Buy Sell and Tell Investments

Looks like oil and gas stocks weren’t immune to the stock market crash as I had been hoping. As has been written a number of times on this site, it was expected that markets would crash but it was hoped that oil stocks would outperform as record earnings were expected given that oil prices in the second quarter were the highest ever. As expected, the general market crashed but unfortunately oil stocks joined the crowd and have now corrected 15-20% from their peak.

Oil stocks (e.g. Nexen Inc. T-NXY, N-NXY) were hit with a double whammy of relatively poor earnings and dropping crude oil prices. Oil is now down over $20 a barrel from its peak. The far worse news for Nexen was its pathetic earnings.

Nexen’s second quarter earnings release seemed to be a rather large string of disappointments: oil production volumes were down 6%, the marketing division lost a whack of money and some of the production volume was held in inventory instead of being sold in the quarter. The worse component of the earnings was the huge equity compensation of over $300 million which knocked $0.45 off the earnings per share to a paltry $0.70…this compares to the Q1 results of $1.17. I was forecasting Q2 earnings closer to $1.68 and had bought July call options on both Nexen and Petro-Canada. Obviously after the poor Nexen earnings release, the whole oil sector sold off 10-15% putting my call options out of the money where they expired worthless.

My only saving grace on the loss was the fact that I had earlier sold my stock positions and replaced them with the call options so that when the stocks dumped, I “only” lost the premium. Had I been holding shares instead of call options, my losses would have been much higher. Still, losing $3 to $5 on call options instead of $10 on the stock is small consolation.

I had originally intended to buy more call options on oil stocks if the July strategy didn’t work, but after the poor earnings release and the continuous sell off in oil stocks I didn’t make anymore purchases. The oil market seems to be very bearish right now and until there are signs that the market has bottomed, I won’t be buying anymore stocks or call options.

I’m expecting that as more oil companies report their earnings, their earnings will also be negatively impacted by large executive equity compensation plans i.e. execs are given large equity positions if the share price increases over a certain price.

Lesson Learned:

Expect a stock that has been doing well to report weaker than expected earnings as a result of the executive equity compensation plans. Stocks that end the quarter close to a record high price will have higher compensation expenses than a stock that is far from its high as the company has to mark to market the stock positions that are owed to the executives.

Also don’t get greedy by doubling up on cheap option positions when the stock trades down especially when the general market is already in a recession.

My investment positions can change at any time. Under no circumstances does the information in this column represent a recommendation to buy, sell or hold any security.

There have been a lot of things happening in the markets recently but it all goes to support the stagflation is here argument. It seems every inflation indicator shows that inflation is getting worse (i.e. higher) regardless of which country is reporting. At the same time, most countries are also reporting weak growth. Today was no different as GM slashes more jobs and eliminates its dividend, Fannie Mae and Freddie Mac are being pummeled as equity investors fear the US government will have to bail out the mortgage insurers and the Producer Price Index in the states grew at a 9.1% clip year over year, the fastest rate in 27 years.

With both the Canadian and US governments more concerned about the recession than inflation; the central banks have let interest rates remain stimulative. It’s been mentioned numerous times in my previous blogs that the governments would take no action to fight inflation other than talk tough. As a result of the stimulative monetary policy, inflation continues to get worse. In such an environment I felt a defensive portfolio was best and my portfolio became weighted mostly to cash, defensive stocks and call options on oil stocks. As the recession continues to get worse, I am having second thoughts on defensive stocks as it appears more and more likely that the recession will bring down all stocks.

Obviously my call options on oil stocks aren’t doing well as oil stocks have been getting hammered along with the general stock market even though the price of oil is only $6 off its peak of $145. I’m still a believer in oil stocks but fear that even with excellent earnings, the stocks may not respond. I’m predicting that Nexen Inc (T-NXY, N-NXY; oil and gas producer) will show a 50% increase in earnings in the second quarter over the first quarter; this compares to most analyst expectations of only a 25% increase in Earnings Per Share. We should know very soon who is correct as Nexen releases its earnings on July 17. Call options are a defensive way to get exposure to the equity market with only having to risk a fraction of the share price of the stock. Of course my plan would have worked quite well if I hadn’t doubled up on my call positions by buying more when the stock initially sold off.

