The last few weeks have been devastating to investors. From the end of April to last week, the Dow and S&P 500 were both down nearly 6%. The old adage of “sell in May and go away” seemed to be right this year. But one area was hit even harder.
While the rest of the market seems to be attempting a bounce now that we’re in June, the energy market isn’t. Crude oil prices continue to slip. In fact, as of today, it has officially entered into bear territory with a 20% decline from its springtime highs.
Trade fears, lower-than-expected job growth, consumer sentiment, international economic dips and uncertainty from the Fed have all sent oil down. Yet, for many people, gas prices remain elevated.
According to the Energy Information Administration, the national average price at the pump remains at $2.89 per gallon. That’s right where it was a year ago at this time, despite oil prices coming down $15 to $20 per barrel.
On the surface, who do you think profits from this situation? Without getting into the nitty gritty details of supply chains, taxes and trade, what kind of company would see margins expand? Refineries, right?
That would make the most sense. If input costs (oil) drop, and product prices (gasoline) remains the same, sixth-grade economics tells us that margins expand, right?
Well, that hasn’t been the case here. It was a bit of a trick. You can’t throw out supply chains, taxes and trade. You can’ throw these things out because they are so important to this business.
For decades, refining oil hasn’t been a very profitable enterprise. At least, it hasn’t been compared to the production of oil and gas. Margins get squeezed hard because of the high cost of equipment, the unstable volumes and the shifting of consumption. And right now, we are in a whirlwind of these fluctuations.
The new tariffs on Mexican goods could halve refinery margins to one of our largest trading partners for the stuff. Other international markets aren’t much better. Economic slowdowns around the world have investors fearful over this fragile industry. In fact, you can see it here.
This is the one-year stock chart for Valero Energy (VLO), one of the largest and closest to a pure-play refinery companies in the world. The company has operations across the U.S., but most significant in the U.S. Gulf Coast. When we’re dealing with gasoline prices, we almost always have to first look at Valero.
As you can see, despite the top-down situation sounding more pleasant for a refinery company (lower costs, flat product prices), the real picture hasn’t been so rosy. Margins in the company’s most recent quarter came in nearly half as large as a year ago.
Startup costs, inventories and consumption issues are all to blame. But when looking at VLO as an investment, we can’t ignore sentiment either. Consumers are beginning to get fearful over the short and medium-term economic outlook both domestically and internationally. And since the production and refining of energy products isn’t as simple as turning off a tap, it’s created plenty of supply chain and volume issues.
This is a problem. But investors are often too hasty. This is a case where investors gone too far.
Yes, Valero suffered a weak quarter in terms of margins. But it actually smashed expectations. Earnings came in nearly 50% higher than analysts expected. Even so, these same analysts expect even greater results going forward. Meaning the company is handily doing better than even optimistic analysts expect.
Yet its stock is down in a big way… especially with the recent decline in energy prices. This presents an opportunity.
Not only is the company actually performing better than expected, it is offering something few other energy companies are right now.
Valero pays a fat and fast-growing dividend. Right now, the company pays a 5% dividend yield. It is growing those payments by double-digit rates each year too. On top of that, it has been steadily buying back its stock:
It’s been able to pay for all of this despite uncertain margins. Even with current trade problems, consumer sentiment worries and rocky supply issues, Valero is doing much better than it is getting credit for.
There’s a real chance to play the market’s overreaction. And with summer here, oil remaining in the investment doghouse and now headlines about interest rate cuts… Valero could offer short-term profits too.
A Strategy to Play Valero’s Bounce Back
A bull call spread is a type of options trade that involves buying a call option on a stock you believe will go up in price and selling a second one.
This helps offset the cost of the trade. But it does limit the maximum profit potential. For a stock like Valero, a large rise could be on the way. Still, we’re not looking for an historic rally. The economic picture is still what it is. This is simply a short-term bounce play.
You can see how a bull call spread works here:
Source: The Options Industry Council
As you can see, the profit potential is capped. But so is the amount at risk. This trade off can often work out much better than a straight bet.
In fact, since this particular play is so contrarian right now, there’s an amazing return vs. risk profile to this strategy.
Let’s look at a specific example…
A Specific Trade on VLO
Right now, a trader could buy a September 20 $75 call for $4.47 per share and sell a September 20 $90 call for $0.68 per share for a cost of $3.79 per share. Since each represent 100 shares of VLO, that’s a net debit of $379.
Now, that’s the most this trader would stand to lose for the full duration of this trade. However, the profit potential is extraordinary.
To find that take the difference in strike prices ($90 – $75 = $15), and subtract that cost ($15 – $3.79 = $11.21). On 100 shares, that’s a potential payout of $1,121 total.
Obviously, that’s a huge return on the amount at risk… nearly 300%. But it will take a bit of work to get there.
Shares of VLO would have to jump to $90… about 21.6%. But that’s not out of the question either. That’s where shares were just a month ago, before the bottom fell out of energy stocks. And like we said, this refinery play was hit harder than it should have been.
Still 20%-plus is no joke. That’s significant. But considering the term of this trade, it is quite achievable. Investors have a full three and a half months to realize their error. That incorporates all of summer gas prices and another earnings season to set the investment community straight.
For a chance to nearly quadruple the return on the amount at risk, this trade could be one of those unicorns we rarely see.