More on the mol-neutral strategy

Molybdenum prices, along with those of all the rest of the commodities, are holding up quite well. The Metals Week average price is 17.40 USD/lb (as of Jan 31, 2011), and the Ryan’s Notes average (as of Feb 1) is 17.50 USD/lb. At those prices, a molybdenum mine is the same thing as a mint.

Last week’s post encapsulated the speculation that deep pockets, deep reserves, and current production are keys to success in the molybdenum business. More than any other player, Freeport McMoran (FCX) seems to be firing on all three cylinders (with TC doing just fine as well, thankyouverymuch).

A look at the mol price graph in 2008 shows that where molybdenum is concerned, past performance is not necessarily a solid indication of future performance. Indeed, when one looks at forward looking estimates by the producers themselves, it seems that those in the know tend to focus on how operations hold up at 10 USD/lb. Rather than being a long-at-all-costs molybdenum “bug”, a better investment strategy might be to design a long-short “molybdenum-neutral” portfolio that focuses on finding out-performance, that is, mol sector alpha.

From the molybdenum investor’s standpoint, the difficulty with FCX is that its mol business is buried within a much larger metals set-up. As of the recent 2010 annual statement, FCX’s revenues were 3.9e+9 lbs x 3.59 USD/lb = 1.4e+10 USD from Cu, 1.4e+6 oz x 1271 USD/oz = 1.7e+9 USD from AU, and 6.7e+7 lbs x 16.47 USD/lb = 1.1e+9 USD from Mo. On a revenue basis, then, FCX is 83% Cu, 10% Au, and 7% Mo (which sounds like the perfect alloy for a gleaming 10 lb paperweight on the trading desk of a heavy-hitting molybdenum speculator).

Last week’s model portfolio sought to isolate the relative outperformance of FCX’s mol business by (1) going long 100K FCX, and going (2) short 83K worth of COPX (copper producer index ETF), and (3) short 10K worth of GDX (gold producer index ETF). The net 7K of FCX is, in theory, “all mol”, and this 7K of exposure is in turn balanced against a short 7K position in General Moly (GMO), who are currently working to get Nevada’s Mt. Hope deposit into production. An even better strategy would be to short 7K worth of Adanac and Roca Mines, but I’m guessing that it’d be difficult to get the locates on the shares.

The plan last week was to implement the mol-neutral strategy on the onging VSE UCSC Capitalism Club stock contest. Sadly, due to some technical difficulties on VSE’s side, the COPX and GDX trades failed to clear, and I was left 93% long FCX. On Friday, I issued a “stop gain” order to cut my advance to  up a mere 4% on the week. We’ll try again next week by issuing an order to go (1) long 1,763 shares FCX, (2) short 4,067 shares  COPX, (3) short 178 shares GDX, and (4) short 1,277 shares GMO.

As pointed out last week, this portfolio would be a total failure as a real-world product. It chews up a huge amount of margin. For a mere 7K of FCX-GMO molybdenum alpha, one ties up ~200,000 USD of capital (or similar depending on specific brokerage rules). Also, in constructing the product, I assume that FCX’s copper and gold businesses have a beta of one to the respective producer indices — almost certainly not the case. The error in this assumption is exacerbated by the huge fraction of FCX that’s tied up in the copper business.

Looks like I need to work with an investment bank to structure a special product…

A mol-neutral strategy

Source: Climax Molybdenum.

The 2010 earnings call makes it pretty clear that when it comes to mol, Freeport-McMoran is calling at least some of the shots.

Now let’s be realistic and get a full disclosure out in front: having written a molybdenum research web log on an erratically part-time basis for one month in no way qualifies me as a molybdenum expert. In particular, I don’t yet have any understanding for the demand side of the molybdenum market, which appears to be high-beta to the economy in general and to China in particular. So as of yet, I have no mechanism for predicting the spot price of mol a year out, two years out, five years out.

One thing that does seem plausible, however, is that the FCX molybdenum business has structural advantages over junior molybdenum miners such as General Moly, Roca Mines, Adanac et al. who are individually scrambling to either bring a new project on line, or ramp up production, or reorganize following bankruptcy. The junior miners face vagaries of financing, regulatory hurdles, single-point failure modes, etc. FCX, on the other hand is printing billions of dollars, has 60 billion dollars worth of mol reserves sitting in the ground and essentially no debt, and can bring the Climax mine into production more or less at will.

As an exercise, it’s interesting to construct a portfolio that attempts to (1) isolate the molybdenum business from the much larger Cu-Au section of FCX, and (2) is (to zeroth-order) “mol neutral” in that it is long FCX molybdenum, and short the junior mol miners.

Specifically, to achieve USD 10,000 exposure to pure FCX mol, we go (i) long 938 shares FCX, (ii) short 4398 shares COPX, (iii) short 185 shares GDX, and (iv) short 2000 shares GMO. As of the market close on 1/28/2011, this portfolio is long-short balanced.

UCSC Grad Student Neil Miller has been running a stock-market contest on the Virtual Stock Exchange (Game id: UCSC_Club). I’m currently in 4th place out of 48 players, as a result of a strategy that during December of ’10 went long TC and short CRM. I guess I’m ol’ fashioned, but I like companies that make a lot of money relative to their share price. I took the strategy off at the beginning of ’11, just after TC jumped upward on the (partial) basis of the rare-Earth confusion. As of 1/28/2011, I’m sitting on a 16.43% return, and my book’s off:

Time for another full disclosure: At the start of the contest, on Nov. 1, 2010, I threw caution to the wind, and put my whole book into a leveraged short position on LIZ.

Now, while this position would now be up enough to have me in first place in the contest, I got hit with a succession of margin calls during LIZ’s inexplicable late-November run-up, and Neil deleted my account:

After successfully losing 40 percent of his account within the first month of trading, user greglaughlin has been found to have insufficient margin for 5 consecutive market closes on November 30th and account was promptly deleted as promised.

(So, as is often the case when genius fails, I was fully recapitalized without suffering any particular personal penalty or loss.)

I’ve submitted orders to put on the above mol-neutral “Climax” strategy at the market open tomorrow (Jan 31, 2011). It’s certainly not optimally engineered: no accounting of the various betas has been incorporated, and it chews up a hell of a lot of margin for a mere 10K of FCX-Climax-outperformance exposure. Nevertheless, I bet it will outperform its inverse position, so I’m putting no money where my mouth is!