Fundamentally, I don’t think it’s possible to bring anything to the discussion of embattled Whiting Petroleum (NYSE:WLL) that my InvestorPlace colleagues haven’t already covered, and quite comprehensively I might add. But what hasn’t been discussed as frequently is the trading dynamics surrounding WLL stock. Look, as much as you might think shares are irrational, clearly someone is buying them.
Why? On the surface, it’s difficult to imagine the thought process or the incentive. By nature, companies that declare bankruptcy do so because they have severe problems that lack other forms of resolution. Right there, that should dissuade the vast majority of investors from WLL stock.
In addition, the outside fundamentals are simply terrible for Whiting Petroleum. As an oil firm, it needs the underlying asset to move higher. And that means retail demand must improve dramatically from where we are. But months after the initial onset of the novel coronavirus, several major driving hubs — like Los Angeles — are seeing traffic levels that are down more than 60% from the year-ago period.
Further, much has been made about rising air travel demand. However, at best, air travel is only operating at around 30% of capacity. Also, the demand uptick is sporadic. For instance, on Aug. 9, nearly 832,000 passengers crossed through TSA checkpoints. Three days later, that figure was 590,749 passengers, less than 25% of capacity year-over-year.
But again, people are buying WLL stock. Although I hate bringing this up like a broken record, it probably has much to do with the Robinhood phenomenon. Not that Robinhood is to blame specifically. Rather, with so many workers stuck at home, everybody is becoming a trader.
WLL Stock Lost Rationality
Years ago, I read a book on an advanced trading mechanism involving arbitrage strategies. At its most basic form, arbitrage is the practice of exploiting price differences between two or more markets. What this book referred to wasn’t traditional arbitrage trading. Rather, the author advocated taking two highly correlated assets and buying the undervalued (or shorting the overvalued) asset in this carefully defined system.
It was a complicated book involving market theories and complex mathematical derivations. Hardly dinner table conversation but it’s an incredibly relevant topic for WLL stock.
You see, in order to profit on the long side of Whiting, you’re only a rational player if you’re assuming a recovery in the oil market (and likely a substantial one). Even among Robinhooders, I’ve got to believe that those who are piling into WLL stock believe in the last statement.
However, this arbitrage strategy — the belief that WLL stock is undervalued relative to the oil market — only works if Whiting shares a statistical correlation with oil. Between November 2003 (when WLL went public) to the end of 2019, that was exactly the case. WLL shared a strong, 80% direct correlation coefficient with oil prices (West Texas Intermediate).
But so far this year, the correlation coefficient dropped to 71.9%. No problem, you might say. However, WLL stock became mathematically “unhinged” from the benchmark oil index starting from April, having a weak coefficient of 34.6%. Statisticians usually have a cutoff at 40% (or -40% for inverse relationships) as a minimum threshold for statistically meaningful data.
Thus, when you’re trading WLL stock post-March, you cannot depend on oil prices as your arbitrage “partner.” Instead, you’re flying blind. Oil price movements are no longer correlated with Whiting’s share price.
The Math Says Run!
From my understanding, casinos set up (rig) their slot machines so that over the long run, you have a less than a coin toss chance of winning money. However, at the point where science, art and the metaphysical converge onto no-man’s-land, you really don’t know what your probability is that your next pull is a winner or not.
And that’s the catalyst for these games of chance, despite their not being favorable to the gambler. In the back of our minds, there’s a lingering thought that this time, yes, this time, could be the one. So we pull.
Frankly, that’s the “logic” behind Whiting stock. I’m confident that most players recognize that gambling on speculative oil companies is a low-probability proposition. But they do it because there’s always that chance that you can strike it rich.
Maybe there’s some juice to be squeezed on the “if-come” of management change news? Whiting announced on Aug. 14 that industry veteran Lynn Peterson will replace CEO Bradley Holly. Earlier that day, Holly announced he will exit the company after it emerges from Chapter 11, expected around Sept. 1. That should free him up to spend some of the $6.4 million bonus that he got just before Whiting’s bankruptcy. I don’t see it doing much though for the stock.
Of course, the main problem here is that because WLL stock is not tethered to the oil market, we don’t know what the valuation probabilities are on a technical basis. If you do trade Whiting, know that you’re swinging on a highly variable and unpredictable slot machine. For the rational investor, just stay away.
A former senior business analyst for Sony Electronics, Josh Enomoto has helped broker major contracts with Fortune Global 500 companies. Over the past several years, he has delivered unique, critical insights for the investment markets, as well as various other industries including legal, construction management, and healthcare. As of this writing, he did not hold a position in any of the aforementioned securities.