Big Oilers - Big Profits

Jarrod is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

I am bullish on the oil sector. I am bullish because of what I see as fundamental and structural reasons. The prime reasons that make me bullish on the Oil sector are:

  1. The easy oil is gone – With most of the easy to reach, known reserves of oil already being drilled what remains will be more costly to extract. Initially this may appear to be a bearish feature, however, it is my view that this will lead to greater consolidation, allowing the large players to further consolidate their positions.
  2. Renewed global (Asian) growth – With the slump in global growth appearing to be moving behind us and the renewed vigor of Asia, demand for oil looks set to continue and grow.
  3. You still can’t fly a plane on solar – Green energy is certainly growing yet many industries are still dependent on oil. Heavy industry will still depend on and consume oil and its derivative products for quite some time.

Ok so my view is bullish on the Oil sector but how do apply this view so I stand the best chance of making money?

I think there are 3 main Oilers that offer a good mix of growth potential and as Buffet puts it a ‘wide competitive moat.’

ExxonMobil (NYSE: XOM) – ExxonMobil has recently regained the title of the ‘World’s Biggest Company’ I think it is safe to assume you don’t achieve this title without being an exceptional money manager and allocator of capital.

Being the world’s largest company gives ExxonMobil considerable power to make acquisitions, muscle out smaller competitors, and negotiate better procurement / supply rates than anyone else. Ultimately this aids in better margins and increased returns on capital. With a return on equity of 26% and a forward PE of 11, I think it is hard to argue ExxonMobil is overpriced. Add to this ExxonMobil is paying a 2.6% dividend that is funded by just 22% of its earnings. ExxonMobil could well be considered a powerful cash generator.

Chevron (NYSE: CVX) – If you are not the world’s largest company then being valued at a quarter of a trillion dollars is still an excellent position to be in. Chevron is positioned ideally to make sizeable acquisitions with its $21 billion of cash sitting idle on its balance sheet.  With a very healthy 3.1% dividend funded from just 26% of its earnings, Chevron is structured ideally to provide a consistent and growing dividend stream.

Another strong pillar underpinning Chevron's operational business is it is carrying virtually no debt. With just $12 billion of debt on its books, it could if need be eliminate all of the debt tomorrow and still have nearly $10 billion of spare cash available.

The third big oil company that appeals to me is BP (NYSE: BP). Notwithstanding recent environmental and governmental issues, BP still presents a potentially lucrative investment opportunity.

Currently BP is priced at quite a low PE of 7.2 reflecting uncertainty over the Gulf of Mexico disaster. While many may see BP as a stock that should be relegated to the rubbish pile it might well be this very fact that makes it a proverbial diamond in the rough.

Since the spill, BP has essentially traded in a channel seemingly range bound between $37 and $47 for over 2 years now. It may well be that ‘time heals all wounds’ and the market may be getting closer to putting the disaster behind it and moving on with the future earnings potential.

With 3 big players in an industry that is offering bullish prospects how best to apply a view? Does an investor look at buying each stock, or perhaps one? How can an investor position themselves to receive upside potential whilst minimizing risk?

One way might be via long dated call options.

Currently (2/20/13) the companies are trading at: BP - $41.46 ExxonMobil - $89.32 Chevron - $115.92. Despite the bullish potential of these stocks, option writers seem to be willing to sell long dated call options at relatively low premiums.

To buy what are virtually at the money call options will cost the following

<table> <tbody> <tr> <td> <p><strong>Stock</strong></p> </td> <td> <p><strong>Current Price</strong></p> </td> <td> <p><strong>Strike</strong></p> </td> <td> <p><strong>Call Premium</strong></p> </td> <td> <p><strong>Premium as % of Stock Price</strong></p> </td> </tr> <tr> <td> <p>BP</p> </td> <td> <p>$41.46</p> </td> <td> <p>$42</p> </td> <td> <p>$3.50</p> </td> <td> <p>8.3%</p> </td> </tr> <tr> <td> <p>XOM</p> </td> <td> <p>$89.32</p> </td> <td> <p>$90</p> </td> <td> <p>$6.45</p> </td> <td> <p>7.15%</p> </td> </tr> <tr> <td> <p>CVX</p> </td> <td> <p>$115.92</p> </td> <td> <p>$115</p> </td> <td> <p>$9.90</p> </td> <td> <p>8.6%</p> </td> </tr> </tbody> </table>

As a risk vs. reward proposition it appears that paying just 7-8% in premium to have exposure to virtually 1-1 upward price appreciation to a stock for 23 months is a great deal.

It is not unreasonable nor without precedent to see stock price growth of 3-4% per annum – which is all an investor would need to recoup the cost of the options. Every one percent after that equates to 12-14% return on at risk capital. Capital that will be working for the investor for the next 23 months.

And the downside? Well, the premium paid for the call options. That’s it, no risk of margin calls or your retirement funds being exposed to overly leveraged downturns or draw downs. Just the premium paid up front.

With such low premiums and a time frame of 2 years it might well pay to not focus on ‘which stock is best,’ but rather have a small amount of capital in each so that if one were to run you can ensure you get a piece of the pie!

JarrodBailey1 has no position in any stocks mentioned. The Motley Fool recommends Chevron. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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