August 2005 Archives

Melanie Trottman wrote an interesting Wall Street Journal article HEARD ON THE STREET: Ouch! Jet-Fuel Prices Outpace Crude (subscription required).

The widening gaps between the price of crude oil and various types of fuel -- known in the industry as crack spreads -- are dealing a one-two punch to an industry that can ill afford it, where fuel is the second-biggest expense after labor. The average crack spread for jet fuel topped $11 per barrel in the first half of this year. That is up from an average $2.59 per barrel in 2002, with the biggest jump occurring in the past six months, said Mike Lovett, chief executive of Muse, Stancil, a Dallas global-energy consulting firm.

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Tight refining capacity has played a role in the price run-up. The industry has a shortage of capacity to refine heavy oils, which has pushed up the price of lighter oils, like the benchmark West Texas Intermediate.

To a reeling airline industry, the widening crack spread couldn't come at a worse time. For nine of the nation's largest airlines, the second-quarter fuel bill totaled a combined $4.34 billion, said Bear Stearns analyst David Strine. Had the crack spread held at year-earlier levels, the fuel would have cost $3.92 billion, a difference of more than $420 million. That is more than enough to erase the $227.4 million those airlines collectively lost in the period.

"Those of us in the airline industry are being doubly hurt," said Gerard Arpey, chief executive of American Airlines, whose annual fuel costs rise by $29 million for each one-cent rise in the cost of jet fuel per gallon.

I found the article interesting on a few different fronts. First, I am surprised the economy and the stock market have done as well as they have with oil prices at prices hovering at about $60. Second, although I do not like to invest in airline stocks, I wonder if airline stocks would be a good speculative trade in a declining oil price environment. Perhaps the larger question is, Will we get a declining oil price environment soon? Third, I am surprised by how far the crack spread has widened and the inability of the refining industry to react. In the article, Trottman states that the refining industry has a shortage of capacity to handle heavy oils, which explains the large differential. And fourth, because Canadian oilsands produce heavy oil, this problem would seem likely to grow in future years as oilsands producers continue to increase their production or, in the case of new producers, begin production. A good depiction of the heavy spreads can be seen from the Sproule Associates graph of heavy oil price differentials. In the graph, however, Sproule predicts that the heavy oil differentials will shrink dramatically over the next couple years, although the anticipated spreads in year 2007 are still well above historical norms. Thus, I assume that the refining industry is investing heavily to address the abundance of heavy oil. In the article Gene Edwards, senior vice president of supply, trading and wholesale marketing for refiner Valero Energy, indicated that his industry is currently enjoying a return on capital in the range of 20% compared to its normal return of about 5%. He further stated that he expects the return on capital to remain at an elevated level. I am dubious of any business enjoying an abnormally high rate of return for a sustained period, and I am especially dubious of high returns for those industries that are investing heavily in future capacity. I found Melanie Trottman's article interesting because of all uncertainties that surround oil, and how those uncertainties affect investment decisions.

Update

Andrew Dowell and Beth Heinsohn write a good complimentary article in the Wall Street Journal More Outages Hit U.S. Refineries. They discuss how U.S. refineries have been hit by unusual number of outages, which has resulted in a higher oil price.

This is just a quick note to let you know that I have updated my Favorite Photography Related Websites to include three photoblogs. Be sure to visit all three for great photography.

The Wall Street Journal Online in its article Russian Mini-Submarine, Seven-Member Crew Rescued (subscription required) reports that the Russian sailors have been saved.

PETROPAVLOVSK-KAMCHATSKY, Russia -- A Russian mini-submarine that was trapped for nearly three days in the Pacific Ocean surfaced Sunday with all seven people aboard alive after a British remote-controlled vehicle cut away the undersea cables that had trapped it.

All seven aboard the AS-28 mini-submarine appeared to be in satisfactory condition, naval spokesman Capt. Igor Dygalo said. They were examined in the clinic of a naval ship, then transferred to a larger vessel to return to the mainland.

"The crew opened the hatch themselves, exited the vessel and climbed aboard a speedboat," Rear Adm. Vladimir Pepelyayev, deputy head of the naval general staff, told reporters. "Preliminary indications are that their condition is satisfactory."

"I can only thank our English colleagues for their joint work and the help they gave in order to complete this operation within the time we had available - that is, before the oxygen reserves ran out," he said.

A similar story can be found in The New York Times Online All 7 Men Alive as Russian Submarine Is Raised (free registration required)

This is absolutely fantastic news. I hope that the sailors are recovering well after their ordeal.

Stacey Briere in this weekend's Barron's wrote an article Hard-to-Borrow Stocks May Offer Easy Discounts (subscription required) where she discussed how to create a synthetic short position by purchasing a put and selling a call at the same strike price. Creating a synthetic short position using options is especially helpful when the outstanding short position is already substantial. However, crowded shorts often make very poor candidates for shorting because of the potential short squeeze. So be careful.

While I certainly understand the synthetic short position described by Briere, I might simply purchase a deep-in-the-money put to achieve the same effect. A deep in the money put is effectively a short position. As the stock goes down, the put position increases in value. As the stock rises, the put position looses value.

I am going to ask Adam Warner at Daily Options Report (one of my Favorite Financial Websites) to comment on the two different methods of creating a synthetic short. Which method is better and why? When would one method be preferable over the other? I look forward to his comments.

Update

You can read Adam's response at Buying Deep Puts vs. Synthetic Stock Shorting.

THE NATIONWIDE INFATUATION with property has spilled over into the stock market, where shares of real-estate investment trusts have soared, despite spotty operating results and higher interest rates.

The run-up in REIT shares, which have doubled since early 2003, has raised concern on Wall Street that a bubble could be forming in the $300 billion sector. "Our view is that valuations are in uncharted territory, and the group is very susceptible to a correction," says Jonathan Litt, the REIT analyst at Smith Barney. What's the downside? Litt says that shares of real-estate investment trusts could fall more than 10%. This year, the major REIT indexes are up about 10% (including dividends) after 30%-plus returns in both 2003 and 2004.

Some cracks may be starting to form in the REIT sector. The group declined 2% Thursday and was down about 3% Friday., hurt by a setback in the bond market that followed the release of stronger-than-expected July employment data Friday morning.

The two-day selloff illustrates the volatility in REIT stocks. Morgan Stanley's REIT index, for instance, dropped 10% in January and had rallied 25% from late March until the middle of last week. Still, REITs often appeal to risk-averse investors who don't recognize this.

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"REITs are being priced for perfection," says Peter Siris, who heads Guerrilla Capital, a New York investment firm. "REITs have benefited because the economy has stayed strong while rates haven't gone up. But I don't think you're going to have a decent consumer economy and lower rates forever." Siris points to steady insider selling by REIT executives as a sign of the sector's overvaluation.

Andrew Bary in this weekend's Barron's wrote an excellent article Pop! The Other Real-Estate Bubble on REITS (subscription required). Much has been written about the impending bursting of the real estate bubble. This article outline clear reasons why you should be cautious about REITs. I highly recommend this article even if you are not invested in REITs because it demonstrates, once again, how easily markets can become disconnected from the underlying fundamentals. Whenever something is priced to perfection, you should be cautious because your upside is limited while your downside is substantial.