JPMorgan’s capped buffered leveraged notes on Energy Select Sector index seen as too risky

By Emma Trincal

New York, July 15 –With the recent decline in crude oil prices, market participants questioned the timing and safety of an upcoming trade on the energy sector.

JPMorgan Chase Financial Co. LLC’s 0% capped buffered enhanced participation equity notes due Aug. 30, 2023 linked to the Energy Select Sector index did not offer enough downside protection in a rapidly evolving and inherently volatile industry, they said.

If the index return is greater than the initial level, the payout at maturity will be par plus two times the index return, subject to a maximum settlement amount of par plus 39.22% to 46%. The exact maximum settlement amount will be set at pricing, according to a 424B2 filing with the Securities and Exchange Commission.

If the index return is flat, or greater than or equal to the 90% buffer level, investors will receive par.

If the index falls by more than 10%, investors will lose 1.1111% for each 1% decline beyond the buffer.

“What comes to mind when you look at XLE is the fact that it’s been trading in a very wide range over the past 20 years,” said Jeff Pietsch, founder of Capital Advisors 360.

The Energy Select Sector SPDR fund, listed under the ticker “XLE” tracks the energy sector in the S&P 500 index, as does the underlier. The ETF hit an all-time high in June 2014 at around $100 a share. The second highest level was reached earlier last month at $93.31. On Friday, the price closed at $68.83, or a 26% drop since the recent high of June 8.

Stock prices in oil and gas have declined in unison with the price of the commodity itself. Brent crude futures have fallen by 16.5% from $121 a barrel on June 8 to $101 on Friday.

Supply and demand

“I would be cautious with this underlying. The sector is very sensitive to recession fears,” said Pietsch.

“Oil is so tightly correlated to macroeconomic factors...I see the return of this note geared to the downside.

A lasting reversal to lower oil prices will have a negative impact on the margins of oil-and-gas companies that populate the underlying index, he said.

“Oil is falling because demand is slowing,” he added.

“There is a global growth slowdown: less shipping, less production, less use of energy. People are not taking summer vacations because gas prices remain too high.”

Pietsch said he was not comfortable with the amount of downside protection.

“Given the current economic slowdown, you could breach that 10% buffer very quickly,” he said.

Trending down

The war in Ukraine has contributed to skyrocketing oil prices worldwide. But the trend could be reversed.

“The situation in Eastern Europe might have helped keep prices high. But right now, the fear of a recession is what drives the market,” he said.

Pietsch warned that several recessions in the past were preceded by inflation peaks. He pointed to high oil prices in July 2008 just ahead of the stock market collapse.

“It’s a self-correcting process. Demand sort of peaks, and suddenly, it doesn’t. The market moves in cycles. After the inflation peaks the market can all of a sudden move into a downturn.”

A continued drop in oil prices would weigh on the financial health of oil companies.

“Oil stocks are so correlated to the economy; the timing of this note, especially as the war in Ukraine is still going on, doesn’t seem to be optimal. The volatility in the sector is too high. Look how fast the ETF has dropped in the past month...”

The implied volatility of the Energy Select Sector SPDR ETF is 44.41% versus 29.9% for the S&P 500 index.

Structural shortcomings

Two features in the notes aggravated the downside risk, according to this adviser.

“It’s a levered bet over a short duration. If you’re up, great. But if the price is down, you probably won’t have enough time to recover,” he said.

“Also, I’m not a fan of the 1.11 times leverage on the downside, especially when you have such a volatile underlying.

“The duration is too short. The buffer is geared. This is not a bet I’m willing to take.

Difficult environment

Another market participant shared Pietsch’s concerns about the market risk associated with the trade.

“What goes up fast tends to fall rapidly,” said Howard Simons, president of Rosewood Trading.

“Oil companies are facing higher costs and lower demand. With growing fears of a global slowdown, the price of oil is now falling, which reduces their forward prospects even more.

“I usually don’t get involved with politics but add to that a very hostile environment in the U.S. with a government trying to put the fossil fuel industry out of business and you don’t really have any reason to be optimistic.

“Energy producers are not drilling as much, they’re facing rising operating costs, a changing energy consuming behavior...a falling demand...The only way they can still make money is by lowering prices.”

Wildcard

Another major risk was the uncertainty around the nearly four-month-old war in Ukraine.

“At some point this war will be over. When will that happen? We don’t know when. I certainly don’t know when. But the day it’s over, the price of oil is going to crater.”

Investors in energy stocks also face downward pressures common to a great number of “value stocks,” he added.

“One of the appeals of energy stocks is their high dividends. When interest rates go up, those stocks show some of the characteristics of a bond: their value goes down,” he explained.

“Oil stocks are very vulnerable to interest rate risk. That’s another source of uncertainty, something that can certainly negatively impact their share prices.”

Exxon Mobil Corp. and Chevron Corp., the top two holdings in the ETF with a combined weight of 45% have a dividend yield of 4.24% and 4.18% respectively.

Precarious bet

For Simons, the 10% buffer was far from sufficient.

“This put option is probably cheap. It doesn’t do much given the volatility of the index. So why would you cap your upside for that with such a volatile index?”

While the 39% to 46% cap range seemed “high,” such level was somewhat irrelevant, he noted.

“Historically, that’s a big stretch to go up that much so it’s unlikely that the cap would hurt you. But why take a chance?

“I’d much rather be long the sector and control my allocation and my liquidity, buying my own protection if I have to. Why would I want to limit my upside, especially when I have a fairly high probability of losses?

“This investment looks like a high-risk gamble to me.”

The notes are guaranteed by JPMorgan Chase & Co.

J.P. Morgan Securities LLC is the agent.

The notes will price on July 27 and settle on Aug. 3.

The Cusip number is 48133LPS5.

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