At the same time, the company receives a downgrade from Merrill Lynch from Buy to Neutral. So much for good news—Anadarko is still in trouble.6/9/2003: Amerada Hess (NYSE: AHC) announces that it has sold $260million Gulf of Mexico assets to Anadarko.6/24/2003: Apache announces that it will no longer have its natural gasmarketed by Cinergy (NYSE: CIN) and will now take over its own marketing.At this time, natural gas is over $6 per BTU, almost double where the pricewas in 2000.6/30/2003: Tropical Storm Bill passes and does not affect the productionof Anadarko’s Gulf of Mexico’s operations—a great break for Anadarko.However, the price of oil continues to stay high, as an oil strike in Nigeriagives investors more concern about supply issues.7/11/2003: Gulf Storm Claudette causes Anadarko to evacuate some personnel from platforms, and eventually causes it to shut down 10 percent ofits Gulf production. Claudette passes and operations are back to normal bythe latter half of the month.7/24/2003: Apache reports second-quarter earnings; the company discloses $1.76 a share, topping analyst estimates of $1.74. However, the company added in a one-time charge due to the weaker dollar; thus, the stockcame under selling pressure after investors realize that the company reallyearned only $1.49 a share. The charge amounted to approximately $45 million in unrealized currency losses. Though investors were disappointed withthe immediate outcome of earnings, Apache is still on track to higher production targets.7/29/2003: Anadarko announces that it will begin shutting down somerigs to make sure it stays within its allotted 2003 budget. Didn’t the company say in April that it had cut its drilling expenses by 40 percent in some
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areas? I guess this wasn’t one of them. Expect more divergence from thetwo stocks.7/31/2003: In a further effort to trim costs, Anadarko announces that it iscutting 400 jobs and is closing some of its offices in Texas. The cost-cuttingmove is anticipated to save $100 million a year. One third of the jobs arebeing cut in the company’s exploration and production division, with therest of the jobs being slashed in departments that support the aforementioned unit. As a result, Bank of America downgrades the stock from Buy toNeutral, citing growth concerns for 2004 production. Anadarko also reportssecond-quarter earnings of $1.20 a share, below the consensus estimate of$1.25. In addition, the company trims its full-year guidance to $5.17 a share,down from $5.77. Remember on 4/25/2003, when we mentioned that thecommon investor might be asking him/herself: “How can you beat estimatesfor the year, when you lowered expectations for the quarter?” Well, the common (or should we say commonsense) investor was right.At this time, speculation that Anadarko is for sale is gaining momentum. TheCEO won’t deny any possible takeover rumors of Anadarko. Analysts arealso estimating that the company is worth only a price in the low $50s (as in$50 per share), as the bulk of Anadarko’s assets are in the United States, andthe company has roughly $5 billion in debt. However, with over 2 millionbarrels of proved oil and natural gas reserves, Anadarko would be a greatasset to buy . . . and then tear apart.8/15/2003: Apache announces that the company is shutting down severalplatform valves in western Gulf of Mexico due to Tropical Storm Erika.8/16/2003: Apache returns workers to rigs one day after evacuation; nodamages are incurred, just production losses.There is speculation that Anadarko is talking to Italian firm Eni about a possible sale. Takeover rumors generally drive a stock price up. Also, Anadarkomentions that recent cost cutting has freed up capital to spend on exploration and development. The extra cash the company is talking about camefrom eliminating part of its exploration and development division and thejobs that support it. However, the company also attributes lower costs todiscoveries and profitable developments.9/12/2003: Apache announces that the stock will split 2 for 1 early in 2004and that it is increasing its dividend from 10 cents to 12 cents, payable onNovember 21 to shareholders on record October 22.
