Commodity stocks gain popularity as underlier for reverse convertibles

By Emma Trincal

New York, June 1 - Investors are tapping into commodities via reverse convertibles, recent data compiled by Prospect News shows.

In both April and May, about a third of all reverse convertibles offerings were tied to a commodity stock, according to the data.

In May, $201 million, or 35%, of the $568 million of reverse convertible issuance was based on commodity stocks.

In April, the proportion of commodities stocks was even higher at 45%. That month, $199 million of commodity stock-linked reverse convertibles priced out of a total of $442 million in this structure type.

Favorite names

Among the most popular names are Anadarko Petroleum Corp. and Chesapeake Energy Corp.

In May, the most popular deal, Citigroup Funding Inc.'s $87.63 million of 7.5% Equity LinKed Securities due Nov. 23, 2011, was linked to Schlumberger NV shares.

Other very popular names include Freeport-McMoRan Copper & Gold Inc., Silver Wheaton Corp., Peabody Energy Corp., Northern Oil and Gas, Inc., Patriot Coal Corp., ATP Oil & Gas Corp. and Northern Oil and Gas, Inc.

Avoiding contango

"Commodity indexes tend not to track the price of commodities well and you run into problems of contango," said a structurer.

"You can use very technical commodity indexes to resolve this problem, such as the [UBS Bloomberg Constant Maturity Commodity index], but they're a little bit too technical for retail investors.

"Getting commodity exposure via a single stock takes care of the contango problem."

Investors in commodity futures face a so-called "contango" market when the longer-dated contracts are priced higher than the near-dated contracts and spot prices. The result is an upward sloping futures curve that creates a negative roll yield, ultimately eroding performance.

The structurer added that commodity stocks, in particular oil stocks, offer their own advantages.

"Oil stocks are very cheap. They have PEs between five and 10. They have not profited that much from the rising oil price yet.

"If you drill oil and the cost of the barrel goes up, your margin increases too because there is little elasticity in the production cost for oil.

"All of this bodes well for commodity stocks as opposed to trying to figure out what type of futures contract to bet on."

Volatility push

Because volatility in commodities has been up last month, many investors have gravitated around reverse convertibles tied to commodities stocks in order to generate higher coupons, sources said.

"Reverse convertibles are linked to very volatile stocks, and investors are driven to the high coupons," said structured products analyst Suzi Hampson at Future Value Consultants.

"You're trying to pick up some coupon, but you're taking market risk for that," said Steve Doucette, financial adviser at Proctor Financial.

"The more volatile the stock is, the higher the coupon since you're selling volatility. But you're also selling the upside. You're capped."

Buyer beware

The structure and the underlying both involve risks, sources said.

"Everybody is sort of chasing the hot dog. It's unfortunate that the investing public is caught in the news. They're chasing returns toward the top, where you have the highest chance of reversing," said Tim Fortier, managing partner at Structured Products Advisors, LLC.

"I'm sort of a contrarian. The commodity market has been running for a good couple of years. You've had a strong correlation between commodities and equities thanks to the Fed engineering. What happens when this support goes away? The downside risk is much greater," he said.

Fortier said that investors should demand bigger downside barriers and concentrate on very short-term deals such as those with three-month tenors.

"When you get knocked out, you get stuck with the stock," he said.

"I wish people could expect more moderate coupons with better downside protection."

Some are not sure whether investors' appetite for commodity stocks is likely to persist in the long term.

"There is always a trend," said Hampson. "You had the bank stocks a little while ago and the tech stocks. There is always one sector over another where you find the influx of money."

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