Investor Implications:

If your portfolio isn’t already defensive, it’s probably a good idea to cut your losses and increase the cash weighting in the portfolio as the stock markets in general will get a lot worse before they get better. Even if your portfolio is already defensive, a portfolio close to 100% cash would be ideal if the markets unfold as badly as I anticipate.

My investment positions can change at any time. Under no circumstances does the information in this column represent a recommendation to buy, sell or hold any security.

Economics:

Stock markets in North America have been taking a beating recently especially the oil and gas sector. Oil has dropped about $10 in 2 days and oil stocks have sold off to much lower levels than when oil was last back at this level. It’s not just oil and gas stocks that are selling off as most commodity based stocks seem to be in a free fall and the Dow Jones has hit a technical recession i.e. some arbitrarily defined 20% drop from its high. Of course the big question is what’s an investor to do?

In a previous blog on July 1 (Time to get defensive, sell stocks buy calls), I mentioned that it was time to get defensive as I felt the economy would become even more recessionary and that stocks in general would perform poorly. It seems that I was correct on this point. I also thought that oil stocks were probably going to be one of the few sectors that would do well in the recession, on this point, it seems I’m wrong as no sector seems to be performing well. However, I imagine that when the oil company earnings are released, they will confirm my opinion about their excellent earnings.

Money Supply Growth:

Looking at the money supply numbers out of the US and Canada helps shed some light on what is happening with the stock markets and the currencies. In the US, the growth in money supply has been much lower and was even negative at the M1 level. If the money supply is growing very slowly, this should have very little if no inflationary impact; as a result the prices of everything will remain stagnant including the stock market. When inflation is high the price of everything rises. Since the US economy is fundamentally weak in so many different ways (i.e. budget deficit, trace deficits, housing crisis, credit crisis, job losses etc), it’s not at all surprising that without the support of money supply growth, the stock market is declining.

Canada’s situation is a little different as its money supply growth is much faster than the US, as a result this has been more supportive to its stock market but less supportive to the currency.

Investor Implications:

It’s probably best to maintain a defensive position as the recession in the US is only going to get worse and spread. For those wanting to maintain some exposure to the stock market, the best strategy is probably to sell the stock and replace the position with call options. As mentioned a number of times in previous blogs, when markets are this volatile and options are cheap, it’s better to hold calls rather than stocks. With call options, your risk is lower as the price of the option is only a fraction of the stock price.

My investment positions can change at any time. Under no circumstances does the information in this column represent a recommendation to buy, sell or hold any security.

Oil hit another high of $145 today and oil stocks were down again but the US stock markets (Dow and S&P) were both up. This doesn’t make any sense to me as obviously the oil stocks should be going up (not continuously down) when oil continues to hit record highs. I’m expecting that when companies report their 2nd quarter results, the general stock market will report some poor results whereas oil companies will report on average a 50% increase in earnings.

It’s been pointed out to me a number of times that although the price of oil is up, the price of oil companies have already fully priced in the increases. Yet if you were to compare a graph of oil versus oil company, you would see that the price of oil companies have increased very little in comparison to the increase in oil. One should be looking to buy oil companies because they are cheapest sector; when the 2nd quarter earnings are released, it’ll become apparent how cheap they are relative to their earnings.

Buying stocks just because they are cheap isn’t the best strategy. However when you consider that the oil and gas sector is one of most attractive sectors to be investing in (fertilizers is the other), the fact that the stocks in the oil and gas sector are cheap is a huge bonus (unlike fertilizers which have increased immensely in a very short period of time). Oddly enough, it’s the fertilizer sector that people seem most interested in even though the stocks prices have doubled or tripled in less than a year. In my opinion the current oil sector represents one of those rare situations where you have a very attractive sector and cheap valuations.

