Barclays’ Accelerated Return Notes tied to oil and gas index seen as bold bet, repair strategy

By Emma Trincal

New York, Nov. 4 – With oil prices at a three-year low, Barclays Bank plc’s 0% Accelerated Return Notes due January 2016 linked to the S&P Oil & Gas Exploration and Production Select Industry index may be a timely play for contrarian investors betting on a recovery and willing to take on risk on the view that prices have already fallen near trough levels, advisers said.

The notes may be linked to an equity index, but they are correlated to oil prices as the underlying index tracks the performance of companies involved in the exploration and production of oil and gas, sources said.

At maturity, investors in the notes get three times the index gain subject to a 21% to 25% cap. If the index return is negative, investors will be fully exposed to the decline, according to an FWP filing with the Securities and Exchange Commission.

Repair strategy

Tom Balcom, founder of 1650 Wealth Management, said the notes may offer a way for investors long the asset class to recover from losses.

The S&P Oil & Gas Exploration and Production Select Industry index is in bear market territory, down 20.36% for the year, according to Standard & Poor’s website. Crude oil prices have declined by 21.5% for the year.

“Given the current drop in price, using this type of note could fit into a recovery and repair strategy,” he said.

A repair strategy is a technique that allows investors who have a long position in a stock to recover from losses through the use of options.

“For these who own the index or oil and gas stocks and are already down quite a bit, you may do that to repair part of the portfolio because the leverage, if it goes back up even just a bit, would be a welcome gain,” he said.

“We did something similar in 2008 when oil was down to $35 a barrel. The trade did well because the price of oil moved back up. The outcome was actually a good one for us.”

Investors in the notes have a moderately bullish outlook on oil short term, he said.

“All prices have been hit so hard lately; it makes sense to bet on the upside. If we get a strong rally in the next few months, there is always the risk of missing up on the move since the notes are capped,” he said.

Audacious bet

But the product is not designed for the typical oil bull, he added. For those, a long position would be more adequate.

“If you think the selloff is overdone, if you have no exposure and see good value in it, then in that case you’re better off buying the index directly without limiting your upside,” he said.

Investors should consider the investment only if they don’t need downside protection, he said.

“Getting a 20% drop in price from the beginning of the year may be a good entry point. But it’s not the equivalent of a buffer or barrier. This note is a contrarian bet. While the upside is capped, it’s still a bet on the upside,” he said.

Whether investors have good reason to invest during a correction and give up any downside protection is a function of their market outlook, a market participant said.

“It really depends on what the investor wants to do. It depends on where he believes the index is going,” he said.

“This is a note for investors who are bullish on the return.

“But the notes are not forgiving if the investor is wrong about the direction, obviously.”

Leveraging up

Sources noted that it would not take much index growth for investors to reach the cap, which represents a risk of “missing out” on the upside. As an example, a 6% annualized return on a compounded basis would be enough to maximize investors’ gains based on a hypothetical 21% cap.

But the market participant said that “missing some of the upside” because investors only receive the capped return is not a “risk.” It is merely an “opportunity cost.”

“If you hit the cap, you’re not losing anything. You may have done better with the index or you may not have. You don’t know. Leverage, especially three times up, gives you a chance to outperform. And if you had tried to replicate the note by leveraging up the index three times yourself, you would have lost the benefit of the one-to-one downside exposure on the downside which the note gives you,” he said.

Donald McCoy, financial adviser at Planners Financial Services, said the leveraged upside is attractive.

“Investors in the notes expect some sort of a recovery from current prices,” he said.

“If the cap is at 24%, best-case scenario, oil is up 8%, you get the full ride. What you’re betting on is a small positive range from zero to 8%,” he said.

“But the 24% upside you get with three times is significant. You may max up with the market up 8%, but you get three times that.

“The deal makes sense if you think we are at the bottom and if you’re not banking on a big upside. In that case, the leverage will allow you to beat the index. You have three times up and one-to-one down. It’s a good play in that way.”

Global growth

But the full exposure to losses is a concern.

“You have no protection. Oil is in bear market territory. We just had a big price drop today due to Saudi Arabia,” he said.

Oil prices fell to a three-year low Tuesday after Saudi Arabia cut prices of crude oil sold to the United States.

“There is no reason why over the next several months, oil couldn’t go down more,” he added.

“Just because a market has dropped and it looks like it’s a value doesn’t mean it couldn’t drop more. There is no reason to believe the U.S. will slow down its oil and gas development. If Europe goes into a recession and China slows down, we could have a glut of oil and not enough global growth to increase demand. So the downside risk is there.”

BofA Merrill Lynch is the agent.

The notes will price in November and settle in December.

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