Video Source: Clip Syndicate Bloomberg
Rainfall has been over 3 times the normal amount in the Midwest the last few weeks, with more rain on the way. The heavy rains are affecting corn and soybean yields, with just 74% of corn emerged from the ground, and only 32% of soybeans emerged. Farmers are now at a point of needing to make a decision of whether to take the Government subsidized crop insurance and keep the ground idle, or plant and take the risks of lower yields, which could be potentially as low as 75% of normal yield levels. As much as 500,000 to 3 million acres may become idle. Analysts are already cutting corn crop yields by 4 bushels per acre. As ethanol production continues to increase, expect corn prices to rise, with consumers feeling the effects at both the pump and in the grocery store.

Companies to watch that may be impacted include Archer Daniels Midland (ADM) and Bugne (BG). Others that are likely to continue to benefit from rising demand for food commodities include fertilizer companies such as Mosaic (MOS), Potash (POT), and Agrium (AGU), chemical and seed companies such as Dow Chemical (DOW) and Monsanto (MON), and agricultural machinery makers such as Deere (DE). On the direct downside are the users of corn, especially the restaurants and food producers with lower margins and less pricing power, such as Darden (DRI) and Tyson Foods (TSN).

Cambridge Energy Research Associates is estimating that the Tupi-area fields in Brazil will cost between $200-$240 billion to develop. As reported in Bloomberg, labor and equipment costs are rising as oil prices increase. Recently, deepwater rigs have received rents of $600,000 a day. As a result of the huge project, Brazil and Petroleo Brasileiro SA will need international partners with lots of capital. Nonetheless, the effort and cost might be worth it given that the offshore fields are expected to hold up to 50 billion barrels, or $6 trillion of petroleum at today's prices. If estimates are correct, the wells could help to make Brazil a top 10 oil producer.

As discussed before, Petrobras has already leased approximately 80% of the deepest-drilling offshore rigs. Astonishingly, the company also plans to hire 14,000 engineers, geologist, and drillers to help with the project. They are also buying new rigs and production platforms. As periphery plays in the short-term, this is certainly good news for the drilling contractors, such as Transocean (RIG), Nobel (NE), and Nabors (NBR). For longer-term investment, some capital-intensive E&P oil companies such as Exxon Mobil (XOM) should do well, although these companies may require direct involvement to see any benefit.

As discussed in a recent Bloomberg article, the spread between the 3-month Libor and the overnight index swap (OIS) rate, traded forward 3 months, is greater than similar expiring spreads. This recent movement in the spread is signaling that traders are concerned that banks will have difficulties obtaining cash to fund existing assets, as well as putting into question their ability to shore-up their balance sheets. In general, an increasing spread signals that funds are becoming less available. The recent activity appears to be driven more by traders leaving the short-term, closer to expire positions early over worries about Libor and its reliability.

The spread has averaged about 11 basis points over the last 10 years, but has ranged between 24 bps to 90 bps this year, and has gotten as high as 106 bps last December. The activity in the swaps market is worrisome, indicating that derivative traders do not feel that the sell-off of financial companies in March was the low, and that the worst is not behind us. Recent problems/concerns with Lehman Brothers, Wachovia, and UBS, as well as the recent sell-offs in Goldman Sachs, Merrill Lynch, JP Morgan, and Citigroup are also highlighting concerns with the financial companies. As usual, this is not good news for the economy and the market as a whole as it needs a strong financial system to keep greasing the gears of expansion. It may be a long summer until the credit markets start showing a little more confidence.

A recent Reuters article highlights how 57% of U.S. venture capitalist are now investing outside the U.S., compared to 46% last year. While a contrarian might argue that this is an indication of a top in the international markets, it does give clues as to which markets are still receiving capital, and what sectors in each market are receiving attention. While the top countries for receiving new U.S. capital continue to be China and India (approximately 20%, or $9 billion of total capital flowed outside the U.S., with about $2.5 billion going to China and India, with software mentioned as one of India's strengths), money is also beginning to flow into other markets.

In addition to the usual BRIC countries (Brazil and Russia in addition to India and China), VC money is flowing into Taiwan (for semiconductors), Japan, Israel (software), Germany (alternative energy, medical devices, software), and the United Kingdom (software). U.S. companies, even when not making direct investments, are also stepping up interest in partnering with developing international companies. In particular, IBM was mention as a company looking for partners in technological innovation. It is continuing to invest in the BRIC countries, along with interest in Canada, Peru, Vietnam, Russia, and Ireland, although no specific companies were given. Warren Buffett and Berkshire Hathaway have recently been looking for opportunities in Germany and Asia.

