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.

No comments: