Stepping Into Energy

Is the energy market becoming energized? It is a tough question laden with ambiguity. Evidenced by reams of well thought out research where slight changes in the inputs can shift the bias from bull to bear and back again.

Interesting the foundation for most of the research concentrates on output. How much supply OPEC and non-OPEC producers are expected to bring to market! The challenge is that this dataset is volatile and fraught with political bias.

What we do know is that 1) supply is outstripping demand and 2) OPEC will continue to maintain output at a level that will rein in competition both inside OPEC (i.e. Saudi Arabia vs Iran) and across non-OPEC regions (i.e. Russia and North America).

What we don’t know is 1) where oil prices will go in the short to medium term and 2) whether small to medium sized Canadian companies can survive at the US$40 per barrel price point.

Investors wanting to trade aggressively in this space need to understand that normal influences between supply and demand have given way to political grandstanding. Which is to say the energy market is drifting in some very rough waters.

For aggressive traders wanting to increase exposure within the energy space, think about short to medium term strategies. Work with the underlying volatility by dollar cost average your way into a new position.

With that in mind let’s re-visit a strategy talked about a couple of weeks ago (see “Bombardier Covered Straddles,” April 18, 2016). The goal is to implement covered straddles using a couple of small to mid-sized energy names. With the caveat that you should be willing to own the underlying shares for up to a year as the position matures.

The first name is Crescent Point Energy (TMX: CPG, Friday’s close $21.14) which yields 1.70% because of a monthly distribution of 3 cents per share. To highlight the risk associated with this sector consider that CPG was paying a monthly distribution of 23 cents per share in July of last year.

According to the TMX Money website, Crescent Point Energy Corp is involved in acquiring and holding interests in petroleum and natural gas properties and assets related through a general partnership and wholly owned subsidiaries.

With CPG you could look at buying the shares at $21.14 and writing the in-the-money July 20 calls at $2.15 and at-the-money July 20 puts at $1.05. The combined premium from the sale of the call and put is $3.20 per share.

The short calls obligate you to sell your shares of CPG at $20 per share until the third Friday in July. If CPG remains the same or rises it will be called away at the $20 strike price. The eleven week return assuming the stock is called away is 15.14%.

If CPG closes below the $20 strike price in July the CPG July 20 puts will be exercised and you would be obligated to buy an additional block of shares at $20 per share. At that point you would own twice as many shares as were initially purchased and your average cost for the CPG shares would be $18.97.

The second name is Precision Drilling (PG, $6.51). This is a small cap company that does not pay a dividend. The company provides drilling equipment for oil companies in Canada and the US and specializes in providing onshore drilling services in conventional & unconventional oil & natural gas basins in Canada and United States.

The PD straddle works much the same way as you would buy the shares at $6.51 and write the PD July 6 calls (90 cents per share) and PD July 6 puts (38 cents per share) for a total net premium of $1.28 per share.

If PD is above $6.00 per share by the third week in July the calls will be exercised and you would deliver your shares to the call buyer. That would complete the trade. The eleven week return from the sale of the shares is 19.66%.

If PD closes below the $6 strike price in July the PD July 6 puts will be exercised and you would be obligated to buy an additional block at $6 per share. At that point you would own twice as many shares and an average cost of $5.62 per share.

By selling the straddles we as using volatility to establish a low cost initial position with excellent return potential. At the same time we are instituting a mechanism to average down the cost base should the market decline over the short term.