Of course, the real story may be that since many of these countries are continuing to do well, it may be U.S. companies that increase their interest in receiving capital infusions from overseas. Investment from Middle East allies, especially in financial companies, tech, and large industrials have been commonplace for years, but investment from China and India, as well as other countries with double digit growth economies, and/or growing petrodollars, will no doubt increase. Just last month a WSJ article discussed how Brazil, originally thought the be the lightweight newcomer in the BRIC grouping, has set up a sovereign-wealth fund to invest its extra currency generated from its growing position in agriculture and natural resources, in particular its increasing crude oil exports. As the U.S. continues to figure out its energy policy, and whether we even have one, it may find itself not calling the shots anymore as it looks for ways to repatriate its exported dollars (from imported energy) back into the capital needed to continue domestic economic expansion.

As reported from ETFTrends, by way of Seeking Alpha and Yahoo, JP Morgan is launching the first 130/30 Exchange Traded Note (ETN). 130/30 funds were also briefly discussed in this blog a little less than a month ago in a Weekend Link Summary post. As designed, the offered ETN is a modified equal weighted total return index offering 130/30 exposure to large cap stocks.

The offering is certainly an attempt to capture the recent excitement with 130/30 funds, but as mentioned here and elsewhere, many are skeptical that 130/30 funds are nothing more than a traditional long / short fund. In fact, there appears to be nothing magical about the 30% short position, and there is no specific reason to short and only use this level of leverage. A general 1X0/X0 structure could be adapted to develop any long-short strategy that meets your own risk-reward objectives. Hopefully new research, both from academia and industry, will shed some light on whether the 130/30 structure, or something else, provides the best use of the short position and generates the highest risk-adjusted return.

Below are the weekly link summaries for the usual topics, with energy added. As usual, hopefully you find some interesting articles that you may have passed over.

Commodities and Energy

S&P launches new commodities and natural resources indices
Hedgeweek
* Standard & Poor's has launched two new indices, the S&P Global Natural Resource Index (with contributions from 60 large energy, agribusiness, metals, and mining companies), and the S&P PMI Commodities and Resources Index (similar sectors, but with 160 stocks for broader exposure). The indices can be invested in and are available for benchmarking. Often, but not always, this kind of activity begins to mark the top, or at least short-term peak, in a sector or market. Time will tell.

Why Cap-And-Trade Won't Work
Paul Cicio - Forbes
* An opinion article in Forbes about the problems with the proposed cap-and-trade legislation. Beyond the pros and cons of whether cap-and-trade will actually help reduce carbon emissions, of interest is the effect on clean energy. Low carbon alternatives, such as natural gas, should see an increase in price as companies look for ways around new mandates. Nuclear is another carbon-free option for power generation, but given its own regulatory issues, and the 10-20 year backlog for reactor domes and other critical components, it is likely that natural gas will be the only viable short-term alternative. If the legislation is passed, expect natural gas prices and electricity prices (natural gas plants currently set the marginal price) to increase.

Joy Global Mines Money From Commodities Boom
Melinda Peer - Forbes
* As usual, look for and consider the "consequence" or periphery plays when investing in sector booms. As for commodities, mining equipment makers Joy Global and Bucyrus International are doing well, very well. Downturns in these and other similar companies may give an early indication of changes in the commodity landscape. Often it is the pick equipment makers, and not those selling the gold, that make the most money during the rush.

Coal seam gas seen as Asia's next hot energy play
Reuters
* Interesting article from Reuters talking about how some countries are using coalbed methane (CBM) as an energy source to power cars and electricity plants, among with things. Methane stores in Asia are estimated at 2,100 trillion cubic feet. As LNG prices continue to rise, CBM is hoped to be a viable alternative for both developing and developed countries with large coal deposits. Storage is still a problem for some counties as they retool existing plants. Coal seam gas also has a lower heating value compare to natural gas, but is able to be blended with LPG (liquefied petroleum gas). The gas does have a low sulfur and carbon content, allowing it to burn cleaner.

