Picking The Survivor In A Battered Oil Market

Oil markets have followed equity markets this week into free fall, dropping to $32 - a repeat of the lows of 2009. We're now at a place where the lunacy of unsustainably low oil prices need their time to play out, finding a bottom only the gods might venture to guess at.

Still, we've got several reasons to continue to slowly and carefully deploy cash into energy stocks that we know will represent superb value once this maniacal momentum play has finished - but we need to do it with as much safety as we can manage. The old saying goes that markets can stay irrational longer than one can stay solvent, and we've no need to test that adage in order to continue to position ourselves for the long-term oil renaissance that will inevitably come. This column will show you how I try to do that.

Chinese equity markets have been halted twice already this week, finally paying the piper for vastly overrated growth projections. With the world's second largest economy in crisis and Chinese currency on a fast devalue track, oil prices continued to slide rapidly towards $30, replaying their lows from the financial collapse of 2008.

Lots of things are different in oil markets today than in 2008, the most important of which is that credit is in nowhere near as much stress. In 2008, the fast removal of leverage from the oil markets dropped prices whereas this collapse is overwhelmingly being pressured by mostly algorithmic momentum selling.

If anything, the selling today ignores oil fundamentals even more grossly than in 2008 - the marginal barrel of oil costs at least $10 more today than it did 8 years ago. If you were looking for oil to reach $20, you could say that with the cost of oil 'inflation', you've already gotten it - compared to 2007 at least.

All of this preface I use to make the argument that oil stocks perhaps represent an even better value than they did in 2008 near that $32 low. A further rationale for finding a way to safely own oil stocks is in the multiples of the stock market itself. While many are frightened by relatively higher stock index multiples and foresee this last week as the start of a collapse of general stock market indexes in 2016, you could reasonably argue that oil stocks that de-levered in 2015 shed a good part of their multiple "froth" already - promising less risk from multiple contraction as opposed to just about every other sector.

So, how should you play this?

I believe that the China devaluation and equity mess changes the targets in oil, but not the timing - and fundamentals point to another two quarters of low prices before oil finally becomes constructive.

With that in mind, a targeted buy of select energy shares, even better if they offer safe dividends, along with a concurrent sale of fairly close-strike calls, represents the safest way to continue accumulating shares with relatively lower risk of being forced out by the wild market action. This is a strategy I use frequently, particularly when volatility starts to peak - taking advantage of the increased premium and vega in the options.

Let's take a quick look at one such trade idea:

EOG Resources is a big favorite of mine, one that I've been accumulating slowly. But with share prices below $70, some further protection is worthwhile if I want to continue to accumulate it. Today, you can buy EOG somewhere near $68 a share, while selling April $72.5 calls above $3. This gives you, and the markets, a three month window to 'stabilize', while allowing you to try to pick off strong value where you see it. Your downside protection extends below $65 on the stock, although you've limited your upside on these buys to $7 a share (the premium + the strike price).

Let's look at one more:

Conoco-Philips (COP) can be bought at $45, and the $46 May calls can be sold over $3 a share. This gives protection down below $42, with a limited upside potential of about $5.50 (premium + strike price + 2 quarters of dividends)

The big plus in selling protective calls is if nothing significant happens between now and the expiration date - you collect premiums and dividends and can replay the scenario or just sell.

The big negative is in a continued disaster in the shares of these stocks - which is why I prefaced this column with my macro outlook on oil and oil shares. You must believe that, even if oil were to go much lower from here, it would be a relatively short term move (I do) and that oil stocks have already seen much of their multiple contraction already (I do).

And you also need to believe this collapse isn't the beginning of a 2008 replay.

I believe that too, but at times like these, that may be the hardest thing to believe.