Getting Back to Business!

After a much needed respite from exams, it's time to get back to business.

Let's start the New Year by discussing updates to the portfolio over the past four weeks.

The Gold Trade:
It looks like the violent interruption in gold's strong trend during early December was likely just a reversion to the mean. It was during that correction that GLD options appeared to be reasonably priced relative to the past several months (see Chart #1, at right). However, it looks like the short-term will be characterized by turbulent trading, with a skew toward the upside (see Chart #2, at right).

The fundamental rationale for being long-gold (ideally not in USD-terms) still seems intact. As highlighted in today's Gartman Letter, the logic behind the problematic nature of the EUR as a reserve currency strengthens the notion of owning gold, not in US dollar terms but in terms of the EUR, Sterling and the Yen (particularly in light of recent comments made by Naoto Kan, the newly appointed Finance Minister in Japan). Gold is now being seen by more and more governments as reserve currency. More so, with a weakened EuroZone, which is increasingly threatened by the weighing divergence from member nations' (i.e., the PIIGs), it would seem reasonable that capital, which may have been earmarked for euro-denominated assets, on the margin, may more likely be allocated to gold denominated in euro terms.

Energy - Fundamental Book: XTO Bought up by XOM
On Dec-14, ExxonMobil (XOM) announced that it had reached an agreement to buy XTO Energy in an all-stock transaction valued at $41 billion, including approximately $10 billion of XTO debt. The deal implies a ~25% premium for XTO shareholders based on Dec-11 prices.

I first recommended getting long XTO's equity and neutral on CDS in early Mar-09. The thesis was that XTO was more highly levered than peers, and the market was uncertain that they could successfully digest their mammoth acquisitions of 2008 and develop the acquired resources successfully.

However, from a technicals standpoint, XTO initially underperformed relative to key peer Anadarko (APC) by nearly 22% over the subsequent 5 weeks due to crude's nearly 25% rally. After some humbling analysis, I discovered the reason was related to XTO's tighter correlation to natural gas prices and greater hedging toward crude. However, this exercise validated that the underlying fundamental thesis was still intact: because of XTO's best-in-class hedging program and strong management expertise, they would likely maintain the flexibility to successfully development acquired resources on schedule in 2009 while reducing debt through stronger-than-expected operating cash flows. The market had not appreciated their strong CF position via hedging and operational expertise.

XTO's strategic move to acquire promising, high-profile shale assets in 2008 (45 Tcfe resource base and 14 Tcfe of proved reserves at YE08) has paid off. The transaction price comes out to about $0.90 / Mcfe of 3P (proved, probable and possible) reserves and ~$2.88/Mcfe of proved reserves.

In the end, gross of hedging costs (which detracted approximately 950 bps from performance; Jun-09 38 strike ATM puts bought in advance of May 6, 2009 earnings call), the trade returned approximately 48% cumulative, or 78% annualized.

Looking at the bigger picture, the deal meaningfully expands Exxon’s exposure to North America natural gas prices and unconventional natural gas resources. North America unconventional gas has been dominated by the E&P companies, most notably XTO and CHK amongst many others. Now, Exxon will need to demonstrate that it can develop XTO’s resources at an even lower all-in cost than XTO. I would not be surprised if this is the catalyst which sets off massive M&A activity in the shale space, particularly as the Majors look to secure a longer-term energy outlook amidst record low NG prices.

Technical Options Trade: Short Brazil via EWZ Puts
The long Brazilian Jan-10 80 strike ATM EWZ put position, recommended on Dec-2 was closed on Dec-8 when the +/- 40% PnL threshold was reached (this is my internal trading guideline for 1M ATM options where time to expiry is greater than 20 days). Again, I failed to participate in even further upside due, perhaps, to too conservative risk limits and return thresholds; had I held on to the position until Dec-21 (theoretically assuming perfect market timing), the position would have generated twice the return, with 79.6% cumulatively over a three week period. As I get more experience under my belt, I will come back to re-evaluate these guidelines, but in the meantime, the over-arching credo is that the market can remain irrational far longer than I can remain solvent... so, I'll stick to the side of prudence in the meantime.