A few months ago there was a discussion regarding the problems with Libor, in particular, how many banks may have been under-reporting their actual cost of borrowing. At the time there was speculation that a new way was necessary to insure that the rates quoted actually represented the true cost of borrowing. A recent article in the Financial News discusses how swap traders are once again beginning to show interest in alternatives to Libor.

Potential alternatives include the Sonia (Sterling overnight index average) and Eonia (Euro overnight index average). While Libor is calculated each day as an average of what banks state (think) are their borrowing costs, the Sonia and Eonia are effective rates computed as a weighted average of overnight unsecured lending in the interbank market. The Eonia is one of the benchmarks for the euro zone money and capital markets and is the standard interest rate for Euro currency deposits. The European Central Bank calculates the Eonia daily.

Most interest rate swaps have short maturities under two years, but more than one day. Swaps pegged against an overnight fixing are known as an Overnight Indexed Swap (OIS). This overnight market is a small part of the overall interest rate market, but interest in the market is increasing as traders look for alternatives to Libor. Numerous traders, from FX traders, hedge funds, mortgage lenders, and asset swap traders are showing interest for two curves, one against Libor for longer-term swaps, and one for overnight fixings.

Even with its problems, it is probably too early to write-off the Libor rate, as highlighted in a recent Reuters article (posted on Forbes.com). Many feel that the Libor system is not broken, but that recent volatility can be blamed on the reluctance among member banks to lend to each other as a result of the on-going credit crunch. The number of assets pegged to Libor is too large to make a quick transition. It is more likely that further steps will be taken instead to insure that banks are reporting the correct borrowing rates.

As reported in an LA Times article, the country of Bolivia is opening up a 40 billion ton deposit of iron ore for mining - the world's largest concentration of iron ore at a single site. The Indian company Jindal Steel and Power has been granted a 40 year concession to mine the ore at El Mutun, extending over 23 square miles. The rush to secure iron ore has increased as the demand for steel continues to climb.

In order to run the operation, it is expected that natural gas will be used as the energy source to power the necessary machinery. Bolivia has been one of South America's poorest nation despite a number of natural resources, such as natural gas, tin, zinc, silver and gold. Nonetheless, environmental and political issues have kept the resources in the ground. High commodity prices have a way of changing perspective. It is expected that revenue from the iron ore deposits will supply about 5% of the annual revenue of the Bolivian government. In addition to India, companies from China and Europe have been bidding on projects in the area.

As reported in a Financial Times article, banks are reporting a 65% increase in the practice of supply chain financing (SCF). This practice essentially involves using a company's unpaid invoices, or receivables, to secure financing. In some cases the company can also receive a lower borrowing rate. As reported:

"SCF involves companies and their suppliers agreeing to extend the payment period to the supplier, who still obtains early payment from the buyer’s bank. The buyer gets the benefit of longer payment times, the supplier lowers its working capital costs, which it can then pass back to the buyer in lower prices. The bank in the middle has the invoices to secure its lending and earns a margin on the loan."

The technique is essentially an alternative to the traditional asset-backed commercial paper market, where banks have also used receivables as the assets to back the paper. When the commercial paper market froze up, many started considering using supply chain financing. While SCF is an alternative source of financing for companies having difficulty obtaining traditional credit, it is also giving some banks a more efficient use of their balance sheet capital.

Looks pretty similar to me. Financial innovation never sleeps ......... or do ways for finding new sources of funding.

As reported in a recent Barron's article, how much money investors get back from auction-rate securities depends on who originally issued the securities. Auction-rate securities are debt that matures in 30 year or more, sometimes in perpetuity. The recent increase in the number sellers compared to buyers has caused some problems in the market, with some issuers running for the door. How the security was initially issued, and for what purpose, may impact how fast you are able to redeem the security.

The investors of auction-rate securities sold by a municipality or a closed-end taxable mutual fund have already received their money or will be receiving it soon. Investors in closed-end tax-free municipal-bond funds will also likely receive their money, but may have to wait a little longer. Not surprisingly, the investors that purchased auction-rate securities sold by a CDO or student-loan trust will not get their money back for some time, up to many years. Many auction-rate security holders have no idea what the CDOs own since the information is not disclosed. Estimates have about $20 billion of CDO auction-rate securities that are failing to be sold in auction and therefore illiquid. Many of these securities will not be redeemed, and will essentially stay outstanding until the CDO either collapses, or the investment within the CDO mature - in some cases, many years out.

For student loans, many loans are financed by selling them into a trust, and the trust then sells medium and long-term debt, some of which are auction-rate securities. For the trust, there are not many refinancing options given that student-loan financing costs have gone up quickly. Initial rates from some failed auctions were 10% or higher. To prevent problems, some trust have a mechanism that prevents the average rate from going high enough so as to push a trust into default. Some student-loan based auction-rate securities are therefore offering 0% rates to investors, with average rates of 3%. With such low rates, this doesn't encourage student-loan trusts to fix the liquidity problems anytime soon.

Unfortunately, auction-rate securities are probably just one example of what is no doubt becoming a much larger problem. As investment companies continue to deal with their own credit issues, expect more of the fixes, and consequences, to roll down hill.

Below are the weekly link summaries for the usual groups: commodities, derivatives, hedge funds, private equity, quantitative finance and financial engineering, and trading. As usual, hopefully you find some articles that you may have passed over, but might be interested in reading. Enjoy the long holiday weekend.

Commodities

Oil's tense trading scene may sway a move to Dubai
Myra Saefong - MarketWatch.com
* The Dubai Gold and Commodities Exchange will begin trading crude-oil futures on Tuesday. This planned commodity trade is turning out to be a timely move given the talk from Congress and elsewhere about the regulation of speculators in the commodity markets. As with many actions in Congress, there are unintended consequences. The movement of trading off-shore may be one such consequence. Without really affecting the overall problem, the move may just end up taking the control of the issue out of our hands - to the extent it can even be controlled. Liquidity and volume are low in comparison, but in a few years the Dubai exchange could see an increase in volume as traders look for a friendly environment.

Derivatives

Citigroup Says Swaps Mania in Muniland Is Finished: Joe Mysak
Joe Mysak - Bloomberg
* Sales of synthetic fixed-rate munis, used to help the municipal market hedge their bond issue interest rate risk, are being scaled back, in part due to counterparty risk, but mainly due to inexperience. Many local municipalities are realizing that they don't have the experience and knowledge to understand the risk involved, the money to hire professionals, or the ability to know if the professionals (if hired) are taking advantage of them. As a result, they are eliminating one type of risk, but are in some instances now leaving themselves without a hedged position.

