Some more indepth thoughts on the oil space right now:
I don’t think there’s been enough bloodletting yet.
Sure, the last few months have been ugly for oil stocks… and odds are we won’t experience the same kind of nasty downside action that we saw late last year.
Yet there haven’t been enough fundamental catalysts to justify oil stocks starting a new bull market.
We need more dividend cuts, more dilution through secondaries, and more pain for investors before this is all over.
Given the fact that many of these oil stocks have seen aggressive rallies since January, now is a time to consider some new downside trades.
A Quick Look At Oil
The major reason that many of these stocks have bounced has been because oil has stopped collapsing.
The premise here is simple:
If the price of oil is lower than your cost to pull it out of the ground, you’re in trouble.
And if you can’t generate enough cash to finance your outstanding debt, you’re in more trouble.
That was the overall driver for many of the leveraged oil stocks last year.
That story hasn’t gone away, it just has subsided because oil has seen one of its strongest moves in a very, very long time.
If oil starts to rollover and if we start to see downside catalysts, that selling momentum could pick up very soon.
How to Trade It
Put Buys On Leveraged Oil Stocks
With this large countertrend rally in oil, now is the time to consider a strategy of anticipating dilutive events in oil stocks that are still in a position of weakness in the market.
Kinder Morgan (KMI) is a great example.
A year ago, the stock was in the 40s.
2 months ago, the stock was headed to the single digits as investors puked up their shares. Odds are the company will have a dilutive event sooner than later, and that tends to hurt the share price of the stock.
These broken oil companies will be forced to raise cash not to finance growth, but just to survive.
The main risk here is that some of these companies could find strategic alternatives… going private (not likely) or a buyout from a firm like XOM. Because of that asymmetric risk, it’s best to consider some put buys that limit your risk.
The KMI Jun 15 put is currently priced at 0.50.
Considering the implied volatility of KMI options has been holding around 60% since it’s collapse, these puts are relatively cheap and could offer a good payout if oil softens and we see a secondary come into play.
Investing in the Majors Will Be Easier
If you do want to take a shot with some long oil stocks, then it makes sense to go with larger market cap stocks with better balance sheets.
Exxon Mobile (XOM) is the best example of this.
They’ve got enough cash to weather this kind of ugliness in the oil markets. It may not be all roses, but they probably will never have a problem with debt issuance and their business model will survive.
The technicals align with this idea. While the rest of the oil patch was getting obliterated, XOM made a higher low this year. Same for Chevron (CVX).
Furthermore, it’s actually very difficult to get exposure to oil. Oil exchange traded funds (ETFs) have issues with futures rollover and many of them will continue to structurally underperform as long as the oil markets are in contango. It’s easier to just buy a company and collect the dividend.
If you’re looking for an ETF, then XLE is going to be your best bet as 30% of the total size in the ETF is just XOM and CVX.
Pairs Trade ETFs
One trend I expect to continue is the outperformance of XLE relative to OIH. The balance sheets are better and there are less risks involved with the larger companies.
Any time this relationship stretches to the downside, consider starting a position.
Put Sales Post Secondary
Once you see some kind of ugly fundamental catalyst, the downside momentum will generate higher option premiums and a good opportunity for longer term investors.
Of course, there’s always the possibility that a stock just goes to zero. That’s the risk you’re playing with.
You could consider buying calls to limit your downside, but then you run the risk of the stock just going sideways and nothing happening.