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9/21/2003: The Sunday Financial Times reports that Royal Dutch/ShellGroup is thinking about a $19.5 billion bid for Anadarko. Credit Suisse FirstBoston has been hired as the official negotiator for a possible deal.9/25/2003: In response to an article earlier in the week by the FinancialTimes, Eni publicly announces that it is not in a partnership with RoyalDutch/Shell to purchase Anadarko.And that brings us to where we are now—looking for a trade in this pair. Wehave to ask ourselves, why would this be the time when these two stockshave finally reached the maximum point of expansion, and what would drivethem back together? When we review all of the events over the last two years,we can see why the two have diverged as much as they have. Apache hasbeen a strong company, aggressively trying to expand its drilling operations,while paying down debt. Anadarko would like to do the same thing, but as amuch larger company, it has had trouble gaining its footing. In addition,Anadarko has been fighting to keep investors happy with the stock, while trying to restructure the company to a more profitable entity. It would be a greatsurprise for Apache’s stock to decline in the future, unless analysts orinvestors begin to view the stock as being overvalued. If the price of oil dropsdramatically, the stock would fall, but then again, so would Anadarko’s. Inshort, we are looking for an opportunity where Apache is overbought, whileAnadarko is able to either solidify a merger or post some sort of decent newsthat shows the company is trying to do more than just hold onto its provenreserves.You may be asking yourself: Why all of that? Why write all of the majorevents for both of these two companies for two years? Because when Iinvest money, I want to be sure I know what’s going on in both the past andpresent. And this is the type of historical news and earnings research I do onall my pairs. The great part is that I will trade Apache/Anadarko again in thefuture, and because of my notes, the bulk of the research will have alreadybeen done. All I will need to do is update my files, check current events andearnings, update my spreadsheet, and factor in both technical and fundamental analysis—and I will be ready to trade. This may seem like a ton ofwork even for an updated pair, but we want to know everything that is goingfor or against us when we trade. Why leave any stone unturned?
CHAPTER 21
The CurrentSetupUnderstanding Where the PairIs NowApache Oil1, Fundamentals,Earnings, Technical Analysis,Statistics, SummaryAnadarko PetroleumFundamentalsEarnings, Technical Analysis,Statistics, Summary
UNDERSTANDING WHERE THE PAIR IS NOWLet’s look at both of the companies now. We will make a checklist of whatwe are examining. We will look at:• Fundamentals• Earnings• Technical Analysis• Statistics• SummaryNow that we have a plan, let’s start with Apache Oil.
1
Note: All charts for Apache Oil reflect post split prices, though the text includes pre-split numbers(the stock split 2-for-1 on January 15, 2004 after the text was written).
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APACHE OIL1
FundamentalsUnless noted otherwise all numbers are from Yahoo.com.To begin, the stock is trading with a price-to-earnings (PE) ratio of 13,and a forward PE of 12. The difference between a regular PE (known as atrailing PE) and a forward PE is that a regular PE takes into considerationthe last four quarters of earnings. A forward PE looks at the earnings estimates for the next four quarters that have yet to happen. Thus, we canassume that Apache is trading at 13 times earnings now, and will be almostthe same in the next year. The industry average PE is 18; thus, on a valuationbasis, our company is trading at fewer times earnings than its competitors.PEG (PE to growth) is 1.7, while the industry average is 1.5. The result hereis that the market is expecting the earnings growth for Apache to be slightlygreater than the industry average. While a PEG number above one indicatesthat the stock could be overvalued, Apache is not in this case, as the industry average is also greater than one. One quick point to note: I doublechecked the PEG ratio on Smartmoney.com, which lists a PEG of 0.9. If thisnumber is correct, then Apache is actually undervalued. The problem withforward-looking numbers is that different sources use different growth numbers. This is exactly the case in this situation. My general rule of thumb is toaverage the two numbers. In this case, it would be 1.3, a reasonable forwardlooking number, but not completely accurate. However, more diligent investorscan figure out what the PEG is by using the information in Chapter 3.Next, Apache is trading at 3.3 times sales, while the industry average is1.8. This number is concerning, and indicates that the company might be a little top heavy in regard to revenue, which is good considering that we arethinking about shorting the stock. Next, the book value of the stock is $36;thus, the stock is trading at 1.9 times book. Obviously, the actual value of thestock is less than the stock itself. Just for a refresher, book value is the netasset value of the company, minus intangible assets and liabilities. (EN 21.1)We will wait to see what Anadarko’s book value is and compare the two. Thecurrent ratio is 1.3, indicating that if disaster struck, the company would beable to pay its bills 1.3 times over, before it runs out of current (liquid) assets.Apache is reasonably valued at the current price, but may be getting alittle top heavy in regard to future earnings. The stock can ascend only sofar before institutional investors stop and ask themselves if the price isworth the risk. Long-term holders will not exit the stock unless fundamentals
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erode, which is not likely. So from a fundamental basis, we are counting onshorter-term money to sell the stock based on valuation. These types of institutional investors use a combination of market timing and fundamental valuation to protect profits while occasionally trading in and out of positions.
