Presented by Naufal Sanaullah, David Murray, Nilesh Bajoria,

Chanipha Pocharakorn, Atindra Mahajan, & Andrew Puff

SECTOR PITCH:
UNDERWEIGHT
ENERGY

MAIZE & BLUE FUND – ECONOMIST GROUP

Pitch overview
 Recommendation: underweight energy
 Time horizon: 3-6 months
 Thesis:
Oil contango trade unwind
USD strength
General market headwinds
 Underlying theme: a substantial portion of recent
energy demand originates from speculative
and/or indirect sources, rather than organic,
sustainable drivers, and the inflection point for
the former to unwind has finally arrived

MAIZE & BLUE FUND – ECONOMIST GROUP

Sector overview
 The energy sector is divided into six main sub-
sectors/industries:
Integrated oil & gas
Oil & gas refining & marketing
Oil & gas exploration & production
Oil related services & equipment
Oil & gas drilling
Coal
 Companies responsible for supplying energy and
energy-related commodities for global consumption
 Represented by SPDR ETF XLE

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XLE chart vs SPY

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Oil contango trade unwind
 Crude oil is a highly significant
commodity in the energy
sector
 In late 2008-early 2009, the
crude oil futures market went
into extreme contango
 This led to a massive oil-
storage trade that spurred
speculative demand, led by
banks
 With the contango curve
significantly flattened, the
contango trade cannot be
rolled over and the previous
demand will become supply

MAIZE & BLUE FUND – ECONOMIST GROUP

Background on contango
 Contango is a condition when the forward (futures)
price is greater than the spot price
 The crude market spends a lot of time in contango, as
the spread represents costs of carry (including storage,
financing, etc)
 Mass liquidation during the depths of the financial
crisis depressed spot prices significantly more than
futures prices, due to a rush to liquidity
 The selling also depressed storage costs (crashing
demand) while central bank policy actions
simultaneously depressed financing costs due to
lowered interest rates (eg the Fed’s ZIRP in Dec 2009)

MAIZE & BLUE FUND – ECONOMIST GROUP

Crude super contango
 In late 2008-early 2009, the crude market
went into super contango, as the
contango basis exceeded carrying costs,
due to a supply glut at the front end of the
curve and increasing financing costs (for
storage, transportation, etc) during the
depths of the financial crisis
 The widest contango spreads hovered
around $8-9/bbl for successive months
and $25/bbl for 1m-12m basis at the
contango’s peak
 This was extremely greater than the
$5/bbl cost of carry at the time and led to
a riskfree basis for investors able and
willing to buy crude for future delivery and
finance its storage in the meantime
 The arbitrage led to a record 24 million
tons of oil being hoarded in 168 tankers
(about 6% of the world’s tanker fleet) by
the end of 2009, according to Bloomberg

MAIZE & BLUE FUND – ECONOMIST GROUP

Implications of super contango on crude
prices

At the height of super 12 months later

contango
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Now what?
 Contango has narrowed to around
40 cents a barrel, and “to cover your
freight and other costs you need at
least 90 cents,” said Torbjorn Kjus,
an oil analyst at DnB NOR Markets,
last month.
 Ship broker ICAP expects oil in
storage to fall to about 20 million bbl
by next month, from a peak of about
90 million bbl last summer
 Oil prices are up less than 10% in
the last 6 months after more than
doubling in the 6 months after the
contango trade took off
 Without the contango basis bid, any
weakness in crude should spark
heavy selling, sending oil prices into
a positive-feedback selling loop

MAIZE & BLUE FUND – ECONOMIST GROUP

Crude oil vs XLE

MAIZE & BLUE FUND – ECONOMIST GROUP

USD significance to energy sector
 As the previous slide shows, crude oil (and commodities
in general) prices share very significant correlations with
energy sector share prices
 Commodities, in turn, are highly sensitive to fluctuations
in the US Dollar, because of its status as the international
reserve currency (in which commodities are priced) and
as the go-to security in rushes to liquidity and “safety”
(ha-ha)
 The big variable in the past 18 months for financial
markets has been policymaker actions, and in America’s
case, the Fed’s actions directly affect the USD, which in
turn affects oil & commodity prices, which in turn effect
energy stocks

MAIZE & BLUE FUND – ECONOMIST GROUP

Key USD events & fluctuations
 During the summer and fall of 2008, the US Dollar
surged as commodities and risk assets tanked and a
financial crisis sparked a rush to liquidity and safety
 By December 2008, the Fed had lowered the Fed
Funds rate target to 0-25bps, causing USD weakness
in late 2008
 After a last leg up in early 2009, the Fed announced
its QE program in March 2009, corresponding with the
USD’s top and the beginning of its new downtrend
 The Fed’s actions caused spreads to normalize and
the excess liquidity that entered the markets chased
yield in various USD-funded carry trades

