Bottom Fishing Cenovus? Hedging may be Appropriate

Cenovus stirred up the Canadian oil industry back on March 29^th with an announcement on the $17.7 billion-dollar purchase of ConocoPhillips’ Canadian oil sand assets. To say the deal was not well received is an understatement as the stock dropped over 10% on the announcement and continued to actively distribute lower. From its peak prices at $22.00 back in December 2016, the stock proceeded to decline to a low under $13.00 a share.

Chart: Courtesy of StockCharts.com

There are two very distinct sets of opinions on the deal. First off there are a core group of investors and analysts that feel the company grossly overpaid and the shareholders will suffer from the increased stresses on the balance sheet and generally has been destructive to the company’s investment value. To add further concerns to the deal, many are alarmed about the timing of the acquisition, just as crude oil has begun to weaken potentially adding stress on the company over the short-term.

The second, more optimistic group of investors, believes that while there will be short-term financial stress, the company will demonstrate operational synergies that would allow the company to trade at much higher valuations.

Clearly those looking to abandon Cenovus on the short-term are prevailing as the stock has now approached the levels it traded in the 1^st quarter of 2016 when spot prices of West Texas Intermediate flirted under $30.00 a barrel.

So how do we size this up as traders?

The first observation is that the stock is very oversold and the current velocity of the selling must slow as it approaches the price levels where value investors see little risk to accumulate. But the problem with just randomly buying the dip is that there is little evidence that this is where the selling stops and that the stock cannot lose further value. This emotionally keeps many traders on the sideline observing, but not acting.

This is where exchange traded options can offer a valuable tool to hedge risk for those bold enough to start their buying. Those familiar with options know that there are many alternative hedging strategies to build the asymmetry, but my focus is to demonstrate the use of a protective put hedge as an insurance to define the maximum risk to give the investor staying power to see through a potential bounce.

Details at the time of writing (May 8, 2017):

• Cenovus (TSX:CVE) is trading at $13.18
• June $12.00 put option (39 days) is asking $0.25

In this example, our investor believes the stock can trade from its current price of $13.18 back to $15.00-$17.00 on the upside but clearly is concerned about the short term selling pressure on the stock and the immediate risk that they may be early.

Our investor buys 1000 shares for $13,180 and simultaneously purchases 10x June $12.00 put options for $0.25 or $250.00. What has our investor done? They have contained their maximum risk over the next 39 days down to $12.00 a share where they have secured a guaranteed price exit.

To some value investors that appears to be unnecessary, but that is a matter of opinion. To me the cost of the protection offers an important safety net to take a decisive stance on an investment theme, knowing you have a clear exit strategy if you find out you are early or some further news accelerates the selling pressure lower. The certainty of knowing you have a fixed exit strategy if you are wrong gives the investor an important psychological anchor to make an initial investment with conviction.