For some time, stock prices of two oil and gas majors Conoco Phillips (NYSE:COP) and Chevron (NYSE:CVX) have approximately tracked each other . The result has been a fairly flat price of the equity pair: long Chevron, short Conoco. The graph below shows the performance of a pair ratio of 1 Chevron (long) to 2 Conoco (short).
Over the last week, the Conoco price rose 3.6% (to $63.84) whilst Chevron firmed 5.3% (to $107.03) to give a 1.7% increase in the price of the pair. This was accompanied by a flat fair value of the pair, analyzed in the table below –
|
Chevron/Conoco pair last week |
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|
Driver |
Wtd price change |
Contribution to fair value change |
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| US dollar |
-1.2% |
0.12% |
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| VIX |
-18.6% |
-0.02% |
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| Interest rates |
-11.8% |
-0.03% |
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| Stock markets |
0.3% |
0.02% |
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| Oil price |
3.7% |
0.01% |
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| Other commodities |
1.4% |
-0.03% |
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|
Total |
0.07% |
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As can be seen, the pair was well hedged to movements in its drivers, particularly the US dollar and oil price.
An excess of price increase over fair value increase would normally be a signal to sell or go short the pair (ie. short Chevron, buy Conoco). Following this signal over the last 90 days would have provided an annualized gain (on gross – long plus short - exposure) of 35.7% with volatility of 14.9% (before trading costs).
We have also applied this methodology to a number of other pairs of related stocks –(NYSE:IBM)/(NYSE:Oracle), (NYSE:Wells Fargo)/(NYSE:JPMorgan), (NYSE:AT&T)/(NYSE:Verizon) and (NYSE:XOM))/Royal Dutch Shell). The portfolio of all these pairs traded using the disparity between price and fair value change (as above) has returned an annualized 17.3% with volatility of 5.8% over the 90 day back test period.
We find a fair value of the Chevron/Conoco pair below the current price, suggesting that the pair is overvalued and confirming the signal analyzed above. Trading the pair using this indicator over the 90 day back test period showed a 41.4% annualized return with volatility of 14.8%.
Volatility
The graph below shows the sensitivity of the pair’s fair value to its drivers –
The graph suggests that the pair is reasonably well insulated from driver shocks. This is reflected in our finding that, on its own, the volatility of the pair, traded as suggested in this article, was only 2% points higher than the S&P 500. The return was 25% points higher.
As can be seen, the Chevron/Conoco pair is slightly negatively correlated to the US dollar. Our fair value indicators suggest some short term upside in the US dollar index which would assist the pair trade recommended above.
The historical volatility of the pair over the last 90 days, at 15%, is lower than the volatility of each of Chevron (24%) and Conoco (28%) individually. This reflects positive correlation between the two stocks and hence risk netting by pairing them.
Held as part of a US equity portfolio, lower volatility and higher return may be achieved. A portfolio of 5% allocated to the pair (traded as recommended in this article) and 95% allocated to the S&P 500 index had a volatility of 12.3% over the last 90 days vs 12.8% for 100% in the S&P 500. The annualized returns were 9.1% (5% allocated to pair) vs 8.2% (100% S&P 500).