EarningsIn the second quarter, Apache reported earnings of $243 million, or $1.49 ashare, up from $143 million, or 0.95 cents in the prior year. However, the company missed analyst expectations of $1.74 a share. Excluding charges, thecompany beat by two pennies, but in real terms, the company missed. Thecompany cited fluctuations in foreign currencies as the cause for the shortfall; however, in the real world, things like currencies always fluctuate. Whatis important is that oil production rose by 40 percent in the quarter, while natural gas production leaped 15 percent. The company stated: “We had significant drilling successes and we have completed $1.5 billion in acquisitionsyear-to-date, the impact of which will be reflected in future quarters.” (EN21.2) Despite the optimistic view from the CEO, the company’s one-timecharge of $45 million—attributed to currency fluctuations—was due to aweaker U.S. dollar. This is significant because recently several Asian countries announced that they would stop artificially supporting the U.S. dollar tokeep their currencies down. The reason Asian countries have been doing thisis that when their currencies are low relative to the dollar, then they exportmore, which brings additional money into their countries. More exportingmeans increased manufacturing, which means more jobs overall. Thus, without artificial support propping the greenback up, the U.S. dollar is destined tofall lower in the near term. We know from the second quarter that a weakerdollar is bad for Apache. Do you see where I am going? We can generallyassume that the company will have the same type of “charge” in the thirdquarter, unless the company has instituted some sort of currency hedge.However, considering that the Asian currency announcement occurred inSeptember, we can assume Apache probably didn’t see it coming. Thus, forthe third quarter, I will bet that the company will miss estimates (aftercharges) again. And the company reports on October 23, just a few weeksfrom when this is being written. If I am correct, than the missed earnings willhelp the short side of our pair commence its decline. And none too soon!
Technical AnalysisLooking at the one-year chart for Apache (Figure 21.1), we can see severalthings. First, the stock is trading near resistance, which it has tested three
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FIGURE 21.1 APA Chart
times and been unable to break through. Second, just two days ago, thestock gapped up on news that the company was paying down more debt, buthas since been unable to hold onto gains. There are several implicationshere. Generally, when a stock gaps up, it then falls back in the succeedingdays to close the window—fill the gap—and then resumes the previous uptrend. However, because the stock gapped up and immediately made a lowerlow in the following session, the actual pattern is called an Evening Star,where the three-day pattern indicates that buying orders did not support theelevated price of the stock. Evening Stars are usually good indications of ashort-term reversal, assuming the stock breaches the gap window support—roughly $68 in this case.Third, we also like that the larger one-year pattern is an ascendingwedge, as the stock is trading right at resistance. Ascending wedges arebullish patterns, but in our case, we are seeking another leg of consolidation. In layman’s terms, we are looking for the stock to fall (consolidate)back to the large rising line crossing the chart in Figure 21.1. Ascendingsupport is resting near $63, which would be very profitable for our trade,should the stock fall that low. Daily stochastics are also indicating that thestock may be overbought, and may need to cool off before heading higher.This supports our theory that Apache will pursue one more leg of consolidation.
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One trouble spot is the moving average convergence divergence (MACD),which has just witnessed a bullish crossover. We do not like this event andwould like to see the 12-day moving average (12-DMA) quickly fall backbeneath the 26-DMA. Given that the last two days have declined, and thatMACD is a trailing indicator, it would be fair to assume the 12-DMA will decline.