Derivatives

Banks launch central clearer for derivatives
Hal Weitzman - Financial Times
* To mitigate some of the risk of privately negotiated credit derivatives, 11 of the world's biggest banks announced the creation of the first central clearer for derivatives, in particular credit derivatives. The clearer will use funds contributed by traders to guarantee against counterparty default. The clearing will be run by The Clearing Corporation, a Chicago-based institution backed by the banks.

Canada's emissions-trading market open for business
Boyd Erman - Globe and Mail
* Short article about a new emission-trading market, called the Montreal Climate Exchange, from the TSX Group. The exchange will allow companies (AKA "polluters" in the article) to buy and sell carbon credits. Look for emissions trading to continue to be a big business going forward. It will be of interest to see if these markets allow for "greener" companies to develop and survive. Since carbon credits can be traded from non-polluters to polluters, a green company could sell its carbon credits to the polluters, essentially making the polluting companies subsidize part of their business. In fact, just about any business, with or without environmental intentions, could do this. I guess it depends on how the credits are distributed, but the system may leave itself open for gaming and profit opportunities.

Climate-Bond Plan by UN Official Aims to Boost Energy Investing
Alex Morales - Bloomberg
* Why should Canada have all the fun? The United Nations is considering a new climate bond that would be sold to investors in developing countries as a way to spur investment in green projects. How would they work? Mature bonds, after they have been used to finance green projects, could be exchanged for credits that allow industrial plants to emit a certain amount of carbon gases. How are they funded and priced? The amount of money generated would depend on the level of emissions-reduction targets set in the current round of UN climate talks. I guess if you need more funds, you could raise emission targets. As with the Canadian system, the effort is noble in intentions, but has the potential to kill the goose that laid the golden egg (or provides the revenues in this case), while not really solving the problem. Hopefully safeguards will be put in place to prevent abuse. In its current form it is also not clear that overall emissions will actually be reduced. Time will tell.

US and European debt markets flash new warning signals
Ambrose Evans-Pritchard - Telegraph (London)
* The cost of insuring against default on bonds of Lehman Brothers, Merrill Lynch, and others has increased in the last few weeks, as debt markets are signaling fears that the global credit problems are still here, and could be entering another phase of write-downs. Inter-bank Libor and Euribor spreads are back to near record levels, with Lehman Brothers debt credit default swaps rising from 130 to 247 in a little over one month. Merrill Lynch debt has spiked to 196. As reported by Willem Sels, a credit analyst at Dresdner Kleinwort, ".... banks are beginning to face waves of defaults on credit card, car loans, and now corporate loans. We believe we're entering Phase II. The liquidity crisis has eased a little, but the real credit losses are accelerating. The worst is yet to come." It is also felt that the increase in corporate bankruptcies is not yet being seen by the usual indicators, which tend to lag the market.

Bonds Insuring Next Hurricane Hugo Beat Subprime
Erik Holm - Bloomberg
* As hurricane season begins, investors are clamoring once again for catastrophe bonds, the market of which as tripled over the past three years to more than $13 billion. Some of these bonds yield near 15%, with the average around 11% - assuming that we don't get another Rita, Katrina, or Hugo. One attraction to the bonds is their lack of correlation with the stock and bond markets. The key here is weather or natural disasters, and not credit. Given the problems with mortgages and subprime, hurricanes and earthquakes seem like a safer alternative for some - but it is still possible to lose your entire cat bond investment if the big one does occur. What I find interesting is how the whole market is somewhat circular. Cat bonds are often offered by insurance companies as a form of reinsurance to protect themselves if a catastrophe does occur and they are forced to pay out. Who buys the bonds? We do, through pension funds, hedge funds, and less so through individual investments. We are essentially taking out insurance with the insurance companies to protect against an event happening, and then buying bonds against the event actually happening. On the other hand, insurance companies are selling us the insurance to protect us in case the event does happen, betting themselves that it won't, and then selling us bonds to protect themselves in case it does. Confused? Ah, you have to love the markets. Who are the big reinsurance companies? Swiss Re, Munich Re, and General Re (Warren Buffett's Berkshire Hathaway's reinsurance company).

Hedge Funds

Hedgeweek Comment: Going with the flow
Hedgeweek
* There was been a lot of talk about hedge funds looking for investment in Asia, but not as much action as the talk (although some investments). It appears that now some funds are entering Asia, and not just for opportunity (which they can take advantage of stationed nearly anywhere). Instead, funds are opening in Asia to take advantage of liquidity and capital that is not as available in the west, as in the past.

