You Must Be Nuts: Short Exxon and Buy BP?

ExxonMobil (NYSE: XOM) is the largest company in the world and arguably one of the best managed. Yet, Jeff Hamrick, a Ph.D., CFA charter holder and Principal of Bulwark Capital Management, has decided to bet against Exxon and place his chips on oil villain BP (NYSE: BP)!

Is this hedge fund manager nuts? I gave him a call to find out.

Use shorting for safety
Bryan Hinmon: Jeff, most individual investors shudder at the thought of shorting. Should they?

Jeff Hamrick: Absolutely not. In fact, going short can be a great way to reduce risk in your portfolio. In a perfect world, we would be able to isolate our investment theses and make direct bets on their outcome, but that usually isn't the case. We use shorting to help eliminate some of the market-based or industry-based risk by setting up a "pairs trade."

Hinmon: What exactly is a pairs trade?

Hamrick: Typically a pairs trade is the act of buying and selling short two related securities that historically zig and zag in unison. The investment becomes attractive when, for some reason, the historical zig-zag relationship comes undone and an unusual spread between the two securities exists. An investor makes money as the spread between the two narrows and their historical zig-zag nature resumes.

But even though I'm a statistician by training, I don't just go by the statistics. Pairs trading can make a lot of sense focusing on business fundamentals too. Because the two securities are related, their shared characteristics -- like general industry factors -- cancel one another out.

Short Exxon, buy BP? You must be nuts.
Hinmon: Perhaps a Foolish example would help clear up your definition.

Hamrick: I may quickly be relegated to the mad scientist realm, but my firm has a pairs trade. We are long BP and short ExxonMobil.

Hinmon: Jeff, that's like choosing to own The Penguin and shorting Batman.

Hamrick: Ha-ha. I'll stay away from the issue of good versus evil, but I'll note that it's good to make money. Heavy research, recent events, historical precedent and a dose of opinion lead me to believe shares of BP will rise significantly over the next few years. But I don't have a clue what will happen to the price of oil over that time, and I don't want falling oil prices to get in the way of being right about the fate of BP. So, my fund is using a pairs trade to isolate our views on BP-specific outcomes by shorting ExxonMobil.

The case for shorting Exxon
Hamrick: Exxon is one of the best-run and financially strong companies this side of Gotham -- there is nothing wrong with it per se. But the company is inextricably tied to the movements in oil prices -- its co-movement with oil prices is statistically significant, so it makes a good proxy. Basically, I want to remove the impact of oil price fluctuations from my investment in BP and I can do that by betting against Exxon.

Hinmon: Why don't you use an oil-linked ETF, like United States Oil (NYSE: USO)?

Hamrick : For two reasons. First, the correlation between BP and Exxon has historically been strong (about 0.80), and it has been stronger than either's correlation directly to oil prices. This is because both BP and Exxon are oil majors, so they have many other oil-related businesses.

Right now, the correlation between BP and Exxon is at a low (about 0.55) and I expect that make its way back to historical norms. Plus, United States Oil, and other similar ETFs don't track their indexes as well as you might think.

Second, Exxon carries a premium valuation. Now, it very likely deserves to have a premium valuation because it is so well run. But if investors choose to flee big oil in droves, Exxon has the farthest to fall because of its lofty valuation compared to its peers.

Data provided by Capital IQ, a division of Standard & Poor's. *Enterprise value divided by debt-adjusted operating cash flow.

The case for buying BP
Hinmon: OK, so you are basically using a short position in ExxonMobil to eliminate the general business performance of the energy sector, fluctuations in the price of oil and investor sentiment toward the sector. What is your thesis for wanting to own shares of BP?

Hamrick: The overarching reason to own BP is that its business is still fundamentally in place. The company has great assets, and those assets can be bough cheaply right now because of fears and uncertainty over the size of potential future obligations relating to the oil spill.

BP has already set aside $20 billion for an escrow fund that will pay claimants directly affected by the gulf spill -- and that should be enough for two reasons. First, the man running that fund, Ken Feinberg, has indicated that he is unlikely to offer remuneration to secondary and tertiary claimants.

Second, the scope of the oil creep seems to be wildly overblown. Originally, fears were that oil would be washing up on the east cost of the U.S., meaning that the potential number of people affected -- and therefore with legitimate claims against BP -- has been wildly overstated.

As far as the civil fines to be levied via the U.S. government and court system, BP has the benefit of historical precedent. The Oil Pollution Act and the Clean Water Act will limit the size of the fine. Using the Exxon Valdez spill as a basis, the fines should come in between $5 and $18 billion, depending on what the final leakage tally is. We suspect the fine will be somewhere in between the two extremes.

And ultimately, because BP has engaged in asset sales and suspended its dividend, it is shored up its financial position. This company should not trade at 60% of its enterprise value.

Not without risks
Hinmon: What risks are introduced in this investment?

Hamrick: There is no law that says Exxon will be a good hedge for oil prices, the industry performance, or that its shares won't command a higher valuation. In the worst case, shares of Exxon go up and shares of BP go down, and investors lose on both legs of the trade. In addition, shorting Exxon means we're on the hook to pay the company's 2.9% dividend. So this is an extra hurdle. Finally, this trade could take a while to play out, so having a multi-year time horizon is key.

The Foolish bottom line
So there you have it, Fools. Shorting can actually be used to decrease the risk in a portfolio and allow you to isolate a thesis about which you have high conviction.

To learn about other ways shorting stocks can help your portfolio and how you can find candidates to short, enter your email in the box below. You'll get "5 Red Flags -- How to Find the BIG Short," a brand new report by John Del Vecchio, CFA, a leading forensic accountant, free right now to start you on your way.