StatisticsTo bring the statistics as current in our spreadsheet, we will need to updateour data through the close of September 26 for both stocks. Also, all of thespreadsheets for each day of the trading diary are located on the CD-ROMin the back of the book. I encourage you to pull up the spreadsheets onyour computer and sift through the data as each day passes. After all, theentire trading diary is meant to be a “hands-on” experience to unveil themystery of pairs.Looking at the Main portion of our spreadsheet, we see that the pair ispresently trading above two standard deviations on the sell side at 26.72. Inaddition, the ratio is also above two standard deviations at 1.64. However,we also see that the pair has gained risk over the last two years, as it is nowtrading with a correlation of 0.59.In the Pair Data portion of the sheet, the density curve is the key to ourtrade. Over the past several years, the density curve has been slowly opening up and is now at 0.994. My concern for the sake of the book is that I willnot get a sell signal before my publishing date. What’s more, if the densitycurve wobbles in this area for the next three weeks and then we do get a signal, there may not be enough time before November 14 to allow the pairroom to collapse. Though there are many risks here, my instincts tell menow that the density curve is above 0.990—after several years of divergence—we should get a signal fairly soon. Looking at our pairs charts, weimmediately recognize the divergence that has occurred over the last fewyears. As a side note, you can also see how, if we had been on the ball fundamentally, we could have traded the divergence of these two stocks overthe past few years. However, divergence is generally not measurable by statistics, as when a pair is trading on the mean, it can go either way. Statistically, our odds are no better trading the pair either way. Thus, when seekingdivergence trades, we must be fully aware of the fundamental events that aretranspiring. In short, convergence trading balances statistical odds againstfundamental information, while divergence trading—from the mean—doesnot have the added benefit of trading on the outlying standard deviations.
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SummaryWe haven’t unearthed any information indicating that Apache is anunhealthy company by any means. It is important to distinguish this point inour pairs trading mentality. On the contrary, the information we have foundsimply indicates that Apache has been extremely strong over the last twoyears. What we are looking for is an overvalued situation that will present apullback for us to take advantage of as the stock falls to more reasonablelevels. Thus, it is crucial to understand that by considering shorting thisstock, we are going against the grain of “trading with the trend.” We are contrarians and consequently have more risk. Our risk comes from the fact thatwe are trying to short a strong stock; we are in essence trying to pick a nearterm top. Even with proper due diligence, this can be a losing battle simplybecause of investor’s emotions. Overall, people prefer to buy stocks thanshort them—after all, many investors don’t even know how to short a stock.The point I am trying to get across here is that even though we are trying toimplement a hedge, we have considerable risk ahead. I know this is simplyredundant rhetoric; I just want to make it extremely clear that we are bettingagainst the flow of each stock.The crux of our summary is that Apache is starting to look a little topheavy fundamentally, statistically, and technically. There is no doubt inmy mind that the stock can go higher, but in the near term it’s due for apullback.
ANADARKO PETROLEUMFundamentalsWe will begin with a little overview of Anadarko. The company is much largerthan Apache, with balance sheet assets over $20 billion as of June 30. This company is almost twice the size of Apache in terms of financial statement assets.Looking at fundamentals, the company has a PE ratio of 9 and a PEG of0.86. While these numbers aren’t exactly sparkling, they aren’t exactlytreacherous either. Just to start, we have to be encouraged at the fundamental numbers that Anadarko is posting. Both numbers are lower thanApache’s, which is what we would like to see for our trade. What’s more, thecompany has a price to sales of 2.2, and a price to book of 1.4. Figure 21.2show Anadarko’s fundamentals according to Yahoo.com.Going over the numbers that we have just mentioned, we can assumethat the company is fairly valued at present levels and is poised for gains,
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FIGURE 21.2 Yahoo.com Fundamentals
as news surrounding the stock improves. One of the most encouragingnumbers is the PEG ratio of 0.86. This ratio lets us know that the stock hasroom to grow, as future earnings improve. One definite concern is the current ratio, which Yahoo.com (not shown) shows as 0.77. After entering thesymbol for a quote on yahoo.com, we click on the “Key Statistics” tab to seethe actual numbers. In the last earnings report, Anadarko reported currentassets of $1,494 million versus $2,250 million. Thus, to get our current ratio,we divide current assets by current liabilities and we get a ratio of 0.66.Ouch, this is even worse than the number we had before. Our conclusionhere is that the company would be pressed for cash if it had to cover all ofits short-term liabilities at once. While this is not likely to happen, the company’s lack of a heaping cash reserve may have investors on edge, andhence is part of the reason for the stock’s lack of performance over the lastfew years.The stock is well poised for gains, as it is trading at reasonable levels inconsideration to valuation. However, investors may be slightly nervous with
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the company having grown to such a large entity that it does not have theexpendable greenbacks to aggressively grow further. Regardless, the tradingfundamentals (i.e., PE, PEG, and price to sales) are all well within ourballpark of acceptable numbers.