Prime Brokerage Will Make $11B in ’08: Study
Christopher Glynn - HedgeFundfont>.net
* Prime brokerages are expected to receive $11 billion in hedge fund money in 2008, a 15% increase over the 2008 value. Goldman Sachs, Morgan Stanley, and JP Morgan, who own the majority of prime brokerage market share, are expected to be the biggest beneficiaries.

Private Equity

Morgan Stanley, Citigroupfont> Bankers Leave as LBOsfont> Slow
Pierre Pauldenfont> and Jonathan Keehnerfont> - Bloombergfont>
* Top bankers are leaving larger firms, such as Morgan Stanley and Citigroupfont>, as the LBOfont> market grinds to a near-halt, compared to recent years. Many banks are still trying to clear out old loans that they are unable to get off their books. Banks have traditionally made money twice, once on the deal, and once when they sell the debt to others. Many banks are now being forced to hang on to the bad debt that in the past they were able to push off on other investors. Some of this debt is now selling for less than 70 cents on the dollar, making it difficult unload without taking a huge loss.

FT REPORT - CORPORATE FINANCE 2008: Public life after private equity
Chris Hughes - Financial Times
* Interesting case study of one company, now public after it was floated on the stock market by a private equity group, is now having difficult dealing with current high energy and raw material cost after taking on previous private equity debt. Companies with high leverage can do well in boom times, but suffer more in downturns given that their fixed cost per unit begin to rise rapidly as sales decrease. The effect on the bottom line is intensified as variable cost increase, as they have for many companies highly dependent on raw materials and energy. We often hear about the slowdown and problems with private equity investors, but often forget about the companies that are now dealing with the debt issues directly.

An unlikely financier
Janet Morrisseyfont> - Investment News
* Yes, you too can start you own private equity firm. Interesting story of Malonfont> Wilkusfont>, a college dropout that started his own private equity firm, American Capital Strategies, with a focus on middle-market companies. So far the fund has delivered annual compound returns of 18%, including an average dividend yield of nearly 10%. Not bad, although last year the firm was down 22% with other financial stocks.

Quantitative Finance, Financial Engineering, and Trading

Prospectors join Canada's electronic gold rush
Melanie Wold - Financial News
* Not a specific trading strategy article, but does highlight to impact of the recent commodity boom on trading, at least in Canada. Given the rise and interest in trading in the commodity-rich country, investors are taking an increased interest in the Canadian markets. As such, market technology vendors and investors are increasing, providing numerous alternative trading systems, platforms, and trade crossing networks, causing Canadian regulators to implement institutional trade matching, settlement framework, and best practice guidelines. This looks very similar to the buildup of ECNsfont> and exchanges in the late 1990s during the U.S. technology dot-com boom. Hopefully it does not end the same way for the Canadian market.

China rebukes west’s lack of regulation
Jamil Anderlinint> - Financial Times
* Interesting perspective from Liaont> Min, the head of the China Banking Regulatory Commission, about how western governments must strengthen oversight of their financial markets. There argument is that by giving the market too much leeway, problems such as the subpriment> crisis were allowed to develop. It is believed that tight regulation has made it nearly impossible for exotic financial instruments to be developed in China. Of interest from the regulator is worries regarding the increased flow of money into their market, as a result of investors abandoning the dollar and U.S. markets (argued as being due to our regulation-lacking induced problems). This shift in funds is causing a potential asset bubble and rising inflation in the Chinese market. As a result, China is considering advocating new international laws and regulations for providing timely and accurate information during crisis. Even so, as international economies develop and mature, and the flow of money into the "new" economies slows down, I would not be surprised to see their use of derivatives increase (in order to internally reallocate capital), regardless of current perspectives.

Three ETF-of-ETFsnt> are launched
David Hoffman - Investment News
* Admit it. You knew it was going to happen. It was just a matter of time. Invescont> PowerSharesnt> Capital Management has launched three new ETFsnt> that invest in ...... what you say ..... other ETFsnt>. While providing investment advisers more choice, especially those that are not investment strategists, many advisers are not happy. Why, the ETFsnt> of ETFsnt> (ETFsnt> squared anyone - you heard it here first, I think) reduce the fees that advisers receive for recommending and selling products to investor. Why get one fee when you can get three by selling three different ETFsnt>. Even worse, some investors may realize that they don't even need an adviser, and can just invest in a diversified exchange traded pool of diversified asset classes. Then again, some investors probably will not know what that means, so the advisers job is probably safe. Now, if we only had derivatives on ETF-squares. Ah, Wall Street can dream.

