A New Kind Of Oil Price Speculation by Cook & Bynum

Sometimes structured products are only masquerading as investments, when in reality they are time-bound gambling vehicles.  Jason Zweig recently highlighted a case study where “investors” were simply speculating with options on near to intermediate-term oil price movements.  We suspect that the originating banks will prove to be the biggest winners from these bets.

In 2015, units of Bank of America Corp., Citigroup, Credit Suisse Group AG, Goldman Sachs Group, J.P. Morgan Chase & Co., Morgan Stanley, UBS Group AG and other top financial firms issued at least 300 “structured notes,” or short-term borrowings, whose returns are linked to the price of oil or other energy-related assets. These securities total at least $1.3 billion. The buyers include wealthy families, individual investors, and brokers and financial advisers who want to limit the risk or amplify the return of more-conventional investments. Typically maturing in two years or less, these notes pay commissions of about 2% to the brokerages that sell them. They use intricate combinations of options contracts to skew the payoffs from changes in energy prices: You can make a lot of money if oil goes up a little, and you can lose much or all of your money if it goes down a lot…

Consider $6.9 million in one such security, issued by HSBC USA last May and distributed by Morgan Stanley Wealth Management. Linked to the share price of the Energy Select Sector SPDR, an exchange-traded fund of about 40 leading oil and gas stocks, the notes mature in September 2016 and promise to triple any gain in the share price of the fund – but only up to a point. When the note came out, the ETF was priced at $78.37, down from more than $100 in the summer of 2014. If it rises to $82.54, or a mere 5.33%, by the end of August, then the note will triple that – paying out a 16% capital gain upon maturity. However, investors can’t earn more than 16%, no matter how much higher the ETF goes. And if the fund goes down instead of up, investors in the note will lose money – dollar for dollar, without limit.

Mind you, most of these securities don’t start maturing until late 2016, and the prices of oil and related assets could well recover by then – in which case the interim losses would disappear or turn into gains. “But this is not really an investment strategy so much as a wager on which way oil prices are going,” says Craig McCann, principal at Securities Litigation and Consulting Group, a research firm in Fairfax, Va. “And some of the risks and costs of that wager are masked by the complexity of it.”

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Oil Price Speculation

Oil Price Speculation