Less Filling, Tastes Great
By Eric J. Fry
"Pair-trading" is the non-alcoholic wine of investing. It
may resemble the real thing, but delivers none of the
"buzz"…or so some folks believe.
But pair trading – just like non-alcoholic wine or fat-free
ice cream or any of the other culinary atrocities
perpetrated by Americans – provides a worthwhile function
in specific settings. Pair trading, by capitalizing on
market volatility, provides the opportunity to profit, even
when the broad equity indices are "range-bound."
If the following discussion is to render any insight of
value, we must define our terms. Pair trading, quite
simply, refers to the strategy of investing simultaneously
in related long and short positions. For example, buying
the shares of Daimler-Chrysler (DCX) and simultaneously
selling short the shares of General Motors (GM) would
establish a pair trade. Two stocks from the same industry –
one long and one short.
The pair trader who established such a trade would
expect/hope that DCX would outperform GM over the ensuing
weeks or months. In other words, if both stocks rose, but
DCX rose more, the pair trader could close out both sides
of the trade for a profit. Conversely, if both stocks
dropped, but DCX dropped LESS, the pair trade could close
out the trade for a profit. Obviously, if GM outperformed
DCX, either to the upside or the downside, the pair trade
would produce a loss.
Pair trading, therefore, is a kind of "Zen" approach to
investing, in which the investor relishes the market’s
volatility, rather than resisting it.
Not all pair trading relies upon fundamental (qualitative)
relationships between securities. Indeed, most professional
pair trading strategies employ some form of "black-box"
approach that tries to capitalize upon brief statistical
(quantitative) divergences between specific securities or
baskets of securities. But today’s column will not address
this particular form of pair trading.
Stated simply, whether one utilizes qualitative or
quantitative process, pair trading relies on the mean-
reverting tendency of securities. That is, when two related
securities diverge from one another, they tend to re-
converge at some point. Typically, therefore, pair trading
opportunities present themselves more often in
"oscillating" markets than in "trending" markets.
Now that we have defined our terms, let’s probe the
possibilities that may now be unfolding among oil and gas
The energy sector has become one of the most volatile
sectors in the entire stock market, as yesterday’s trading
action clearly demonstrated. Oil stocks have abruptly
reversed course multiple times over the past few months,
rendering it very difficult for investors to make money, no
matter whether they are trading from the short side or the
long side. As such, the energy sector provides an ideal
environment in which to ply pair trading strategies.
A couple days ago, my friend Michael Martin, a resource-
stock broker for R.F. Lafferty, volunteered, "Hey Eric,
have you checked out these Canadian oil service companies?
I think there might be a few pair trades in the group
relative to U.S. oil service companies."
"Sounds interesting," we replied. "It’s probably a good
idea to hide out in pair trades for a while, rather than
trying to eke out a buck from this maelstrom…so what’s
"It’s pretty simple really; Canadian contract oil-drillers
and oil service companies sell for very steep discounts to
their American counterparts. So, for example, based on a
BMO Nesbitt Burns spreadsheet I’ve got in front of me here,
Canadian oilfield services and equipment companies are
trading for about 18 times estimated earnings, whereas the
American companies are selling for about 25 times
"Okay, that’s mildly interesting," we conceded, "but not
"I agree, but the contract-drilling sector looks much more
interesting. On both earnings and cash flow, the Canadians
are trading for about half the American multiples."
"Alright, NOW I’m intrigued," we said. "Do you have any
names? Are these things all micro-caps or something?"
"Not at all. You’ve heard of Precision Drilling haven’t
"Okay, well Precision drilling sells for about 17-times
earnings and 7-times enterprise value to cash flow [defined
as EV/EBITDA]. That compares to about 28-times earnings and
12-times EV/EBITDA for the American drillers."
"Wow!" your editor exclaimed. "That’s a bit surprising,
given the close commercial connections between the Canadian
and American energy industries. You and I both know, of
course, that valuation discrepancies like these can persist
for years. But if the bull market in energy continues, the
Canadian discount should narrow, if not disappear
completely. After all there’ll probably be much more
drilling to do in Canada over the next 10 years than in the
U.S…Do you have a specific pair you’d recommend?"
"Sorry, not yet. I just started looking at this situation."
…And so have we it, dear investor. Nevertheless, we
present below an EXAMPLE of the divergences upon which a
pair-trader might seek to capitalize.
For most of the last two years, the shares of Canada-based
Ensign Resource Service Group (TSE: ESI) have closely
tracked the upwardly sloping trend of U.S.-based Helmerich
& Payne (NYSE: HP). Recently however, as the nearby chart
illustrates, Ensign has failed to keep pace. The timorous
oil bull, therefore, might wish to buy Ensign, while
simultaneously selling short HP.
