Tuesday, April 15, 2008

Who says Oil and Water don't Mix?

As the summer of 2008 approaches, we can expect the typical Hollywood big-budget blockbuster movies and we can also expect blockbuster oil prices. With the price of oil on a steady rise, $4.00 a gallon may become a familiar sight this upcoming driving season. Based on analysis by Haye Capital Group (HCG), the probability of oil reaching $125.00 per barrel in 2008 is 78.9%. With the specter of recession in the background and the rise in commodity prices (corn, wheat, etc.) in the foreground, we need to find ways to hedge these seemingly never ending fiscal difficulties. Seventy percent of the price you pay at the pump is attributed to the oil per barrel price, $113.79 as of this past Tuesday, April 15th. The question is how do we make money in this challenging environment?

In this blog we are going to focus on how to take advantage these oil price increases. One possibility is to focus on an oil exchange traded fund or ETF such as (USO) while another possibility is dealing with oil stocks of those companies directly or indirectly servicing the oil industry. For example, the companies that transport crude oil and petroleum products are an essential link in the global energy supply chain. Most oil is transported either by ship or by pipeline. Two out of every three barrels of this transported oil is shipped in oil tankers. The remaining third is moved via pipeline. It is clear that the shipping industry plays a crucial role in the oil business.

The best way to play oil prices is to invest in the global shipping business. This is one of the least followed aspects of the oil service industry. In addition to never going out of business, they offer an extremely high dividend. Certain shipping companies responsible for the transportation of crude and petroleum could make an interesting oil play if they've made a sufficient investment in their fleets. Due to various environmental incidents , the International Maritime Organization has ordered that by 2010, all single hull ships transporting oil be phased out, and only double hull ships be used for oil transport. This new, stricter regulation has reduced the number of tankers available to ship oil. Therefore, assuming oil consumption remains the same, there will now be reduced supply to meet the original demand. A supply-side crunch will increase tanker spot rates. This implication adds increased pressures on the price of oil, and makes the shipping companies with the most double hull ships much more attractive to shippers than their single hull brethren.

We've reviewed several shipping companies and their related stock, taking into account the beta and dividend yield of each in order to determine the shipping stocks which best act as a hedge to higher gas prices in the real world. All of the stocks chosen move in a narrow and predictable range which keeps their yields relatively steady. This is advantageous as an oil hedge since the key to using these stocks as a hedge includes taking advantage of the cash dividends paid out by each company. HCG is most concerned with the dividend yield and the low beta value of those stocks with lower volatility, since it allows us to build a dividend yield that acts as a bond yield, and provides a hedge to the prices at the pump.

Based on analysis by HCG, the five most promising investments in descending order (first to last) are:

Frontline (HCG favorite) : (FRO) is one of the oldest and largest tanker companies in the world with a true global presence extending from the Persian Gulf to the Gulf of Mexico. With a current beta of 1.22 and a dividend yield of 17.1% that translates into an $8.00 dividend. This stock historically trades in the $31.00-$42.00 range.

Ship Finance International: (SFL) is a shipping company that is engaged in the ownership and operation of vessels and offshore related assets.

Knightsbridge Tankers: (VLCCF) is an international tanker company whose primary business activity is the international seaborne transportation of crude oil.

Double Hull Tankers: (DHT) operates a fleet of double hull tankers.

General Maritime (speculative): (GMR) is the most speculative play of our five. They had a decrease in both revenue and net income in 2007. Their positives include an aggressive share buyback program and the maintenance of their dividend. They didn't cut their already high dividend in spite of a decrease in revenue and net profit for 2007. The company is positioning itself for a rebound in the second half of 2008.

The oil shipping industry is dependent on a strong global economy with a healthy appetite for crude oil and crude products. If the global economy is thrown into a recession, and the global demand for oil declines, you can expect tanker stocks to take a hit as well. Also take note that tanker spot rates and fixed rates, which are the prices shippers set for their services based on the number of ships chartered, are tracked by and provide the bulk of a shipping company╩╝s revenue stream. These rates also tend to be highly cyclical. However, as long as there is demand for crude oil to be transported from producers to consumers, oil shippers will remain afloat and an investment in oil shippers should be profitable.

With any stock please do your own due diligence to see if it is a good fit for your portfolio. We do not own a position in any of the stocks mentioned in this blog.

