Hedging is a concept too often misunderstood, or worse, badly executed. To many investors and traders, a hedge simply consists of a trade that directly opposes their main position. They may be long a portfolio of stocks, and then buy puts on an index, for example. To my mind this isn’t hedging, it’s just effectively cutting your position size. You could achieve the same thing by just selling some of your stocks. A good hedge is one that gives some degree of protection against an adverse move in your position, but still has a chance of appreciation if things go as you expect.
These thoughts came to mind as I considered the substance of what I wrote here last week. I didn’t want my first piece for Oilprice.com to be a negative, but it would have been dishonest to write anything without first giving my view that crude was more likely to trade down in the coming month or so. With that overall view in mind, I set about finding a few positives to write about, that could be used as an effective hedge should you trade that view and short crude, either through futures or options.
In last week’s piece I mentioned that I liked Cobalt International Energy (CIE) and that is the kind of thing I am talking about. The only problem with that, however, is that I first wrote about that stock on January 28th, and it has gone up by about 25% in the last couple of weeks. That’s great news for anybody who bought it then, but it doesn’t look like such great value now, although there may still be some upside left.
Whiting Petroleum (WLL), a US exploration and production company, also popped today, but may have significantly further to go. The jump was based on Q4 earnings released yesterday. The EPS itself was nothing spectacular, coming in roughly as expected at $0.88, but it was the continued production growth (+9% from Q3 and +17% Y on Y) that caught my eye.
As you can see from yesterday (Thursday)’s jump up above $68, it caught the eye of others too, but Stifel Nicolaus increased their target price to $80 after the release and that doesn’t look unreasonable, so there could still be plenty of appreciation to come. Some of that improved production is down to technological advances (the use of cemented liner completion rather than sliding sleeve) that could open up their nine wells in the Missouri Breaks and add even more revenue. Any retracement today following that big move would set up a nice opportunity to buy.
Another company with good news in an earnings release was Pacific Drilling S.A. (PACD).
Their results, released on Wednesday, showed a significant bottom line beat, with EPS coming in at $0.12 versus consensus estimates of $0.09. PACD is at the opposite end of the spectrum to WLL in many ways. While WLL is all about shale oil, PACD is in the ultra-deep water drilling game. They went public at the end of 2011 and have continued to disappoint investors as they have acquired more highly specialized drill ships, but lacked the contracts to fully utilize them.
The company reported signing a letter of intent for a two year extension for the Pacific Bora contract with Chevron, however and management were extremely upbeat about their prospects. Of course, there is an element of “they would say that, wouldn’t they…” but the optimism is presumably genuine as they also announced plans for a $0.70 annual dividend. Barclays, at least were convinced; they raised their target price for PACD to $13.
Deep water drilling stocks have been under pressure for some time as cheaper shale oil has come online, but remember the idea here is to allow for any increase in crude prices which would encourage production from deep water fields. Buying one shale specialist and one offshore specialist gives some diversification and would serve the purpose of a hedge against rising crude prices if you are positioned for them to fall. If they do go up again, both companies would benefit, but if they drop as I expect, there may still be enough value in these two stocks to provide some protection. Now that’s what I call a hedge.