For those who don’t know my friend Mike Khouw, he and I have sat next to each other on CNBC’s Options Action program for more than five years. Mike is a very experienced and thoughtful options trader and the Chief Strategist at Dash Financial, a Chicago-based broker dealer and financial technology company providing trading services in US Equities, Options and Futures to more than 200 institutional buy and sell side firms in the US.
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Today will be the first of what I hope will be of many guest posts by Mike on RiskReversal as he gives more details on the trades that he highlights on Options Action or other trades that he is involved with personally or through Dash, a firm that interacts with approximately 5% of the US listed Index, ETF, and single-stock options volume. – Dan
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From Mike:
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Tonight on CNBC’s Options Action, Carter Worth of Stern Agee, framed a bullish scenario expecting a “reversion to the mean” in energy stocks, and he’s looking at XLE – the Energy Select Sector SPDR ETF.
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Here is the 3 month XLE chart vs. SPY showing the relative under performance, from Bloomberg:
Here is my sort of deep dive fundamental take on oil and related stocks, and how I would chose to play in line with Carter’s view that the sector plays catch up:
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The nice thing about looking at a single stock as a long (or short) opportunity is that one can usually identify specific catalysts, review financial statements, historical performance, as well as future prospects to determine an appropriate valuation. That analysis can then be viewed in the context of broader secular trends affecting the industry or more broadly the economy and the markets. One can then examine the investment against other opportunities. With an ETF, even a sector ETF such as XLE, we can’t use the same approach. There are many individual stories going on, still to get a sense of what the drivers are we’ll drill down in the sub-industries that comprise XLE: Major integrateds, E&P, oil service, drillers, midstream and downstream.
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For example the major integrated oil companies, such as XOM and CVX which comprise fully 30% of XLE, are largely priced on the value of their reserves. As such we can think of them as a play on global crude prices and extraction costs. Currently these companies look attractive at first blush, with below market multiples and handsome dividends. Oil demand in the US and OECD has been dropping however, and even including China anticipated demand growth is muted. Add that it has been increasingly challenging to add new reserves, and the incremental costs to add reserves have been rising. Avg P/E 12.7 Avg EV/EBITDA 7
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E&P companies as a group also comprise about 30% of the ETF, and while they’re similar to the integrateds in many ways, they’ve been underperforming due to larger exposure to delays developing increasingly challenging and unconventional new oil and gas fields. They also do not have the same safe, utility, growing dividends that makes the majors appealing to investors. Avg P/E 23.3 Avg EV/EBITDA 8.8
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The oil service companies, which comprise just under 20% of the ETF, depend on capex from upstream E&P, and presumably benefit from the scramble to maintain (let alone increase) reserves. As a group lower oil demand and prices could pressure capex generally, but at an individual level the stories vary greatly. US oil production is near the highs seen in 1970, and the unconventional plays in North America tend to mature/deplete more quickly. That should help maintain demand as new rigs need to offset maturing wells. It’s worth noting as well that if geopolitical hotspots settle down, that too could pressure crude prices. Avg P/E 19.4 Avg EV/EBITDA 10.9
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Land drillers such as Nabors should benefit from the dynamic we just described, while offshore the best production has been achieved in deep-water. Despite this, there’s little enthusiasm for the most famous (or infamous) deep-water driller, Transocean (RIG). Despite decent earnings there are concerns not only about utilization and day rates in the years ahead, but also who will benefit from the new rigs slated for completion in the near-future. Six of these have already been committed to the separately traded RIGP. Nevertheless the potential upside, current valuation and Carl Icahn’s holdings might make a tempting bet even as the company’s own forward looking statements and the skeptical street indicate it is a risky one. Drillers comprise about 4% of XLE. Avg P/E 13.9 Avg EV/EBITDA 8.5.
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Here is a 3 year chart of RIG showing just how depressed the stock has been in an environment where Crude Oil has registered significant gains:
Representing just over 7% of XLE, midstream plays, such as the transportation and storage companies have achieved lofty valuations because, as MLPs, several are largely yield plays. How that may change with the announcement earlier this week that Kinder Morgan will roll-up its affiliated MLPs remains an open question. These companies also likely benefited from storage considerations and mid-continent bottlenecks for crude. These demands remain, and as NA overall production continues to grow nothing on the near-term horizon looks poised to hurt that enviable position, but the valuations (25x CF?) do seem a bit heady for heavily levered companies where investors seem to be investing as if they’re buying bonds, but with considerable equity risk. Avg P/E 49.3 Avg EV/EBITDA 22.5
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Finally, the downstream plays, the refining and marketing companies also represent about 7% of the energy ETF. For several years NA refiners, particularly those situated in the mid-continent where the regional glut of crude was greatest, benefited tremendously from being able to purchase a regionally depressed commodity (mid-continent crude) and sell a global commodity in the form of products such as gasoline and fuel oils. Their business rides the waves of the crack spread, but specifically their crack spread. That is which crude do they buy, and for NA refiners the huge increases in domestic production have seen WTI trade at a discount to Brent, often a considerable discount. With NA production remaining high the question for the refiners is whether global demand is sufficient to maintain prices for products and Brent. Nothing seems likely to hurt their performance in the immediate future, but remember that although they’re priced at only historical multiples, the denominator could be quite volatile. These co’s are not as cheap as they might appear. Avg P/E 13.5 Avg EV/EBITDA 9.5
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Looking at all of this might seem confusing, but fortunately this is where trading an ETF can be helpful. As a group they have lagged and could be poised to catch up with the broader market. Moreover because each sub-industry has its own drivers, there is a bit of diversification in this basket of energy plays and that diversification mutes already low volatility for the basket, and as volatility declines, so to do options prices.
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This creates the opportunity for an interestingly inexpensive levered directional bet, with defined risk. When I looked at this today, with XLE trading ~ $96, one could make a bullish bet buy purchasing the Dec 31, 2014 95 call options for about $4.00, or just over 4% of the price of the underlying. Given that one gets to play the catch-up trade, as well as trade alongside Icahn on the most hated (oversold) deep water driller, and make a play on a persistently broad crack spread for NA refiners, while continuing to bet on servicing growing NA production. On a weighted basis the street sees nearly 15% worth of upside for all the constituents, we’ll make that trade, but we’ll only risk 4%.
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Here is a 4 year chart of implied volatility of XLE showing relative cheapness, nearing the lows:
