Jubak's Journal
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Airlines and the epidemic of risk
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Once upon a time, this was a tiny market, with banks arranging these contracts for a large investor such as an insurance company. Now, banks such as JP Morgan Chase (JPM, news, msgs) or Citibank (C, news, msgs) create CDOs for a wide range of investors. And those investors then trade these CDOs with each other, as they're estimation or appetite for risk changes. Today there are $8.4 trillion (yes, that's trillion with a T) in credit derivative contracts outstanding. That's up from just $919 billion at the end of 2001.
Passing the buck
What are the takeaways here?
First, note that this is a huge financial market -- and the market for credit derivatives is just one part of the much larger market for derivatives of all kinds. For reference, the entire U.S. money supply (measured by M3, the widest definition of money) at the end of August was $9.9 trillion. The size of the credit derivatives market as of end of June 2005 was $12.4 trillion, up 128% in a year, according to the International Swaps and Derivatives Association. It's no wonder that the Federal Reserve has less clout than it did when this derivative money supply was a mere $919 billion.
Second, note what the credit derivatives market actually buys and sells: risk. Want a little more risk? Sell a contract guaranteeing someone else against default. Less risk? Buy a contract guaranteeing you against loss.
Third, note how this market changes the way that an investor treats risk. In the old days, Disney, or the bank or insurer that put together the lease, did due diligence on the creditworthiness of the airline making the lease payment. Getting that creditworthiness right was all that guaranteed you against loss, and you made sure that you were getting paid enough to compensate for the risk you were taking.
Now, thanks to derivatives, investors have a second kind of guarantee: they can buy insurance against the default of the bond issuer. Now that doesn't mean that all companies that buy and sell in the credit derivatives have stopped doing due diligence. But the ability to buy and sell risk is a powerful incentive to stop worrying about the fundamental risk of the original creditor. This is going on right now in the home mortgage and home-equity loan market. Some of the biggest mortgage lenders continue to offer interest-only or other risky mortgages to customers with marginal credit and then shed that risk by packaging the loans and selling them to investors who, in turn, sell their risk in the derivatives market. (More on this in a future column.)
The no-worries worry
In this system, no one really needs to worry about the risk of the loan they've made, the mortgage they've extended or the bond they've bought. They can lay off that risk on someone else -- for a price -- in the derivatives market.
The problem, of course, is that this system only works until it doesn't. Because derivative contracts are frequently bought and sold by the original purchaser, it's hard to tell who is now guaranteeing whom against loss. That's not a minor point if a big debtor goes into default and the guarantor doesn't have deep pockets to pay out on the guarantee. The derivatives market is not very efficient -- in June there was a backlog of 13 days before trades were completed, according to the International Swaps and Derivatives Association. Nor is it transparent -- since derivative contracts are still relatively hand-crafted it is hard to price them. So the market is not very good at detecting and pricing imbalances.
The greatest danger is a very human one: complacency. Since the derivatives market lets investors control risk, they stop worrying about taking on more risk. And that, as we all know from experience, creates an accident just waiting to happen. Which is exactly what Alan Greenspan is worried about.
Updates
Sell Occidental Petroleum (OXY, news, msgs)
For holders of shares of Occidental Petroleum it's Christmas in September. The stock has reached my December price target of $84 a share and then some. I think there's probably some life left in these shares -- especially with winter shortages of heating oil and natural gas a real possibility -- but the stock has been losing momentum relative to the market as a whole, and I think I can find a better candidate (see my buy on Ultra Petroleum (UPL, news, msgs) below) for the next stage of the energy rally. As of September 30, 2005, I'm selling with a 22% gain since I bought these shares on April 22, 2005. (Full disclosure: I will sell my personal shares of Occidental Petroleum three days after this column is posted.)
Buy Ultra Petroleum
Right now I think investors can get more leverage on high oil prices from the shares of what are called "unconventional" oil and gas producers. These are companies that get their oil and natural gas from mining oil sands, drilling into oil shales or tight sand formations, or tapping into coal bed methane. Ultra Petroleum has all its unconventional assets in the tight sands basket. The company controls 93,000 acres in the Jonah natural gas field and the Pinedale Anticline in Wyoming's Green River Basin. Gas was first discovered here in 1939 but the problem has been getting it out at a profit. New completion technology applied only in the 1990s increased the flow to commercially viable rates and high gas prices have done the rest. The company is currently looking to get approval in 2006 from Wyoming to increase the density of its wells on Pinedale to 10- or 20-acres per well from the current 40-acres per well spacing. That will increase production from the Pinedale field. Ultra Petroleum also has a stake in the Bohai Bay oil field in China. As of September 30, 2005, I'm adding these shares to Jubak's Picks with a June price target of $70 a share. I'd set a stop loss at $48. (Full disclosure: I will buy shares of Ultra Petroleum for my personal account three days after this column is posted.)
New developments on past columns
When will oil run out of gas?
As of September 30, I'm raising my target price on Marathon Oil (MRO, news, msgs) -- again. The catalyst for the new higher target is the shortage of refinery capacity that has driven the price gap between a barrel of crude oil and a barrel of refined petroleum product, called the "crack spread," to a record high. That is driving the profit margins to refiners such as Marathon to new heights. Crack spreads at U.S. refineries using domestic light crude jumped to $23.30 a barrel at the start of this week from $12.90 a week ago. Crack spreads are even wider at refineries that can use the much more plentiful but harder to refine sour grades of crude. My new target price is $82 a share by February 2006, up from the previous target price of $70. I'd set a stop loss at $59.50. (Full disclosure: I own shares of Marathon Oil.)
Editor's Note: A new Jubaks Journal is posted every Tuesday and Friday. Please note that Jubak's Picks recommendations are for a 12-to-18 month time horizon. See Jubak's CNBC Picks for shorter six month recommendations. For picks with a truly long-term perspective see Jubak's 50 best stocks in the world or Future Fantastic 50 Portfolio.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Marathon Oil and Occidental Petroleum. He doesn't own short positions in any stock mentioned in this column.
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