MAIZE & BLUE FUND – ECONOMIST GROUP

The USD going forward
 The Fed’s QE program expires at the end of this month, and without
marginal excess liquidity chasing yield, risk assets may have
substantial downside risk
 The money supply expansion caused by QE sent the USD plunging,
but with marginal supply eliminated, demand from real-economy
deleveraging may send the USD into a new uptrend (depressing
commodities prices and consequently energy sector share prices)
 Heightened sovereign credit risk, combined with the expiration of
Fed liquidity programs and facilities, have indeed sparked a rally in
the USD since last November
 As sovereign credit risk intensifies (policymaker reaction to the crisis
merely shifted risk from bank balance sheets to more-solvent
sovereign balance sheets), more carry trades should unwind, further
supporting the USD in the short to intermediate term

MAIZE & BLUE FUND – ECONOMIST GROUP

Charting the USD ETF UUP

MAIZE & BLUE FUND – ECONOMIST GROUP

Downside risk to general market
 Risk assets had dramatic rises in 2009, including US equity markets
 USD-funded carry trades and significant marginal excess liquidity (now dried up)
gifted by the Fed were significant factors behind the rally
 Liquidity can prop markets, but can only lead to sustainable growth if backdrop
implies liquidity crunch, not solvency crisis
 Shiller’s normalized P/E ratio implies a 20% overvaluation in equities, while Tobin’s q
ratio implies a 50% overvaluation
 Massive dividend recaps (eg $750 million CCU, $525 QTRN) reminiscent of 2007
bubble top
 United States fixed-income demand necessitates elevenfold increase YoY to match
issuance, due to QE’s maturation
 Contagion risk of Greek solvency crisis is high, as Portugal, Poland, and Latvia have
all had failed bond auctions in the last six months and European sovereign maturities
spike this spring and summer
 The USD needs to continue down for risk assets to continue rallying, but widening
sovereign credit spreads (and IG peaking two weeks ago) combined with matured
liquidity programs (QE & TALF) and a commercial real estate bust (largest foreclosure
in history earlier this year with Stuyvesant Town) pose substantial risk to risk-chasing

MAIZE & BLUE FUND – ECONOMIST GROUP

The China factor
 China is an originator of massive energy demand, with the
IEA predicting an oil consumption rate of 16.3 million
barrels a day by 2030
 However, the Chinese government recently pledged to
decrease energy “intensity” by 40% to 45% per unit of gross
domestic product by 2020
 Meanwhile, China is facing possible property and equity
bubbles, increasing political pressure for floating CNY, and
a record $8 billion trade deficit in March (its first since
2004), all behind a backdrop of monetary tightening
 “China has, in part, merely been swapping official dollar
purchases of US Treasuries with surging imports of dollar-
denominated commodities on the trade account.” –Albert
Edwards, SocGen (see chart at right)
 This represents large commodity investment demand rather
than consumption demand and is an inflation hedge for
China’s FX reserves, particularly for its USD-denominated
securities
 This investment demand is funded by China’s exports,
which are weakening
 As American consumer credit declines, marginal Chinese
demand for commodities and energy follow
 Additionally, the trade deficit in China represents a secular
policy shift away from recycling export revenues into Tsys &
USD and could signify competitive CNY debasement (even
devaluation),which is USD-bullish, and depressive to
energy & commodity prices
 Though long-term inflation may manifest and be bullish for
energy, the 2009 reflation trade has run dry of its source
(marginal excess dollar liquidity) and a contrarian deflation
bet may prove prescient (Bill Gross & Paul Tudor Jones are
both favoring a flattener in Tsys for the intermediate term)

MAIZE & BLUE FUND – ECONOMIST GROUP

So why energy?
 USD strength in the intermediate
term due to sovereign credit risk
abroad and QE maturing poses
downside risk to commodities and
thus energy shares
 Oil already has sizable downside
risk as the contango trade unwinds
and brings tens of millions of barrels
of crude to the market as supply
 Energy/commodity shares have led
the market since summer 2008 and
are showing relative weakness to
broader indices
 XLE has had heavy distribution
since January and may be forming
a massive head-and-shoulders top
around a $53-54 neckline area

MAIZE & BLUE FUND – ECONOMIST GROUP

Recommended strategies
 Decrease stake in NOV and/or TDW
 Decrease holdings overall to raise cash (long
USD)
 Short energy-related ETFs (eg XLE, DIG,
USO)
 Short weaker energy names that are already
breaking down (eg CHK, HK, DVN)
 Long inverse ETFs (eg DDG, SZO, DNO)
 Reallocation away from energy to materials or
healthcare

MAIZE & BLUE FUND – ECONOMIST GROUP

Risks
 Global and/or domestic growth exceeding expectations could
cause consumption levels to rise and energy shares to follow
higher
 Energy’s recent relative weakness to broader markets could
represent buy-the-dip opportunity rather than leading indicator
for market top
 Maturing liquidity facilities could be extended, increasing the
amount of marginal liquidity existent in markets
 Sovereign credit crisis could shift to United States, depressing
the USD and propping up commodities (and thus energy shares)
 Inflationary pressures domestically and abroad from central bank
actions could cause rocketing energy prices
 Constant geopolitical risks pervade oil markets and Iran/Israel
pressures could provide further bid

MAIZE & BLUE FUND – ECONOMIST GROUP