Archive | April, 2012

Top Oil Stocks To Hedge Against Dollar Slide

3 Apr

Energy stocks are presenting a brilliant opportunity for investors right now. The way we see it, the industry is undervalued as a whole, trading at low multiples. Many of the largest companies in the industry boast current P/E ratios below 20 and forward P/E ratios below 15.

Hedge funds like energy stocks too. Many oil and gas companies are very popular amongst the hedge funds we track. For example, BP Plc (BP) was held by 57 hedge funds at the end of last year. Famous energy hedge fund manager T. Boone Pickens had over 12% of his portfolio invested in BP. Pickens was also bullish about National Oilwell Varco Inc (NOV), Exxon Mobil Corporation (XOM), Halliburton Company (HAL), Occidental Petroleum Corporation (OXY), and Schlumberger Limited (SLB), which were all very popular among other hedge funds. For instance, there were 51 hedge funds with Halliburton positions in their 13F portfolios at the end of 2011. The most bullish money manager about the stock was Ken Griffin, whose Citadel Investment Group boosted its stake by nearly 600% to $175 million.

More importantly though, investing in the energy sector also provides a way for investors to hedge against a decline in the US dollar – which, given the economy, is a major benefit right now.

It is not hard to understand the negative correlation between oil price and US dollar. Intuitively, the global oil price is denominated in US dollars. Therefore, if the US dollar depreciates, oil providers are paid by fewer units of foreign currencies for the same amount of oil. In order to keep their purchasing power unchanged, oil providers will raise oil prices.

To verify the relationship between oil price and the US dollar, we collected the monthly data points of WTI spot crude oil price (dollars per barrel) and US dollar index from January 1986 to May 2011, as shown in Chart 1.

Chart 1: Oil Prices and USDX Over Time

As shown in the chart, there definitely seems to be a negative correlation between oil price and US dollar index. For example, oil prices soared when the US dollar depreciated during the 2008 financial crisis. However, when the US dollar appreciated, the decline in oil price was not very obvious. The US dollar appreciated in 1997 and 1998, went down slightly in 1999, and went up again in 2000 and 2001. Correspondingly, oil prices dropped in 1997 and 1998, climbed from early 1999 to mid 2000, and fell again in 2001. However, the overall trends of both US dollar index and oil prices were growing in late 1990s and early 2000s.

So, how closely are the US dollar index and oil price related to each other? In order to see the relation more clearly, we made a scatterplot of the two data series (Chart 2).

Chart 2: Scatterplot of Crude Oil vs. USDX

Obviously, Chart 2 shows that oil prices are negatively correlated with the US dollar index. We also found the correlation between the two data series to be -0.706, which indicates a quite strong negative correlation.

Lastly, we constructed a simple regression model. We used US dollar index to explain the changes in oil price. The R-Square is about 50%, which means US dollar index can only partially explain the changes in oil prices. There are other factors that influence the oil prices, such as macroeconomics. Plus, an improved regression model may also include the US dollar index at t-1 as an independent variable. Despite that, our simple regression has already shown us some valuable results. The coefficient of US dollar index of -1.82 indicates a negative correlation between US dollar index and oil price, which is in accordance with our previous findings. The p-value of the coefficient is lower than 0.0001, which means that the negative correlation is statistically significant at a 99% confidence level.

Overall, our study shows that there is a negative correlation between oil prices and US dollar. If investors want to protect themselves from dollar depreciation, they should probably gain some exposure to the oil market. And we think one of the most practical ways of gaining exposure to oil prices is to invest in oil companies, especially those with large hedge fund interest.