World Watches EU's Carbon Trading Scheme
Leigh Phillips - BusinessWeek
* Another article about the law of unintended consequences. This time with carbon trading. When Europe first implemented carbon trading, the scheme resulted in windfall profits for energy companies, drops in the price for carbon credits (due to over-allocation), and a disincentive for the industry to increase expenditures on clean energy infrastructure and efficiency measures. The result were higher consumer prices, higher energy company profits, and higher carbon emissions. Hopefully the EU experiment will provide lessons. They are currently taking measures to correct mistakes.

Derivatives Market Grows to $596 Trillion on Hedging
Abigail Moses - Bloomberg
* Data shows that derivatives on debt, currencies, commodities, stocks, and interest rates has increased 44% compared to last year, to $596 trillion. Amazing numbers indeed. CDS protection doubled during this time to $58 trillion of debt. Interest rate derivatives were up 35%, foreign exchange derivatives were up 40%, equity derivatives were up 14%, and commodity derivatives were up 26.5%.

OTC platform to offer iron ore access
Javier Blas - FT.com
* Both Credit Suisse and Deutsche Bank are teaming together to create an off-exchange over-the-counter (OTC) market to trade iron ore swaps. The swaps will have initial maturities out to December 2009 and be cash settled on a monthly basis against an iron ore index published by the Metal Bulletin. Iron ore was one of the largest commodities without a market, and given the rising demand and prices for steel, it makes sense that a new hedging (and speculation) contract would be offered.

Hedge Funds

Global Hedge Funds Rose in April as Worldwide Stocks Gained
Tomoko Yamazaki - Bloomberg
* Overview of global hedge fund performance. Of interest is how hedge funds worldwide were up in April as global stock markets recovered. In particular, managers of long-short equity fund were the best performers.

Age is key to hedge funds
Anuj Gangahar - FT.com
* A recent study finds that hedge funds that are less than two years old produced higher returns on average than older funds (11.7% per year to 10.2% per year), but that older funds tended to have returns that were more steady. In a sense, as managers get older, return is given up for risk management. It was not mentioned in the article, but this may results from the manager having so much of their wealth in the fund the he or she starts to get a little more conservative.

Hedge Funds in Swaps Face Peril With Rising Junk Bond Defaults
David Evans - Bloomberg
* Interesting article on the problems with trading in swaps in the current market. This is a longer article, but well worth the read. In part, it discusses how given that the swap markets are basically unregulated, counterparty risk is not only present, but it is difficult to quantify. But this is not stopping the swap market, which has doubled every year since 2000, and is currently larger in dollar value than the entire NYSE. As of now, 40% of credit default swap protection sold worldwide is on companies or securities that are rated below investment grade. Estimates have hedge funds selling about 31% of all CDS protection, yet many have not been asked to post adequate collateral to back up their positions, and no set regulations are in place. Many hedge funds do not have the necessary funds in place if a problem does develops.

Ex-Amaranth Trader Hunter Helps Deliver 17% Gain for Peak Ridge
Saijel Kishan - Bloomberg
* Well, if you are wondering why anyone would hire Brian Hunter, the hedge fund trader that helped bring down Amaranth Advisors in 2006, this is why: His new fund returned 17% last month using a similar strategy as that employed at Amaranth. The fund is using option spreading strategies on natural gas prices, nearly the same strategy to that was used at Amaranth. The quote of the day comes from energy analyst Kent Bayzaitoglu: "To have lost that amount of money and get back into the market with a similar-type trade takes a lot of confidence, if not arrogance."

Private Equity

Mideast Private Equity Looks to India
Saikat Das - BusinessWeek
* Middle East sovereign wealth funds are beginning to focus on the country of India as a result of believing that the country’s long-term growth prospects are good and that the country is decoupled from the United States. Areas of interest include real estate, health care, retail, and education. The number of private equity deals in India for the first four months of year were 156 ($4.94 billion) compared with 136 deals ($3.42 billion) over the same four months in 2007.

The year of the vulture
Allan Sloan and Katie Benner - Fortune
* Article on private equity, discussing how those that will profit are most likely to be the firms that profit from other's misfortunes. In particular, firms are "double cropping," or in other words, making a second profit from the buyouts already done by offering capital to the institutions that financed the original deals and now need help. In a sense, they are buying their own debt back from the banks at reduced cost, given that the banks were unable to unload it after the credit crunch, not only eliminating the extra commissions and fees, but also now exposing themselves to credit risk. Ah, the old golden rule - those with the gold make the rules, and in this case, profit from the misfortunes in the market. Those with capital truly can buy when things look the worst, and not just pray on others, but also help them out of difficult positions.

Quantitative Finance and Financial Engineering

Quantitative funds aim to retool models
Mark Copley and Ben Wright - WSJ
* Interesting article on how quant funds suffered as the credit crisis unfolded, causing many of their models to breakdown. One aspect that has the quant managers worried is how many of the quant strategies that are being used seemed to be affected in the same way at the same time for certain market conditions, suggesting that the models were using the same techniques - a kind of quantitative herd mentality. It is believed that one of the problems is that they tend to use the same type of academic research, and be trained by the same set of researchers. Many are now trying to considering non-traditional public information (at least non-traditional for quants), such as short interest, quality of R&D, and insider buying.

Quant to Double Assets This Year After Beating Hedge Fund Peers
Netty Ismail - Bloomberg
* The rise of the quants from the ashes. Well, not exactly, but the QAM Asian Equities fund, a small Singapore-based quant hedge fund is doing well by betting against stock index futures. The QAM global fund rose 44.5%, while the Asian portfolio gained 66.2% in 2007. Not bad in the current market, especially for a fund not concentrated totally in energy. The fund has only $150 million in total assets under management, but is growing at 30% per year. The fund manager has a Masters in computer engineering, among other graduate degrees.

Trading

The Most Promising ETF's? Russia and Coal
Dash of Insight Blog
* A discussion of various ETFs, with an emphasis on an ETF from Russia and a Coal EFT. A sector ETF report is also provided by Dash of Insight. Of interest, not surprisingly, are that energy and international EFTs continue to rise to the top of the list.

Straddle Strangle Swaps
Condor Options Blog
* A nice overview of the straddle strangle swap, which is a specific type of double diagonal that involves selling a front month straddle and buying a back month strangle. Too much detail (see the article) without reprinting everything in the article, but the position has a number of positive attributes. In particular, it has a larger width (more profit opportunity) and positive vega, but only half the theta of a swap (for the example given). It can also be entered for a credit rather than a debit. Nonetheless, it does require more commissions.

There is an interesting Barrons' article this weekend that highlights the difference between reported and operating earnings, including their overall effect on P/E ratios (which are used to make bull and bear cases). In a nutshell, operating earnings exclude write-offs, while reported earnings do not. In the past, the two were nearly the same for most companies, and certainly the market on average, but recently there has been a divergence given the level of housing and credit write-offs that companies are now taking. As reported in Barron's, with data from Comstock Partners:

"Reported earnings for the S&P 500 for 2007 were just over $66. The operating earnings for 2007 were $84.54. The estimated numbers for 2008 are about $69 for reported earnings and about $90 for operating earnings."

This of course will affect your view of whether we are in a bull or bear market, or somewhere in-between. The article goes on to mention how:

"If you are a bull, you will say that the market is trading at a very reasonable 16 multiple on the $89.44 of earnings in 2008 and 13 times the 2009 estimate of $110.44. On the other hand, if you are a bear or just a reasonable person you can see the market is trading at 24 times trailing earnings and about 21 times the estimate of 2008 reported earnings."

Given that markets tend to peak at P/E ratios around 20 and bottom at P/E ratios around 10, your earnings estimate, whether using operating or reported earnings, is important. Of additional interest is how earnings typically will only grow at about 6% per year over the long-term, a trend that reflects growth in real GDP plus inflation, with real GDP constrained on average by increases in the labor force and the level of productivity of those same labor force workers. When the earnings of the market rise above this 6% number, we see reversion to the mean. Given the current market multiples, it is expected that the market will not only go lower, but that it is likely to overshoot and fall below the 6% average trend line earnings, as it often does in corrections.

The old saying "Sell in May and Go Away" has not worked much in the last few years. Maybe this is the year we revert back to the actual mean ..... or meaning of the old saw.

A recent WSJ article highlights a commonly overlooked effect or consequence of commodity trading - that of bad hedging or speculation bets causing buying pressure, driving prices higher. As for speculators, we often assume that they are just following the short-term trend, which is currently up, adding further momentum buying pressure. Sometimes the buying pressure comes from speculators and hedgers that are simply exiting out of a bad past position, either due to margin calls, or simply because they can no longer take the pain.

Many producers entered into contracts to sell crude oil in the future, locking into higher prices for future delivery. While the future prices were higher than the spot price at the time the contract was written, some of the contact prices are now as little as half the current spot price, even for contracts with a delivery of less than one year. As a result, companies and traders are being forced to close these deals by buying back existing contracts that were wrote just months ago.

Longer-term trading has increased over they years, with Nymex oil futures contracts tripling over the last four years, with much of the growth coming from futures contracts that expire more than one year out. This form of long-term hedging and speculation was relatively rare in the past and is certainly contributing to some of the current increase in trading activity and price movement as these trades, which were probably not expected to be as speculative, are now needing to be unwound.

A recent Bloomberg article also discusses the impact of speculators selling out their contracts, but focuses more on short-term speculators that have recently closed out short positions after making bets that the price of crude oil would decrease after the recent run-up. The closing of these contracts has put further buying pressure on the commodity. As evidence, open interest has been falling for months. The CFTC list how "non-reportable" small-size speculators have been closing out their short positions, which were 47% higher than long positions. Any time you have a rising and shrinking market (open interest is decreasing, while prices are rising), it is usually a good indication that speculators are closing out positions and leaving the market.

As recently reported in a WSJ article, the International Energy Agency IEA is apparently preparing a downward revision of its oil-supply forecast. An analysis of the top 400 oil fields is expected to show that future supplies of crude oil will be tighter than previously thought. As seen in the WSJ chart below (source: IEA World Energy Outlook, 2007), a November 2007 analysis found that there needs to be 12.5 million barrels of oil added each day to keep the supply-demand balance in order out to 2015. Over the last 6 month the situation has probably stayed the same, at best, even with higher crude oil and gasoline prices.


While the IEA has predicted over the years a steady increase in supply to keep up with rising demand, even assuming the increases would continue out until 2030, there is now worry that the world will have a difficult time over the next two decades supplying a level of demand much above 100 million barrels a day. Demand is currently at about 87 million barrels, with supply about 85 million barrels. As of now, the lack of supply is being made up by some reduced demand (from higher prices), as well as pulling from inventories, but inventories will eventually be drawn-down too much and will be unable to make up the difference.

Many note that the data is always somewhat suspect. The IEA is funded by the oil consuming countries and is sometimes thought to be used as a way to encourage the countries flush in oil to supply more, thereby driving the price down for consumers. Furthermore, given that the major oil producing countries are secretive as to the real level of reserves left and available for production, it is also difficult to get an exact reading on the supply number.

Nonetheless, the hand-writing is on the wall, causing many firms on Wall Street to begin raising estimates for the price of crude (Goldman predicting $200 a barrel next year) as more data suggests that supply will not be able to keep up with demand. It looks like the volatility and movement in crude oil prices will continue until they reach a level where real demand destruction begins.

During a recent post I made a case for the steel stocks, along with a follow-up article. During the original article I mentioned how "steel companies themselves are also taking steps to reduce costs. This is becoming more of a worry as iron-ore prices have risen 71%, while prices for coking coal and scrap steel have more than doubled. To meet the problem head-on, some companies are attempting to purchase iron-ore mines, coal mines, and deposits, as well as hording scrap steel in an attempt to hedge against higher raw material prices."

We are now beginning to see more of this phenomenon being played out. ArcelorMittal (MT) has agreed to pay $631 million for a 14.9% stake in Macarthur Coal, a move that not only provides a source of coal for ArcelorMittal, but also makes it less likely that Macarthur will be taken over by Xstrata PLC. The purchase was made from two large shareholders agreeing to sell for $19.96 a share, or an 8.5% premium to Macarthur's last trade. Macarthur is the world's largest exporter of pulverized coal, the coking coal used when making steel. ArcelorMittal has traditionally purchased more than 20% of Macarthur's output. This move insures that ArcelorMittal can continue to receive this raw material. They has also recently signed new long-term contracts for iron ore and pellets with Vale, and a off-take agreement with Coal of Africa Limited.

To help possibly fund this stake and others, ArcelorMittal had recently completed the pricing of a $3 billion bond issue of 5 and 10 year notes. Interestingly, Nucor Corporation (NUE) just recently started a secondary offering of 25 million shares of common stock, and also plans to raise up to $1 billion in the debt capital markets. Press releases state that the secondary offering funds will be used for "general corporate purposes, including acquisitions, capital expenditures, working capital needs and repayment of debt." Don't be surprised if an acquisition or stake in a coal company ends up being considered by Nucor and other coal companies as coal prices continue to rise in price and the commodity becomes more in demand. Many steel companies are already considering similar secondaries and bond offerings to remain flexible for such moves.

