Wednesday Rebound

What a crazy day!

Despite dumping 36M barrels of crude in one day on the NYMEX, energy traders were still caught with their pants down as the inventory report showed a 9.4M barrel build in crude inventories, a 400Kb build in distillates along with a 6.3Mb drawdown in gasoline as refineries ground to a virtual halt, running at just 85.6% capacity.  The hot potato game continued with the 29,492 remaining September contracts as they changed hands 149,293 times, no doubt by earnest hedgers who really thought they needed the barrels just before they changed their minds 45 seconds later.  Today was the last day of September trading and tomorrow we will see the October contracts, which are priced about .50 higher. 

Despite the MASSIVE build in crude, someone who must have REALLY needed oil decided they needed a lot of it right at 1:50 pm and they bid the contracts up from $113.50 (USO $92) all the way up to $115.50 in the last 45 minutes of trading.  This is easy to do on expiration day as there are fewer open contracts so near the close, a little goes a long way.  Currently it costs a NYMEX member $10,175 to control 1,000 barrels of crude ($115,650 at the moment) – so much for raising requirements to reign in speculators…  With just 29,492 open contracts remaining, a trader could raise or lower the price of oil pretty much at will by trading 5,000 contracts ($578M worth of oil)  for $50M.  That is 1/2 of the oil the US imports in a day!  Since we have a very tight relationship between the price of oil and the Dow, that means that for $50M, that trader can give you a 100-point plus move in the Dow on demand.  Do you think you can use that to make some cash? 

I say let's all get in on this scam, why leave it to the oil boys when we can start manipulating the entire $30Tn market for just $50M?  Since our government has no interest in regulating this nonsense, I'm sure some industrious fellow could figure out a way to, perhaps, short one or two Billion dollars worth of Dow components (maybe the financials) and then jam oil up $3 and tank the market (maybe he could even have one of his firms' analysts make a call that oil would hit $149 before the market opens to maximize the effect – maybe even backdating the note to cover your tracks).  After your trader is done BUYBUYBUYing oil, he can then flip the position and SELLSELLSELL and drop it back $3 and, presto, another nice gain playing the Dow for a rebound. 

It's even better if you rotate your sectors, let's say you set up shorts on financials Tuesday afternoon, then have your analysts downgrade them Tuesday after the market closes and then you jack up oil and tank the Dow (very financial heavy since the rebalance).  Once you get to the bottom (you spent your whole $50M at the NYMEX and drove it up to today's high of $117) then you switch to the Transports and drop oil all the way down to $112.  Even assuming you bought every barrel of oil at $117 and sold every barrel at the day's low of $112, your loss on energy trading is "just" $25M.  On the other hand, trading $2Bn of securities that fall 1% when you're short and rise 1% when you are long net's you $40M.  Of course we could do MUCH better than that with options and we can even offset the energy trading losses by including some puts and calls on USO.

Manipulating the markets like this would be wrong and certainly no one we know would have their analysts downgrade the financials after the market closes and then come out with a statement that oil would go back to $149 when it was at $113 in the morning.  Certainly no one with hundreds of Billions of dollars at play in the market and close ties to the administration under pressure to make their quarter – certainly people like that would be above reproach and would never do something like that just to make a few hundred million in a day.  It would be wrong and I'm sure it never, ever happens…

True to form, the Dow continued its inverse dance with the POO and the market rocketed up 100 points as oil fell $3.50 after the inventory report, then retreated back as oil was forced up in the afternoon.  The market did manage to pull off the floor into the close but never made our levels but we'll be starting tomorrow just shy of where we were last Thursday (11,450) and that was a nice 300-point morning so we'll just have to see what happens.

I'm hoping for something good because FRE dropped fast and hard and there was so much negative news I decided to go against the grain and buy more.  That left me with more than a comfortable amount of FRE common stock at $3.81 per share, down about 15% in a position that is now 1/3 of the Stock virtual portfolio.  I don't feel all alone though, Bill Miller upped his stake in FRE to 12.2% so he's on the hook for $256M and he averaged in a little higher than I did.  Richard Pzena and David Dreman  have upped their stake on FRE as well on the premise that, if the company can make it 2-3 years out, earnings should be in the $3-$5 per share range – that's not bad for a $3 stock! 