Sunday, March 2, 2008

Your Future Housing Options, Part 3

Currently, an insurance solution for the homeowner is to buy a put option which is generally considered safer than a futures contract as they cannot lose more than they invest. With a futures contract, the purchaser could lose more than the initial investment, although the upside is also greater than with an option. The buyer fixes a strike price and an expiration date, then pays a premium. If the index ends up being higher than the strike price on the expiration date, they do not owe any money. It is like buying car insurance and never filing a claim. If they fix a strike price and the index ends up lower than the strike price, they will receive the difference.

A comparison of buying a put option to buying insurance would be the following. Suppose you own a San Francisco home worth $1 million and want to protect yourself against a steep decline one year from now. To protect a $1 million house a year from now, you would have to buy 20 put options at a total cost of $70,000 today. To recoup the $70,000 investment, the San Francisco home-price index would have to be 12 percent lower in December 2007 than in December 2006. "It would have to go down more than 12 percent to make any money off the trade," states Fritz Siebel. “Why 12 percent? Because the market is already expecting a drop of roughly 6 percent, the other 6 percent represents the premium you are paying to buy the insurance. It's high today because there is more demand for this type of insurance than there are people willing to sell it. The premium will come down as more players enter the market.”

The Chicago Exchange is hoping that the housing contracts will catch on first with companies that need to hedge against the risk of falling real estate prices, such as homebuilders and mortgage lenders. Some of the issues preventing this are the lack of liquidity for these companies that have suffered immense losses and the cost of trades. Some insurers are also not sure of the reliability of the indexes to measure the fluctuation of home prices. Another problematic issue is the time frame of the contracts with many developers interested in long-term contracts of two to six years. The longest contract currently offered expires in one year. In addition to attracting companies from industries that have the most to lose, in order for the market to work, it will have to attract a large number of speculators, people who have no underlying risk to hedge, but who want to gamble on housing prices.

Since December 7th 2007, only 1,041 futures contracts and approximately 1,000 options contracts are outstanding. Together, those contracts insure about $100 million worth of U.S. housing. However, investors contributed only a small fraction of this amount, less than $10 million, due to the fact that investors generally buy futures and options on margin, similar to the way home buyers put down a fraction of the home's value and borrow the rest.

Although the individual homeowner could stand to benefit by investing in these futures, they do not necessarily offer a direct hedge against the price of an individual's home. Because contracts are offered in only 10 geographic regions and home prices within those 10 regions will most likely change in varying degrees, an individual could potentially see the value of his investment fall with the value of his house. Siebel feels that individuals can benefit from the investments; however, "futures markets are professional markets" and an individual should "fully understand what they're getting themselves into."

Waiting for the real estate market to rebound will be a long wait, an estimated 4 to 5 years. However, an investor still can make money in this market. With housing costs dropping at record rates, a wise investor can find properties to purchase far below market value to keep as rentals until the market stabilizes. Research of foreclosure filings, particularly tax sales, can also reveal properties with enough equity to make them good investments for a quick flip or to hold for more long term gains. With an influx of repossessed housing and properties that are heavily over mortgaged, lenders are often willing to negotiate short sales, or reduced mortgage payoffs, to avoid costly legal proceedings and repossession of properties that they do not want.

However, for a select few with discretionary income and an understanding of the derivatives markets, the Chicago Mercantile Exchange introduced housing futures and option contracts hold immense potential. These derivative instruments take advantage of declining house prices by allowing investors to purchase futures contracts, essentially betting that the values will go down, in a market almost certain to continue its historic decline. Utilizing the price-to-rent metric discussed, the current P/R ratio is at 24, 60% above the historical average of 15. Most economists agree that it will take approximately 5yrs for the P/R ratio to return to this historical average and that the foreclosure numbers have only begun to surface. Futures contracts or options as a form of home equity insurance to hedge against and/or profit from the prospective decline in housing prices are a creative and potentially lucrative option for an investor in this roller coaster economy.

Tuesday, February 5, 2008

Your Future Housing Options, Part 2

Continued from Your Future Housing Options, Part 1

Homeowners and investors looking to hedge against the decline in housing prices may find respite in an old corner of the financial market that allows them to bet on changes in future prices. Futures and options, known in the financial world as derivatives, help investors offset the risk exposure of their portfolios. A futures contract is a legal agreement to buy or sell a product for a given price at a given time in the future (hence its name), typically commodities such as pork bellies or oil. An option gives the buyer the right, but not the obligation, to buy or sell a security at a given price at or within a given time. Speculators buy futures and options to try to profit from market volatility; hedgers use them to offset the risks of adverse market movements on their investments. Most futures contracts are for physical commodities such as cattle, pork bellies or coffee beans, while the housing contracts are pegged to a more complex index of housing prices. The contracts for housing are tied to the S & P/Case-Shiller Home Price Index, a survey of housing prices in 10 metro areas (Boston, Washington DC, San Francisco, Denver, Chicago, Miami, L.A., Las Vegas, New York, San Diego) developed by Shiller in conjunction with Professor Karl Case and Standard & Poor's.