As for coal companies, these stocks have also been doing well. Popular and widely held companies to begin looking at include Arch Coal (ACI), CONSOL Energy (CNX), Massey Energy (MEE), Alliance Resource Partners (ARLP), and Peabody Energy (BTU). Each have had nice runs this year. Other plays also exist. More about coal in a later post.

The WSJ has an interesting article that describes a situation of how even the best intentions for hedging risk do not always work out exactly how you had hoped. In an effort to stem the tide of losses resulting from bad real estate and leveraged loans, many firms on Wall Street began shorting vehicles that would allow them to profit as these markets collapsed. Unfortunately, tracking error raised its ugly head, and now many are finding that not only were they not getting close to 1-1 back ($1 loss in assets followed by a $1 gain in the hedge - often unrealistic, but a high goal nonetheless), many are getting much less, with a 70% efficiency being a relatively good recovery. To add insult to injury, some are finding that their assets are continuing to fall in price, even as the tracking index they shorted against has been rallying - causing a double loss on both the falling long asset and the rising short index.

It looks like the company with the worst hedges in place is Lehman Brothers, which is expected have write-downs on BOTH assets and ineffective hedges somewhere in the range of $1.5-2 billion. Morgan Stanley will have about half this amount of losses, with both Goldman Sachs and Merrill Lynch being less effected, so far - Goldman in particular has less real estate, but more leveraged loans than its competitors, and may eventually post some losses from these hedges.

As highlighted in the article, it looks like Wall Street has a long way to go in the area of risk management.

As recently reported in a Bloomberg article and elsewhere, the TED spread has been shrinking, and a number of analysts are stating this as evidence that the economy is getting back on firmer footing. While the spread does get mentioned when it starts spiking, and correcting, it is not as widely followed as some of the other more popular indicators.

In short, the TED spread is the difference between the yield on 3-month Treasury bill interest rates and the 3-month Libor. It was originally the spread between the 3-month Treasury contract and the 3-month Eurodollar contract represented by Libor before the CME quit offering T-bill futures contracts - thus giving the name TED (Treasury - Eurodollar) spread. The current quote is around 0.8. The normal range is usually between 0.1% and 0.5%. The spread has been over 2% on three different occasions in the last year, and has been elevated above it normal range since August of last year. The combination of investors looking for the safety of Treasuries (driving prices up and yields down), while incurring higher borrowing costs due to credit issues (driving 3 month Libor yields up), have increased the spread over the last year.

But now the spread is decreasing. Does this imply that all is clear in the economy? Maybe, but maybe not. A decreasing spread is a sign that liquidity is increasing, reflecting at least in part the success of the recent unconventional Federal Reserve actions to increase liquidity. The overnight Libor rate has dropped to around 2.11%, the lowest value in three and a half years. The 3-month rate has also declined to around 2.66%. Yet lenders still continue to hold cash, given that the Libor-OIS spread, the spread between the 3-month loans and the overnight indexed swap rate, is still around 0.66%, compared to an average rate of about 0.11%.

In fact, when you dig deeper, as discussed at the WSJ marketbeat blog, the recent narrowing of the TED spread is due mainly to an increase in T-bill yields which have risen by about 1.25% in the last few months. This has had a bigger impact than a drop in Libor, which has only fallen about 0.25% in the last month. As a result, traders are not as impressed, at least not quite yet. If the situation was reversed, where Libor was falling by 1.25%, this would imply that the liquidity issue and credit problems were abating, but this is not yet being indicated by the action in Libor. Instead, the T-bill supply is above average, putting pressure on prices and raising the yields, thereby lowering the spread. Things are improving, but it may still be too early to assume the credit and liquidity problems are behind us.

Reuters has an article this morning that continues the story we have recently discussed regarding rising steel prices. The story begins with a qualifier of how steel prices, currently around $1,100-$1,150 per ton, may drop to $800-$900 a ton in the near future, but will probably not fall back to the $400 a ton that was priced last year. Nonetheless, pricing power remains. ArcelorMittal (MT) raised prices by $186 per ton, a 20% increase, raising prices $40 to $60 per ton for June and July, and has notified customers to expect the same increases in August. AK Steel Holding (AKS) raised spot prices for carbon steel products $150 per ton. The CEO of U.S. Steel Corporation (X) sees flat-rolled steel prices in Q2 rising as much as $300 per ton higher, or 50% higher than the average Q1 price of $646 per ton.

Yet, not all analyst see blue skies. Peter Marcus of World Steel Dynamics believes that eventually steel makers will be unable to pass along raw material price increases, and that banks will begin refusing to finance inventories at these prices. Ironically, this may be a plus for U.S. steel makers since rising steel prices, and dollar issues, have made them more cost effective while making foreign imports less attractive. This is good news for U.S. steel. For additional information on U.S. companies, seekingalpha.com has a nice article written a few weeks ago by William Ellard that discusses a few of the smaller steel companies. It is worth a read. You can also check out my original article here or here.

As reported by the WSJ, Microsoft and Yahoo! are apparently talking again. In the statement provided by Microsoft, the company highlighted that it is "considering and has raised with Yahoo an alternative that would involve a transaction with Yahoo but not an acquisition of all of Yahoo." This is certainly a change of approach from the recent "take it or we will go hostile" strategy. Interesting indeed.

For Yahoo! this new discussion makes sense, given that it would allow Yang and the Board to potentially save face and give Yahoo! the strategic partnership it needs, while also maintaining control of their company (depending on the stake). For Microsoft, the motivations are less clear. In the short-term it does show that once again they are willing to negotiate, moving further away from the hostile disposition that did not go over well with some investors. As for strategy, it would make Yahoo! pullback on its talks with Google, at least in the short-term, as the potential partnership/merger between Microsoft and Yahoo! progresses. A partnership with Google was always an unwritten poison pill for Microsoft, and Yahoo! had certainly been playing its card. Whether Google wanted to partner or not really did not matter. It served both of their needs as it continued to distract each company while helping Yahoo! fend off a hostile takeover. If a deal with Google has fallen through (which some suspected after the Microsoft merger talks fell through), then it would also allow Yahoo! to save face, once again.