Investor Implications:

Buy oil companies before they release their second quarter results.

Stock Portfolio Change:

Since the market thinks so poorly of oil companies (causing the stocks to trade down), I bought call options on Petro-Canada (T-PCA, N-PCZ) for $3.50. The Petro-Canada calls expire July 18 and have a strike price of $52.00. This means that I have the option of buying Petro Canada shares at $52.00 up until July 18. If I exercise my option and buy the stock, my effective purchase price becomes $55.50

I also bought more call options on Nexen Inc (T-NXY, N-NXY) for $2.95. The Nexen calls also expire July 18 and have a strike price of $36.00. I had purchased Nexen calls prior to today but these were in USD; the ones purchased today were in Cdn. My preference right now is to hold my long positions in Cdn so that I can use my limited USD to buy puts on US stocks. As a result, I will be looking at selling my US Nexen calls shortly.

If the options expire before the stocks have increased or before the earnings have been released, I’ll be looking to roll the positions into August and then September. Once the downside volatility in the markets has decreased, I’ll be looking at holding the stocks instead of the options.

I’ve done a number of trades (see below) in the last few days, as a result of all the trades, my exposure to the oil patch is only the call options on Nexen Inc, as I sold heavily overweighted positions in Petro-Canada positions as well as my Nexen stock positions for gains.

If you’ve been following this blog you know that I feel very bullish on oil and gas stocks and bearish on the economy as a whole. In other words I’m bearish of most other sectors and of most stocks. Hopefully readers of this blog have been following a similar strategy to mine also allowing them to profit from the oil and gas sector and avoiding the losses that are sweeping through the rest of the US economy. As a result of this bearish view, my portfolio is now quite defensive as it is now 60% cash.

In addition, the Quadra Mining (T-QUA; copper producer) has been hedged by writing a call option against the entire position.

The BCE Inc position (T-BCE, N-BCE; telecom) which was purchased as an arbitrage on the pending takeover will also be hedged with call options written against it. The pending takeover should also provide a floor to the stock price and as a result is considered defensive.

The only position that isn’t considered defensive is the investment in Destiny Resource Services (T-DSC; oil and gas services) which only makes up 6-7% of the portfolio. With the price of natural gas increasing but still cheap relative to oil, this stock should do well and is being kept as a long term investment. So far the stock is up about 10% from the purchase price and I would add to my position if the stock dropped back down. Attempts were made to buy more stock when it was trading around $4.00 but the low liquidity only resulted in my buy order being half filled. Due to the low liquidity in Destiny you wouldn’t be able to make frequent (profitable) trades as sometimes the bid/ask spread is $0.30 to $0.50 with total trading volumes usually less than 10,000 shares. If you’re wondering why I don’t replace this stock position with call options it’s because no options trade on this stock.

Investor Implications:

If I’m correct and the entire stock market crashes except perhaps for the oil & gas sector and fertilizers, you’ll want to position your portfolio so that it is more defensive. As noted above, my portfolio is now defensive as a result of the high cash position (60%), the call options written against the stocks and by replacing oil stocks with call options on the stocks. As mentioned in previous blogs it costs much less to buy a call option on a stock than it does to by the stock itself.

Stock Portfolio Update:

On June 26 I bought call options on Nexen Inc. (N-NXY,T-NXY; oil and gas producer) for USD$3.90; the call options have a strike price of $35 and expire July 18. The call options allow me to purchase the Nexen stock at USD$35.00 any time prior to the maturity date.

On June 27 I sold both my positions on Petro-Canada (T-PCA,N-PCZ; integrated oil and gas) which included the stock position and my call options. The Petro-Canada stock was sold at $55.13 (bought at $49.98) for a pre-tax gain of 10%. The Petro-Canada call options were sold at $4.70 (bought at $4.10) for a pre-tax gain of 15%.

