JPMorgan’s $6.23 million digitals on SPDR S&P Oil & Gas ETF offer range-bound play

By Emma Trincal

New York, Jan. 31 – JPMorgan Chase Financial Co. LLC’s $6.23 million of 0% digital equity notes due Feb. 28, 2024 linked to the SPDR S&P Oil & Gas Exploration & Production ETF allow investors to outperform the ETF even in a down market, making the product attractive to investors expecting more muted returns than last year, when energy was the top performing sector.

If the ETF finishes at or above 80% of its initial level, the payout at maturity will par plus 17.6%, according to a 424B2 filing with the Securities and Exchange Commission.

Otherwise, investors will lose 1.25% for every 1% of ETF decline beyond 20%.

Mildly bullish bet

Scott Cramer, president of Cramer & Rauchegger, Inc., said the notes offered a good risk-adjusted return for investors who do not necessarily have the bullish conviction to be long the ETF.

“This is a good bet if you expect good returns in the sector in the next 13 months. The only positive sector last year was energy. Is energy going to do well or is it going to go down? You’re hoping it will continue to go up,” he said.

The buffer provided some protection on the downside.

“If you’re looking for a positive return, you’re getting it with protection. That’s why people buy structured products in the first place,” he said.

One caveat was the type of downside protection offered.

“I don’t like these geared buffers. I’m not even comparing it with a traditional buffer or with barrier. If it goes below 20% your loss gets compounded. That’s what I don’t like,” he said.

Once, not twice

There is a chance that investors may miss some of the return over the period.

“It wouldn’t surprise me if XOP returned more than 17.6% over the course of 13 months,” he said, referring to the underlying ETF, which trades on the NYSE Arca under the ticker “XOP.”

But noteholders were able to mitigate some of the downside risk.

“If you can get that return with the 20% downside protection, that’s a good bet,” he said.

Some investors expect a more modest uptrend this year after last year’s strong performance.

“You could have a reversal, or a slower rate of growth,” he said.

“After all, rarely do sectors go up two years in a row. When a mutual fund is up a lot on a given year, it usually doesn’t post the same rate of return during the following year.”

The SPDR S&P Oil & Gas Exploration & Production ETF jumped more than 45% last year. While it’s unlikely the same performance could be repeated this year, Cramer said he remained very bullish on energy.

Strong fundamentals

He pointed to Exxon Mobil Corp., which on Tuesday reported record annual earnings of $55.7 billion for 2022.

Chevron also made the headlines when it reported its fourth-quarter earnings last week.

“They raised their dividend another 6% and increased their share buyback from $35 billion last quarter to $75 billion,” he said.

“Say what you want about the technical, but energy companies have great fundamentals.

“They have less debt than 12 months ago. They’re making money. Their capital expenditures are going down.”

Cramer however said he would not use the notes for his clients.

“I’m pretty familiar with the sector and quite bullish. I wouldn’t do this deal. I’d rather assume the downside risk on energy with no cap.

“But if you like the sector without trusting it that much, that’s a great note,” he said.

Short options

Don Roose, president of U.S. Commodities, Inc., said the notes were designed to generate premium. But investors had to be familiar with the underlying oil market even if the underlier was an equity ETF.

“You’re betting on the ETF to trade between -20% and less than 17%. It seems like a reasonable range. But there’s always the potential for a surprise,” he said.

“What they’re doing here is selling derivatives and options. You’re selling a call that caps your upside and you’re selling a put.”

The buffer provided a protection not available to those who buy the ETF outright. Meanwhile investors in the notes would always underperform the ETF anywhere above the 17.6% payout, he said.

“You’re outperforming on the downside but not on the upside. It’s asymmetrical,” he added.

“You’re not buying the market. Your selling options. You’re really collecting premium on both sides.”

Investors in the notes are also betting on the volatility of the underlying.

“You hope to stay in the range. That’s your trade. You’re taking a chance if it moves a lot. If it goes up a lot, you’re capped. But you’re still getting the upside up to the cap. If it goes down more than the buffer, at least you still outperform the ETF. On the downside, you’re better off. It’s better than buying the ETF. It’s the best of the worst,” he said.

Risky proposition

Roose said that even though the ETF consisted of stocks, investors should be knowledgeable about commodities.

“It’s an equity ETF. But you’re still in the futures market. You still have contango for instance,” he said.

A futures market is in contango when current contract prices are lower than future prices, which makes the cost of rolling the underlying contracts at expiration more expensive. Contango erodes the returns of a long futures position, he explained.

Moreover, investors should be ready to tolerate wide price swings, which are the hallmark of commodities investing.

“Just look at natural gas. It was at 10 in September. Now it’s at 2.6. That’s a 75% drop. You have to be prepared to manage it,” he said.

“With commodities, you can get a black swan. Anything can happen. Covid. A war. An economic constraint. Something you don’t know anything about,” he said.

Unscripted developments

The decline in natural gas prices for instance was a big surprise to most market participants, he said.

“We were supposed to see a shortage because of Russia. Demand in Europe during the winter was supposed to push natural gas prices higher. It turned out the weather was warmer than expected,” he said.

The collapse of oil prices was another surprise especially in the context of the war in Ukraine. Since March just after Russia’s attack on Ukraine, Brent crude oil has dropped nearly a third from $125 a barrel to $85 today.

“There could be a number of reasons. The most likely is a decline in demand. We have more electric cars. Consumption is down,” he said.

The profitability of oil companies that compose the ETF despite the declining oil prices is a result of their business model, he explained.

“When you know your cost of production, if oil goes down, you stop. You can adjust supply based on what makes sense. It’s a bit like an insurance company. If the price goes down too much, you shut off supply.”

Roose concluded that the notes were a typical derivatives instrument designed to generate premium from the writing of call and put options.

“You just have to be familiar with the commodities market. Things can change rapidly. My advice would be buyers beware,” he said.

The notes are guaranteed by JPMorgan Chase & Co.

J.P. Morgan Securities LLC is the agent.

The notes will settle on Wednesday.

The Cusip number is 48133TYU3.

The fee is 0.93%.

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