Terrible Oil Deal Could Generate 160% Return

Google+ Pinterest LinkedIn Tumblr

The fossil fuel industry is going through absolute chaos right now. Oil, in particular, is facing unbelievably tough challenges.

It shouldn’t come as any surprise that the latest news from the trade talks between the U.S. and China have resulted in a bad week for the black stuff. After all, oil prices are the first to fall when the global economy crunches… even a small amount. New U.S. tariffs on more than $300 billion of Chinese goods certainly don’t help.

But that’s definitely not the only trouble investors in crude face. U.S. geopolitical posturing is become a real threat. The failed U.S.-backed coup in Venezuela is only going to result in a choppier relationship and aggressive stances that will come with further oil supply problems… possibly even increases as Maduro will need to pay for his seat of power.

Iran, one of the world’s largest producers, is clearly a target for the current White House. New military maneuvers, including a personnel and equipment buildup in the area signal some sort of ugly conflict on the horizon, including the movement of the USS Abraham Lincoln aircraft carrier to the Suez Canal — a strategic target for oil trade around the world.

Russia has been dealing with its own troubles in the crude market, with a contamination in its European pipeline system. After three weeks, the system is only now likely to come back online. But the lost volume will continue to be a concern.

In short, the global oil situation is tenuous. But when isn’t it?

What’s new, however, on the investment side is a boom in mergers and acquisitions. This culminated this week with the Chevron, Occidental and Anadarko standoff.

A Trade Opportunity On Occidental’s Awful Deal

To catch you up on it, since it has been a wild ride, Anadarko Petroleum Corp. (APC) has officially agreed to the latest of Occidental Petroleum Corp.’s (OXY) buyout offers. The two have been wrangling for a deal for more than six months. But Anadarko has been trying to solicit ever-higher offers from Chevron Corp. (CVX).

Without getting too much into the weeds on this one, the long story-short is this: Occidental really wanted to buy Anadarko out. Anadarko, preferred Chevron because of its stability. Chevron only agreed to weaker offers over the last several months, of which Anadarko continuously accepted. Each time, Occidental came in with a better one. This week, Chevron said the latest was a price too high. It was out.

So, Occidental wins, right?

Well, it does look like it will get its prize, with the help of $10 billion from Warren Buffett and a post-acquisition African operations sale to Total SA (TOT) in France. But investors can’t be too pleased with it. At least, they shouldn’t be.

Chevron actually looks like the winner here. As negotiations were ongoing, the price of oil whipsawed as low as $42 per barrel to as high as $66 per barrel. Right now, it certainly looks like another large downturn is on the horizon, especially considering the most recent trade talks.

Screen Shot 2019-05-10 at 3.54.24 PM.png

This means that by the time Occidental actually pays for the deal, it will have paid far too much. One reason is its Buffett-friendly terms to his money. Another is the terms of the overall deal.

Each renegotiation over terms, Anadarko asked for a higher and higher percentage of the deal to be in cash. Occidental obliged nearly every time. Now, this final agreement states that 78% of it will be in cash. This is a huge turnaround from the 25% cash component in the early drafts.

That cash will now be buying a fundamentally less valuable product – Anadarko’s oil assets. With oil prices likely in the toilet, this makes for a terrible deal.

Investors are sensing that, with a slight sell off today. Occidental is down 2.6% as we write. But that’s nothing compared to how much they should be reacting.

If oil does indeed remain weak, Occidental could be looking at a final picture it will regret. Weaker oil prices, costly reorganization and a shredded balance sheet. Even considering its fall from $68 to $55 per share over the last month, the end result could get worse.

The company just announced its first quarter earnings a week ago. So, this final deal will have a long time to sink in for investors before they see any reason to turn around their opinions on it.

Of course, one way to play this bad deal is to short shares of OXY. But with a favorite strategy of ours, there’s a better way.

A Strategy For Short Term Bears

A bear put spread is a type of options trade that involves going long one put option on a stock you believe will fall, and selling a second put option with a lower strike price.

This results in a net debit, but a far lower entry cost than you’d otherwise see. This is also the most risk in the trade – the amount it costs to enter it. The trader isn’t liable for any more money even if the stock rallies rather than falls.

Of course, the exchange for this decreased amount of risk is a cap to the maximum potential profit. You can see how this trade works here:


Source: The Options Industry Council

For a company like Occidental, this trade off makes sense. No one can know exactly what’ll happen in the oil industry. And a deal this wild could have some curveballs in it.

Still, the premise is solid. Occidental is likely to suffer for at least the next month as investors digest this terrible deal. Let’s look at a specific example of a bear put spread on OXY to see just how much traders stand to make on it.

A Specific Trade On OXY

Right now, traders could buy June 21 $55 OXY puts for $2.71 per share and sell June 21 $50 puts for $0.79 per share for a net debit of $1.92 per share. Since each is worth 100 shares, that’s a total cost of $192.

That’s the most any trader using this strategy would stand to lose. For them to lose this whole amount, shares of OXY would have to remain stay above $55 for the duration of this trade, an unlikely possibility.

In exchange for that risk, they’d find an even better profit potential. To find that, take the difference in strike prices ($55 – $50 = $5), and subtract the cost ($5 – $1.92 = $3.08). On 100 shares, that’s $308.

Think about that. For $192 down, traders are looking at a $308 return. That’s a 160% return on the amount at risk.

For them to collect that full return, shares of OXY would have to fall just $5 to below $50. With how poor this deal looks, investors could easily make that happen over the next six weeks.

Write A Comment