Bank of America's notes on PHLX Oil Sector fit risk-taking, moderately bullish view on oil

By Emma Trincal

New York, April 12 - Bank of America Corp.'s planned notes tied to the PHLX Oil Service Sector index should be considered with caution given the lack of downside protection and the volatility of the underlying, sources said.

Bank of America plans to price 0% Accelerated Return Notes due June 2011 based on the performance of the index, according to an FWP filing with the Securities and Exchange Commission.

The index tracks the performance of 15 oil companies' stocks.

The payout at maturity will be par of $10 plus triple any gain in the index, up to a maximum return that will be set at pricing. Investors will be exposed to any losses.

Investors will have a capped return of 20% to 24%, which means that an index performance of only approximately 7% over the 14-month term will allow investors to maximize their payout, according to the prospectus.

Not for bears, strong bulls

The notes are only suitable for investors expecting that the index will increase "moderately," according to the prospectus.

The index rose by 55% from 138 in February 2009 to 214 on April 7.

Market participants cited as their main objections to this investment the risk of a correction in the oil market. Crude oil prices have more than doubled from $37 in March 2009 to approximately $85 Monday.

Correction fears

"The price of oil has been weakening in the past four to eight weeks, and we think we're very close to the high of 2010," said James Cordier, president and head trader at Liberty Trading Group.

"We think prices topped last week," said Cordier. "I'm no longer bullish on oil although I have been for the past four or five months. We think oil by the end of the year will trade lower than today."

On Monday, crude oil prices on the New York Mercantile Exchange fell for a fourth day to $84.32.

Cordier said that he turned bearish due to fundamentals, citing first, excess supply.

"Crude oil supply in the U.S. has increased for 12 weeks in a row, and at this time of the year, we normally see the opposite," he said.

In addition, Cordier said he doubted demand would be strong enough to absorb the glut of supply.

"The idea that the economy is better and the consumer is back, we think, is an exaggeration," Cordier said.

Too volatile

Sources also expressed concerns about the volatility of the underlying index, which does not track oil as a commodity but rather the performance of oil stocks.

Some of the names included in the index are Transocean Ltd., Lufkin Industries Inc., Oceaneering International Inc., Baker Hughes Inc., Schlumberger Ltd., etc.

The PHLX Oil Service Sector index, due to its concentration in one sector, is highly volatile, according to the prospectus.

"An investment related to the oil service industry can be volatile" said the prospectus, adding that, "historically, stock prices of oil service companies, and hence the level of the index, have been highly volatile."

Given the strong price fluctuations of oil, investors need to have a strong appetite for risk, said a financial adviser, adding that he would not recommend the notes to his clients partly for that reason.

"I've seen crude oil intraday trading below $50 last year and now it's at $85. You have to ask yourself: Has the economy really recovered by that much since last year? The answer is no. Since last year, oil has up-paced GDP. It can only go on for a limited period of time," he said.

This adviser noted that without any downside protection, the risk of being exposed to oil via those notes might be too great or not worth being taken given that the upside is limited.

"I saw oil prices collapse in the 1980s. It's very volatile. Any sort of derivative pinned to the price of oil will be inherently speculative just like the price of oil," he said.

Cost

This adviser said that he would not recommend the notes - even to investors for whom the product may be relatively suitable, such as investors moderately bullish on oil - due to costs.

"If you're bullish, you should find a commodity broker and buy oil futures. You can negotiate commissions down and buy something cheaper than a structured product. A structured product will give you layers of complexity, caps and floors. It will be sold to you at a markup. In general we don't do structured products because the ones that I've seen have high fees that are proportionate to the endeavor of putting those products together. Somebody has got to be paid for that," he said.

The notes carry a 2% fee.

The notes are expected to price in April and settle in May.

Merrill Lynch, Pierce, Fenner & Smith Inc. and First Republic Securities Co. LLC are the agents.

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