UBS’ trigger phoenix autocalls on SPDR Oil & Gas lack sufficient protection

By Emma Trincal

New York, Sept. 10 – UBS AG, London Branch’s $320,000 of trigger phoenix autocallable optimization securities due Sept. 13, 2022 linked to the SPDR S&P Oil & Gas Exploration & Production ETF is an attractive deal at first glance due to its generous coupon. But the underlying is too volatile and the barrier too thin to make the trade anything else but a speculative bet, said Clemens Kownatzki, finance professor at Pepperdine University.

If the ETF closes at or above the trigger price – 80% of the initial share price – on a half yearly observation date, the issuer will pay a contingent coupon for that half year at the rate of 16.95%, according to a 424B2 filing with the Securities and Exchange Commission.

Otherwise, no coupon will be paid that half year.

If the shares close at or above the initial price on a half yearly observation date, the notes will be called at par plus the contingent coupon.

If the notes are not called and the shares finish at or above the trigger price, the payout at maturity will be par plus the contingent coupon. Otherwise, investors will be exposed to the share price decline from the initial price.

Fracking and oil prices

Kownatzki analyzed the terms of the notes in relation to the volatility of the underlying, finding the coupon attractive but the protection inadequate.

“XOP is a very volatile ETF because the underlying industry is volatile,” he said.

He designated the SPDR S&P Oil & Gas Exploration & Production ETF by its ticker symbol “XOP.”

“It’s more volatile than other oil exploration ETFs because it’s more sensitive to oil prices. A number of this fund’s components depend on an expensive fracking technology.”

Fracking is the process of extracting oil from underground rocks rather than drilling it from liquid oil reservoirs, the classic way.

Oil companies using fracking technology are very dependent on high oil prices, he explained.

He gave the example of the year 2014 which saw a sharp drop in oil prices.

“Oil was at around $100 a barrel. It finished the year at $40. That’s when a lot of those shale companies went out of business,” he said.

“It costs more to drill oil from the ground. You need to invest in expensive technology and the whole manufacturing process relies on high oil prices. If oil drops below a certain breakeven point, then fracking is no longer viable for those companies,” he said.

That breakeven is often estimated to be between $30 and $50 a barrel.

Volatile ETF

Geopolitical factors drive oil prices too. The role of the OPEC+ is significant, he said. OPEC+ can lift the price of oil when the cartel decides to cut production, he said. Inversely, removing production limits, which floods more supply in the market, will be bearish for oil.

Since the underlying ETF is highly sensitive to the price of a commodity, the ETF shows an elevated implied volatility of 40% on an annualized basis.

“It means the price at expiration can move up or down by 40% within a year.

“That’s twice the level of the barrier.

“Obviously you can easily breach that barrier. Not only is your coupon at risk but your principal at maturity could be wiped out,” he said.

Richly valued market

Another risk is the state of high market valuations.

“With all the money-printing in the economy since the last year-and-a-half, most asset classes – commodities, stocks, real estate – are seemingly richly priced,” he said.

“I don’t know if that 20% protection is enough.”

The notes priced on Wednesday at an initial level of $83.31 a share, setting the barrier level at $66.65.

In October, the ETF hit a 52-week low at $38.39 a share, which was significantly below the barrier price, he noted.

Fast, big moves

“The return is nice. But I’m a bit concerned about the downside. Given the volatility of the fund again, you should probably get more protection than just 20%,” he said.

“In July the ETF was trading at around $100 a share. By mid-August, it was down to $71-72. That’s already a drop of more than 20% in six weeks.”

For Kownatzki, the trade was highly “speculative.”

“We were at the barrier level back in January. And for most of last year, we were below that level,” he said.

“Look, you might be lucky. But precisely. If you try to time those moves, it’s the luck of the draw.”

In conclusion, Kownatzki said the note was “attractive at first glance” because of its high coupon rate.

But the barrier was “too thin.”

“You could easily get hit with big losses,” he said.

Over a longer timeframe, the note could be a “less risky proposition,” he noted.

“If the economy is doing better, people will consume more oil. If oil prices go up, that’s bullish for the notes.

“Still, 20% seems too narrow.”

UBS Financial Services Inc. and UBS Investment Bank are the underwriters.

The notes (Cusip: 90300W842) settled on Friday.

The fee is 1.35%.

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