Name That Trade – This $RIG Could Roar if Oil Doesn’t Spill

by Enis January 3, 2014 11:56 am • Commentary

Transocean (RIG) stock was slammed by BP’s Gulf of Mexico oil spill in 2010, and the stock has never really recovered.  I delved into the financial and business details in my Deep Dive post a month ago, with the following takeaway:

Even as earnings have totally disappointed over the last 5 years, investors have been willing to pay for the underlying asset value of Transocean as a company.  That has really been the floor in terms of valuation from an investor perspective.  The fact that the P/B ratio is still near 1 implies quite limited downside for the stock.  If the company can improve its earnings power, then expect strong stock appreciation.  But even if operations don’t immediately improve, an investor in RIG is likely risking only 20-30% (based on book value) for a potential 50-100% return over the next couple years.

RIG is an interesting value investment here based on fundamental metrics and Icahn’s involvement.  The key risk to me is a potential decline in oil prices to levels where offshore projects become unprofitable.  Barring that, the risk/reward for a stock like RIG is skewed to the upside, after the woes it has experienced since that 2010 disaster.  We’ll keep our eye on this one on the long side – piggybacking off of Carl Icahn has been a rather profitable affair for good reason.

RIG and crude oil are both slightly lower since I wrote that post.  Oil’s decline yesterday was especially notable, however, for two reasons.  First, it was the largest 1 day decline for WTI oil since 2012 (front month WTI oil did not decline 3% or more in 2013).  Second, it occurred on the first trading day of 2014.  On top of the short-term technical warning signs in oil, I am relatively negative on the long-term prospects for oil prices, which I highlighted in my Macro Wrap post in August:

But the real long-term crux for the oil majors is the rapidly changing global energy backdrop.  The Economist argues that we might be close to peak demand, citing improvements in automotive efficiency, increased reliance on natural gas as opposed to oil, and more stringent regulatory regimes.

I agree that oil’s importance in the energy supply chain will be reduced in the coming years.  Yet, the Economist omitted perhaps the one area with the largest long-term potential – renewable energy.  While I concede that the promise of renewable energy has not met expectations for decades, cost comparisons with fossil fuels are rapidly approaching parity.  Oil demand could contract if replacement technologies continue to improve, while oil supply continues to increase as extraction gets more nifty as well.

Of course, that’s a very long-term story, but add that backdrop to the short-term technicals, and oil is far from attractive in my mind.

So I like RIG, but I’m negative on oil – is there a trade here?  

Well, if WTI oil at least stabilizes above $90, then I still view RIG as a nice asymmetric risk/reward opportunity.  Moreover, if oil actually rises, I anticipate that RIG would handily outperform most other oil-related stocks given its depressed valuation.  The risk in owning RIG is in the oil-down-10%-or-more scenario.

Given that situation, here’s a potential pairs trade using options that looks interesting:

NOTE 1:  Since oil is already down almost 6% this week, we don’t like the entry on this pairs trade right here, so we are NOT executing it ourselves today, but wanted to lay out the idea

NOTE 2:  This trade would be down with the USO piece 1.5 times the size of the RIG piece to match notional exposures.  IT IS NOT 1 for 1.

TRADE: RIG ($49.00) Buy the Feb 50 Call for $1.20

-Buy 1 Feb 50 Call for $1.20

Break-Even on Feb Expiration:

Profits:  Profits above $51.20 unlimited

Losses:  Loss of up to $1.20 between $50 and $51.20, with max loss of $1.20 at $50 or below

TRADE: USO (33.94) Sell the Feb 34 Call at $0.85

-Sell 1.5 Feb 34 Calls at $0.85

Break-Even on Feb Expiration:

Profits:  Profits of up to $0.85 between 34 and 34.85, max profit of 0.85 at 34 or below

Losses:  Unlimited above $34.85

Trade Rationale:  Since the USO leg would be done at 1.5x the size of the RIG leg, the structure would be about even money.  The presumption with this structure is that RIG will rally more than USO over the next 7 weeks on the upside, with no premium lost if both calls end up worthless.

One last point – if you do not have sufficient margin (or do not want to risk) for this trade with the short naked USO call, then you could do this spread trade with call spreads instead.