Energize Your Returns with BP

NYSE:BP - July 29, 2009: $49.45 (2:50 PM EST)
52-week range: $33.70 (Mar. 3, 2009) - $62.49 (Aug. 7, 2008)
Dividend = $0.84 quarterly = 6.79% current yield

With crude prices down $4.50 bbl today, it’s a good time to be picking up some BP ADRs. I expect higher oil prices somewhere in the reasonable future and the generous 6.79% yield makes waiting for that day quite palatable.

Consensus estimates for 2009 and 2010 now run about $3.70 and $5.75 respectively making the P/E 13.4x this year’s depressed earnings and around 8.6x next year’s expectations. That compares with a 10-year median multiple of 13x.

BP gets Value Line’shighest ratings for both safety and financial strength. ‘Stock price stability’ and ‘earnings predictability’ also score well at the 90th and 80th percentiles (with 100th being best).

Unless you’re a real bear on oil prices BP looks to have very nice upside without a ton of risk. BP shares peaked at levels between $72.70 and $79.80 during each calendar year 2005-2006-2007-2008 and never got below $56.60 at any time during 2005-2006-2007.

Here’s a relatively conservative play for just under 1 ½ years that can generate very nice total return even if the shares don’t do much other than hang around current levels.

..........................................................Cash Outlay ........... Cash Inflow
Buy 1000 BP @ $49.45 .................. $49,450
Sell 10 Jan. 2011 $50 calls @$4.80 ............................... $4,800
Sell 10 Jan. 2011 $50 puts @$9.40 ............................... $9,400
Net Cash Out-of-Pocket .................. $35,250

If BP finishes at $50 or better (up 1.1%) by the January 2011 expiration date:

• The $50 calls will be exercised.
• You will sell your shares for $50,000.
• The $50 puts will expire worthless.
• You will likely have collected $5,040 in dividends.
• You will have no further option obligations.
• You will hold no shares and $55,040 in cash.

That would represent a best-case scenario net profit of $19,790 / $35,250 = 61.3% achieved on shares that only needed to rise by at least 1.1% over the next 17.6 months.

What’s the risk?

If BP finishes below $50 on the January 2011 expiration date:

• The $50 calls will expire worthless.
• The $50 puts will be exercised.
• You will be forced to buy another 1000 BP ADRs.
• You will need to lay out an additional $50,000 in cash.
• You will have no further option obligations.
• You will likely have collected $5,040 in dividends.

What’s the break-even on the whole trade?

On the first 1000 shares it’s their $49.45 purchase price less the $4.80 /share call premium = $44.65 /share.

On the ‘put’ shares it’s the $50 strike price less The $9.40 /share put premium = $40.60 /share.

Your break-even would be $42.63 /share (excluding dividends) and $37.59 /share (including yield).

BP ADRs could drop by up to 23.9% without causing a loss on this trade.

Summary:

BP represents a good play on an oil price recovery as well as a ‘weak dollar’ hedge. I think these high-yielding shares are likely to rise over the next 18 months. As long as they pass and hold the $50 mark on January 2011’s expiration date your total return should exceed 61% even though the shares only needed to rise by 1.1%.

In a worst-case scenario you’ll end up owning 2000 ADRs at an average price almost 24% below today’s already reasonable quote.

Disclosure: Author is long BP ADRs and short BP options.

Comments

[newbietech:]

Why do the puts and calls have to be sold at the same strike price? Why not sell puts at a slightly lower strike price and increase your margin of safety?

Jul 29 05:36 PM

[newbietech:]

Like Selling 10 Jan. 2011 $45 puts @$6.3. You'll get $6,300. But the shares would have to decline all the way to 39 before you are likely to be forced to by 1000 more.

Jul 29 05:39 PM

[Paul Price:]

As with all insurance, having more than you need costs you money.

I have no problem with your strategy if you feel BP won't hold above $40,60 (the net cost from the $50 puts in my example). Really, though, if you don't believe BP will be at least that high, you should be looking at a different underlying stock.

Jul 29 07:10 PM

[RP 95839:]

Paul:
I find your research and option ideas quite informative and potentially profitabe. I was wondering is you ever thought to offer your ideas in the contect of a portfolio? I can only assume that most readers would not contemplate, nor afford to invest in all of your ideas that run concurrently. Since you post very often, I would think that unless you are just promoting your book, a lot of your efforts are being under utilized.

Jul 30 08:46 AM

[dcsohl:]

Is that really the break-even point? Here's how I would have calculated break-even:

Initial outlay, as calculated: $35,250.
Likely dividend yield: $-5040.
Assignment of puts: $50,000.
Total cost: $80,210.

And, at the end, you'd have 2000 ADRs, so that would be $40.105 each. Isn't that the real break-even point on the whole trade? Without the yield, my numbers agree with you (85,250/2,000 = 42.625)...

Jul 30 09:45 AM

[Paul Price:]

dcsohl,

You are correct. The final break-even would be $40.105 after dividends. I failed to adjust properly on this example.

BP could drop by 18.9% from the starting price without causing a loss.

Thanks for the heads up.

Jul 30 09:55 AM

[claudio.lan...:]

I just took a look at the 5 yr BP chart and only during the crash in Mar 09 and only for a short period did BP fall below $40.00 in a general statement. As we know Mar 09 was heck of day in market history. That setting aside with a break even of $40.15 on this trade, I think this is as close to a slam dunk as I can ask for. Paul your great with your straightforward and simple to understand posts. Have you gone back, I am sure you have and could you post or send an email on how your portfolio has performed over say the last year.

Jul 30 10:59 AM

[Paul Price:]

claudio.Jan,

My non-IRA account (where I do exactly what i describe here) is now up 72.75% YTD and my non-levered IRA (where i can only buy shares and sell covered calls) is up 29.15% YTD.

Both accounts were down > 20% in early March.

Jul 30 12:34 PM

[Paul Price:]

Check out my own site..

BeatingBuffett.com to see my entire history of postings all in one place.

Jul 30 12:36 PM

[DuffBeer:]

Paul ,
From one airman to another thanks for what you do . I have followed many who try to explain the covered call strategy but no one does it as you. Easier to understand and alot less painful then a root canal.
Keep up the great work, Major Covered Call
Cheers DuffBeer USAF 69-73 AC 119 gunships

Jul 31 03:31 PM

[Paul Price:]

BP's 'giant' oil find. BP (BP) announced this morning a 'giant' oil discovery in a very deep well drilled in U.S. waters in the Gulf of Mexico, but said an appraisal is necessary to determine the exact size and commerciality of the find. BP is already the largest individual producer in the area. Shares +3.6% premarket

Sep 02 08:39 AM

[Paul Price:]

BP (BP): Q3 earnings of $4.67B vs. consensus of $3.25B. Sees 2009 costs down by $4B vs. a previous $3B. Total production +6.9%.

Shares +5% premarket to $58.55

Oct 27 07:19 AM