Julian Close's Insights
August 24, 2015 - Williams - Read the Meter and Count Your Money
Williams is a national oil and gas pipeline company. Unlike many companies in the pipeline industry, Williams has a long and storied history, going all the way back to 1908. It is structured as a holding company, which allows it to own a majority stake in its own master limited partnership, WPZ, as well as being flexible enough to buy and sell sizable positions in other energy MLPs.
You may wonder why pipeline companies inevitably put so much energy into financial engineering, and the answer is – what else are they going to do? Once you build a pipeline and take steps to see to its maintenance, there’s not much else to do but read the meter and count your money. Back in 2012, Williams wisely spun off its remaining exploration business – wisely, because the exploration side of the business carries the overwhelming share of the commodity price risk, and the price of natural gas today is very low.
WMB stock began the year at $44.98 per share and is currently trading at $50.80. The company has provided guidance to suggest that it will increase its dividend by between 10% and 15% annually through 2020, and as the stock price should keep pace, the forecast is bullish.
We seek to take advantage of this strength with a bull-put credit spread on WMB.
This sort of trade is a bet that the stock won't fall below a certain level, plus a hedge against catastrophe. To make the trade, you will sell an out-of-the money WMB put, (which means the strike price will be lower than the current price of the stock). By selling a put, you are taking on the obligation to buy the stock at a particular price. You will make money from the sale, but you could lose money if the stock drops sharply. To limit your downside, you will also buy a put that is further out of the money than the put you sell, meaning at an even lower strike price. That will give you the right to sell the stock for just a small amount less than you are forced to buy it, even if the worst happens and the stock falls unexpectedly. Because the put you buy will be cheaper than the put you sell, you will get to keep the difference – that is your profit in the trade.
In this case, the trade is the November 45/47 bull-put credit spread for at least a $0.50 credit. In making this trade, you will be putting up $2 (the difference between the strike prices) per share of WMB to make $0.50 per share. A typical trade would involve 10 WMB options contracts which is the equivalent of 1000 shares. Scale as appropriate. You will make the full return of $500 unless WMB falls below $47 per share, which would be a decline of 8.8% for the stock. If WMB stock falls all the way to $45 per share, you will lose the $2 per share that you risked on the trade, which is a loss of $2,000 which will be mitigated by the $500 you will make up front, making your total maximum loss $1,500.
This trade targets a return of 33% over 88 days, which is an annualized return of 138% (for comparison purposes only).
Chart courtesy of stockcharts.com
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