Still, on first read it is difficult to tell whether a merger or partnership would be better for Microsoft. A partnership would allow both companies to remain intact (for the most part), maintaining the two diverse corporate cultures. It may also prevent talent at both companies from bolting out the door, or Googling for jobs at, well, Google. Of course without a merger, Microsoft would certainly have less input on Yahoo! search and advertising, making integration slightly more difficult. The WSJ article also stated that the deal "... would involve Yahoo carrying search advertisements from Microsoft." This seems hard to believe considering how Yahoo! was testing and considering farming out aspects of its advertising to Google. This alone makes me think we have not heard, or are being told, the whole story.

How this will play out for each stock is yet to be seen. It really depends on the type and size of the deal, as well as how much control Yahoo! retains. Whether Icahn and numerous other investors and speculators will get paid is also yet to be seen. Any formal predictions on a final outcome? Not from me. At this point it seems foolish to predict that we might be near the end game when the game keeps changing.

We often hear a lot of discussion, and rightly so, about the prices of crude oil and the agricultural commodities. Their moves over the last year have in some cases been parabolic. Their effect on produced gasoline and food prices are also well documented. Less talked about, but increasingly visible and important is steel. Steel price are continuing to rise, with the alloy's average composite weighted price for all carbon-steel products around $1,000 per metric ton (see chart below, from the WSJ article, by way of MEPS International).


Stock prices of related steel companies have also seen a similar rise in the last few months. The SLX exchange traded fund (see below, chart from stockcharts.com) contains various industry companies that are weighted based on their exposure to the price of steel. The daily chart of the SLX has recently broken out over $100 and is in a nice uptrend. The weekly chart (not shown) has also recently broken out from resistance that was a little below the $90 price.


How are some of the big players in the industry holding up? In a word .... great. Below are the charts for US Steel (X), ArcelorMittal (MT), and Nucor (NUE). Many smaller, less well known players have similar looking price trends. As seen in the charts, the price patterns all look very similar, and also mimic the recent price pattern in the SLX, as to be expected.




While the charts certainly look nice, you have to wonder how long companies can continue to increase prices - not only in response to demand, which could decrease, but also with regard to raw material cost, which have been rising. Will costs get so high that demand destruction will occur? Will raw material cost increase faster than companies can increase product prices, thereby reducing profit margins? Both customers and companies are beginning to take action, but in some cases they are at the mercy of the markets.

In Turkey, a number of construction companies are going on strike, protesting price increases. In India, transportation and housing projects have been put on hold. Other countries are limiting the amount of steel that can leave the country as exports, while at the same time freezing prices and reducing tariffs to increase imports. Even oil companies are beginning to worry that they cannot build or obtain the equipment they need to extract the oil that is in such high demand.

Steel companies themselves are also taking steps to reduce costs. This is becoming more of a worry as iron-ore prices have risen 71%, while prices for coking coal and scrap steel have more than doubled. To meet the problem head-on, some companies are attempting to purchase iron-ore mines, coal mines, and deposits, as well as hording scrap steel in an attempt to hedge against higher raw material prices. Many are worried that the higher raw material costs, which are forcing them to raise their own prices, will in fact reduce demand as customers start looking for cheaper substitutes, such as aluminum and higher strength plastics.

As it turns out, all is not bad for the steel companies. Construction is still strong in many places outside the U.S., and demand for oil is causing a need for increased production for the capital assets used by the oil drilling, exploration, and services industries. Many of the oil service companies do not have an adequate supply of machinery to service their industry, and many of the machines they do have are wearing out and need to be replaced. This replacement cycle could take a number of years to unwind. Given the profits that crude oil companies are generating, it is likely that these companies will continue to spend to upgrade and add to their current assets. This of course is good news for the steel makers.

Car companies, another user of steel, also need to keep their supply up to meet international demand, yet they too are at the mercy of the steel makers. One such example is Toyota Motors, who is expected to agree to a steel sheet price hike exceeding 20,000 yen per ton from Nippon Steel. The demand is also not just coming from oil services, automotive, or commercial construction, but from all corners of the globe. This is even forcing changes within the industry. ArcelorMittal is set to increase prices for its flat carbon products that are sold in Europe. The Russian company OAO Severstal is buying the Ohio steelmaker WCI Steel. Nucor has applied for permits to build an iron-making facility in Louisiana that will produce 3 million tons/year of iron, and has reached a joint venture with Sidenor for the production and distribution of long steel products and plate in the Balkans, Turkey, Cyprus, and North Africa. The story goes on. The international growth and level of demand are exciting.

So what is an investor to do? While raw material cost are increasing for steel companies, they are currently able to raise steel prices to keep up with cost, and in some cases, raise steel prices beyond their current cost increases, generating higher profit margins. Given that demand is strong, and inventory levels are low, it is likely that demand will continue to stay strong for the near future, probably through this year and into 2009. The capital expenditures by the oil service companies, automotive industry, and aerospace industry (with its huge backlog) is also likely to keep demand steady, if not growing.

As for an entry point, it is always hard to buy right after a stock has run up so far and so fast, but looking at the charts of X, MT, and NUE, it is hard to argue that these stocks are not in a strong uptrend. Pullback are likely, but given the recent price action, global demand story, and current shortages, it is more likely than not that pullbacks to the uptrend line (but not breaking it) present buying opportunities, and not a reason to head for the exits.

Below are the weekly link summaries for the usual groups: commodities, derivatives, hedge funds, private equity, quantitative finance and financial engineering, and trading. Hopefully you find some articles that you may have passed over, but might be interested in reading. Have a good week.

Commodities

Limited trading gains dampen corporate wheat purchases
Harish Damodaran - Business Line
* There is a cutback in demand for wheat from India this year as many companies got burned when the price of wheat did not keep rising, and sold off quickly. Many corporations in India that use wheat have large stockpiles left over from the previous year.

Soaring freight costs add to price of basics
Javier Blas - Financial Times
* Freight cost for basic commodities are rising as the Blatic Dry Index rose to an all-time high, increasing inflationary pressures on countries importing natural resources, in particular India and China. One of the main reasons is a surge in demand for iron ore in China, but consumption is high for nearly all commodities. Analysts are finding that there are not enough new vessels entering the market to match the increases in demand. Port delays are also rising across the globe, adding another element to drive shipping prices higher.

European Coal Rises to Record on Limited Supply, Power Demand
Alistair Holloway - Bloomberg
* Interesting article on how coal for delivery in Europe has rose to record levels as global supplies become limited. Demand from India and elsewhere is increasing as these countries need coal for new coal-fired power stations being built across the globe. Of particular interest is the quote: "We are in a long-term pattern because the world is building a massive amount of coal-fired generation. Current supply is definitely running under global demand.'' The need for coal is also strong in the European Union, where the 27 nations in the union use coal for about 30% of their power. Given that a lot of the coal comes from the U.S. and elsewhere, hauling costs are currently accounting for as much as half the price of delivered coal.

