Burning Some Oil

Richard Croft
October 12, 2011
5 minutes read

Canada’s S&P/TSX Capped Energy Index slumped 38% from its March high to last week’s low, as the price of Nymex crude oil for future delivery collapsed from US$114 per barrel in late April to US$76 per barrel this past week. The principal reason cited, and there are many points of view as to what is actually driving the price of oil, is fear that the spreading global economic slowdown will turn into a double-dip recession. Recessions translate into across the board slowdowns which dampen demand for oil. Although, in fairness, those fears may be overblown.

Talk to most people, and they will tell you that it feels like a recession. But the fact is, we are more likely witnessing a prolonged period of slow growth with low interest rates. Not the worst scenario for people with a job and decent cash flow. But for those downsizing their job and their home, not to mention the unemployed, a slow growth scenario offers little hope.

In fact we are beginning to see social unrest sparked by the middle class “Occupy Wall Street” protests which seem to be gaining momentum. Something that was unheard of in previous downturns. But all too familiar in economies where a macabre environment lasted for prolonged periods. But I digress!

If we are able to look longer term – say beyond the end of 2011 – the numbers suggest that the global economy may dodge a full-blown double-dip recession. The one wildcard being Europe where politicians are inclined to observe the Eurozone crisis through rose colored glasses. There inability or unwillingness to act will likely cause some of the weaker EU members to slip into recession by the first quarter of 2012.

However, demand from emerging markets like China, India, Brazil, and Russia remains buoyant, which from the perspective of this thesis, will likely provide a floor for the price of oil. In addition, the supply side is still questionable, as recent inventories in the US were less than the market had expected. Not to mention the supply chain which is potentially threatened by continuing political tensions in the mid-East and Northern Africa, where any disruption to “easy” oil in the coming months could give crude oil prices a quick boost.

With Canada’s energy sector deep into bear territory, this may be the best sector to begin dipping a toe into the water. You could argue as some analysts have the you should buy on a pullback. But in this case, why not take a position that obligates you to buy on a pullback.

Here are some examples; Suncor (TSX: SU, recent price $28.07), Imperial Oil Ltd (TSX: IMO, $38.10), and individual companies with heavy oilsands exposure like Canadian Oil Sands (TSX: COS, $20.10).

With Suncor, you might look at selling the SU Dec 28 puts at $2.35. The sale of the puts obligates you to buy Suncor at $28 per share until the third Friday in December. The idea is to dip your toe at a price you are comfortable with. If the shares are put to you, the cost if $28 per share less the $2.35 per share premium received, which makes $25.65 your net cost should you be put the stock.

You can use the same strategy with Imperial Oil Ltd by writing the IMO Nov 38 puts at $1.70. If the shares are below $38 per share in November, you will be put the stock, but your net cost will be $28.00 less the $1.70 per share premium which equals $26.30. For Canadian Oil Sands, look at writing the COS Nov 20 puts at $1.35. If the stock is put to you, your out of pocket cost will be $20 per share less the $1.35 premium which equals $18.65 per share.

In all cases, if the stocks rise or stay the same, the short puts will expire worthless and you will pocket the premium as your profit. Retaining a profit for taking a stance that you are dipping a toe into water and not quicksand.

Richard Croft
Richard Croft http://www.croftgroup.com/

President, CIO & Portfolio Manager

Croft Financial Group

Richard Croft has been in the securities business since 1975. Since February 1993, Mr. Croft has been licensed as an investment counselor/portfolio manager, operating under the corporate name R. N. Croft Financial Group Inc. Richard has written extensively on utilizing individual stocks, mutual funds and exchangetraded funds within a portfolio model. His work includes nine books and thousands of articles and commentaries for Canada’s largest media channels. In 1998, Richard co‐developed three FPX Indexes geared to average Canadian investors for the National Post. In 2004, he extended that concept to include three RealWorld portfolio indexes, which demonstrate the performance of the FPX portfolio indexes adjusted for real-world costs. He also developed two option writing indexes for the Montreal Exchange, and developed the FundLine methodology, which is a graphic interpretation of portfolio diversification. Richard has also developed a Manager Value Added Index for rating the performance of fund managers on a risk adjusted basis relative to a benchmark. And In 1999, he co-developed a portfolio management system for Charles Schwab Canada. As global portfolio manager who focuses on risk-adjusted performance. Richard believes that performance is not just about return, it is about how that return was achieved.

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