On June 30 I sold my Nexen Inc. stock (N-NXY,T-NXY) for Cdn$40.36 (bought at $39.37) for a pre-tax gain of 3%. I then purchased call options on Petro-Canada (N-PCZ,T-PCA) for USD$5.80; the call options have a $50 strike price and expire July 18. These call options allow me to purchase PetroCanada stock at USD$50 any time prior to maturity date.

On July 1 I sold my call options on PetroCanada (N-PCZ,T-PCA) for USD$6.95 (bought yesterday at USD$5.80) for a pre-tax gain of 20%. I bought more of the July USD$35 call options on Nexen Inc (N-NXY, T-NXY) for USD$5.00, as a result my average price of the calls in my portfolio is now USD$4.63.

The price of oil increased $5 to $139 a barrel another record, not surprising the stock markets were down; surprisingly oil stocks were down as well. It’s certainly interesting times when the Dow Jones is at a 21 month low and oil is at an all time high. I bought call options on Petro-Canada (T-PCA, N-PCZ; integrated oil and gas) as the stock was down again even with oil hitting another record. With the whole market selling off, this could be the start of the big stock market correction I had been anticipating, as a result, it’s much safer to buy call options rather than the stock as the amount risked is much smaller. The July US$50 calls were purchased for $4.10 which means only $4.10 is at risk rather than US$53.20 which is what it would have cost to buy the stock. As my previous analysis showed, the $25 increase in average oil prices in the second quarter over the 1st quarter should lead to a 50% increase in oil company earnings for Q2. The markets certainly aren’t pricing in solid future earnings and must think the price of oil will drop well below $100. Obviously I don’t feel that way as the longer oil stays above $100 a barrel, the more likely analysts and investor will have to revise their estimates for future earnings higher. It should be interesting to see how much higher oil company profits will be compared to their 1st quarter earnings when results are released in the next few weeks.

Investor Implications:

if the market sell off has you thinking that now is a good time to buy stocks, it might be a good idea to look at buying the call options on the stock instead. The reasoning is if the market sell off continues, all you lose from buying the call option is the premium (which is only a fraction of the price of the stock). If the market rebounds, the stocks will obviously participate in the upside as will the call options (but to a slightly lesser extent than buying the stock). In this volatile stock market where there is a good chance of a big movement up and/or down, buying call options is safer than buying the stock.

Nexen Inc (T-NXY, N-NXY; oil and gas producer) shares were down over $2.00 yesterday on no news when oil prices were actually up. The sell off continued today after the US reported a draw down in crude oil inventories sending the price of crude down over $4.00 a barrel before recovering to $134 a barrel (down $3). The price of Nexen shares initially dropped below my original purchase price of $39.40 before ending the day up slightly. Nexen made $1.19 of earnings in the first quarter when the average price of oil was $98 a barrel. So far in Q2, the average price of oil is $123 which means that for every barrel of oil Nexen (and all oil companies produce) they are earning an extra $25. When you consider that Nexen produces 267,000 barrels a day, this adds up to a lot of extra profit/cash. My quick calculation results in Nexen’s 2nd quarter earnings being 50% higher at $1.80 per share assuming production, taxes, royalties and costs remain the same. For a company to be able to generate $7.20 in annual earnings and to only be trading at $39.00 seemed much too tempting for me. Nexen is also in the process of bringing on more oil sands production via it’s partnership with Opti Canada which should result in higher production levels. The improvement in technology used in recovering the oil from the sands should result in an addition $10 per barrel in additional savings. Even without the savings from the new technology, Nexen shares seem to be very undervalued.

Stock portfolio change:

As a result of the sell off in Nexen, I bought the USD$35 call options for $3.90. If I was to exercise the call options, my effective purchase price would be US$38.90

Investor implications:

Obviously I”m very bullish on Nexen as it’s in a great industry, is highly profitable and the stock is cheap. Nexen makes up the largest holdings in my portfolio which is the highest recommendation one can have. Hopefully putting my money where my mouth is pays off.