After a devastating May for stocks of all kinds, June has so far reversed that trend. After five straight days of positive stock gains for the broader market, today, we’re seeing a tiny cool off.
While it’s impossible to predict the future, we can say for sure that one industry remains in the doghouse even though investors are seemingly changing their minds: oil services.
Oil and gas prices have taken severe hits over the last few months. During the most recent quarterly earnings season, companies from Exxon and Chevron to lesser-known exploration and production companies have all noted a weaker market for the second half of 2019. That has trickled down to services companies that depend on new spending.
Companies like Halliburton, Transocean and Schlumberger have been hit hard with headlines about decreased capex spending and fewer new production from the oil and gas giants. Shares of each of these dominate services companies have been in a freefall… and for a long time.
Here, we have the VanEck Oil Services ETF (OIH), which holds the major players in this field. As you can see, the past five years haven’t been kind to these companies.
As pricing pressure has forced the major oil and gas producers into belt-tightening mode, spending for new equipment has dropped significantly. And that’s this industry’s whole business.
At least, this is the story that’s running nonstop about Halliburton and Schlumberger. But there’s another side to it.
You see, these companies don’t only sell products for new wells and drill sites. They are also key to mature and already-producing operations… new drill bits, optimization solutions and field-centric reservoir improvements. These are not what the major oil producers are talking about when they tell investors they are cutting capex. These are ongoing costs that they will have to eat no matter what the price of oil does.
That’s our opportunity here.
Oil’s decline and production spending problems aren’t some unforeseen issue. This trend has been going on for years. And companies like Halliburton and Schlumberger aren’t the kinds of players to sit still and hope for the best.
They have been making moves themselves to counter these trends. Spending cuts to development and production of new-well products, refocused approach to mature fields products and ongoing operations and their own cost-savings plans to put a wedge in their margins despite lower industry spending.
Both Halliburton and Schlumberger have incredibly low valuations despite all of these moves. The market is valuing these giants as if they were going to go out of business any day. Despite this, each have solid balance sheets, ongoing contracts with the $280 billion production industry and essential products with low competition.
In short, oil services – as an industry – isn’t going anywhere. This group of stocks might not be the most visible right now… and it certainly isn’t the most popular. But with the recent freefall last month, it has short-term rebound potential.
If shares of these two giants alone come back in line with historical valuations, we’re looking at share price recovery in the range of 20-30% over just the next few weeks.
You don’t have to be a cheerleader or complete contrarian investor to see the near-term opportunity here.
There’s one final piece worth touching on before we get into a specific way to play this. The companies that lead this industry – Halliburton and Schlumberger – carry extraordinarily high dividend yields right now.
The recent decline in prices have made each of these company’s shareholder income streams more attractive. Neither has plans for any cuts to these programs. In fact, both have considered to boost them alongside share repurchase plans.
With the premise that interest rate cuts are already being priced into the stock market, companies with large shareholder value programs will be the most sought after. That’s not to say all investors will turn back to oilfield services companies. But enough should to jumpstart this industry… at least for the next few weeks.
So, how do we play it? It shouldn’t surprise you that simply buying shares of these companies isn’t likely the best way to take advantage. And trying to pick which one of these will do the best is a crapshoot.
Instead, we have a strategy and a specific target that offers a higher return potential and a lower risk profile than all of those other options. Let’s get right into it.
A Strategy For a Short Term Price Bounce
A bull call spread is a type of options trade that involves buying a call on a stock you believe will increase in value and selling a second call to help offset the cost of the trade.
This results in a lower amount at risk – limited to just the amount it takes to enter the trade. It does cap the potential profit. But if done right, that can be a tradeoff well worth taking.
You can see how this strategy looks here:
Source: The Options Industry Council
The best time to use this strategy is when you find a play that you believe is set to grow over the short term. If you have a specific target date for that movement in mind, that’s usually the best expiration to choose for the call options.
With oil services, this recover should be sharp. So, we can look at July expirations. And as for which specific equity to use, why not all of them?
A Specific Bull Call Spread Trade on OIH
As noted above, OIH is an ETF that holds all of the major oil and gas service companies. While HAL and SLB make up just over one-third of its portfolio, this ETF covers 21 other major players in nearly equal amounts.
Right now, a trader could buy a July 19 $14 call on OIH for $0.58 per share and sell a July 19 $15 call for $0.22 per share. That works out to a cost of just $0.36 per share or $36 total (each call represents 100 shares of OIH).
That’s the total cost… just $36. The potential profit is much larger. To find that, take the difference in strike prices ($15 – $14 = $1), and subtract the cost ($1 – $0.36 = $0.64). On 100 shares, that’s a maxed out return of $64.
In other words, if this industry does finally get a bit of relief from the incredibly negative news stories at least for the next month or so, this trader would be looking at a return of 178% on the amount at risk.
Remember, these companies offer high dividend yields, historically low valuations and steady cash flows. A bounce here is a great possibility. And for this return on risk profile, you can’t beat it.