The Exxon Mobil/Conoco Philips pairs trade is looking interesting. XOM at $73 and COP at $46 gives a $27 spread. The plan is short XOM and buy COP.
Basis of the trade. Over long periods, the XOM price has been about 10% higher than the COP price. Right now it is 59% higher. Is this big a gap justified? Morningstar has a fair value for XOM of $87 and a fair value for COP of $70, i.e., they rate XOM as 24% more valuable. I think the fair value gap is somewhat less, maybe 20%.
XOM vs COP stats
price/cash flow 7.8 3.8
gross margin 40.9% 31.8%
debt/equity 7% 53%
Clearly XOM is the superior company, with higher margins and better debt/equity. Also COP is more dependent on natural gas than XOM, and there seems to be somewhat of a glut of natural gas, and the price is falling. However, it looks like COP is more undervalued based on cash flow.
The pairs trade is a bet that the wide gap in price will disappear over time, and it cancels out sensitivity to the price of oil and gas and the health of the economy. If XOM remains fixed and COP closes the gap, COP needs to reach $61, which is a gain of $15. But we want a margin of safety, so we would close the pairs trade when the gap closes to 25%, which would be at a price of $58 for a $12 profit.
To set up the pairs trade, we short 4 shares of XOM and go long 5 shares of COP. Assuming the relative valuations are as stated, this cancels out the market risk from the combo. Money at risk is 4x$73 + 5x$46 = $522, and profit when the gap closes is 5x$12 = $60. If the gap closes in a year, which seems reasonable, the gain is 11.5%. Not horrible but not especially great. However, this is a very safe combo. It is likely that anything that affects the price of one stock has a similar effect on the other. Thus we can use margin debt to lever up. Putting up 50% margin for the long and short sides reduceds the money tied up to $260, and increases the profit to 23%. Now we're talking turkey.
One can further reduce the money tied up in this combo via the use of options. Instead of shorting XOM, sell a call and buy a put at a strike of, say $70. The call will bring in $11.25 and the put will cost $10 at today's close (6/4/09). Such a short call/long put is mathematically equivalent to shorting the underlying stock, and there is no net time decay of the options premiums. You will have to put up margin of 20% of the XOM price plus the market value of the call. So you can buy the COP on 30% margin, use another 20% margin from the COP to satisfiy the short call margin requirement, and you will have tied up just $230 to hold the position, for an expected profit of $26%.
Risk. The only risk here is that something bad will happen to Conoco that doesn't affect Exxon, or something good will happen to Exxon that doesn't affect Conoco. Anything that affects both companies equally cancels out. So the price of oil is irrelevant, as is the state of the economy. If we have a really terrible economy that threatens solvency, COP is more at risk with its higher debt/equity ratio. Also hyper inflation will hurt COP a little more than XOM, when COP has to refinance their debt. A large oil or gas strike by one or the other company might change their relative values. Both companies operate in politically unstable places, so a political event might change their relative values.
Disclosure. I am short 500 shares of XOM via short call/long put options, and I own 600 shares of COP. That makes me slightly on the net short side for oil+gas integrated companies.
Basis of the trade. Over long periods, the XOM price has been about 10% higher than the COP price. Right now it is 59% higher. Is this big a gap justified? Morningstar has a fair value for XOM of $87 and a fair value for COP of $70, i.e., they rate XOM as 24% more valuable. I think the fair value gap is somewhat less, maybe 20%.
XOM vs COP stats
price/cash flow 7.8 3.8
gross margin 40.9% 31.8%
debt/equity 7% 53%
Clearly XOM is the superior company, with higher margins and better debt/equity. Also COP is more dependent on natural gas than XOM, and there seems to be somewhat of a glut of natural gas, and the price is falling. However, it looks like COP is more undervalued based on cash flow.
The pairs trade is a bet that the wide gap in price will disappear over time, and it cancels out sensitivity to the price of oil and gas and the health of the economy. If XOM remains fixed and COP closes the gap, COP needs to reach $61, which is a gain of $15. But we want a margin of safety, so we would close the pairs trade when the gap closes to 25%, which would be at a price of $58 for a $12 profit.
To set up the pairs trade, we short 4 shares of XOM and go long 5 shares of COP. Assuming the relative valuations are as stated, this cancels out the market risk from the combo. Money at risk is 4x$73 + 5x$46 = $522, and profit when the gap closes is 5x$12 = $60. If the gap closes in a year, which seems reasonable, the gain is 11.5%. Not horrible but not especially great. However, this is a very safe combo. It is likely that anything that affects the price of one stock has a similar effect on the other. Thus we can use margin debt to lever up. Putting up 50% margin for the long and short sides reduceds the money tied up to $260, and increases the profit to 23%. Now we're talking turkey.
One can further reduce the money tied up in this combo via the use of options. Instead of shorting XOM, sell a call and buy a put at a strike of, say $70. The call will bring in $11.25 and the put will cost $10 at today's close (6/4/09). Such a short call/long put is mathematically equivalent to shorting the underlying stock, and there is no net time decay of the options premiums. You will have to put up margin of 20% of the XOM price plus the market value of the call. So you can buy the COP on 30% margin, use another 20% margin from the COP to satisfiy the short call margin requirement, and you will have tied up just $230 to hold the position, for an expected profit of $26%.
Risk. The only risk here is that something bad will happen to Conoco that doesn't affect Exxon, or something good will happen to Exxon that doesn't affect Conoco. Anything that affects both companies equally cancels out. So the price of oil is irrelevant, as is the state of the economy. If we have a really terrible economy that threatens solvency, COP is more at risk with its higher debt/equity ratio. Also hyper inflation will hurt COP a little more than XOM, when COP has to refinance their debt. A large oil or gas strike by one or the other company might change their relative values. Both companies operate in politically unstable places, so a political event might change their relative values.
Disclosure. I am short 500 shares of XOM via short call/long put options, and I own 600 shares of COP. That makes me slightly on the net short side for oil+gas integrated companies.