Bears begin to separate the wheat prices from the corn
Javier Blas - Financial Times
* A discussion of how wheat and corn prices, which have at times risen together, have been diverging in price as corn continues to increase in price, while wheat prices decrease. Analysts expect them to begin tracking each other at some point. The key is to determine whether it will be wheat going back up, or corn correcting and selling off. Given that there have been record harvests of wheat in the Northern hemisphere, wheat is expected to continue to fall in price. Nonetheless, the amount of corn in the ground, on a percentage basis, is still below average levels, suggesting that prices will not selling off.

Derivatives

Libor Alternatives Used for Liffe Futures Contracts
Nandini Sukumar - Bloomberg
* Problems with Libor are causing some to look for alternatives. As it turns out, the NYSE Euronext's Liffe derivatives market will begin trading contracts on alternatives to the Libor. The Liffe's contracts include futures based on the euro overnight interbank average, a borrowing rate calculated by the European Central Bank, along with contracts on the sterling overnight interbank average, calculated by the Wholesale Markets Brokers' Association. ICAP Plc is also planning a U.S. alternative to Libor called the New York Funding Rate, based on an anonymous daily survey of at least 24 banks.

Futures suspension fails to trim commodity prices
The Economic Times
* The government of India has suspended futures trading in soy oil, chick peas, potatoes and rubber for at least four months. Last year India banned futures trading in rice and wheat, each in an effort to reduce inflation. Critics feel the ban will simply make the problem worse by shutting down the market-pricing mechanisms, essentially encouraging traders into the country's unregulated black market, further reducing tax receipts and causing even more unpredictability in prices.

Swaption Volatility Rises Amid Risk of Higher Revision in Libor
Liz Capo McCormick - Bloomberg
* The volatility on options for U.S. interest rate swaps increased as investors became worried that the benchmark for borrowing costs may be adjusted higher, causing an increase in hedges against changes in rates. Swaption volatility tracks options on interest rate swaps with maturities of 1 to 10 years. The increase in volatility is due in part to the current issue with the Libor rate, increasing the number of people interested in using swaptions to hedge interest rate risk. The swap spread has contracted about 27 basis points since it reached 112.56 basis points on March 7, the biggest contraction since November 1988, reflecting an improvement in the opinion of the interest rate market as to where the U.S. economy is going. Interestingly, the spreads have contracted also in part as fixed-rate corporate bond issuance increased, given that there has been more corporations using bond issuance to raise capital. Much of this fixed rate paper gets swapped back to Libor. The increase in fixed-to-floating swapping has caused tightening of the swap spread.

China to Develop Currency Derivatives This Year, Official Says
Li Yanping and Judy Chen - Bloomberg
* China has announced that it will continue with its plan to develop existing currency derivatives this year. The derivative products are being produced to help exporters and importers within China hedge their currency risks. The yuan, foreign exchange swaps, and forwards are already being traded.

Hedge Funds

A Commodity Hedge Fund in Every Pot
Paul Kedrosky - Seekingalpha.com
* Click on the link to the article to see the growth rate of commodity hedge funds. It will not continue forever (as humorously mentioned by the author), but does show the recent growth in such funds. Not sure if this is a sign of a top or not.

Gas Deposit Lures Hedge Funds
Eric Baum - WSJ
* A discussion of how hedge funds are betting on the three companies, Chesapeake Energy, Petrohawk Energy, and Goodrich Petroleum, buying land and drilling for natural gas in parts of Arkansas, eastern Texas, and northwest Louisiana. Some funds are placing bets on all three companies as each scrambles for land and mineral rights, while others are placing their bets (and investment dollars) on the two smaller companies, and not the larger Chesapeake, assuming the smaller companies will be able to get more bang for their buck if the estimated reserves come anywhere close to being realized.

Private Equity

Clawback Rule Takes a Bite
Peter Lattman - Deal Journal, WSJ
* Interesting article about clawbacks. In short, a clawback is an investor protection that prevents a company from performance fees and forces them to refund already booked performance fees to investors when unrealized investments fall in price below the stated minimum return. The firm can recover fees if the firm earns positive profits on future deals, essentially digging itself out of a hole by clawing back, causing the clawback accural to disappear.

Fears of private equity talent vacuum
Martin Arnold and Lina Saigol - Financial Times
* A discussion of how some of the largest banks in the world are getting rid of their private equity groups, which is causing some concern that there will not be the proper expertise available regarding financing on leveraged buy-outs when the market eventually corrects. While financing LBOs for private equity is very profitable for banks, many feel that it will be a number of years before a profitable level returns, therefore they are timing staff in the meantime.

ICICI Seeks $3 Billion for India Private Equity, Property Funds
Sumit Sharma - Bloomberg
* ICICI Bank, which is the second biggest lender in India, plans to raise up to $3 billion for two private equity funds as it competes with U.S. firms. ICICI joins Blackstone in seeking opportunity in India. Private equity fund investments in India were seven times more than that investment in China in Q1 of this year.

Why U.S. Highways Are Falling Into Private Equity Hands
Heidi N. Moore - Deal Journal, WSJ
* An article about private equity bidding for transportation assets, including KKR's recent bid for assets in Pennslyania. If you don't like toll roads - too bad. You are likely to see more of them in your future.

Quantitative Finance and Financial Engineering

Amaranth Founder Maounis to Start New Multistrategy Hedge Fund
Katherine Burton - Bloomberg
* Nicholas Maounis, whose hedge fund Amaranth Advisors collapsed after a $6.6 billion loss in 2006, is developing a new fund. The fund, called Verition (Latin for truth), will initially utilize three strategies: quantitative (uses computer models to pick trades), bonds and loans, and special situations (focusing on convertible bonds issued by companies going through corporate events). Maybe the talk I have been hearing about the death of my beloved quantitative funds is true. Just kidding. Really.

