How To Play An Uncertain Oil Market With Near-Certain Returns With Halliburton, Baker Hughes

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Includes: BHGE, HAL
by: Todd Hagopian

Summary

Uncertainty surrounding the Halliburton and Baker Hughes merger is creating a very rare buying opportunity.

The Iran deal makes the oil and gas equipment and services sector extremely interesting, providing more revenue if it goes through, and higher oil prices if it fails.

By purchasing Baker Hughes shares and writing Halliburton calls, you can limit your downside risk, and still participate in strong gains over the next 6 months.

For those of you who believe that oil companies will rise in the long-term, there is currently a very interesting play available between Halliburton (NYSE:HAL) and Baker Hughes (BHI).

There are two dynamics at play, which make this a once-in-a-decade type of investment.

1) Due to a requested extension of the antitrust review of their announced merger, the market has some doubts that Halliburton's acquisition of Baker Hughes will go through.

2) Due to the volatility in the oil market, because of the Iran deal, options premiums are trading a little richer than they generally due.

This strategy works if you believe three key things

Halliburton will be successful in its acquisition of Baker Hughes.

  • Over 90% of announced acquisitions go through
  • HAL has to pay BHI $3.5 Billion if the deal fails, the largest breakup fee in history
  • HAL and BHI say that they will shed assets until the government approves the deal

Oil Service stocks are a solid play in today's environment

  • Iran deal should help Oil Service stocks, due to the increased activity in Iran
  • If Iran deal fails, oil prices will rise, which will also help the stocks in this sector
  • HAL and BHI are 46% and 23% off their highs, lots of room to recover if oil does

HAL is a good long term buy, but will not rise more than 20% before 1/1/2016

  • If you like the idea of owning HAL long-term, this is an excellent strategy
  • If HAL ends above $48/share, you make 19.9%, but less than investing purely in HAL
  • If acquisition closes in 2015, and HAL stays below $48/share, this strategy works

Here are the mechanics of executing this strategy:

  1. Buy 180 Shares of BHI
  2. Write two HAL160115C00042000 calls

BHI - $58.87/share

HAL - $40.21/share

HAL160115C00042000 = HAL call with Jan 2016 Exp. with a $42 Strike price and a $2.48 bid price

Per the Halliburton acquisition, shareholders will receive 1.12 shares of HAL plus $19 of cash per share. Therefore, if the acquisition goes through, you will wind up with 200 shares of HAL, and $3,420 in cash.

180 shares of BHI at $58.87 = $10,597 Investment

200 Shares of HAL + $3,420 in cash = $11,462 in value

Write the 2 calls = $496 in value, bringing your total to $11,958

So, on day one of this investment, assuming the acquisition goes through sometime in 2015, you have made a paper return of 12.8%, if HAL stays exactly at $40.21/share.

Obviously, if the underlying stock falls, your return will be less than that, and if it rises, your overall return will be more than that. I have put together a chart showing your Return on Investment (NYSE:ROI) versus the ROI you would have gotten if you had simply invested in HAL stock.

Initial Investment - $10,597

1/2016 Price

Total Return

HAL Return

Delta vs. HAL

$34.00

1.1%

-15.4%

16.5%

$36.00

4.9%

-10.4%

15.3%

$38.00

8.7%

-5.5%

14.1%

$40.00

12.4%

-0.5%

12.9%

$42.00

16.2%

4.5%

11.7%

$44.00

19.9%

9.5%

10.5%

$46.00

19.9%

14.4%

5.5%

$48.00

19.9%

19.4%

0.5%

As you can see, this strategy allows you to share in the profit potential up to a $48 share price (which would represent a 6-month share price move of 19.4%). After that, you would have capped your gains at 19.9% 6-month return (38.8% annualized ROI). The beauty of this strategy is that you have allowed yourself the ability to see a significant return, while drastically limiting your potential loss. As you can see, the underlying stock could move down 15.4% over the next six months, and your investment would still be sitting at a positive 1.1% return.

Again, this strategy only works if you believe that HAL is a long-term buy, you believe that the HAL/BHI acquisition will close in 2015, and you have the financial means to cover the naked call if it were to be exercised prior to the acquisition closing.

This is a rare opportunity to limit your downside risk, while buying a fantastic stock in an inexpensive way. If you do not have HAL in your portfolio, and you are looking for a way to add an oil position, this is the most effective way to participate in the Oil recovery with a deeply-reduced risk profile.

Disclosure: I am/we are long HAL, BHI.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I purchased BHI this week, and have yet to write the planned calls on HAL. Calls will be written when the price of HAL moves up to my target level.