The decline in the price of oil has attracted a lot of attention from investors and traders alike.
The intrigue of making of a fat return if oil moves higher is obvious. Leverage has a two-way effect: As oil started falling below $80 a barrel, energy-related companies saw share prices decline by 50% or more in some cases. Today, with oil sitting above $50 a barrel, the move back up to $70 would likely cause a similar effect to the upside.
News that investors are buying up vast amounts of oil and storing it on oil tankers should come as no surprise. Oil tanker company Frontline (FRO) has seen its share price nearly triple over the past several months on the expectation that demand for oil tankers will continue to surge. Value-seeking investors are also expected to shift their focus to energy stocks.
For the average investor who can't buy boatloads of oil and store it on a tanker, opportunities exist to make an outsized return on the potential increase in the price of oil. The easiest way, but one with a fair degree of risk, is to buy one-year call options on companies with battered share prices likely to see a significant pop if and when oil makes a move. Just consider that someone who bought the February 2015 $2 call options on Frontline back in November likely paid $0.05 to $0.10. That option is worth $1 today, a return of 10 to 20 times.
Of course, with that potential upside comes the higher likelihood of a significant loss of capital. So I would make such commitments very small, say 0.5% to 1% of your portfolio, and make several of them. One winner will make up for the losers.
One interesting idea is the June 2015 $2 call options on Exco Resources (XCO). Exco currently trades for $2.50 and this option will cost you $0.65 to $0.75. The option is 50 cents in the money, but Exco has been very volatile lately -- shares could drop right back below $2 in a single day. On the other hand, the company has some savvy investors as shareholders and if oil rises above $60 by June, the stock could be trading closer to $4, creating a return of 200% in less than four months.
Goodrich Petroleum (GDP) would be another outsized gain if oil prices rebound. But because GDP is so debt-laden, the potential downside is meaningful. But the decline in oil prices has sent shares from $30 to less than $4 in a matter of months. The June 2015 $5 calls are selling for about $0.25 today. You can do the math. But a $10 share price -- not likely but very possible if oil makes a move -- will make these options worth $5, a 20-fold return. The downside is a 100% loss of investment if shares don't breach $5.
If you can build a basket of five to 10 of these bets, perhaps making up no more than 2% to 5% of your portfolio, one or two successful outcomes will more than likely create a very tidy overall return. The singular determinant, however, is going to be the price of oil, so it's wise to come to your own informed conclusions on what it's likely to do. Of course, one could also lengthen the option life to the end of the year, thereby paying a bigger premium and diminishing the return somewhat, but the extra window of time may be well worth it.