EarningsIn the most recent earnings report on July 31, the company announced thatit had earned $300 million, or $1.20 a share, versus $240 million, or 93 centsin the same quarter 2002. The company fell short of analyst expectations of$1.25; it did, however, see increased net income year over year. The oil magnate attributed the gains to higher oil and natural gas prices. Despite thebetter-than-expected numbers, the company also mentioned that it was planning on cutting 400 jobs and closing several offices in Texas to save $100 million a year. While this was already mentioned earlier in the book, what wasleft out is that the company will take a $35 million charge in the third quarterbecause of the plan.At the same time, the company also trimmed its full-year earnings outlook from $5.77 a share to $5.17. Obviously, the company is also havingtrouble with currency exchanges, cited as “falling commodity prices,” andwill continue to see weakness in future earnings unless the companyintervenes in some type of currency hedging. Overall volume output forboth natural gas and oil declined in the quarter. Looking forward,Anadarko needs to pull a rabbit out of its hat and either show some signof an interested buyer, discover a few stellar oil fields, or figure out someway to increase oil production. Again, I am not an oil analyst and am simplymaking the same observations that the average Joe investor would make.
Technical AnalysisThe technical picture for Anadarko looks slightly contrarian, but encouragingnonetheless. The stock is trading on the lower portion of its one-year range,shown in Figure 21.3. The stock has been trading between $40 and $50 sinceAugust 2002 and has most recently tested support in early August 2003. Overthe last year, the stock has attempted twice to break through $50, but failedboth times.The technical picture depicts short-term descending resistance of thelast four months at roughly $45. If the stock can break out above the $45level, the short-term trend will have been reversed indicating another potential test of $50 on the horizon. Conversely, if ascending support just over $40
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FIGURE 21.3 Anadarko Trading Range
and horizontal support (not pictured) at the $40 whole number is broken, wemay then want to close both sides of our position. Next, the slow stochastichas been hovering near the overbought region and may now be indicatingthat some additional profit taking is on the horizon. The MACD appears tohave been consolidating near the 0 line and has now started to edge higher.Overall, the technical picture is good for our stock; we are trying to buy nearsupport with a tight stop just below the whole number. The MACD hasrecently turned up and the stock is close to breaking a short-term trend linethat, if breached, would bring momentum traders in off the fence. I like thetechnical setup—though not exactly a typical bullish chart, but good for ourpairs trading format.
StatisticsRefer to the statistics for Apache Oil on page 137.
SummaryThe fundamental picture for Anadarko looks good; the stock is trading withfundamentals that support the current price and possible gains in the future.
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Most encouraging is the PEG ratio, which alludes to growth on the horizon.Earnings were decent due to higher oil and crude prices, and the company’srestructuring program (including job cuts) will save money in the future.However, I am concerned that volumes for both natural gas and oil both fellin the second quarter and thus, have concerns about production growth. Thecompany is obviously looking for a merger, which will be a positive if itsurfaces, but is not something we can count on. The technical picture isgood for our setup, as the stock is trading on the lower portion of the range,with a clear stop at the $40 whole number. Overall, the setup is ideal for thistrade and is encouraging with the current statistical data as well.
CHAPTER 22
Trading Diary1
Friday, September 26As you already know, I have just come across this pair and found that it maypresent some interesting opportunity in the near future. You may be askingyourself how I found the pair to begin with? I have a spreadsheet with over200 pairs that I check every day. The sheet updates itself with a macro I hadprogrammed that self-extracts data from Yahoo.com. While this portion ofthe program is proprietary and not available in this book, it should not stopyou from finding great pairs. In fact, the macro is a recent addition to my trading, and only several months ago, I would scan charts each night to find possible pairs divergences. What I do is keep a running “watch list” of pairs thatare beginning to separate with their correlations. Then, instead of scanning200 charts a night, I can look through only 50 or so. When I hear news abouttwo related stocks that may have diverged, I put them on the watch list andkeep a close eye on them. What’s more, every two weeks I go through my entirepairs universe of about 400 stocks to find possible convergence setups or fundamental events that could lead to additional divergence. In my scans, I ranacross Apache/Anadarko, a pair that I have not traded in a long, long time.Obviously, I was not on board for the divergence (though I wish I had been) andam now trying to find a point where the rubber band will cease expanding.Initially, I like the technical picture (see Figure 22.1) of the two stocksand the divergence that has occurred. Fundamentally, it feels like Apache isgetting top heavy, while Anadarko has been suppressed because of managerial1
Note: All charts for Apache Oil reflect post split prices, though the text includes pre-split numbers(the stock split 2-for-1 on January 15, 2004 after the text was written).
