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Michael Fowlkes' Analyst Insights

Options and ETF Analyst Writer
Michael Fowlkes
Author Bio

July 29, 2013 - A Nice Hedged Trade on Oil Sector Ahead of Earnings

The recent run up in oil prices has resulted in a lot of enthusiasm in the energy sector. This week Wall Street will get a clearer picture on the health of the sector with some of the biggest companies reporting their quarterly numbers.

An improved economy in the U.S. has helped push prices higher, but we are starting to see oil prices hit some resistance, mainly due to concerns over the current situation in China.

A recent report from HSBC showed that manufacturing activity in China fell to its lowest level in 11 months during July. The fear is that a slowing of the world's second largest economy will lead to oversupply and send oil prices lower.

Despite concerns over China, oil prices have not fallen too much. After hitting a high of $108.93 on July 19, prices have fallen, but are still trading at $104.72.

Oil will test support at $104, and if it is unable to stay above that level we will see a greater drop in prices, possibly falling to the high $90's, but I do not expect prices to fall too much more than that over the next few months.

The primary reason I expect oil prices to remain strong is the improving economic picture in the U.S. Unemployment is improving, the housing market continues its rebound, and consumer sentiment is on the rise. All of these three factors point to a strong U.S. economy, which should help keep oil prices elevated.

The rise in oil prices has resulted in rising share prices for the world's biggest energy companies, and in order for stocks to hold these gains they must report solid quarterly results.

One reason to be optimistic is the positive earnings report from Schlumberger Limited (SLB), which reported on July 19. The company had earnings of $1.15 per share, which were above analyst estimates calling for $1.10. The stock has traded up 3.8% since its earnings report.

This week we are going to see earnings numbers out of some of the biggest names in the sector, including Exxon Mobil (XOM), Chevron (CVX), and ConocoPhillips (COP).

While I am bullish on the sector as a whole, I would prefer to take a more hedged approach to playing the sector ahead of earnings from these big stocks. I expect strong numbers from these companies, but if worries over China continue to push oil prices lower then these stocks could still face selling pressure.

A great way to make a bullish play on the sector while still hedging for the potential impact from China is with a hedged trade on the exchange-traded fund Energy Select Sector SPDR (XLE). XLE holds some of the biggest names in energy, with its top five holdings being Exxon Mobile, Chevron, Schlumberger, Occidental (OXY), and ConocoPhillips.

The rise in oil prices has helped XLE enjoy a strong year, with shares up 16.8% since the start of the year. A nice hedged trade on XLE would be the December 65/70 bull put credit spread. In this trade, you would sell the December 70 put while buying the same number of December 65 puts for a credit of 40 cents. This trade has a target return of 8.7%, which is 21.4% on an annualized basis (for comparison purposes only). With XLE currently trading at $82.61, this trade has 14.8% downside protection.

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