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Rio Vs. BHP: A Very Attractive Pairs Trade Opportunity

Summary

A timely proposal for an iron ore versus oil pairs trade delivered early returns that suggest it could remain an attractive trade for some time to come.

Rio Tinto on the long side and BHP Billiton on the short side generate a trade to leverage a large discrepancy in analyst expectations and historical correlations.

The volatility in prices means the best pairs trade configuration will likely be a dynamic one that takes into account commodity markets, the Australian dollar, and stock market technicals.

Last week was a great week for a pairs trade in iron ore.

A tweet on an attractive pairs trade

The consensus expectation for oil in 2019 is $62/barrel. The consensus for iron ore in 2019 is $55/ton. The current 6-year correlation between the daily prices of iron ore and oil is 0.72. If the correlation holds for the next three years, then analysts should expect iron ore to hit $89/ton in 2019. Since Rio Tinto (NYSE:RIO) is much more dependent on iron ore than BHP Billiton (NYSE:BHP) is, and BHP still holds substantial oil assets, an iron ore rally could favor RIO over BHP. BHP should lag relative to RIO if oil comes short. A pairs trade then goes long RIO and short BHP.

Note that Bernstein makes a strong assumption that current 2019 price forecasts are already baked into RIO and BHP, at least on a relative basis. The article does not even address a number of other important assumptions required to make this pairs trade work. For example, we do not know whether the same set of analysts have made the oil and iron ore forecasts (doubtful). Whatever the overlap of analysts, we do not know whether the relationship of forecasts across the analyst communities is stable over time. In other words, the current discrepancy may be trending up or down, or could even be a temporary aberration. We do not even know how these groups of analysts respond to the volatility and trends in prices. The article did not give a downside estimate for oil if a reversion to historical correlations sends oil down rather than iron ore up for 2019. There is also the issue of time frames: the article does not explain the use of 6-year correlation and 3-year forecasts, or how to properly structure trades given the extended nature of these time frames.

Regardless, I like the trading concept, even if all the mechanical details are not readily apparent. In this case, there is seemingly no fundamental reason for analysts to expect oil to trade a lot stronger than iron ore over an extended period of time. So, this pairs trade is a potentially robust way to play iron ore from the long side with a solid hedge. As it turned out, the Barron's article appeared right before a substantial lift-off in iron ore AND oil-related plays. This lift-off provided a very early payoff to the pairs trade. BHP is up 21% since the Barron's article. RIO has soared 18%. For reference, Cliffs Natural Resources Inc. (NYSE:CLF) has increased 44% since then. Vale S.A. (NYSE:VALE) is up 30%. United States Oil (NYSEARCA:USO) jumped 8%.

Note that the numbers on RIO's chart below represent approximate spot prices for iron ore on the given day. Although iron ore has significantly rallied from the December low, RIO and BHP have benefited little on net. All the iron ore plays even continued to trade lower into January, along with the global financial markets.

Rio Tinto held onto support at its 50-day moving average (DMA) and now faces a test of resistance at its 200-DMA.

BHP Billiton Limited experienced a shorter test of its 50-DMA support than RIO. Like RIO, it now faces a critical test of 200-DMA resistance.

Vale first broke its downtrend from 200-DMA resistance in March. The current streak has confirmed that breakout, with the 50-DMA rapidly rising now. Political developments in Brazil could be key.

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