysis assuming a $50,000 position, short 4,878 shares of DCR.
|% change in spread||(Loss)/Gain on Position|
Table 2: Sensitivity analysis if oil goes over $120 in 3 day Termination Period of DCR.
|Price of Oil||(Loss)/Gain on Position|
The loss on the short oil position could be protected by buying a call option on USO or oil futures at 120 to 130. You could probably buy a deeply out of the money call option on oil futures pretty inexpensively. If you want to go without the call option on USO or oil futures, then you are taking a view on whether oil is going to explode above its current price. If you don’t even go short oil to hedge your short of DCR, then you have to express a view on whether oil is going up or down.
Let’s turn our attention finally to speculation on the direction of the price of oil. The Prince thinks the best oil analyst in the marketplace is T. Boone Pickens. Pickens sees the long-term trend for oil as up, but he sees prices going back into the low $90s periodically this year. Crude oil futures are firmly above $100 a barrel right now, so Pickens would seem to be on the other side of that trade. However he is not alone according to the WSJ:
Oil has traded at an average price of $95.12 a barrel this year on the New York Mercantile Exchange, up 65.5% from the start of last year. That has left many analysts’ forecasts in the dust. Lehman Brothers, for example, recently boosted its first-quarter forecast for benchmark Nymex crude to $93 a barrel, up $7 from its earlier outlook. The bank sees oil averaging $86 this year, but acknowledges the pitfalls it’s facing. "We still expect a correction in the prices of several commodities, notably crude oil, but investors’ recent focus on longer-term bullish structural factors, many of which we agree with, make it difficult to call for anything other than a pause in oil’s rise," Edward Morse, Lehman’s chief energy economist, said in a letter to clients on Thursday.
The Prince agrees that oil, commodities, and other hard assets are being supported by unprecedented demand from China’s infrastructure needs. Furthermore, these assets are a good place to put your money to try to escape a falling dollar or a dollar which will probably be up against some inflationary pressure as rates continue to be cut. Furthermore, a recession in the U.S. and the slowing effect it would have on other export driven economies like China’s, will certainly take some of the pressure out of the demand side. Although the WSJ does point out that a team of Goldman analysts has contradictory scenario.
A team of Goldman Sachs equity analysts, who three years ago made waves by predicting a price "super spike" to as high as a then-unheard of $105, weighed in again last week. They suggested prices could rocket as high as $200 a barrel if the U.S. economy regains momentum or a wrench is thrown in the world’s oil supply.
Mr. Wittner at Société Générale (SCGLY.PK) in London is on the other side of Goldman’s analysts.
Analysts say there are plenty of actual tensions to underpin prices. Michael Wittner, global head of oil research at Société Générale in London, acknowledges the impact of financial flows on commodities. But he says strength in futures prices for delivery dates years into the future demonstrates that real concerns about supply and demand underpin today’s market frenzy. Contracts for delivery four years from now, for example, settled at about $97 a barrel on Friday. "The long-term argument is strong Asian-led demand growth meets maturing supply," he said. Mr. Wittner’s last forecast, made in December, saw crude prices averaging $81 a barrel this year. "I am in the process of revising the forecast," he said. "I’m not revising it down."
The Prince is going to have to side with Mr. Pickens and Mr. Wittner on this one. He sees spot oil going to $90 over the next three months and possibly as low as $85 periodically throughout 2008. The trade outlined above discussed if this forecast happens as the NAV to price spread closes, while money is made on the oil short.
Disclosure: The Prince does not have a position in UCR, DCR, OIL, USO, or the oil futures market.