Name That Trade – $OIH: Oil Slick

by Enis November 4, 2014 1:57 pm • Commentary

With the fall in the energy sector since July, the oil services stocks have been some of the hardest hit.  OIH, the oil services ETF, is down 25% from its July high, trading near a 18 month low after the steep descent:

OIH weekly chart, courtesy of Bloomberg
OIH weekly chart, courtesy of Bloomberg

On Friday, there was aggressive buying of upside calls in OIH, which I highlighted in a  Notable Activity post:

7.  OIH – Buyer of 21,500 of the Dec5th 47.50 calls for 0.50.  Separately, the Dec2oth 48 calls traded over 25k on the session, at an average price of 0.61, mostly buyer initiated.  OIH last traded above $47.50 on October 7th.

Those long call positions look increasingly like long shots as OIH has continued its fall today.  Oil has made another multi-year low this morning, pressuring the entire sector.  The situation for the major oil services stocks today is in stark contrast to 6 months ago, when oil was around $100, and the energy sector was one of the market leaders for 2014.

I wrote about the relatively attractive valuations of the two largest oil services stocks, HAL and SLB, in an April Macro Wrap post:

With that in mind, I took a closer look at individual stocks in the energy sector for those that looked appealing both fundamentally and technically.  First off, the two major services behemoths, SLB and HAL, have been stellar performers so far in 2014, both up more than 10%.  Moreover, their earnings growth prospects are much higher than the stalwart conglomerates like XOM, CVX, and COP.  Analysts have modeled in 5-10% sales growth and 15-25% earnings growth for both SLB and HAL over the next 3 years, which would be especially impressive considering that SLB is already a $130 billion market cap company, and HAL is around $50 billion in value.

On valuation, HAL and SLB are both trading around a 20 P/E multiple, which is quite cheap vs. the broader market if those analyst estimates come to fruition in the next few years.  HAL reported earnings this morning, and beat both earnings and sales expectations.  Business trends look solid, with a diversified order book globally, and second half strength expected in the U.S.  SLB reported a decent number on Thursday morning, though management disappointed the market a bit on its guidance.  Nonetheless, both of these stocks are on our radar for further outperformance in the months ahead.

The outlook for SLB and HAL today looks drastically different.  Investors have rapidly reduced expectations for future sales and earnings growth, as evidenced by the sharp drop in both stocks’ P/E multiples in the past few months.  SLB now trades at a 16.5x P/E multiple, with EPS growth estimates for the next two years at 10-15%.  However, analysts have not really revised those numbers to reflect the steep drop in oil, and likely a related drop in oil services spending in 2015 as well.  HAL looks even cheaper, with a P/E of 12.5x vs. EPS growth estimates of 15-20%.  HAL has more leverage than SLB, though, so a business slowdown will hurt it even more.

Investors, however, are rapidly amending their expectations for sales and earnings for the sector going forward.  At the rate of the current selloff, investors are likely starting to price in flat to maybe slight earnings growth in 2015 and 2016, though the situation is quite fluid given how quickly oil prices have moved in just the past few months.  

Implied volatility is very elevated in OIH after the recent volatility as well as the options buying:

[caption id="attachment_47650" align="alignnone" width="600"]OIH 30 day implied volatility, courtesy of Bloomberg OIH 30 day implied volatility, courtesy of Bloomberg[/caption]


Given the high level of implied volatility, and the ETF near the $40 technical support level, but with ample upside resistance around $46, this situation offers decent risk/reward for a range trade into the end of the year.  The bigger risk is probably to the downside rather than the upside given OIH’s inability to rally above $46 even with the S&P 500 making a new all-time high this week, so this trade only makes sense for those who think oil stabilizes soon:

(I don’t have an interest in catching a falling knife, so I didn’t execute this trade ourselves.  I wanted to lay out what I thought was a better way to put on a slightly bullish trade in OIH compared to the outright call buying that we saw in the sector in the past week.)

Hypothetical Trade OIH ($42.50) Buy the Dec20th 40/45/50 call butterfly for $2.00

-Buy 1 Dec20th 40 call for $3.70

-Sell 2 Dec20th 45 calls at $.90 each or $1.80 total

-Buy 1 Dec20th 50 call for $0.10

Break-Even on Dec20th Expiration:

Profits: between 42 and 48 make up to 3, with max gain of 3 at 45

Losses: between 40 & 42 and between 48 and 50 lose up to 2, with max loss of 2 below 40 and above 50

Rationale:  I chose Dec20th expiration because that is lower risk than trying for a shorter expiration and seeing OIH hang around $40 in the next few weeks.  Dec20th gives the trade enough time for OIH to stabilize, and costs less than a shorter-dated expiry.  The trade does best if OIH remains between $42 and $48 between now and December.