Trading

Is A Low VIX A Short Trigger?
Quantifiable Edges
* Interesting analysis of using the VIX as a short trigger. From the blog Quantifiable Edges: "Over the last 10 years, owning the S&P 500 when the VIX was more than 10% below its 10-day moving average was significantly more profitable on average than owning it when it wasn’t. Let me repeat that. Owning the S&P 500 when the VIX was more than 10% below its 10-day moving average was significantly more profitable on average than owning it when it wasn’t. To illustrate I ran a study: Short the VIX on a cross of the lower 10% envelope of the 10-day moving average. Cover when it moved back above this envelope. From 5/98 until now there were 87 such trades. The average lasted just over 3 days. The S&P actually GAINED 91.09 points in the 272 days that this was in effect. That is an average of about 0.33 points per day. In the other 2,379 days the market only managed to gain 184.22 points – about 0.08 points per day. In other words, the market actually performed over 4 times BETTER when the VIX was stretched more than 10% below its 10-day moving average. Also, when this VIX-stretch was active the S&P made nearly 1/3 of its total gains in only 9% of the time." Interesting indeed. This follows a comment by Adam Warner at the Daily Options Report blog stating that: “Also, oversold VIX does not provide as good an indicator as overbought. Outright fear tends to lead to big turns, outright disinterest can just linger.”

Pension Funds `Diversify' Into Commodity Bubble: Caroline Baum
Commentary by Caroline Baum - Bloomberg
* Interesting second half of the article regarding the way pension funds and others are getting around the position limits for speculators. As mention in the article, the CFTC - Commodity Futures Trading Commission, has historically reported the futures positions of hedgers (called commercials, and engaged in the cash market) and speculators (called non-commercials, not engaged in selling the commodity) in its Commitment of Traders report. Speculators, pension funds in this example, can use total return index swaps to get around current positions limits. From the article: "Let's say a pension fund, like the California Public Employees Retirement System, wants to increase its exposure to commodities. Calpers, a speculator according to the CFTC, does a total-return swap with Goldman Sachs Group Inc., a hedger. Goldman promises to pay Calpers the total return on the Goldman Sachs Commodity Index and hedges the swap by buying futures contracts. Calpers's speculative bet on commodities gets recorded as Goldman's hedging in the COT report. In so doing, investors circumvent the position limits on non-commercials." Beyond the regulator issues, the practice causes problems with the reporting of the Commitment of Traders number. Research shows that the swap index positions account for over 41% of the total market capitalization, much more than the positions held by both non-index hedgers and regular speculators.

After recently trashing the stock of Berkshire Hathaway just six months ago in December, Barron's is now making a case for its purchase with an article entitled "Cheap Stock?" To their credit the stock has sold off since December. This comes after an article a few weeks ago entitled "The Next Buffett," which discussed how David Sokol, the chairman of MidAmerican Energy, a Berkshire unit, is now the most likely successor to Buffett to be CEO of Berkshire - and more importantly, how he is probably ready for the job. Not wanting to flip-flop too much, or at least provide some balance, this week's issue also has an interview with Doug Kass, the popular short-selling hedge fund manager who is still bearish on Berkshire stock, and has also reiterated this view for readers.

While the criticism of Berkshire has varied over the years, the issues of the exposure of the company to its insurance business and that of Buffett's age are still often cited as reasons for selling and staying out of the stock. As for the insurance business, its impact seems to show up in October, as seen in the weekly chart below (from stockcharts.com), although this is simply a three year view and anecdotal. Nonetheless, for the past three Octobers, after the annual hurricane and storm season is over - and the quarterly results begin to show how much of the float is left for Buffet to invest, the stock will often have a nice end of the year rally before leveling off or making a slower accent to the next October.


The difference of course has been this year, where the stock has sold off and been more volatile after the December Barron's article, and recent news of other hedge fund managers, such as Kass, taking a short position in the stock. The latest positive article and opinion from Barron's may stem the tide, but many of the short-sellers remain. Even Buffett at the recent "Woodstock for Capitalist" shareholders meeting in May alluded that Berkshire may under-perform (at least its historical self), and there may therefore be better opportunities elsewhere. But then again, Buffett is known for lowering expectations and feigning a sense of weakness, only to later make large acquisitions and investment, such as the recent decision to help finance the Mars acquisition of Wrigley, while taking a small position for himself.

While it is difficult to value Berkshire Hathaway, compared to some other public companies, and even more difficult to predict where Buffett is deploying his capital - at least until the quarterly reports are released, it does appear that the recent sell-off of the stock has taken some of the "Buffett premium" out of the stock. This extra boost to the valuation of Berkshire, simply because of his skill and the brand that Buffett has become, is often cited as one of the concerns for the stock as it relates to both the valuation and Buffett's age. In the past the premium has seemed justified based on past performance, and still does, but if Buffett were to step down for any reason, there is an expectation that the premium will be immediately taken out of the stock. Yet, Buffett appears to be in good health and even better spirits, not to mention remaining active in looking for investment opportunities (not withstanding showing up on soap-operas and CNBC at every chance Becky Quick gets).

Still, some investors are waiting on the sidelines for fear that Buffet will be replaced. This seems silly to me since you are missing out on the opportunity of letting one of the greatest investor of all time put your money to work. Furthermore, what happens if Berkshire is then run by someone else, maybe 1, 5, or 10 or more years from now? Will this give you a reason to jump in? Sure, succession will be more clear, but the management of your money will be less so, regardless of Barron's pick (or guess) for a successor - for CEO, not CIO(s). In a sense it comes down to staying out of the stock while you wait for a pullback and possibly new management, compared to staying in the stock and benefiting from Buffett's expertise, even with a lack of succession clarity. I think many current investors will continue to take their chances.

In the end, maybe the biggest hurdle for Buffett may not be his age, or overcoming the "Buffett premium," or worrying about the next catastrophe that will reduce the investment float. What may be more of a challenge is overcoming the law of large numbers. The company's cash for investment is considerable. To make any dent in the stock price of Berkshire, Buffett has to take a considerable position in an outside company in order for it to register enough to potentially affect earnings and move the stock. This takes time, and certainly offers less flexibility to get in and out at an acceptable price. More than likely this is one reason why Berkshire Hathaway has simply made large equity investments and outright purchases of companies in the last few years, although the recent volatility and credit / housing related sell-offs in the stock market have created more of the values that Buffett looks for, and has resulted in more equity positions - recent purchases include Kraft (KFT) , Ingersoll Rand (IR), Burlington Northern Sante Fe (BNI), US Bankcorp (USB), United Health Group (UNH), Wells Fargo (WFC), and Wellpoint (WLP), along with small positions in Carmax (KMX), M&T Bank (MTB), and Sanofi Aventis (SNY) - see previous post for share numbers and dollar values. Of these position, only the added positions in Kraft and Burlington Northern Sante Fe were large enough to generate any interest on the buy side, and even then, they were adding to already existing positions.

