Dipping Into Oil Through this Energy Exchange Traded Fund

Posted On February 2, 2015 12:33 pm

Use a Calendar Spread to Profit while Waiting For Energy Stocks to Recover

No one predicted the price of oil to crash by 50% to below $50 per barrel over the past six months. And no one can honestly predict where it will be in the next six months. But I do think the share price of the energy companies will recover or at least stabilize before price of the underlying commodity.

That’s not to say that some of the smaller players that took on debt, especially to finance the fracking of shale boom, there might be more pain to come through sinking share prices, cutting of dividends or forced sell assets at fire sale prices.

I can’t pretend to have the analytic ability to dig into each income statement and balance sheets of every company. That’s why I want to stick with a basket of the largest companies using the SPDR Energy Select (XLE) as my investment vehicle.

Nor do I know the exact timing of recovering; therefore I’m using a calendar spread to and reduce my risk as I wait. Ultimately I could generate up up to 10% of income per month.

Bigger is Better

But one thing I can say with a good deal of confidence is that the major energy companies, such Exxon Mobil (XOM), Chevron (CVX) and Schlumberger (SLB) are not going out of business anytime soon. Even if oil stays near $50 will still be incredibly profitable and able to generate sufficient free cash flow to support healthy dividend payments.

Indeed, ExxonMobile’s recent earnings report showed it earned $6.6 billion on $87.3 billion in sales for the fourth quarter revenue. Granted this was down 21% from a year earlier but still good enough to deliver $1.56 per share, well above the $1.34 analyst estimates. Likewise, Chevron saw a 30% decline in revenues but still beat analyst estimates.

Because they operate and are diversified across all aspects of the energy stream, where one area such as drilling suffers from low oil price others, such as refining, benefits from improved margins. Plans to slash their capital expenditures through shutting less profitable wells and curtailing exploration will slow growth but will reduce costs and therefore help maintain profitability.

Indeed, their size and solid balance sheets might eventually allow them to pick up the assets of weaker companies on the cheap and help accelerate profit growth sooner than expected or even if the price of oil remains below below the $50 level.

The SPDR Energy Select (XLE) is comprised of some largest energy companies as my investment vehicle for establishing a bullish position in the energy sector. It’s three top holding, Exxon Mobil (XOM), Chevron (CVX) and Schlumberger (SLB) represent 36% of the ETF weighting.

The perception that oil for will stay down for a while and reduced profits appears to already be reflected in the current share prices.   Indeed savvy investors are starting to nibble away to build bullish positions.

One can see that even as oil ht a new now of $43 per barrel last week the shares of XLE held their January low and now have a solid double bottom at the $72 level.

XLE 020215

Using a Calendar Spread to Pays to Wait

This is not to say the energy stocks are suddenly going to zoom higher. It’s much more likely their recover will be gradual and possibly uneven.   Using a calendar spread is a great way to establish a long term bullish position that pays out income as you wait for share prices to gain.

A calendar spread consists of buying a longer term call and simultaneously selling a call with a shorter term expiration date.   The sale of the short term call helps finance the purchase of the longer term call. The near term call sold benefits from accelerated time decay. The call I’m selling has a slightly higher strike price than the call I’m purchasing which provides for more upside profit potential. This is called a diagonal calendar spread.

The Trade:

Specifically with the XLE trading at $77 a share I’m buying the June $78 call and selling the February $79 call for a $2.75 net debit. The trade looks like this:

-Buy June $78 call for $3.90 a contract

-Sell February $79 call for $1.15 a contract

This is a $2.75 net debit. The call sold short expires on February 20th. The call being purchased expires June 20th.

As the near term call expires, most likely worthless, that premium is collected. A new round of near term calls can then be sold to collect more premium. Every month will offer approximately 25% of the initial cost.

The XLE offers weekly options so once the initial monthly calls expire the sale cycles can shortened to take in more premium on an accelerated basis. Assuming XLE remains between $76 and $79 per share it would take just three weekly rolls or zero cost basis position.

This means by the end of March you start generating income, approximately 10% per month, with each near term call sold. Or you can have a “free” ride of unlimited profit potential on the June calls you own.

About author

Steve Smith

Steve Smith have been involved in all facets of the investment industry in a variety of roles ranging from speculator, educator, manager and advisor. This has taken him from the trading floors of Chicago to hedge funds on Wall Street to the world online. From 1987 to 1996, he served as a market maker at the Chicago Board of Options Exchange (CBOE) and Chicago Board of Trade (CBOT). From 1997 to 2007, he was a Senior Columnist and Managing Editor for TheStreet.com, handling their Option Alert and Short Report newsletters. The Option Alert was awarded the MIN “best business newsletter” in 2006. From 2009 to 2013, Smith was a Senior Columnist and Managing Editor for Minyanville’s OptionSmith newsletter, as well as a Risk Manager Consultant for New Vernon Capital LLC. Smith acted as an advisor to build models and option strategies to reduce portfolio exposure and enhance returns for the four main funds. Since 2015, he has worked for Adam Mesh Trading Group. There, he has managed Options360 and Earning 360, been co-leader of Option Academy, and contributed to The Option Specialist website.