Over the weekend, roughly 7% of the world’s oil production was completely wiped out with a surprise attack on a refinery in Saudi Arabia. Tuesday, half of it was already back online, with the rest due to be restored within two months.
As you can imagine, that’s played havoc on oil prices:
Crude price jumped by nearly $10 on Monday, its highest one-day jump in years. Then, those prices have come back down to earth since.
After nearly everyone in the energy industry suspected that this attack would be many months or years in the cleanup, Saudi energy minister Prince Abdulaziz bin Salman told reporters on Tuesday that his country has already restored about 50% of pre-strike production, with the rest coming online much sooner than expected.
In the meantime, President Trump announced he was opening the U.S. Strategic Oil Reserves to ease supply problems… thus actually creating more volatility in prices.
The long and short of it is that this out-of-the-blue volatility has had investors running in and out of every stock with the word oil in it. One subsector that was particularly disrupted was oil and gas equipment companies, specifically Halliburton Co (HAL) and Schlumberger Ltd (SLB).
These two industry leaders have seen their stock prices track the price of oil throughout this strange news cycle. But that doesn’t tell the whole story.
Unlike oil producers, equipment companies like these two rely on longer-term price forecasts. You see, an oil producer can increase or decrease production in a much quicker time than Halliburton or Schlumberger can fill an equipment contract.
Those producers – these equipment makers’ customers – don’t make long-term decisions such as how many new wells to dig and when to do it based on three-day news cycles like this most recent one. So, in a saner market, these two companies should not have seen the kind of price action they have. The truth is, their bottom lines won’t be affected in the slightest because of this… at least not yet.
This story, however, does point out one major problem they face. With more volatility in the market, increased threats of further war in the Middle East and the threat of dipping into the Strategic Reserves of the U.S., oil producers are far less likely to make any long-term projections on oil prices. They are far less likely to sign contracts for oilfield equipment with Halliburton or Schlumberger.
All of this points to short-term weakness for these two. With production set to come back online at or near 100% pre-strike levels, you can see that both stocks remain far too inflated. In fact, if we step back a hair further, we can see that their performance over the last month far outpaced oil’s:
Both have jumped by around 10% over the last 30 days. Yet oil has actually only gone up around 3.5%. This presents us with an opportunity to take advantage of overhyped investors. Specifically, with Halliburton’s far more active daily trading range, we can play a near-term price decline to our favor.
Let’s get right into it…
A Strategy For Short Term Bears
While Halliburton is certainly overpriced, at least in the short term, it is unlikely to collapse completely. It does share the market leading position of an industry crucial to global energy needs. So, instead of shorting shares or outright betting on a put option, we turn to another strategy… one we favor for these more conservative short-term price movements.
A bear put spread is a type of options trade that involves buying a put option with a near-the-money strike price and selling as second put with a lower strike price.
The premium received from the sold put helps offset the cost of purchasing the other one. This reduces the total entry cost of the trade, and therefore the total amount at risk.
In exchange for that risk reduction, it does cap the potential profits. But as noted, a complete collapse is unlikely over the next two months. Instead, this risk/reward balance turns into a positive for traders.
You can see how this kind of trade pays out at different price levels:
Source: The Options Industry Council
To see just how much the risk/reward balance favors the trader, we need to look at a specific example of a bear put spread.
A Specific Trade on HAL
Right now, a trader could buy a November 15 $20 put for $0.86 per share and sell a November 15 $17.50 put on HAL for $0.27 per share for a cost of $0.59 per share. Since each contract is worth 100 shares of HAL, that’s an entry price of $59.
That’s the total amount at risk from now until November 15th. In this time period, not only will the anxiety of this specific refinery attack subside in energy markets, but both Halliburton and Schlumberger will also report quarterly earnings. And there’s nothing better to reshape an investment picture than sitting analysts and managements down together on an earnings call.
If shares slide, as they should following this recent runup, this trade’s profits will climb. To find out how high those profits could go, take the difference in strike prices ($20 – $17.50 = $2.50), and subtract the trade’s cost ($2.50 – $0.59 = $1.91). Again, on 100 shares per contract, that’s a maximum profit potential of $191.
Now, shares would have to fall significantly to below $17.50 for the trader to capture that whole amount. But considering that’s where they were less than a full month ago, before all of this volatility, that’s not out of the question.
With the recent news-dominating volatility combined with upcoming earnings to settle things down, look for both companies to suffer a pullback. Since Halliburton seems to trade in larger swings, this bear put spread offers an ideal risk/reward scenario. Smart traders should lock this in while they can.