As reported in Financial News and the WSJ, people are starting to talk more about the potential counterparty risk problems with the credit default swap (CDS) market. It often gets reported how large the CDS market has become, from $180 million more than 10 years ago, to over $62 trillion now. Of course, the $62 trillion in notional value is somewhat misleading given that the CDS market is a "closed system" or zero-sum game such that the losses of one party are offset by the gains of another. When looked at like normal insurance, and protection against specific assets, the cost to replace contracts and provide protection is being reported by the WSJ to be more like $2 trillion.

The real issue is the counterparty risk from an investment bank not meeting their obligations. Beyond affecting just one specific type of corporate debt, failure of an investment bank could affect the entire CDS market and the underlying securities (i.e., corporate bonds) upon which the swaps are valued. This effect was seen last March at the height of the credit crisis as Bear Stearns was being bailed out (sorry, purchased), causing CDS cost to rise. A similar increase in cost is now occurring with Lehman Brothers and Merrill Lynch. It is yet to be seen if this is a short-term blip. Nonetheless, you can expect that the Federal Reserve is keeping an eye on this market and be ready to take future action to protect the bond and equity markets, and potential international market contagion.

As mentioned in recent WSJ and Bloomberg articles, the Commodity Futures Trading Commission is conducting an investigation into potential crude oil price manipulation. What is interesting about the story is not only how the CFTC is initiating an investigation, but that they are making a formal announcement of what they are doing, an indirect indication that they are also aware of the public and political outrage given higher energy costs. The CFTC commissioner said it best:

"It's important that people who are paying high gas prices understand the CFTC is on the case and that we're closely monitoring and in this instance deeply investigating any potential abuse in this important energy market"

I guess we will have to wait and see if the investigation uncovers anything of interest, or if it is simply being used to keep regulators and Congress at bay until energy prices hopefully retreat to more "normal" levels (or the public gets used to current prices, which is doubtful).

In addition to reporting about the investigation, the WSJ article does highlight some potential abuses, including using the Platts price-reporting system to manipulate prices. Essentially, traders could issue numerous orders during the window of time that Platts uses for setting the prices that it reports to subscribers. This artificially high or low price could then be used to profit in other markets by taking an opposite position based on the move in reported prices. Another potential manipulation includes spreading false information about oil tankers being either empty or full, sending the wrong impression about supply, and thereby affecting price. Whether either of these potential abuses (if true) could be classified as wide-spread speculation, and thereby causing a larger scale lasting move toward higher energy prices, is yet to be determined.

When considering potential abuses it is important to remember that a company can actually take advantage of insider information regarding its own production and demand when it makes trades, either for hedging or for increasing/decreasing its own position. Since insider information is not technically illegal in the same way it is with equities, this forces regulators to work a little harder to prove that traders were intentionally trying to create an artificial price in order to profit from speculation. Something tells me that this aspect will either be ignored or put into question as some look for validation of out-of-control speculation abuses.

Libor rose 0.03% to 2.68% after a recent Wall Street Journal article that once again questioned the validity of the key rate (update article). While 3 bps does not seem like a large move, it is the largest move in the last two weeks. The British Bankers' Association, which oversees and sets Libor, has been reviewing the system and is expected to report its finding on Friday. Potential changes include shaking-up the 16 member bank panel that provide quotes of borrowing costs to the association, as well as examining quote reporting and the Libor methodology. Given that nearly everything, including mortgages, corporate debt, and numerous financial derivatives are pegged in some degree to Libor, the ramification could be tremendous, and should probably be something investors are paying more attention to. No doubt that banks and financial institutions are considering the effects on capital and hedged positions. The effects on investors will be both obvious (mortgages) and not so obvious (derivatives) as the rate continues to come under scrutiny, and potentially rises to meet other benchmarks.

Update: The BBA met today and basically decided to do nothing, other than say they would get tough with offending members that misquote rates. They did mention that they will strengthen the oversight of BBA Libor, with details "published in due course."

