ConocoPhillips: A Smart Way To Trade Oil

 |  About: ConocoPhillips (COP), Includes: USO
by: Bret Kenwell

Oil has been the talk of Wall Street for the better part of several weeks now. With all of the geopolitical tension surrounding the Middle East, I can only expect oil to go higher from here. Analysts are predicting $125 oil by summer, but if tensions quickly rise, we may see that price, or even higher, much sooner. Some analysts are even predicting $200 oil if things really get out of control.

Iran is battling to keep their nuclear program afloat, Europe is grappling with oil import changes, and we are hearing such things as false explosion reports in Saudi Arabia. Now President Obama is stating he will use force if necessary to combat potential Middle East conflicts, which will all but heighten the already stressed tensions in the Middle East. Oil may go down, but in my humble opinion is has a lot higher to go before that happens.

Aside from trading oil futures to capture these moves, there are a few more ways to profit from the likely rise in oil. One could invest in either the United States Oil ETF (NYSEARCA:USO) or in the ProShares DJ-AIG Crude Oil ETF (NYSEARCA:UCO), which is the double levered crude oil ETF. Though these two ETFs are the most natural way to profit from the rise (or fall) in oil, outside of the futures market, I plan on trading oil companies that are highly correlated to the moves in crude prices. By doing so, one can take advantage of a more cost efficient investment in a business, rather than a fund, collect dividends (if purchasing the stock outright), and see decreased volatility.

While many oil companies move with oil, some move better than others. Exxon (NYSE:XOM) trades relatively well, but not as good as British Petroleum (NYSE:BP) and ConocoPhillips (NYSE:COP). However, I plan on purchasing calls on only one these companies, ConocoPhillips. By looking at the 1 year chart tracking USO and comparing it to ConocoPhillips, it is quite apparent they track crude oil extremely well. Below is a 1 year chart of USO compared with ConocoPhillips:

Above: COP is in blue while USO is in orange.

Currently oil is trading just under $107 per barrel, USO is priced at $40.85, and ConocoPhillips is $77.33. I think buying the stock outright would be a wise decision, in order to collect dividend payments in the rare event that crude oil falls, dragging ConocoPhillips down with it.

However, because of the leverage and preference of using options, I plan to purchase at-the-money call options to capture the predicted rise in oil. A simple breakdown will show why using call options in ConocoPhillips is a more efficient, as well as safer, than purchasing call options in USO. Below are the strike prices, expiration month, price per contract, delta, and implied volatility for each of the two companies:

Strike Price
Expiration Month
Asking Price
Implied Volatility
Click to enlarge

Right away one can spot some similarities from the chart above. First, both options for either month have nearly the same delta, since they are both at-the-money. Secondly, they are relatively close in price, especially considering that the underlying security price of ConocoPhillips is nearly double that of USO. Also, another contributing factor to the higher price in USO is the higher implied volatility. USO has an implied vol near 30, while ConocoPhillips is closer to 20, respectively.

I have several reason for preferring ConocoPhillips to USO, or any other oil company for that matter. ConocoPhillips tracks oil better than any other oil company out there, and by wanting to take part in the move in crude oil, they are the best company for the intended task. Also, ConocoPhillips has a much lower volatility, so when geopolitical tensions sway the prices of crude oil with each new headline, I won't have to see my portfolio tossed around as much and will be better protected in the event oil ceases to extend its recent run up. Another reason I like ConocoPhillips to USO is that on a dollar per share basis, they are much more expensive.

For instance, if Israel were to attack Iran, and crude oil shot up as a result, we would see both USO and ConocoPhillips rise in price. So hypothetically, if USO went up to $45 per share, that would represent an approximate increase of 10%. By purchasing the 41 call, one would be in the money by $4. However, if the price of ConocoPhillips increase by 10%, since it tracks crude oil very accurately, we would see its price shoot to $85. If the 77.5 call option was used, it would be in the money by $7.50, and therefore have a much more valuable price when exiting or exercising the contract.

While it is true that oil could fail to advance higher, making oil plays such as this one a losing investment, there is good chance crude oil won't decrease much by price very soon. We are one big headline away from seeing crude oil skyrocket. By using call options on ConocoPhillips it allows traders to take advantage of the nearly inevitable move in oil, while limiting risk and using the leverage of options.

Disclosure: I am long COP and COP call options.