How to “Rig” the Game for Energy Profits
A friend came into some money recently. Not a lot, but enough for him to think about the different ways he might use it. After making some improvements to his home, he figures he’ll have a few thousand dollars left over.
Since he never expected to have this money in the first place, he wants to gamble with it. So, he asked me what stock he could buy that might double or triple in value over the next year or two.
If only it were that easy. I explained that any investment with that much upside potential also carried considerable risk. After reading him the riot act, I made the following observation.
The energy sector has taken a beating this year. The price of oil plunged in April as the coronavirus pandemic greatly reduced demand for gasoline. That month, vehicle traffic fell by 40% versus the same period last year.
Since then, the price of oil has stabilized near $42 per barrel. That is more than double its $17 average closing price during the month of April, but still not high enough for most drillers to make a profit.
As my colleague Robert Rapier recently pointed out, the number of active drilling rigs in the United States has declined by 77% over the past 12 months. He went on to note that the stock (inventory) of crude oil and petroleum products rose 7.1% during that span despite the declining rig count.
As a result, most energy stocks have taken a big hit. The damage is not limited to only smaller operators with limited capital budgets. Exxon Mobil (NYSE: XOM) is down 38% so far this year while Chevron (NYSE: CVX) has lost 26%.
Adding insult to injury, the Dow Jones Industrial Average this week announced that it was removing Exxon Mobil from its 30-stock index.
The change at the benchmark Dow reflects a watershed for the global economy and financial markets, as “Big Oil” faces uncertain prospects.
An Ocean of Debt
I did not recommend to my friend that he buy Exxon Mobil or Chevron. They are each too big to fail, so they have not fallen nearly as far as some of their smaller rivals. There is no chance of their share prices doubling anytime soon.
The company I did suggest he consider is Transocean (NYSE: RIG). Transocean is an offshore oil driller headquartered in Switzerland, of all places.
The offshore drillers have been particularly hard hit by the oil crisis this year. Their production costs are among the highest in the industry so their breakeven price is higher, too.
RIG opened this year a few pennies below $7. At the end of last week, it was trading for $1.14. That’s a decline of 84% in less than nine months.
There is a very good reason RIG has performed so poorly. Like most oil drillers, Transocean carries a lot of debt, to the tune of about $9 billion at the end of the previous quarter. That is six times the amount of cash it held and about eight times its market cap of $1.2 billion.
No matter how you slice it, Transocean is a company in trouble. Already, rumors are circulating that Transocean may have to declare bankruptcy to reorganize its capital structure.
If that happens, Transocean’s common shareholders are out of luck. The stock would become worthless with little chance of recovery.
However, if Transocean can somehow avoid bankruptcy then RIG could easily double or triple in value over the next couple of years. As I told my friend, it’s a big gamble. Guess right, and you’ll make a lot of money. Guess wrong, and you might lose it all.
Look before you LEAP
That being the case, I further suggested that he consider buying a long term call option, or “LEAP,” on Transocean. A few days ago while RIG was trading around $1.30, the $1.00 call option expiring in January 2022 could be bought for 80 cents.
For that trade to become profitable, RIG must rise above $1.80 within the next 16 months. That is roughly 28% higher than its current share price.
If RIG does double in value and rises to $2.60, this option will have $1.60 of intrinsic value. That would also result in a doubling of your money. For the option trade to be more profitable than simply buying the stock, RIG must rise above $2.60 within the next 16 months.
Let’s say RIG makes it all the way back to $3.50 by the time this option expires, only half its share price prior to the coronavirus pandemic. In that case, the return on this options trade works out to more than 200%.
To be clear, this is a very risky trade that could result in a total loss. But there is reason to believe that it might work out. On August 24, Transocean announced an offer to exchange some of its existing debt that expires within the next year for new debt expiring in 2027.
I don’t see why Transocean would go to the trouble and expense of making this offer if it were planning to declare bankruptcy. In that case, it would make more sense for the company to default on the debt.
Of course, this may turn out to be a case of too little, too late. But the fact the company is making a bona fide attempt to remain solvent makes this trade worth considering.
Editor’s Note: Jim Pearce just provided you with valuable investing advice. But we’ve only scratch the surface of our team’s expertise. Looking for immediate opportunities to reap market-beating gains? Turn to our colleague Jim Fink.
Jim Fink is chief investment strategist of Options for Income and Velocity Trader. He also serves as a senior analyst at our flagship publication, Personal Finance. Jim routinely generates huge returns for his followers, by deploying simple yet powerful options strategies.
The way Jim trades options greatly reduces their risk. After years of painstaking trial-and-error, Jim has perfected an options trading system that’s simple, safe and predictable. How predictable? Out of the 346 total trade recommendations he has made over the past 50 months, 293 were profitable. That’s a “win rate” of 84.68%.
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