There has been a recent resurgence in interest in dark pools of liquidity. No, this is not some Star Wars reference (at least I don't think so), but does refer to a procedure and method of trading that is once again causing some concern on Wall Street. For years, crossing networks have been matching buy and sell orders "off-exchange" in what have been referred to as dark pools of liquidity. The advantage of these pools it that they should make the execution of a large order safe, and allow the two market participants to execute the large order without moving price, while maintaining some privacy. While the amount of dark pool transactions is estimated to be a little over 10% (but including more than 20% of all trades in NYSE-listed stocks), it is continuing to grow as hedge funds look for less transparent ways to sell large positions, and brokerage firms look for more ways to generate trading income and possibly tap into the increase in trading revenue streams that the exchanges have been enjoying over the last few years.

Unfortunately, some are worried that gaming is allowing others to profit from the transaction, and of course potentially leaving one side of the dark pool transaction a little worse off. The problem has gotten significant enough that some are considering no longer using the dark pools, with 60% showing some hesitation. As recently highlighted in a Finanial News article, steps are being taken to tackle the problem, such as putting anti-gaming measures in place at both large and small firms. Steps being used and/or considered include physically monitoring patterns of trade abuse using a human element, using computer algorithms to spot trends, developing fair pricing models, and using anti-gaming logic.

While it is true that it may not always be known exactly what is occurring within the dark pools, it appears as if their operations are simply more organized ways to perform crossing of block trades, with a print of the tape after the transaction is complete. Nonetheless, it is still surprising to me how in the current financial environment that the SEC, other regulators, and some of the exchanges themselves have not spoken more about dark pools, their transparency (or lack of transparency), and the affect this has on price discovery. In fact, it seems to me that given current credit issues, this might not be a something the industry wants to advertise. Yet, this is apparently not stopping some.

As recently reported at the Deal Breaker blog, Goldman Sachs, Morgan Stanley and UBS have agreed to share their dark pools, such that each will allow for the secretive trading to take place between their clients. The dark pools include Goldman Sach's Sigma X, Morgan Stanley's MS POOL, and UBS's PIN ATS. The union further threatens to take business from the exchanges and furthers current consolidation of the brokerage industry. Right now exchanges are at a disadvantage when they try to compete with the dark pools since they are being regulated by the SEC, with new rules being put in place over the last year forcing them to share even more information and route trades to the exchange offering the best price and fastest execution. Dark pools have in many instances been able to avoid regulation by keeping trading volumes under a set threshold.

But again, while this is probably a good move for the financial institutions with regard to generating new business, lowering costs, and helping to tap into the monopolies of the exchanges, it is probably not the most public relations friendly move in the current credit environment. As is often unfortunately the case, this will surely cause some in Congress to start talking of new regulation, especially if someone goes way out on a limb and attempts to tie the practice to home foreclosures or high energy cost - adding a new level of regulation with the usual unintended consequences. If this happens, we may end up wishing that a dark pool of liquidity was truly just a Star War reference.

As reported in a New York Times article, liquefied natural gas (LNG) terminals built in Louisiana are becoming a home to empty supertankers that were expected to be importing LNG from around the world. Shipments of LNG to the U.S. are falling, with the LNG instead going to Spain and Japan, further depleting U.S. stockpiles. Unlike crude oil, natural gas is more of a regional commodity, although its price is connected somewhat to crude oil prices. Historically, crude oil has traded at about a 6-8 multiple to natural gas (or natural gas has traded at a 6-8 times discount to crude oil). Recently, natural gas has not kept up as crude oil continues to climb in price.

Given that competition is increasing for LNG, and since others are willing to pay more for the commodity, the U.S. will continue to get shut out unless changes are made. Due to reduced imports, it is estimated that the U.S. will only have 3.1 trillion cubic feet of natural gas in storage at the end of October, a figure that is almost 1 trillion cubic feet below what is considered full storage. Until the pricing structure in the U.S. becomes competitive with the rest of the world, it is unlikely that storage levels will increase, although the same cannot necessarily be said for natural gas prices. Historically, demand is usually lower in the spring, only to start increasing again in the fall as we enter the winter heating season. This year, natural gas prices have continued to rise through the spring as its price moves with oil, even if not at the same historical multiple. If supply constraints continue we may begin to see natural gas prices continue to rise, even if crude oil prices stay flat or even slightly decrease, as prices move to and stay within historical multiples.

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.