BP: Hedged Value in the Oil Patch

London based BP plc (BP) (45.13) operates in two segments, Exploration & Production, and Refining & Marketing worldwide. In the western US they are the retail gasoline price leader with their many ARCO self-service stations.

The current annual dividend is 3.36 for a yield of 7.45%, which is more than twice the average dividend rate of 3.3% for the last five-years. Since their payout ratio is just 35%, they should be able to maintain the dividend rate from earnings. The total debt is $28.3 billion and the debt to equity ratio appears comfortable at .268. The book value is $33.87, making the current market price just 1.33 times the book value.

The plan is to capture the dividend by purchasing stock while hedging the crude oil risk by selling a call and then using the call sale proceeds to buying a USO bear put spread. With a current Historical Volatility of 79.54 and declining and with an Implied Volatility Index Mean (IVXM) at 51.12 and declining consider this plan.

• Buy 100 shares of BP at 45.13.
• Sell BP Apr 50 call BPDJ 3.10 IV 50.10 Delta .4030

The credit indicated above is based upon Friday’s middle closing prices between the bid and ask. Considering time decay, the credit Monday should be about 3.03 if the stock price remains unchanged. Use the position net delta shown above to adjust for any stock price change or about .40 for each point change in the stock price.

With the estimated call proceeds, we suggest hedging the crude oil risk by purchasing a bear put spread using the crude oil ETF. United States Oil Fund (USO) (33.06) reflects the spot price of West Texas Intermediate (WTI) light, sweet crude oil. For the week, USO declined another 5.04 points on volume twice the average.

Our caution last week ahead of the OPEC meeting in Oran, Algeria on Wednesday December 17, 2008 proved unnecessary and, in fact there is so much of the stuff around that there is apparently no place to store it as traders dumped the spot and near term crude oil contracts.

A noteworthy but somewhat irrelevant development for the near term was the continuation of the OPEC meeting in London last Friday. British Prime Minister Gordon Brown made this observation,

Wild fluctuations in the market prices [of crude oil] harm nations all round the world. They damage consumers and produces alike.

OPEC Secretary-General Abdullah El-Badri, added,

We all know that extreme oil prices whether too high or too low are as bad for producers as they are for consumers.

While everybody seems to agree that extremes are undesirable, nobody seems to know what to do about it. In the meanwhile, following the old Wall Street adage, “the trend is your friend,” we suggest hedging long oil positions with a bear put spread.

The current Historical Volatility is 76 and the Implied Volatility Index Mean (IVXM) is 83.99 and rising.

• Buy USO Apr 35 put UBOPI 6.80 IV 76.12 Delta -.4618
• Sell USO Apr 29 put UBOPC 3.70 IV 79.12 Delta .2995

Debit 3.10 Position net delta -.1623

The debit indicated above is based upon Friday’s middle closing prices between the bid and ask. Considering time decay, the debit Monday should be about 3.09 if the stock price remains unchanged. Use the position net delta shown above to adjust for any ETF price change or about .16 for each point change in the ETF price.

Crude oil could be oversold and may turn higher at some point. In the meanwhile we suggest staying on the short side, but now suggest lowering the SU (stop/unwind) once again to a close above 40.39, the most recent pivot made on December 15, 2008. In order for crude to form a price bottom USO will have to close above 40.39 and when it does, we suggest unwinding this hedge put spread.

The combination position net delta is .4347 or the equivalent of about 43 shares of stock.

The next dividend of .84 will be paid about February 20, 2009.

In the event the stock price is 50 or above by the April options expiration we will have unwound the bear put spread as USO crosses above 40.39 recovering the then remaining portion of the spread cost. Our long stock will be called away from the short call at 50 and without considering the potential recapture of the put spread premium the return on investment would be about 12% in 115 days or about 38% annualized with a risk equivalent to about 43 shares of stock. This remaining risk can be further limited by setting a SU (stop/unwind) to sell the long stock in the event it closes below 40.

For those with a longer time horizon this suggestion represents value in a quality company with hedged risk.

Disclosure: no positions

Comments

[Ishortyou:]

I wonder why we should be relying in the old fossile fuel technology when we have the man hour power to mass produce alternative energies market?

2008 Dec 22 07:09 AM

[jepittman:]

The 'old fossil fuel technology' is going to be with us far longer than most of us suspect.


On Dec 22 07:09 AM Ishortyou wrote:

> I wonder why we should be relying in the old fossile fuel technology
> when we have the man hour power to mass produce alternative energies
> market?

2008 Dec 22 11:34 AM

[Socialism c...:]

Because the "alternative energies" are not as cost-effective yet, nor reliable enough -- for example, wind and solar depend on having either a) continuous supply -- won't happen; or b) cheaper relative cost of storage (which ability as of yet eludes us!!)


On Dec 22 07:09 AM Ishortyou wrote:

> I wonder why we should be relying in the old fossile fuel technology
> when we have the man hour power to mass produce alternative energies
> market?

2008 Dec 22 05:39 PM