Risk Management

Survival of the Fittest in the Oil Patch

Jason Ayres
January 19, 2016
8 minutes read
Survival of the Fittest in the Oil Patch

I was screening some of the headlines in the Globe and Mail this morning and came across an update on Suncor (TSX:SU) and its bid for Canadian Oil Sands (TSX:COS).

According to the Calgary Press, Suncor and Canadian Oil Sands have settled on a $6.6 billion deal which includes stock and debt. Interestingly enough, Suncor increased its bid conceding that its previous one was too low.

Suncor closed on Friday, January 15th at $31.22, well off of its $40.00 highs of the year. Of course the slide in oil stocks is not new considering the downward spiral of the commodity throughout 2015, falling below $28.00 per barrel just last week.

Regardless of why oil continues to weaken, whether it’s USD strength or supply and demand considerations, the financial stability of many energy companies are being tested and this is going to prove to be an interesting opportunity as things unfold.

The recent play for Canadian Oil Sands by Suncor is just one example. As certain companies struggle, the stronger players will step up and take advantage in a Darwinistic, survival of the fittest environment.

What will emerge is a stronger, more efficient collection of companies poised to benefit when oil finally finds a bottom.

If the recent move by Suncor (TSX:SU) is an indication, perhaps there’s an opportunity here to take advantage of what may be one of the stronger players. Admittedly, there is no indication technically that the share price is poised to turn around. However, the move to increase the bid for TSX:COS suggests that management feels they are positioned to weather the current environment and is subscribing to the old Wall Street adage that when there’s blood in the streets it’s time to buy.

I will not be so bold as to predict when things may turn around but what I do believe is that this will not be the last we see as far as mergers and acquisitions are concerned in the energy sector.

That said, if we assume that Suncor will be one of the companies left standing, now might be an interesting time to consider taking a position in the Canadian energy giant.

The risk of course is that we have not yet seen the end of the selling. While this is a valid concern, there can be much to gain by having the nerve to buy when others are afraid.

This is where the option market shines. An investor wishing to secure a position in the stock but concerned about the risk can simply use a call option strategy to achieve their objectives. I know many readers look for the opportunity to learn about some advanced combination, however I am of the belief that it’s better to keep things simple when ever possible.

As I mentioned, trying to predict when a turn around might occur is a bit of a fools game. As such, we need to allow for as much time as possible for our expectations to play out. This is where a long term call option becomes a great stock replacement strategy.

The last price of the January 2018, $30.00 strike call option on TO:SU was $5.90. With the shares at $31.22 on Friday January 15th, 2016, the option premium had $1.22 intrinsic value and $4.68 time value. Since we can’t lose more than the entire premium, $5.90 represents the maximum risk on the investment for the next 2 years. Admittedly, that works out to be about 18% which may be a little high. Keep in mind that we can close the position at any time to cut losses and lock in profits. for example, if we saw a re test of $40.00 over the next 2 years, the $30.00 strike call would be worth at minimum its intrinsic value of $10.00.

While I suggested that we would want to keep this simple, I do believe it is worth looking at strategies that might help reduce our overall cost basis. With this in mind, we could consider making this a Calendar Spread.

While holding the long term call, we could sell short term, out of the money calls to generate monthly cash flow. The objective is to lower our cost which in turn lowers the over all risk and break even point on the position.

For example, While holding the January 2018, 30 strike call, we can sell a February $34.00 strike call and collect $0.50. This lowers our cost by about 8%. Our strategy will be to do this on a regular basis, adjusting the written strike as the shares fluctuate. The ideal scenario is that we are able to do this consistently, collecting our monthly premium while benefiting from a slow and steady appreciation in share price.

Of course there’s always a trade off when creating option combinations and this strategy is no different. The challenge is if the shares jump quickly and significantly before our written contract expires. If, on expiration, the stock is trading above the written strike, we would be assigned to deliver the shares. If we use the above strike prices and premiums as an example, the net cost of the spread would be $5.40. We have the right to own the shares at $30.00 and an obligation to deliver them at $34.00. If we are assigned to deliver the shares at $34.00, We can exercise our right to buy the shares at $30.00. Technically our profit would be $4.00, representing the difference between the strikes. However, because the position cost us $5.40, the early exercise of our long call to cover the assignment will likely end up resulting in a small loss.

The alternative is that we roll the written option by purchasing it back to close the position before expiration. We would then subsequently write a new call at higher strike and further out expiration month. While this may cost us initially, we maintain the upside potential on the longer term call.

For the investor looking to take a longer term outlook on a company and limit the amount of capital that is tied up, the call option is a great stock replacement strategy. The investor can lock in profits or cut losses at any time if the outlook changes to avoid losing the entire premium. An investor who is more pro-active can write short term calls to off set the cost of the longer term contract. While this is well worth considering, they should be prepared to make adjustments along the way should the stock take off in a hurry.

Jason Ayres
Jason Ayres http://www.croftgroup.com/

CEO and Director of Business Development

R.N. Croft Financial Group

Jason is CEO and Director of Business Development at R N Croft Financial Group, a member of the Croft Investment Review Committee and a Derivative Market Specialist by designation. In addition, he is an educational consultant for Learn-To-Trade.com and an instructor for the TMX Montreal Exchange.

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