The oil market is in a tailspin. Energy-related stock prices have not seen this type of pain and extreme selloff in years. Some energy companies will perish. Some will survive and ultimately thrive when profits return to the energy patch.
Profits will return, you can count on that. Notice I didn't say $100 oil will return or even $75 oil. I can't forecast the future price of oil. But what is true is that at some point commodity producers have to make money if the commodity is going to be produced. Supply will shrink until the price enables a profit.
The prices of energy stocks remind of the price of financial stocks in 2008. Companies like Wells Fargo (WFC), American Express (AXP), Citigroup (C), Bank of America (BAC) and others were all trading for less than $10. Today almost all of them are up three to 10 times that. (Wells Fargo and Bank of America are part of TheStreet's Action Alerts PLUS portfolio.)
Indeed, the oil industry is different from the banking industry, but there is a commonality in all stocks -- when there is chaos in the market, prices can get very detached from fair value. In many cases, this price distortion is happening in the energy patch.
One way to seize on the future opportunity is make a basket bet of long-term call options on energy companies. While the downside risk is a 100% loss, the upside potential could be very significant -- in some cases 300% or higher, a lot higher. The idea is to make several small bets, knowing that just one or two winners will absorb any losses and then some.
One very important caveat: The volatility in energy shares has made option prices expensive. Therefore, buying calls today will cost more, making underlying equity selection critical. The best options are purchased with companies that possess enormous upside potential. Such companies also tend to viewed as distressed in the current market environment. Examples include names like Chesapeake Energy (CHK), EXCO Resources (XCO) and Sanchez Energy (SN).
EXCO is a good case in point. Shares are up 15% today on news that the company has restructured its debt. Shares are up nearly 200% since falling to 45 cents in late August. The company just brought in a new CEO who knows how to capitalize on distress. The January 2017 $1 call options will cost you 50 cents today with the stock trading at $1.27. The stock traded as high as $4 a year ago and over $10 during the past three years. If EXCO comes out of this current cycle -- and investors like Wilbur Ross have bet that it will -- a $3 share price has the aforementioned options worth $2, a 300% return.
The math is simple for other energy-related stocks. Create a very sensible options basket supported by companies with substantial upside price potential and the risk/reward scenario may actually be lower than you would think.