Barclays' autocallables linked to Brent crude oil target mild bulls seeking early redemption

By Emma Trincal

New York, Feb. 28 - Barclays Bank plc's 0% autocallable notes due Sept. 7, 2012 linked to the Brent crude oil futures contract are designed for short-term investors hoping to get an attractive call premium. Some say that the capped upside may be the biggest drawback in this trade rather than the downside risk.

The notes are designed for investors who seek an early exit prior to maturity as, beginning June 6, they provide investors with an opportunity to be called at 104.45% of par if the futures contract settlement price on any day is greater than or equal to 95% of the initial price, according to an FWP filing with the Securities and Exchange Commission.

The payout at maturity will be par if the final contract price is at least 80% of the initial price. Otherwise, investors will be exposed to the decline from the initial price.

Downside risk

Investors can lose up to 100% of their principal if the final price declines by more than 20%.

For those concerned about a price correction in oil or who need to reduce the size or amount of their potential losses, the notes, given the volatility of the underlying, would not be appropriate, a market participant said.

"It's a speculative investment. It offers some level of protection but not against a fat tail event," he said.

"Personally, I'm not bearish on oil. But you would have to have your own view and really think it through.

"This note requires a certain degree of knowledge. It's somewhat odd from the retail perspective to take that kind of a bet. If you're talking about a hedge fund, that would be appropriate. But let's assume that you're a sophisticated investor and that you're willing to take that downside risk for the yield; that would be a decent enough structure.

"You can get called at a good premium relatively early, and in exchange, you're willing to cap your upside. Nothing is for free ever."

Opportunity cost

Other sources said that if the oil rally continues, the capping of the upside in this structure could represent the main problem.

Investors will not earn more than the 4.45% call premium if a call is triggered.

In a very bullish scenario, if oil prices appreciated significantly more than the call premium, the opportunity cost could be significant for investors.

Michael Haigh, global head of commodities research at Societe Generale, emphasized that risk based on the volatility skew of oil options in the recent months.

"The market has discounted the prospect of a large downside move relative to an upside move. It's definitely pricing an upside move," Haigh told Prospect News.

Brent crude oil futures are currently trading around $125 a barrel.

Haigh said that on Nov. 17 and in late January, the at-the-money price for oil was around $110. His team measured the implied volatility of puts and calls with a strike at 40 below the at-the-money price for the puts and 40 above the at-the-money price for the calls. The measure was conducted on two different dates, one on Nov. 17 and the other at the end of January.

Haigh found that the implied volatility of the puts dropped from 47% to 27% during that period whereas the implied volatility of the calls did not change.

"We're fundamentally bullish," he said.

"The market is fading the downside price movement relative to the upside."

Without commenting on the potential return outcome on the notes, he said that investors should take into account the market perception.

"In terms of implied volatility, there is more upside risk than downside risk," he said.

Conservative play

Jim Delaney, portfolio manager at Market Strategies Management, who is bullish on oil, agreed but said that the notes could make sense for more neutral and conservative investors.

"For sure, current factors point to higher oil prices, like the tensions in the Middle East, the continuing growth in the U.S. economy, Europe kicking the can down the road, the upcoming driving season. All of that indicates that oil demand is going to rise and as a result, the price of fuel is going to be higher," Delaney said.

"So, yes, some of the risk here is that you're limiting your upside.

"This trade is for people who want to get called at 4.5% in three months. But I can easily see the price of oil up 5% in three months, so it's kind of a wash.

"What adds value to this note is the 20% downside protection.

"When you buy this paper versus buying straight oil, you know you have a 25% range: 20% on the downside and 5% on the upside, and that's OK if you want the protection.

"The market is not moving in a straight line. Oil can continue to go up, and maybe all of a sudden oil trades off. You never know."

The notes would be appealing to more conservative investors seeking above-average yield and hoping to exit their investment early, he said.

"This is not a bearish trade. It's a moderately bullish bet," he said.

Alternatively, a more bullish investor may use the notes as a hedge.

"This is for a middle-of-the-road investor who would want to do a half-and-half sort of play - one half in oil ETFs, for instance, and the other half in this paper. That way you get the downside protection," he said.

The notes (Cusip: 06738KU41) are expected to price March 2 and settle March 7.

Barclays Capital Inc. is the underwriter with JPMorgan Chase Bank, NA and J.P. Morgan Securities LLC as dealers.

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