So what is an investor to do? Barron's does provide some guidance by referring to an analysis by the hedge fund T2 Partners. T2 highlights that the intrinsic value of Berkshire has continued to grow steadily and significantly over the last few years. From Barrons:

Meanwhile, for a truly big company -- with a market cap of $190 billion, total assets at last count of $281 billion, total equity of $119 billion and book value per share of $77,014 -- it has been enjoying quite impressive growth, especially where it really counts. The value of investments per share has climbed to $90,343 in 2007, from $52,507 five years earlier; during this stretch, pretax earnings per share, excluding investment income, has quadrupled from the $1,479 posted in '02; and intrinsic value -- which T2 calculates as investments per share, plus 12 times earnings per share excluding investment income -- at the end of last year ran somewhere between $156,300 and $158,700 a share, or comfortably more than double '02's $70,000.

As a result, T2 believes that Berkshire is undervalued by approximately 20%. Furthermore, if you are to assuming a 10% growth rate for the intrinsic value of the company, which is not speculative for Berkshire by any measure, with a business and cash buildup of $6,000 per share over the next year, the total intrinsic value could approach $178,700 per share. Given the current price, this represents a 46% premium on the stock. Going out further to two years, the number approaches $200,000. While short-sellers like Kass will continue to short Berkshire, and give good explanations - such as Buffett's age and lack of a visible succession plan, new hedge-fund competition, new uncharacteristic exposure to derivatives, and waining benefits from the insurance industry - it is difficult to bet against someone with so much cash to deploy, as well as a track record for wisely putting it to work. While the stock has been volatile, and is receiving attention from the short side, it is difficult for many investors to sell at these levels until more of the issues that Kass describes come to light. For the time being, most of the current long investors will no doubt hold, and look for others to join in - maybe in October.

A recent report provided some insight into the changes in equity holdings for Berkshire Hathaway. While important knowledge for Berkshire investors, this report has also become a market news event, given that any signal that the Oracle of Omaha is buying or selling a company you currently own could make for either a pleasant or long weekend, even though the Berkshire stock transactions may have occurred over three months ago.

As highlighted in the report, Berkshire Hathaway disclosed that it no longer has a position in Ameriprise Financial - AMP, selling 661,742 shares ($34.3 million), but has added to its positions in Kraft - KFT, buying 5.88 million shares ($182.3 million, giving 138 million total shares), increased its position in Ingersoll Rand - IR, buying 300,000 shares ($13.4 million, giving 936,000 total shares), increased its position in Burlington Northern Sante Fe - BNI, buying 2.96 million shares ($272.7 million, giving 63.8 million total shares), and decreased its position in Iron Mountain - IRM, selling 1.29 million shares ($34.2, giving 3.4 million total shares).

Other new positions include purchases of US Bankcorp - USB (1.05 million shares valued at 33.9 million), United Health Group -UNH (400,000 shares valued at $13.7 million), Wells Fargo - WFC (1.4 million shares valued at $40.6 million), and Wellpoint - WLP (300,000 shares valued at $13.2 million). Berkshire also sold a smaller stake in Trane - TT (60,500 shares valued at $2.8 million), and make smaller purchases in Carmax - KMX (300,000 shares valued at $5.8 million), M&T Bank - MTB (6,300 shares valued at $500K), and Sanofi Aventis - SNY (16,828 shares valued at $600K).

As recently reported by IndexUniverse.com, in the last few months the yields on Treasuries have been rising, while yields on corporate bonds have been falling, signaling a shift from Treasuries to corporate bonds. But does this imply that investors are no longer worrying about the economy and therefore don't feel that they need the safety of Treasuries? Are investors simply sector shifting into corporate bonds? Closer inspection shows that while investment grade corporate bond yields have fallen recently (junk bond yields have fallen more), investment-grade corporate yields have actually remained relatively steady over the last year as Treasuries prices fell and their yields increased. Furthermore, even with the recent sell-off of Treasuries, the spreads between investment-grade corporate bonds and Treasuries is still above historical averages, signaling that there are still better deals in investment-grade corporates and that the sector shift is not complete. Rotation is also being suggested in part due to a belief that if Treasury yields do continue to rise, prices could fall much further and change much quicker than corporate bonds on average given that Treasury yields have been down so much in the last year, suggesting prices have gotten ahead of themselves.

UBS is projecting that crude oil will have a yearly average of $156 a barrel by the year 2012, with the price rising steadily over the next four years, even though they see oil averaging $115 a barrel this year, about $10 less than the recent highs. This is a reversal from earlier coverage which predicted a pullback in oil prices as demand fell in the face of a potential U.S. recession. UBS has also stressed that it believes the increase in prices are mainly due to demand growth (not met by equal supply growth), rather than speculation.

Who does UBS see as benefiting from this increase in oil prices over the next four years? As to the major oil companies, UBS believes Chevron (CVX) will benefit, in addition to Occidental Petroleum (OXY), Apache (APA), ConocoPhillips (COP), and Exxon Mobil (XOM), all of which have buy recommendations. In addition to the major oil companies, UBS has also initiated coverage of oil service, drilling, and equipment firms. Current buy recommendations include Transocean (RIG), Diamond Offshore Drilling (DO), Noble (NE), Ensco International (ESV), Atwood Oceanics (ATW), and Rowan (RDC).

Of the group, the oil services and equipment analyst at UBS prefers Transocean, a recommendation that is due in part to the recent news of Petrobras locking up 80% of the deep water rigs, while also attempting to extend contracts with Transocean for over three more years (see earlier post). Current daily rates are topping over $600,000 a day for leasing deep water rigs, almost three times the average rate of $219,700 just a little over 6 months ago. A number of analysts are also picking up on this story.

Bloomberg is reporting how Petrobras (PBR), the state-owned Brazilian oil company, has leased around 80% of the world's deep water offshore drilling oil rigs. The rigs can drill in water approaching 10,000 feet in depth. Currently, the world has a supply of 21 such rigs that are capable of such depths.

Given the need for increased supply to meet current demand (which is slightly outstripping supply), producers are moving to more deep water exploration. While placing rigs under contract can be expensive, it can also give Petrobras a strategic advantage. Not only will they have more ability to tap resources that may end up being extensive, the company is also forcing competitors to pay higher rents for available rigs, in some cases as much as $50,000 more per day. The contract rates Petrobras currently has in place range from $410,000 to $580,000 per day. Truly amazing. Who is the big winner? Possibly Transocean (RIG), the world's largest offshore driller. Petrobras is attempting to extend its leases with Transocean 3 years beyond current expiration dates.