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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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Arbitrage Opportunity For The Individual Energy Investor

Arbitrage Opportunity For The Individual Energy Investor

Hedge funds and other sophisticated investors use a variety of different strategies to earn a profit. Some of these strategies are too complex or costly for most individual investors, but one of the most popular is not.

The idea behind a pair trade is to match two highly correlated securities against one another by taking a long position in one and a short position in the other. The result is a portfolio that is market neutral and instead evolves based on changes in the relative value of the two securities.

One great pair trade right now is NuStar Energy LP (trading under ticker NS) and NuStar General Partners Holdings (trading under ticker NSH). Related: This Is Why A Serious Decline In U.S Shale Plays Is Not Far Away

As the two names suggest, the firms are closely related. So closely in fact, that a pair trade between the two should properly be called arbitrage rather than a trade. NSH is a limited liability company with an ownership interest in NS. Through its ownership of NS, NSH is engaged in “the terminalling and storage of petroleum products, transportation of petroleum products and anhydrous ammonia, and petroleum refining and marketing. It holds a 2% general partner interest, 12.9% limited partner interest, and 100% of the incentive distribution rights in NuStar Energy L.P. The company, through NuStar Energy L.P., has interests in 81 terminal and storage facilities with approximately 93 million barrels of storage capacity; and 8,708 miles of crude oil and refined product pipelines.” NS is an MLP and is the only substantial cash generating asset for NSH.

NS pays out a larger dividend as an MLP (a little under 8%) compared with NSH’s dividend (about 6.5%), so over the long-run the share prices do differ a bit because of that. NSH also holds a cash cushion for operational expenses, but it is an LLC so it passes through most of its income (which comes from its ownership stake in NS) to shareholders. But in theory, over shorter periods of time, the two stocks ought to move largely in step. Related: Saudis Expand Price War Downstream

However, that is not always the case, and when the valuations on the two diverge substantially, investors have a good opportunity to take positions and wait for the divergence to close.

Currently, NS appears to be trading at an unjustified premium for NSH. That distortion should be temporary though. The differential could be a result of the fact that NS generally trades more shares than NSH, and the lack of liquidity in NSH does not result in prices responding as quickly to news (such as the information from the firm’s latest earnings release recently).

Or it could simply be a result of a temporary increase in demand for stocks that pay higher dividends by investors. Regardless, over the last year, NS has outperformed NSH by roughly 10 percent. In particular, from July 20th to the 24th, NSH fell about 5 percent while NS was roughly flat. This gap is not sustainable in the long-run. If the underperformance continues, a large investor could buy enough shares in NSH to force the shared management of NSH/NS to make changes to the corporate structure. Related: 9 Reasons Why We Should Be More Worried About Low Oil Prices

There are a number of ways investors can take advantage of the current valuation discrepancy: either through options or direct equity holdings. In any case, investors should look at opportunities to go long NSH while simultaneously shorting NS. Due diligence is needed here and individual investors need to be careful about their costs, but this is a safer trade than many in the climate of today’s elevated market valuation.

By Michael McDonald for Oilprice.com

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