The ONLY Way to Play a Long-Term Rebound in Oil Prices

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Unless you’ve been living under a rock, you’re probably aware: Energy stocks have gotten absolutely demolished in 2015. A global supply glut sent oil prices tumbling from an already-depressed $57 per barrel to start the year to the mid-$40s today.

oil

Source: ©iStock.com/Zelfit

With investors overwhelmingly negative on crude, opportunity awaits for those willing to take a contrarian view and bet on higher oil prices.

But before you go long oil, it’s important to understand some of the pressures facing it:

It’s a Tough Market …

There’s a reason oil prices and energy stocks are slumping: In the U.S., horizontal drilling and fracking has increased domestic supply dramatically, and we now produce so much oil that the government is lifting long-held bans, actually allowing American companies to export the black gold.

That would seem to be an overwhelmingly positive development for the U.S. economy, but America’s emergence as an independent energy powerhouse has been met with ire by the Organization of Petroleum Exporting Countries.

Why does that matter? Well, because OPEC produces about 40% of the world’s oil. It has the ability to move prices, virtually at will. And that’s precisely what OPEC has done, refusing to slash production in an effort to retain market share in the U.S. and drive the American shale industry into the ground (no pun intended).

As a result, the Vanguard Energy ETF (VDE), which is designed to track the performance of U.S.-based energy stocks, is down 23% in 2015 and 34% in the last year. Being bullish on oil has been a painful play recently, largely because of OPEC’s hard stance on production.

… But It Can’t Go On in Perpetuity

These dynamics have to change eventually — and while there’s no telling when the rebound will begin, OPEC can’t keep this up forever. After all, OPEC members generally have an interest in keeping oil prices as high as possible for the sake of their own economies.

Member country Venezuela, for example, desperately needs oil prices to rebound, and it’s lobbying fellow cartel members to hold an emergency meeting to discuss the subject. In the meantime, President Nicolás Maduro has been meeting with Russia’s Vladimir Putin to try to figure out a solution to the problem. Nigeria, too, is in dire straits, and even de facto OPEC leader Saudi Arabia is projected to exhaust its entire $655 billion in currency reserves by August 2018 if oil prices remain around $40 a barrel for years on end.

Bottom line? Oil prices will rebound. Maybe not next week or by the end of the year, but in the longer term … they almost have to.

And for investors with the foresight, patience and risk tolerance, there’s one strategy involving energy stocks that could be extremely lucrative if oil prices rebound by 2018:

Buy 2018 LEAPS

There are countless ways to wager on a rise in oil prices. More conservative investors might simply want to buy something like the United States Oil Fund ETF (USO), which tracks oil spot prices. It’s tough to go wrong with the major energy stocks like Chevron (CVX) and Exxon Mobil (XOM) too, which currently boast dividend yields of 5.5% and 4%, respectively.

But if you believe crude prices will rebound with a vengeance, you want to look into long-term equity anticipation options, or LEAPS.

LEAPS function just like normal options contracts, except they give the investor more time to see their thesis play out before they expire. Technically, LEAPS are just any options that expire a year or more in the future.

Each LEAPS contract you purchase gives you the right — but not the obligation — to buy or sell 100 shares of the underlying security at an agreed-upon price, on or before an agreed-upon date in the future. It’s attractive because you don’t have to lay down as much cash as you would if you wanted to buy 100 shares of the underlying stock outright.

For instance, if you thought oil prices were going to shoot higher in the next year, you could buy LEAPS that expire in January 2017 on Seadrill (SDRL), a large offshore driller. Seadrill can charge higher rates for its rigs when oil prices increase.

Here’s a snapshot of the Seadrill options chain from Aug. 2, 2015, when SDRL was trading at $7.42 per share:

SDRL-2017-options-chain

In this example, if you were very bullish on SDRL, you could have purchased Jan 2017 $10 call options on SDRL stock for about $1.75 per share. Since an options contract controls 100 shares, one contract would’ve set you back $175.

Fast-forward to January 2017. Let’s say oil has rebounded, business is booming and SDRL is trading for $17 a share. (That’s a huge gain of roughly 130% from that $7.42 trading price, but not unfathomable given Seadrill’s 52-week high of $37).

Your option to buy SDRL stock for $10 would make your contract worth $7 per share, or $700, at expiration. That’s a 300% return and a profit of $525.

If you’d instead bought $175 worth of SDRL stock, you’d be “stuck” with the 130% return … good for a profit of $225. Still substantial, but also substantially less than the LEAPS contract.

Of course, options also involve a higher degree of risk than just buying stocks, because if SDRL stock closed at $10 or less on the expiration date, they would be entirely worthless.

Other LEAPS to Look For

I believe the best way to play a long-term oil price recovery will be to buy out-of-the-money 2018 LEAPS calls on beaten-down energy stocks like Seadrill, National-Oilwell Varco (NOV), and Noble Energy (NBL).

The great thing for investors? Most of those 2018 LEAPS don’t even exist yet. But they will soon, and when they debut, there’s a chance they could be dramatically underpriced given the negative sentiment and the fact that nobody’s really trading them yet. We’ll have to wait and see. Luckily, we won’t have to wait too long.

Knowing when to look for 2018 LEAPS will give you the first crack at owning these powerful investing tools. 2018 LEAPS become available at different times for different stocks — it all depends on what LEAP cycle the stock is on.

In the case of Seadrill, LEAPS became available on Monday, Sept. 14 (it’s on Cycle 1).

2018 LEAPS for National Oilwell Varco will hit the markets on Monday, Oct. 12 (Cycle 2), along with those of Noble Energy. The last round of 2018 LEAPS will become available on Monday, Nov. 16.

Before you play around with options, do some research and educate yourself on the basics. Investopedia has a knack for clearly explaining investment concepts, and KhanAcademy also has a wealth of educational resources and videos working out hypothetical situations and the math behind them.

As of this writing, John Divine did not hold a position in any of the aforementioned securities. You can follow him on Twitter at @divinebizkid or email him at editor@investorplace.com.

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Article printed from InvestorPlace Media, https://investorplace.com/2015/09/oil-prices-2018-leaps-options-energy-stocks/.

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