Morgan Stanley's Philadelphia Oil Service Sector index-linked deals target two types of bulls

By Emma Trincal

New York, May 25 - Morgan Stanley brought to market two deals both based on the price of oil servicing but using two very distinct structures aimed at different outlooks on oil, sources said.

The first deal, which was the second largest in size last week, offered a leveraged structure. Morgan Stanley priced $31.8 million of 0% return enhanced notes due Sept. 26, 2011 linked to the Philadelphia Oil Service Sector index, according to a 424B2 filing with the Securities and Exchange Commission.

The payout at maturity will be par plus double any index gain, up to a maximum return of 15.1%. Investors will be exposed to any index decline.

J.P. Morgan Securities LLC was the dealer, and Morgan Stanley & Co. Inc. the agent.

The second offering was a digital coupon product tied to the same index. Morgan Stanley issued $25.51 million of 0% jump securities due Nov. 23, 2011 with a payout at maturity of par plus 11.3% if the Philadelphia Oil Service Sector index finishes above its initial level. Investors are also fully exposed to losses with these notes.

Morgan Stanley & Co. Inc. is the agent.

Turning point

Russell Catley, partner of Catley Lakeman Securities, said that oil offers attractive pricing as the market is at a turning point.

"Structured products are quite popular when volatility is high. And oil prices have been very volatile this month with the recent correction. Now people expect oil to recover," he said.

"Crude oil prices sold off a lot this month, so people see today's prices as a good entry point," a New York sellsider said.

"Goldman Sachs has just turned bullish on oil, inciting people to get on board," he added.

Oil prices fell earlier this month as the dollar recovered on concerns around the European debt crisis and the slowdown in the Chinese economy, sources said.

On Monday, crude oil for July delivery fell to $97.70 a barrel on the New York Mercantile Exchange.

Goldman Sachs in a bullish report issued Monday night predicted $130.00 a barrel a year from now.

"After the correction, we see a more bullish trajectory for oil prices, leading us to recommend establishing a long position in Brent crude oil," the report said.

Oil futures climbed over $101.00 a barrel on Wednesday.

Enhanced upside

The sellsider said that the lack of downside protection in both deals enhanced the potential returns.

"They give you a very high cap with leveraged returns or an attractive coupon to compensate for the absence of a buffer. A 10% barrier would have dampened returns a lot," he said.

Whether investors would choose the first or second deal would depend on their outlook on oil.

"If you're very bullish, you'd go for the high-cap leveraged note," he said.

"If you're only slightly bullish, the second one would work better because all you need is an increase in the index, it doesn't matter by how much."

Digital, neutral outlook

Andrew Valentine Pool, main trader at Regatta Research & Money Management, said that he would avoid both deals given the full exposure to losses. However, if he had to pick one, his preferred option would be the second offering, he added.

"If we had to, we would go for the digital coupon structure because we think oil will stay flat at around $100.00 for another three or four months," he said.

"Oil tends to get lower after Memorial Day, and all the summer pricing is taking place in the spring. We sold our oil holdings two or three weeks ago."

He said he liked the underlying index because "oil servicing will continue to happen until the slowdown."

But he objected to the lack of protection in both deals.

"We wouldn't do either one of these deals because none of them offer downside protection," he said.

"We would go for the digital coupon if it had a 10% downside protection even for a much lower coupon, like 8% for instance instead of 11%. We would much rather have a lower coupon and some protection than the other way around."

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