I was calling this weeks action in financials (FRE in particular) a hyena attack but Mark Grant, Managing Director of Southwest Securities had this to say: "The Financial World is currently under siege. I am not sure if there is a better way to put it but it might as well be an economic jihad fostered by some terrorist group. There is certainly no let up in the Press and I wonder who is making what bets after reading some of the commentary provided by the tribal leaders and warlords of the global marketplace. Some of the more recent articles such as the one’s recently in IBD and Barron’s struck me as so short sighted as to lack common sense."

I wholeheartedly agree.  The more I heard the non-substantive attacks on FRE and each time another talking head came on CNBC to say "a really BIG bank is going to fail" I became a little more convinced that this was all nonsense.  My position may be wrong, things may be worse than I think, but even BSC shareholders ended up getting $10 per share in the end, and they were valued at just $200M.  FRE is a massive financial institution with $70Bn of cash on the books and "an unencumbered agency morgage-related securities virtual portfolio of $470Bn, which could serve as collateral for additional borrowings." 

On July 13, 2008, the Fed Board of Governors granted the Federal Reserve Bank of New York the authority to lend to Freddie Mac if necessary.  Any such lending would be at the discount rate charged for primary credit, or the primary credit rate, and collateralized by U.S. government and federal agency securities. This authorization was intended to supplement the Treasury's existing authority to purchase obligations of Freddie Mac.   On July 13th the stock was at $4.50, on July 23rd the stock was at $11, now it's back at $3.15 and it takes a very strong stomach to hold it because every single voice you hear in the MSM says SELLSELLSELL. 

This evening the WSJ put out another hack job saying FRE and FNM had to roll (although they make it seem like raise) $225Bn worth of debt by the end of September.  What they don't tell you is that's what they do every month and the only real danger is, like Monday's sale by Freddie, they may pay a little more than usual in interest as the environment is more fearful than usual.  How much more?  The $3Bn auction held Monday led to a yield 1.13% over the 5-year Treasury note.  In March, the last 5-year note auction by FRE went of at 1.055% over the 5-year note. 

So the company says they are well capitalized, they have $70Bn in cash and $470Bn of unencumbered assets and a backstop from the Fed has been in place and remains unused since July 13th.  Those are the facts – the rest is pure speculation…  Now that we are down to $3 on the stock, I do like owning the stock and selling the 2010 $2.50 calls for $2.25.  It's a net of .75 at risk and, if the stock closes anywhere above $2.50, you will get $2.50 for your .75 investment.  If the worst bear fears come true, the play loses .75 BUT, if there is a takeover for any amount over.75, your caller loses all of his premium and you get out early with a very nice profit. 

A nice way to play this is to buy 100 shares each morning for $300+ and wait for a nice run-up to sell a contract against them.  Repeat daily until you get bored and by covering by the end of each day, you avoid the danger of being slammed by a takeover after hours while leaving yourself the possiblility of good news during the day giving you a bonus.  So if I was willing to risk $1,500 on this play, I spend $300 and get $225 back (net $75) for selling the 2010 $2.50 calls and I can do that 20 times, ending up with 2,000 shares of FRE for $1,500 with an obligation to sell them for no more than $2.50 per share ($5,000) in January 2010.  Not a bad return (233%) for 15 months' work if it plays out…

If you believe the WSJ, you can buy Jan $3 puts for protection through the end of September at $1.33, that will cost you an extra .50 to .75 if the stock heads higher but will save your .75 if it heads down.  For those of you in more of a hurry, here's a nice play that pays off from zero to $27 on Jan 16th along with the breakdown per OXPS's Trade Calculator:

You can eliminate the sold Jan puts (so naked on the 2010 $7.50 puts) and load the profile more to the bottom if you are more bearish: