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July 26, 2010 – What's The Best Way To Play Oil With ETFs?
Remember two years ago when oil prices hit $147 a barrel and everyone was wringing their hands over $4-per-gallon gasoline? Those fears seem so quaint now in the wake of the Crash of 2008, Great Recession, and subsequent unemployment spike. Nonetheless, oil companies, some of which had been posting record profits, have been in a bit of a slump lately as oil prices settled back around $80 a barrel. In the aftermath of the BP (BP) Deepwater Horizon spill in the Gulf of Mexico, oil prices have once again fallen off a cliff from which it has yet to fully recover, as the chart below shows:
This drop in prices has hurt the whole industry, not just BP. Part of the reason for the drop was the subsequent freeze on deepwater drilling imposed by the Obama administration in the wake of the spill, but those wells that were shut down were the proverbial drop in the bucket with regards to global production. Besides, a drop in production should actually cause oil prices to rise. The real reason behind the drop in oil is the fear of a crackdown on oil companies by Uncle Sam. These fears grew to a fever pitch as BP set up a $20 billion escrow fund to start settling damages related to the spill.
But with a number of oil stocks reporting earnings this week, the oil sector has a chance to see some upward momentum. Some of the biggest names in the industry will be reporting, including BP (BP), Chevron (CVX), and ConocoPhillips (COP). Here’s what analysts are expecting from these firms:
| Company |
Earnings Date
|
EPS Forecast
|
Year-Ago EPS
|
|
Apache Corp. (APA)
|
7/29
|
2.42
|
1.58
|
|
BP plc (BP)
|
7/27
|
1.39
|
0.94
|
|
Chevron (CVX)
|
7/30
|
2.40
|
0.87
|
|
ConocoPhillips (COP)
|
7/28
|
1.57
|
0.97
|
|
Hess (HES)
|
7/28
|
1.15
|
0.40
|
|
National Oilwell Varco (NOV)
|
7/29
|
0.93
|
0.90
|
|
Noble Energy (NBL)
|
7/29
|
0.75
|
0.66
|
|
Occidental Petroleum (OXY)
|
7/27
|
1.35
|
0.85
|
|
Range Resources (RRC)
|
7/26
|
0.12
|
0.21
|
Investors are expecting a big improvement from most of these stocks compared to last year, but that should be no surprise considering oil was trading below $70 a barrel for much of the second quarter of 2009. On July 19, Halliburton (HAL) reported its second-quarter numbers, posting a profit of $480 million, or 53 cents per share, on revenue of $4.39 billion. Analysts were expecting a profit of 37 cents per share on revenue of $4.09 billion, so perhaps Halliburton's earnings are a good omen ahead of the next wave of oil sector earnings.
Oil investors have a variety of ways to play the commodity using ETFs. For many, the gold standard is the US Oil Fund (USO), which trades oil futures to mimic the daily performance of near-month oil futures. I have pointed out trades on USO before, but you may want to talk to your tax advisor before trading this ETF. A recent Wall Street Journal article pointed out that currency and commodity ETFs are subject to much stricter tax rules than ETFs comprised of stocks. If you hold shares of USO at the end of the year, for instance, you may be required to pay capital gains taxes on the ETF, even if you have not unloaded it. So while USO is perhaps the one ETF whose performance most successfully mirrors that of oil futures, it may not be the best vehicle for you.
Luckily, there is a wealth of ETFs which play oil stocks, rather than oil futures. These include iShares Dow Jones US Oil & Gas Exploration (IEO), Oil Services HOLDRs (OIH), and SPDR S&P Oil & Gas Equipment & Services (XES). Of these three, OIH is the most intriguing, because its holdings are a bit more concentrated than those of IEO or XES. Slumberger (SLB), Halliburton, and Transocean (RIG) comprise almost 40% of OIH’s holdings, giving the ETF a little more volatility than IEO or XES. This could be a good thing for our purposes, since higher volatility leads to higher options prices.
If you are looking for a hedged play on the oil industry, consider an August 90/85 bull-put credit spread on OIH for a net credit of $0.31. This is good for a 6.6% return (86.2% annualized – for comparison purposes only). This spread is 14.6% out of the money, and has a breakeven point of $89.69 with 14.9% downside protection. That extra volatility I was describing in the previous paragraph comes in handy in a bull-put spread, since it allows traders to get a decent credit with a little more downside protection than they can get with a less volatile stock.
I have linked a spreadsheet here to show you the formulas I used to calculate the return and protection in this trade. You can plug in your own trades on the worksheet and use these formulas to calculate returns and protections for any bull-put credit spread you are considering.
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