In late May, the Chicago Mercantile Exchange introduced Housing Market Futures and Options, an investment vehicle similar to futures contracts that allows investors to hedge against changing commodity prices. The exchange hopes that investors will seek protection through these instruments at a time when many anticipate a prolonged real estate decline. Futures contracts traded on the Chicago Mercantile Exchange show that traders expect double-digit declines in 9 out of the 10 biggest housing markets in the U. S. with the only exception Chicago, where prices are still expected to fall by 5.6% over the next year. In the latest batch of data released by Standard & Poor's for its S&P/Case-Shiller home price indexes, the national index of home prices showed a drop of 4.5% (yr/yr) from the third quarter of 2006, and a sequential decline of 1.7%. This sequential 1.7% slide is the largest since the index was first created. Robert Shiller, chief economist at MacroMarkets, responds to this report, "There is no real positive news in today's data."

To further understand how this proven method of investment in a volatile economy can be applied to the current housing market, consider the following. Futures and options are contracts that trade on exchanges to allow investors to bet on prices going up or down. They are known as derivatives because their price movements are derived from the price movements of an underlying security, asset or index. Investors' predictions about these real estate markets are certainly not guaranteed to be accurate. They do provide, however, insights into what people with skin in the game think lies ahead. These types of "predictive markets," have proven to be surprisingly accurate in forecasting everything from the outcome of political elections to housing movements.

To apply this strategy, suppose you own an expensive house in San Francisco that you are afraid will suffer a severe decline in value, but you do not want to sell it and move. You could stay in the house and sell futures or buy put options on the San Francisco housing price index. If home prices in San Francisco fall, the value of your house will probably go down as well. However, this loss will be compensated by the money you will earn on your futures contracts. If you bet wrong, you will lose money on your contracts, but you will have essentially insured yourself against this loss and will have retained the value in your property or possibly realized an increase. Unfortunately, futures and options have a steep learning curve, too steep for the average homeowner who wants to place a one-time bet. The housing contracts are also quite costly at this time as they are still relatively new and thinly traded. While the average homeowner can participate in these publicly traded futures, the cost of hedging might prove prohibitive unless they hold prime and pricey real estate that they want to protect. Each Mercantile housing futures contract is valued at $50,000.00 with an initial buy-in (also called a good faith investment or margin) of $2,500 (five percent of the contract's value), not including brokerage fees. Contract values have not been announced for the CBOE housing futures yet, but its offerings will carry a 10 percent to 15 percent initial buy-in.

Smaller-scale investing in housing futures has been offered since May 2005 at
HedgeStreet.com, a San Mateo, Calif.-based online exchange that offers futures contracts at up to $10 each. The new Housing Price Hedgelets are tradable as both Yes/No and Variable contracts with 3-month and 6-month durations and are benchmarked against the National Association of Realtors (NAR) reported Median Sales Price of Existing Single-Family Homes in Chicago, Los Angeles, Miami, New York, San Diego and San Francisco. Hedgelets are unique financial instruments that do not exist on any other market. John Nafeh, CEO of HedgeStreet states, "For most Americans, their home is their single largest investment and, as such, the desire to reduce risks surrounding that asset is important. Housing Price Hedgelets provide a unique way for them to hedge against depreciation in the value of a home, or conversely, speculate on the degree to which housing prices will appreciate."

The concept of insuring yourself against a big drop in the value of your home, the same way you can insure against losses from fire, hurricane, or a guest who gets drunk and falls down your steps, is a comforting thought. Someday, it might be as easy as adding a rider to your homeowner's policy. Shiller predicts that "Once we have a futures market, then people can develop home equity insurance and mortgage products that protect the equity in the home and they in turn can then use the futures market to hedge the risk they assume by creating these products." The housing futures market will hopefully, in turn, provide large insurers a way to hedge the risk of offering home equity insurance to consumers.

