- Wagner's Knighthead also among hedge funds shorting currency
- `You have a small probability of a big event,' says strategist
As slumping oil prices squeeze Saudi Arabia’s finances, a few big hedge funds are wagering that the kingdom will be forced to abandon a three-decade-old currency peg that has been a bulwark of its economic and financial stability.
Among them is Zach Schreiber’s PointState Capital, a firm backed by billionaire Stan Druckenmiller that made a $1 billion profit in 2014 betting that oil would fall, according to people familiar with the matter. Knighthead Capital Management, the event-driven hedge fund co-founded by Tom Wagner, has also joined the trade, said the people, who asked not to be identified because the information is private.
The firms are using derivatives including forward contracts to bet that the largest Arab economy, which depends on oil for about 75 percent of its export revenues and 80 percent of its budget revenues, will need to devalue the riyal. The currency has been trading at a rate of 3.75 per dollar since 1986, and the kingdom has recently taken steps to make speculating against the riyal harder. That hasn’t deterred the hedge funds, which stand to reap a big payoff for a relatively low upfront cost should the peg fall.
“You have a small probability of a big event,” Arko Sen, a strategist at Bank of America Corp., said by phone from London. “Using the forwards to position for devaluation is a good risk-reward even if the probability is high that they hold the peg.”
Patrick Clifford, a spokesman for PointState, declined to comment. Laura Torrado, general counsel at Knighthead, also declined to comment.
Forward contracts allow users to lock in currency prices at some point in the future. Investors selling the riyal forward make a profit if the currency in the spot market is weaker than the predetermined rate when the contract expires.
Bets on a devaluation of the riyal reached their highest in almost two decades in January as prices for Brent crude tumbled below $30 a barrel. They have since come down as Brent rebounded, rising to almost $37 Monday.
Forward contracts show that investors currently expect just a 3.5 percent drop in the currency over the next two years. Bank of America estimates that if the kingdom decided to devalue, it would have to do so by 50 percent in order to improve its budget and trade deficits.
Betting on such a move is relatively cheap. At current two-year forward prices, the cost of carrying a $100 million short position on the riyal for a year is approximately $2 million, while an investor would make $50 million in the event of a 50 percent devaluation.
It’s not clear how much money PointState has riding on a devaluation of the riyal, but the firm is known to make big, directional bets. Unlike some investors such as Bill Ackman, who are shorting the riyal as a hedge against the impact of falling oil prices, Schreiber’s wager is that the peg will fail, according to one of the people.
Schreiber’s firm returned about 27 percent in 2014 after fees, helped by a large bet that oil prices would slump. The firm’s profit that year was about $2 billion, with roughly half of that from the oil trade, people familiar with the matter said at the time.
Schreiber, who started New York-based PointState in 2011, previously worked for Druckenmiller’s Duquesne Capital Management, where he ran a portfolio of investments in energy, power, utilities and related commodities. Druckenmiller, a former chief strategist for George Soros who orchestrated a $10 billion trade in 1992 against the British pound, invested $1 billion in PointState at the start.
Knighthead has used the riyal forwards both as a defensive hedge, and to position for a windfall from a potential devaluation, said one of the people. The firm’s previous wagers, which usually focus on distressed assets, have included Argentine and Greek bonds, as well as those from the Puerto Rico Electric Power Authority.
Ackman, the billionaire founder of activist hedge fund Pershing Square Capital Management, purchased put options, which allow the owner to sell the currency at a set price in the future, as an “inexpensive” hedge against declining oil prices. The hope is to offset the negative impact from the drop in crude on stocks with gains from that currency trade.
While Saudi Arabia’s continued support of the riyal has kept the options from offsetting declines in the rest of his portfolio, Ackman remains in the position, he told investors in a Jan. 26 letter.
The Saudi Arabian Monetary Agency has repeatedly said it will stick with its currency peg. In a bid to curb speculation on its currency, the agency in January ordered banks in the kingdom to stop offering options contracts on riyal forwards to their clients, five people with knowledge of the matter said at the time. The directive, issued at a Jan. 18 meeting in Riyadh, applies to local banks and the Saudi branches of international banks, the people said.
PointState and Knighthead have owned options and forwards, two of the people said, but the limits on options trading are making it difficult for hedge funds to exit a position ahead of expiry or take on a new position in that market. That leaves the forwards as the primary way investors can now short the riyal, said the people.
Despite oil prices bouncing off their lows this month, the current global oil glut will persist into 2017, limiting any chance of a price rebound in the short term as the surplus takes even longer to clear than previously estimated, according to the International Energy Agency.
Saudi Arabia, the world’s biggest crude exporter, which is pumping at near-record volumes, may decide to cut production before abandoning the peg, said Shahriar Shahida, co-founder of New York-based hedge fund Constellation Capital Management.
“It was the Saudi decision to increase marginal supply that wreaked havoc in the global oil markets,” said Shahida. “It stands to reason that the reversal of that decision can ignite a massive rally in oil, hence filling their coffers once again. That’s why betting against them does not make a lot of sense to me.”
Investors can still make money in the derivatives even if the nation doesn’t devalue, said Bank of America’s Sen. Forwards are likely to be bought on dips as long as oil prices remain low or the nation avoids a budget adjustment, he said.
The ruling al Saud family has taken unprecedented measures to reduce its reliance on oil. The government has raised fuel prices and trimmed spending to narrow the deficit. It floated the possible sale of a stake in the state-owned oil company, Saudi Aramco.
“There’s a trade-off for them in terms of deciding what they want to achieve in the oil market,” said Sen. “Do they give up on that or do they give up on the peg, or do they give up on neither and control their spending.”