Write strategy for oil majors

by Levi Folk | December 6, 2007

The recent experience of super-high oil prices has not translated to an earnings bonanza for the oil majors as some might have expected. The effects of higher oil prices have been nullified by production shortfalls by many of the majors who are being constrained by increasingly unfriendly terms in many of the countries that they produce, Venezuela and Russia to name two, as well as historical profit sharing agreements that reduce their reserve take when oil prices rise. The result has been a weak quarter for earnings for many of these companies.

That said, the integrated oil companies are sitting on piles of cash and below market valuations that should limit the volatility of their share prices going forward. The “Big Five” integrated oil companies (Exxon, BP, Chevron, Royal Dutch Shell, Conoco Phillips) have actually cut spending in inflation –adjusted terms between 1998 and 2006 according to a study by the James A. Baker III Institute for Public Policy as reported in the Financial Times, and are devoting more of their cash flow to dividends and share repurchases.

High cash balances and slowing production growth may translate to lower valuations over the long term but also to lower share price volatility too. Since options are priced off share price volatility, a covered write strategy will prove rewarding if volatility for these companies’ share prices indeed falls.

A covered write strategy requires writing (selling) an out-of-the-money call option on underlying shares that the investor owns. The strategy caps the potential upside above a certain price in exchange for the price of the call. The strategy would seem well-suited to the large-cap integrated energy companies where they stand to benefit over the long term if oil price remain high but are facing challenges associated with increasing production.

Exxon Mobil is a good candidate for a covered write strategy. The company was sitting on over $30bn billion in cash at the end of 2006 and has seen production slow in the most recent quarter. The stock, trading at $88.12 at the time of writing, is not particularly expensive on a price-to-earnings basis of less than 13 times this year’s earnings.

A January 2009 call on Exxon (XOM) with a strike of 100 gives the option buyer the right to buy 100 shares of Exxon at $100 before the option expires in roughly 13 months. The call writer nets a premium in exchange for selling his or her upside. This premium could be considered an income-generating strategy.

The aforementioned call on XOM would earn a premium with roughly an 8 percent yield based on the current share price. In exchange for earning this premium, the investor gives up the stock if it trades above $100 prior to the expiration date of January 2008. Since the upside is capped, it is possible to calculate the maximum possible return by pursuing this strategy.

The total return equals the option premium plus the dividend and any gain or loss in the share price. In the case of Exxon, the total yield is close to 10 percent over 13 months. The maximum possible capital gain is roughly 14 percent. So if the share price rises beyond $100 per share in that time, the maximum possible return is 24 percent in 13 months.

If the share price falls, investors are subject to a capital loss on the investment, so downside risk persists with this strategy but it is partly offset by the option premium. The low valuations for the large-capitalization integrated energy companies make this strategy palatable because it suggests that these companies are not very risky from this standpoint.

The reality is that large-cap oil companies are turning into mature cash machines with fewer growth opportunities. Exxon, for example, produced cash flow from operations in excess of $US40 billion in the first nine months of the year, and net income was a massive $28.9 billion. The company also distributed a total of $26.7 billion to shareholders in 2007 through dividends and share purchases, to reduce shares outstanding.

The risk to the strategy would appear to be to the downside (falling oil prices) than to the upside (having the shares called away). With oil prices at $US90 per barrel, it may not seem like the best time to buy oil; however, the rate of change of oil prices quoted in US dollars is deceiving. Oil prices are up roughly 40 percent in US dollars since August 2005 but only 15 percent when translated to Canadian dollars. Rising oil prices are partly a currency phenomenon and the effects wash out when translated back to Canada .

Oil prices may retreat in dollar terms, but Canadian investors would likely be shielded from this adverse event by a falling Canadian dollar.

The reality is that even though the long-term environment for energy prices appears positive, the large-capitalization energy companies are experiencing slower growth which should see their share prices become less volatile. They are also producing billions of dollars in free cash which can be monetized through a covered write option strategy.