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FIGURE 22.1 APC through 9/26
impotency. While I have no doubt that Apache will go higher in the future, apullback seems right around the corner. And as for Anadarko, the largestindependent oil company, the asset value of the company is sure to attractsome type of merger-related news, and hence, gains for the stock.In recent news, OPEC decided to cut the supply of oil by 900,000 barrelsbeginning on November 1. The news was quite amazing and points out thatthe OPEC cartel sees some type of oversupply surfacing, or simply caresonly about keeping the price of crude artificially high. If oil continues totrade near or above $30 per barrel, both Apache and Anadarko will seeimproved profits in the quarters to come. The move outraged analysts andhas sparked some debate as to what OPEC’s true intentions really are.Looking at the statistics of our trade, I am salivating at the setup. Thedensity curve has now poked its head above 0.990, with it currently at 0.994. It’snot every day that I get into a trade on the day it hits 0.997 or greater, but nowthat I am watching this pair closely, I will not miss a beat. I am concerned thatthe pair has been opening up for several years, and feel that it is quite pompousto think that my style will call the top of the spread to the day. However, I willwait patiently to take a position, and will then keep my stops tight. Once I havetaken a position, I will set breakout and breakdown stops for both Apache andAnadarko (respectively) and close both sides of the position, should eitherstock betray me. After all, it’s not about your entry, it’s all about your exit.
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FIGURE 22.2 Main Spreadsheet
Figures 22.2 and 22.3 show the current density curve data and the Mainspreadsheet with descriptive statistics.My concern now (as I have previously mentioned) is that the pair will notopen up to give us an entry signal with enough time to collapse before thebook is published. However, it is my experience that once a signal is triggered,the trade moves fairly quickly. Also both companies report earnings in thenext month, with Apache on the 23rd of October and Anadarko on the 31st.
Monday, September 29Bingo! Our pair is continuing to open up, with the density curve now at 0.995.What I previously forgot to mention is that this pair is trading above two standarddeviations, for both the differential and the ratio. The differential is currently27.11, with the second standard deviation at 22.33, while the ratio is presently1.65, and the second standard deviation (for the ratio) is 1.51. Thus, as long as thedescriptive statistics indicate that the pair is above two standard deviations—and the density curve closes at or above 0.997—we will immediately take a position on the following day. Figure 22.4 shows how our density curve has beenslowly opening up for the past two years and is now hovering very close to one.There was no news today on either stock. I would like to take a momentand look at the technical picture for Apache. The stock has just concluded
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FIGURE 22.3 Pair Data
the third consecutive down day after the recent evening star candlestickformation. The stock has now fallen below the gap (or window) support,which is a good sign for our trade—with the exception that we need the pairto open up enough that an entry signal is created. Figure 22.5 shows that thestock has support at $66 due to the 50-SMA (simple moving average). Abreach of the 50-SMA would likely bring the stock into ascending support atroughly $64, where we would like to see a further breakdown. I don’t knowabout you, but this betting against a strong stock stuff is stressful.
Trading Diary
FIGURE 22.4 Density Curve
FIGURE 22.5 APA 9/26 50-SMA
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Tuesday, September 30thStandard & Poor’s (S&P) announced that it would leave Apache’s creditrating at A-/Stable/A-2, in light of the company’s repurchase and retirement of preferred interests from three of the company’s subsidiaries. Theannouncement by S&P has caused Apache to gain a little momentum andhold gap window support. This is good for our pair, as we would like it toopen up slightly more or at least enough to produce an entry signal. Thedensity curve data revised yesterday’s data down to 0.994, with today at0.995. The data expansion continues to move in the correct direction, andI have a feeling that either stock could now trigger the 0.002 move weneed