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Michael Fowlkes' Analyst Insights

InvestorsObserver
Options and ETF Analyst Writer
Michael Fowlkes
Author Bio

 

February 1, 2016 - Warren Buffett Sees Potential in Energy Sector

Warren Buffett is perhaps the most idolized investor of all time. Whenever the "Oracle of Omaha" speaks, everyone listens. His moves are closely watched, and lately he appears to have his eye on the energy sector.

Buffett's track record spans decades, and given his solid success rate, it is not surprising why hoards of investors follow his moves and often try to emulate his decisions.

One move that, on the surface, may surprise a lot of his followers is that Buffett has recently made a pretty big buy into the energy sector, with a bullish play on Phillips 66 (PSX).

Oil prices have been under extreme pressure over the last year, and the pressure has come from multiple fronts.

The biggest problem has been oversupply. This is due, in part, to the shale explosion in the U.S., which has led to sharp increases in global supply. Iran is also beginning to contribute, as sanctions being removed on the nation will lead to higher output.

In the past, OPEC has moved in and cut back production in order to boost oil prices under such circumstances, but this time it has yet to make such a move. There are signs that it is now considering cuts, but so far there has been no decision made, and OPEC has been willing to leave the spigot open in order to capture as much market share as possible, regardless of price.

Slowing economic growth in China is also weighing on prices. During decades of blistering growth, China consumed huge quantities of oil, but as growth in China has slowed, its consumption has as well, and is likely to slow even more.

As a result, oil has recently fallen to twelve-year lows, and most big oil and gas companies have suffered major share losses.

One company that Warren Buffett sees promise in is Phillips 66 (PSX). Over the last couple weeks, Buffett has purchased more than 2.3 million shares in the company.

Phillips 66 is a downstream company, which means that it use oil as an input. Low oil prices are a good thing for downstream companies, and a big reason why PSX has enjoyed gains over the last year while other big oil stocks have faltered.

PSX is currently in a downward trend, but the current trend is unlikely to be keeping Buffett up at night. Buffett likes to invest in companies whose business he can understand, and whose stock is a good value, not just now, but moving forward.

Buffett does not take short-term views on positions. He is a long-term investor that establishes positions that he could own for decades. Given his tendency for long-term trades, the recent pullback is a good thing, and has allowed him to get into a company that stands to benefit in the new era of low prices.

As much as I respect Buffett, I have been burned on oil stocks over the last year, so I would like to make sure any trade I made on PSX was hedged with some downside protection.

PSX is currently trading at $77.95, and we are going to look at setting up a March $77.50 covered call on the stock.

Chart courtesy of www.stockcharts.com

In order to set up the trade, you would buy PSX shares (typically 100 share lots, scale as appropriate), while selling the March $77.50 call for a debit of $74.45.

Our original debit will serve as our break-even point on the trade, so as long as PSX is not below $74.45 when our sold calls expire on March 18, the trade will not lose money.

Should the stock be above $77.50 when the calls expire, the calls will be assigned, and the market will exercise its right to purchase our shares at $77.50. With a $74.45 cost basis, the trade has a target return of 4.1%, and with the trade open for 48 days, the target annualized return becomes 31.2%.

There is always the possibility that PSX will trade below $77.50 at March expiration, and should this occur our sold calls will expire worthless and we will be left holding PSX shares.

You will have a few options at this point. You could sell another call on the stock, which would lower your cost basis by the amount of the credit you get for the call, which could easily bring the break-even point lower than where the stock is trading at the time.

You could sell your PSX, and your gain or loss will be determined by where the stock is trading in relation to the $74.45 cost basis. If shares are above that level, you will still realize a profit, but the transaction would yield a loss if shares were lower.

Even though it would lead to a loss by selling shares for less than $74.45, it may be the best move at the time if you have a bearish outlook on the stock.

A final option would be to simply hold your shares and wait for the stock to rebound.

There really is not a horrible outcome to the trade. Because we are able to lower our cost basis on the stock by selling a call against our shares at the trade's inception, we are able to lower our loss, or boost our profit, however it works out.

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