Concluded in Your Future Housing Options, Part 3

Wednesday, January 2, 2008

Your Future Housing Options, Part 1

Research from a multitude of economists, financial experts and housing professionals convey varying levels of negative projection for the U.S. housing market. All cite degrees of blame aimed at self serving lending institutions which made ill advised loans to unqualified buyers, packaged these loans which received a questionable “buy” rating and were then sold in the secondary market. The result, an unprecedented credit collapse in the U.S. economy, opaque institutional liabilities, a lot of finger pointing, and even more questions on how to potentially alleviate further housing depreciation. The resulting housing market plummet affects a large portion of Americans with relatively few solutions on hand. Application of the market strategy of hedging may perhaps be a creative solution for some home owners as a method of protecting what is for most Americans their greatest asset.

Housing valuations commonly utilize a metric based on the house price-to-rent ratio (P/R), which is akin to a price-to-earnings multiple for stocks. This metric is intended to reflect the relative cost of owning versus renting. Naturally, when housing prices are high relative to rents, potential home buyers will choose instead to rent, thus reducing the demand for houses and bring prices back in line with rent costs. Economists suggest that when price-to-rent ratios remain high for a prolonged period, prices are being sustained by unrealistic expectations of future price gains rather than the fundamental rental value, thus creating a bubble.

The application of this price-to-rent formula in key housing markets illustrates the dangerous climb in housing costs over the past seven years.

The price to rent ratio (P/R) compares the median single family home sale price to the median monthly rent for a 3 bedroom apartment in one of the top 10 housing markets. The financing terms assume a 20% down payment on a 30-year fixed rate loan and the historical median home sale price is determined by fitting the HPI index to NAR's median home sale price over the last few years. The median rent is again provided by Housing and Urban Development.

The basic formula suggests buying under the following conditions:

Rental rate + Appreciation - Interest cost > 0

Historically, the real after-tax, after-depreciation interest rate for houses is four percent. From 2000 to 2007 the nationwide P/R jumped from 15 to 24, an increase of 60%. Cities with the largest P/R increases are Tampa, 12 to 21; Washington, D.C., 11 to 26; and California’s east Bay, an area that includes Oakland, 28 to 51. Others argue that the historical P/R value should be 16.7 with the real after-tax, after-depreciation interest rate being 4 percent with additional maintenance costs (roofing, paint, HVAC repairs, broken water pipes, etc) taken into account. These are calculated at 1 percent per year and real estate taxes another 1 percent. To get a real return of 4% given these additional items, annual rent needs to be at least 6% of the house price instead of 4%, which then raises the P/R ratio from 15 to 16.7. For the sake of this blog, we will use the P/R ratio of 15. If the rental rate is 6% of the house price rather than 4%, it lowers annual appreciation rate from 4% to 2% which is not a realistic number. Lower price to rent ratios generally indicate that homes are more affordable.

Correspondingly, the U.S. housing phenomenon is powered indirectly by Asian funding. The Yen Carry Trade by Asian hedge funds exploits a 3.0% differential between U.S. and Japanese long-term interest rates. The yawning U.S. trade gap translates into a gargantuan trade surplus which Asian investors recycle into U.S. Treasury Bonds. Direct Asian central bank intervention, often transferred overnight, offers regular U.S. Dollar support by means of U.S. Treasury Bonds. Thus, Asian bond support is absolutely critical to the housing movement in supplying funds utilized in mortgage financing. Erosion in confidence in the U.S. economy and subsequent reduced investment in U.S. Treasury Bonds, along with the liquidity problem created by the foreclosure crisis, has led to a serious decline in consumer lending and subsequent adverse effects on the housing market.

Many analysts say the worst is yet to come. Banc of America Securities predicted in a report last month that the median U.S. home price would fall 15 percent over the next four years and not rebound until 2012. This is decline is partially fueled by foreclosed housing that causes comparable sales in a given area to under represent their true value. Bank of America, who recently bailed out mega lender CountryWide by injecting them with much needed funds, further estimate that with $361 billion in subprime loans made to borrowers with weak credit scheduled to reset at higher interest rates next year foreclosures will peak in the third quarter of 2008 and will not return to more normal levels until 2011.

The options for homeowners in the face of such negative reports are limited. Few people are willing to sell their homes now to avoid possible declines in the future. But Yale economists Robert Shiller raised one provocative possibility after the latest data was released, suggesting that homeowners may want to consider hedging their homes as a way to protect themselves against declines in their home values.

Continued in Your Future Housing Options, Part II