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Michael McDonald

Michael McDonald

Michael is an assistant professor of finance and a frequent consultant to companies regarding capital structure decisions and investments. He holds a PhD in finance…

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An Energy Pair Trade To Take Advantage Of Current Turmoil

One of the oldest statistical arbitrage techniques on Wall Street is the pairs trade. The concept behind the strategy is simple – find two stocks that have historically moved together and then when they diverge, take a long/short set of positions and wait for the correlations to reassert themselves.

While pairs trading is conceptually simple, it has a long history of being successfully used by Wall Street firms, hedge funds, and many other institutional investors. The only real barrier to entry on the strategy is being able to identify the relevant correlation in the first place. Related: How Leonardo DiCaprio’s Carbon Footprint Clashes With His Climate Claims

Pairs trading is a simple and effective strategy, but it works better under some market conditions than others. The current environment of market volatility is exactly when pairs trading is ideal. Given the low barriers to entry around the strategy, it’s not surprising that pairs trading works best in times of market turmoil since microstructure differences are more likely to cause trading imbalances and distortions in these cases.

One good opportunity in the energy space right now is a long position in Frank’s International and a short position in W&T Offshore. W&T Offshore (WTI) is an oil and gas E&P firm with holdings primarily in the Gulf of Mexico and the Permian Basin. The firm is struggling mightily against a tide of negative economics that are hammering its business. WTI has dropped from around $17 a share in mid-2014 to less than $2 a share until last week. S&P cut the ratings on WTI and a number of other E&P firms to distressed levels last month, reflecting the tough environment that WTI faces. Related: Court Decision Threatens Midstream Sector

In contrast, Franks International, while suffering, is holding up relatively well. Frank’s provides tubular services for offshore firms and it is in a global duopoly with Weatherford in that market. Franks also has an onshore business, but that market is much more competitive. The offshore market has long been the bread and butter of Frank’s operations, but offshore drilling has been absolutely destroyed by the current downturn.

Nearly every OFS company out there is in big trouble and several firms have already declared bankruptcy. In contrast, Franks is a relatively stable player – it has no meaningful debt, limited competition in its core market, and a solid reputation in the industry. In better times, Franks is exactly the kind of firm that might be scooped up by a bigger player like Schlumberger or a private equity firm. Instead Franks has suffered like the rest of the industry. The firm has fallen from around $25 a share in mid-2014 to roughly $15 a share today – a steep drop, but a reasonable one given the distress in the offshore sector overall. Related: Oil Prices Up In Spite Of Crude Inventory Build

WTI is one of the most heavily shorted stocks in the market, and that short interest caused a squeeze recently as W&T Offshore rocketed higher. Franks also moved higher with both stocks benefiting from the recent upswing in oil prices, but WTI’s move was much more violent and likely driven by internal market mechanics rather than fundamental changes in valuation. This creates an opportunity for investors to capitalize on this mispricing and wait for fundamentals to reassert themselves. The chart below illustrates this, showing Franks in blue and W&T in purple.

(Click to enlarge)

Given the distress in the oil sector overall, some investors might wonder why one should bother with either a long position in Franks or W&T Offshore. The answer of course is that it’s impossible to say when oil will begin to recover, and ignoring the energy sector ignores a major value investing opportunity. By taking a long position in FI, and a short position in WTI, investors are poised to capitalize on a market mispricing driven by liquidity needs and short covering.

By Michael McDonald of Oilprice.com

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