A distinct valuation disparity in Ensign’s favor also
recommends this trade. Ensign currently sells for about 13
times estimated 2005 earnings, while HP sells for about 24
times ’05 earnings. Interestingly, Ensign conducts a large
amount of its business in the U.S. Rocky mountain region,
while HP operates in the Gulf of Mexico and South America.
One could say, therefore, that Ensign is just as American
as HP, even though its discounted valuation is 100%
To repeat, we have not conducted adequate due diligence to
recommend this specific trade. Rather, we wished merely to
bring the approximate idea to the attention of Rude
Awakening readers. At a minimum, investors might want to
begin foraging around for opportunities in the Canadian oil
sector, rather than the focusing on the relatively pricey
oil stocks down here below the 42nd parallel.
As a last resort, investors may wish to buy cheap stocks
and hold them for the long-term, while ignoring short-term
But how much fun would that be?
Did You Notice…?
By Eric J. Fry
In last Tuesday’s edition of the Rude Awakening, your New
York editor mistakenly reported, "In the unleaded gasoline
market, the large speculators have amassed a whopping
176,000-contract net long position."
The actual number is about 40,000, which is still the
highest net total in more than a year, albeit SLIGHTLY less
Almost immediately after Tuesday’s edition arrived in
reader’s email boxes, your editor received an email from
Justice Litle, one of the two very capable editors of
For your edification, we will share excerpts of the ensuing
email exchange between Justice and your New York editor.
Justice Litle to Eric Fry:
Quick note regarding the commitment of trader’s data you
cited today. That 176,827 number does not actually
represent the net long position of large speculators – It’s
the total Open Interest across the board, for all parties:
Net non-commercial longs: 47,479
Non-commercial spreading (which includes longs and shorts):
Commercial longs: 95,891
Non-reportable longs: 18,699
Total longs: 176,827
non-commercial shorts: 7,244
non-commercial spreads (which includes longs and shorts):
commercial shorts: 143,489
non-reportable shorts: 11,606
Total shorts: 176,827
Therefore, the net long position for the non-commercial
longs – a.k.a. "large speculators" – would be 40,235.
Also for what it’s worth, the non-reportable positions are
the ones typically referred to as ‘dumb money’ – at least
among commodity brokers. This is because the non-reportable
positions are the untraceable odd lots held by Joe Sixpack
trader… whereas the non-commercial reportable positions
are held by large CTAs and hedge funds, guys like John
Henry, Keith Campbell, Bill Dunn, Paul Tudor Jones etc.
Considering that the biggest CTAs and hedge funds have 20-
year track records of beating the S&P, I’d hesitate to call
them dumb without a substantial caveat.
When I was at Commodity Resource we did a good bit of
research on Commitment of trader’s data… like most
fundamental data sets, we found that sometimes it’s useful
and sometimes not depending on the surrounding
Commercial data has to be tempered, for example, by the
fact that a significant percentage of commercial positions
is dedicated to straight hedging, and thus does not
represent a straight market opinion…perhaps a somewhat
diluted market opinion.
For what it’s worth, I personally view commercial CoT data
as an overbought/oversold oscillator…. if there are
surrounding reasons for a market to turn, it can be a
confirmation of sorts… but in a market that’s trending
strongly, things can go to overbought or oversold and stay
that way for a long, long time.
Eric Fry to Justice Litle:
Thanks for the heads up on the number. I realized my error
this morning. But late last night when I was bleary-eyed, I
simply glanced at the right scale (open interest) instead
of the left scale (net position).
As for dumb money characterizations, obviously they are
simplistic. But simplistically speaking, the "commercials"
have tended to fade extremes in markets better than any
other COT category trader, wouldn’t you agree?
In other words, they are the ones who most often sell into
tops and buy into lows. (And yes, I know the data, just
like the NYSE short-interest data, are flawed because they
cannot distinguish hedges from naked positions. But almost
all data upon which investors rely are imperfect in some
Net-net, as ONE indicator among many, the COT data are
Thus, I agree completely with you that this works best as
an oscillating sort of indicator. And I used it very
effectively as such during the years that I managed money
professionally. Obviously, there is no one indicator that
always works in all environments. But when multiple
indicators flash the same general message, it’s usually
best to heed them.
P.S. Paul Tudor Jones might well be short unleaded against
a long position in natural gas or who knows what. The rest
of the "large specs" might have naked positions. Who knows?
At the end of the day, not all the "large specs" are Paul
Tudor Jones. I don’t try to over-analyze the data. In
general, at extremes, I’d rather be with the commercials
than with either the large specs or the small specs."
Justice Litle to Eric Fry:
Yep, I definitely agree with you in principle…no doubt
the commercials are generally the most well-positioned at
tops and bottoms, and a good portion of the large specs are
mechanical trend followers who routinely give back a chunk
of their gains when a trend reverses.
Wasn’t disagreeing as much as offering an alternative
And the Markets…
WTI NYMEX CRUDE