Rich value, volatility raise risk with UBS’ $445,000 autocalls on Petrobras, contrarian says

By Emma Trincal

New York, Oct. 21 – UBS AG, London Branch’s $445,000 of trigger phoenix autocallable optimization securities due April 23, 2024 linked to the American Depositary Receipts of Petroleo Brasileiro SA offer at first glance an attractive coupon and barrier. But a deeper examination of the valuation and volatility of the stock as well as the macroeconomic environment reveal that the terms are not as attractive as they seem at first glance, according to Steven Jon Kaplan, founder and portfolio manager of True Contrarian Investments.

If Petrobras’ stock closes at or above the trigger price – 50% of the initial share price – on a bimonthly observation date, the issuer will pay a contingent coupon for that two months at the rate of 20.58%. Otherwise, no coupon will be paid that two months, according to a 424B2 filing with the Securities and Exchange Commission.

If the shares close at or above the initial price on a bimonthly observation date, the notes will be called at par plus the contingent coupon.

If the notes are not called and Petrobras shares finish at or above the trigger price, the payout at maturity will be par plus the contingent coupon. Otherwise, investors will be exposed to the share price decline from the initial price.

The bet on the Brazilian national oil company Petrobras was overly risky given the valuation and volatility of the stock, Kaplan said

Energy bubble

“Energy shares are one of the few sectors that are up in 2022. Most sectors are down and only a few, flat,” he said.

“Energy shares have therefore become highly speculative since people always want to buy what goes up. Oil-related stocks are a crowded trade driven by emotions more than fundamentals. Petrobras is no exception,” he said.

He pointed to the price increase of the stock this year, rising from $7.73 adjusted-for-dividends in the start of the year to $16.05 at the close on Friday.

The share price is the highest it’s been in 11 years, since 2011, he noted.

“It doubled this year. This is the type of strong rally you only see in a bubble. It’s reminiscent of the speculative fervor around Tesla or the Nasdaq in 2021,” he said.

Typically, a climbing stock price is not enough to deem a stock overvalued. Valuation metrics such as price-per-earning ratios need to be examined as well, he said. In the case of Petrobras, the P/E is surprisingly low at 3.63.

But Kaplan said that in the case of commodity producers, “P/Es are misleading,” because of the nature of the factors impacting costs, which tend to be temporary.

“The cost structure of a commodity producer is going to be very different than the cost structure of a company like Apple. That’s why P/Es for commodity stocks are quite misleading,” he said.

Politics

Some factors may increase short-term volatility, such as the upcoming Election runoff, he said.

Former president Luiz Inacio Lula da Silva will face current president Jair Bolsonaro on Oct. 30.

“Lula is considered more on the left. The fear is that he may tax oil companies or attempt to further control Petrobras while his rival is perceived as more business friendly,” he said.

Petrobras is a majority-state-owned oil company, which accounts for 73% of Brazil’s oil and gas production, according to the International Trade Administration.

“Corruption in Brazil is endemic. Political scandals happen quite regularly. The impact of the runoff on the stock should be limited in time in my view. Certainly, volatility may increase next week,” he said.

Stock up, oil down

More surprising: oil prices have not been a factor driving the direction of the stock, he said.

“The price of oil is way below its high. And yet, the stock is at record highs,” he said.

Crude oil prices are trading at $85 a barrel, compared to $120 in March.

“The price of the stock is not correlated to the commodity.”

Oil prices have declined because of global demand, he said.

“Asset prices are going down. People are spending less. They’re traveling less,” he said.

“The economy is slowing down. We’re transitioning into a recession.

“So, this is proof that we have a bubble. It’s not oil, but emotions, herd behavior that are propelling the price of Petrobras higher.”

Investors in the stock are not paying attention to the downtrend in oil prices and global demand, he said.

When commodities enter a bear market, the impact on oil stocks can be devastating, he said, noting that during the six-month period between May and November 2008, the share price of Petrobras fell by more than 80%.

“The company is going to face new headwinds. The timing to buy the stock is not right,” he said.

Vulnerable barrier

Kaplan concluded that the structured note was too risky. He questioned the strength of the 50% barrier.

“For the coupon, 50% is OK. You may miss a few coupons a few times, but you will get some. The real question is whether the stock could fall by half in 18 months. That’s the question,” he said.

“My answer is: yes, it can certainly drop more than 50%... Just look at the volatility of the stock.”

The implied volatility of Petrobras is 93.5%. In comparison, the Invesco QQQ Trust, which tracks the Nasdaq-100 index, has an implied volatility of 37% and the S&P 500 index of 28%.

Even the implied volatility of Tesla at 64% is much lower than that of Petrobras, he noted.

“If you had a 50% barrier on the S&P, I would say, it’s exceptionally solid. But with an exceedingly volatile stock like Petrobras, you could lose a lot of money. So, while the coupon looks high at first glance, I don’t think you’re being fairly compensated.

“As a matter of principle, I wouldn’t buy anything that’s trading at an 11-year high and certainly not with that huge level of volatility.

“I don’t see a good risk-return in this trade,” he said.

UBS Financial Services Inc. and UBS Investment Bank are the underwriters.

The notes settled on Thursday.

The Cusip number is 90303W617.

The fee is 1.5%.

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