Tuesday, June 10, 2008

Pick-a-Pay or Pick-a-Prayer?

Ever see the movie Aliens?

In this movie classic, there are hostile alien creatures whose facehugger larvae spring from their eggs onto the faces of their host victims, with the requisite screaming and hysteria of the hosts. However, within a few minutes the facehuggers fall off, and the hosts wake up, seemingly returning to normal.

But all is not normal... soon the hosts feel something throbbing... deep under their ribs.. and then one-by-one a gruesome alien burst out of their chests, instantly killing him. The hatched aliens then proceed to go on a killing rampage.

While the market has seen its fair share of chest bursts over the past 18 months: writedowns for subprime loans and actual subprime portfolio losses, a variety of commercial banks, investment banks, and MBS REITs are still incubating chest bursters of a different breed, in the form of Option ARMs and Alt-A loans.

In order for us to full comprehend the magnitude of the issue, we have to first understand exactly how Option ARMs and Alt-A mortgage loans were issued and how they operate.

Option ARM
A) Option ARM Minimum payment mortgage borrower
B) Option ARM Interest only payment mortgage borrower
C) Option ARM Fully amortizing payment mortgage borrower

Alt-A
X) Alt-A: Intended recipient mortgage borrower
Y) Alt-A: Little white liar mortgage borrower
Z) Alt-A: Big fat liar mortgage borrower

Friday, June 6, 2008

Crude Oil Posts Record Gain of $11/bbl, Record close at $138.54

Crude oil (CL) posted the greatest dollar gain in its trading history today, up $11 per barrel for the front month July contract, closing at a record high of $138.54, and briefly trading as high as $138.80.

Factors at play (from greatest to least importance IMHO):
1) Lehman Raises 2008 Oil-Price Forecast, Profit Outlook for Oil Producers
2) Israeli politician threatens Iran with attack over nukes
3) Nigerian Oil Union Says Chevron Unit Hasn't Met Demands, Threatens Strike

I closed out the XTO long today at $67.50 and the FSLR short at $253. Currently investigating a new energy equity play.

Close Trade: First Solar and XTO

Closed XTO long and First Solar short this morning, at $67.50 and $253 respectively, for ~14% net gain, grossing a 20% gain on XTO plus an 8% loss on the FSLR short weighted ~80:20.

Forgot to mention, Bob Simpson is the Warren Buffet of natural gas and, to a lesser extent, oil. He is, at heart, a super efficient capital allocator. For a buy-and-hold portfolio XTO seems like a good match: as long as Bob is a the helm, XTO returns will outstrip its peers

Thursday, June 5, 2008

Hedging Rationale

What's the point of hedging oil price risk in a long XTO position with a short FSLR position? Why not short USO or crude futures directly?

The rationale is my expectation for divergent responses, both in FSLR's stock to oil price increases versus decreases at the current extremes and in comparison to XTO's stock.

Fear is generally a more powerful motivator than greed in extreme situations. For example, the magnitudes of the largest 1 day declines in the DJIA are far greater than the magnitudes of the largest 1 day advances in the DJIA. One can also see this phenomenon in market bubble formation versus subsequent bursting, typically the bubble bursting is far faster than the bubble formation.

I expect that if we have a sizeable pullback in oil prices from this new extreme high, perhaps analagous to August-September 2006 correction from the then extreme high of $80, FSLR will have an even larger pullback, as solar PV companies tend to have, while XTO has historically had a more muted response by comparison, thanks largely to its hedging and conservative approach.

I also expect that if we have an increase in oil prices, with the recent FSLR CEO sale controversy and its extraordinarily high valuation, XTO will have a more sizeable response compared to FSLR, relative to their betas.

More on First Solar and XTO

I've done some additional fundamental research into FSLR's CdTe solar panel technology and I'm increasing my XTO long:FSLR short ratio to 4:1 from 2:1. While the FSLR P/E ratio of 100 seems stratospheric and its future earnings potential, even as a best-of-breed company, seems priced into the stock, the competitive advantages of FSLR's technology are compelling enough to change the hedging ratio.

CEO Ahearn's sale of half his shares was a bonehead move, but I'm not convinced it signals dark days ahead for FSLR.

Fundamentally FSLR seems to be the only company to have large scale commercialized thin-film CdTe panel production at prices which are even remotely competitive without government subsidies. In fact with an all-in cost per peak watt of approximately $1.30, FSLR's costs are far lower than any other commercial a-Si or multicrystalline Si panel manufacturer (Google funded NanoSolar claims to have a CIGS-based panel with sub-$1/peak watt manufacturing costs, but I'll reserve judgment until there's full scale production). The recent drastic reduction of government solar subsidies in Spain and Germany, two of the largest global solar markets, may make FSLR's manufacturing cost advantage even more valuable.

On another note, West Texas Intermediate Crude Oil (CL) is up today on ECB inflation expectations. The PV solar sector is likewise in the black.

With the 2:1 hedge ratio and entrance into an FSLR short at $245 for the hedge, I'm in the black for the day, though not as much as I would be without the hedge. I've increased my XTO:FSLR hedging ratio to 4:1.

Wednesday, June 4, 2008

Trading Pair: First Solar and XTO Energy

First Solar's (FSLR) CEO sells half his holdings in the company, revealed on Monday.
The stock trades at a P/E > 100.
Only product is CdTe thin-film solar panels.
Chart technicals show Aug 2007 trendline broken today, EMA 100 broken today, and double top formation: in other words the stock technicals seem to be screaming "short me".

Currently I have a very concentrated long position in XTO, but I'm thinking of adding a short on FSLR. Should oil prices drop, FSLR will fall faster than a bat out of hell, making it a good hedge for oil production equities. The whole solar sector seems to be well correlated with the crude strip. However, XTO Energy is primarily a natural gas producer. Still, the correlation between NG and CL has been fairly large as of late and XTO has recently added about 10,000 bpd capacity with its Bakken play.

Fundamentally there should be a correlation between FSLR and the NG strip, not FSLR and the CL strip, since solar photovoltaic electric generation largely displaces natural gas based electric generation.

No one has really used fuel oil for electric production in the last five years, too expensive on a dekatherm basis compared to natural gas for marginal electric production, dual fire generation has been on gas since 2002, and anyone who can convert from fuel oil to natural gas has converted.

Hence the widening spread between NG and CL on a dekatherm basis: CL and its derivative, fuel oil, have more than doubled from last year's lows but the substitution effect is no longer present in full, as fuel switching from fuel oil to natural gas has already largely occurred to the maximum physical extent possible. Limited substitution effect = limited ability of CL rise to cause a rise in NG prices.

I'm looking at a $245 entry for the FSLR short, and targeting the 200 day EMA around $205 for exit, in a 2:1 XTO long:FSLR short ratio, beta ratio between the two is 4:1.