Seeking Alpha

Cash-Secured Puts To Sell On Permian Shale Stocks

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Includes: CVX, DVN, ECA, GS, JAG, MRO, OXY, PE, PXD, XOM
by: Kirk Spano
Kirk Spano
Value + Growth, dividends, Option Income, macro
Summary

Oil stocks are finally in a bottoming process.

While the shale stocks we cover could go a bit lower, there is substantial support in the current price regions.

Selling puts with the currently high premiums with strike prices slightly below current prices appears to be a very viable strategy.

Mind your asset allocation, consider what your portfolio would look like if stocks are assigned to you.

The oil industry has been getting pummeled for a year now. Many oil stocks are down 50% to 70%. Recency bias is preventing more investors from making a real analysis of the value of these companies.

Have no doubt about it, some oil stock prices will never recover. More oil companies will go bankrupt. Mergers, and takeovers without much premium, will remove others from being publicly traded. The majors are at risk of litigation and struggling with their own weight. A select group of low stock price oil companies will be taken private by management and private equity, effectively privatizing the profits of the next decade.

There is a select group of oil companies however, with the right circumstances that can handsomely rebound in the early 2020s as oil supplies flatten and demand continues to rise for at least several more years. I covered this group in two previous articles:

The Dirty Dozen Oil Stocks For 2019

Permian Pure Play Merger And Takeover Targets

Below you will find updates on several of these companies with cash-secured puts that I believe you can sell this week or next. Remember, mind your asset allocation and assume the stocks get put to you.

SPY Asset Allocation by SectorThe S&P 500 allocation to energy stocks is at a generational low 4.5%. I think aggressive investors can put up to 18% into energy, or a 4-times overweight. Moderate and conservative investors would be wise to keep allocations in the 1.5x to 3x range. The overweightings are entirely based on my analysis of industry valuation, specific company businesses and likelihood for an oil rebound in the early 2020s.

Occidental Petroleum (OXY)

Occidental's merger with Anadarko has been much maligned. The reality, in my opinion, is that they are ahead in the game and that investors are behind.

Carl Icahn is also wrong in his criticism. Let us not forget Carl has been wrong about a lot in the past several years. At the heart of his criticism is jealousy over Warren Buffett's financing of the deal and that Occidental has been made harder to acquire.

Occidental CEO Vicki Hollub has made the company far more attractive for long-term shareholders, versus a flipper like Icahn. Hollub was ahead in the game when she redeveloped their Ingleside oil export port and then sold it at a premium. The merged company is rightly divesting virtually all international assets and other non-core holdings. And, most importantly, Occidental is rightly focusing on shale operations, particularly in the Permian, their leading CO2 business which will become far more important in the 2020s and now edging into solar.

(I will have a full analysis published on Occidental in coming weeks, so follow me if you're interested, as I will make that public once members of Margin of Safety have seen it first.)

Occidental is paying a hefty and sustainable dividend with a current yield around 7%. As the company divests assets to pay down debt, I expect the dividend payout to continue to grow.

Like virtually all oil stocks, Occidental has been pummeled. However, a bottom appears to finally be about in.

I am firm believer that money flows are important in finding turning points in stocks. When money is flowing in, the price generally follows upward. When flowing out, prices heads down. Pretty simple supply and demand equation for an asset. What investors need to pay attention to are longer-term charts since big money tends to flow in slowly to disguise itself. Let day traders focus on shorter-term charts.

In the following chart you can see that the Chaikin Money Flow on a monthly chart collapsed over the past year, but has just ticked up:

OXY monthlyIt's easier to see on the weekly chart that money has started to flow into the stock:

OXY weekly chartIf you are simply a dividend growth investor and looking for a good stock to buy, I think buying the dips in coming days on OXY is a solid strategy. If you are looking for a income and a lower entry price, then selling cash-secured puts could be your approach.

Which cash-secured put you sell depends on how much you want the stock and whether or not you own it already. Selling two cash-secured puts might be the right approach if you want income and are happy with a half position or full position.

Remember, selling a cash-secured put means you want the stock, but only at a slightly lower cost basis.

For a more aggressive put sell, the December $42.50 will get you about $2.25 in premium for about a 5% return on your cash held for potential purchase over the next two months. Where else can you get 5% on your cash for 2 months? If the stock is put to you, then your cost basis will be about $40.25, which is about 6.3% lower than Wednesday's close.

A less aggressive put sell would be to set the strike price lower. You can extend the contract length a month to get more time value as well. The January 2020 $40 put is currently offering a premium of about $1.60. That's about 4% on your secured cash for 3 months. Your cost basis would be $38.40 or about 11% below Wednesday's close.

I want that stock in dividend portfolios, so, I would lean towards the December put, but using January, or both is a solid approach as well depending on your circumstances and risk tolerance.

Other Permian Focused Top Shale Stocks

As I referenced in the intro, I prefer Permian focused shale stocks as that is where the best oil production is. There is no government interference as there is in Colorado and no earthquakes limiting production like in Oklahoma. Proximity to infrastructure is good and improving with new pipelines coming on. Refining and export facilities are also nearby.

Here are the other 4 Permian focused shale stocks that my investment firm Bluemound Asset Management holds and cash-secured puts that look attractive now. Consider your accumulation strategy within the confines of your risk-tolerance for volatile energy stocks and other financial circumstances.

Encana (ECA)

Encana is in a similar bottoming process as Occidental. Once again, the company is being hated on by investors who do not like their recent merger with Newfield that has resulted in Encana having the 3rd largest shale production. The deal is now mostly digested and appears ready to yield significant profits to shareholders.

The company's shareholder return has been improving rapidly the past year as the company buys back shares, has been raising a dividend and has been reducing debt. I expect continued improvements as outlined in their current investor presentation. I also expect earnings on October 31st to be favorable:

ECA Shareholder Yield

Going forward, the company is selling non-core assets and focusing on production in the Permian, STACK in Oklahoma and Montney in Canada. A wildcard here is that I have urged the company to also sell the STACK assets as a bolt-on for another company. A recent earthquake in their STACK operations has clouded the profitability outlook in my opinion, however, Enanca appears to be taking the right steps to deal with the more complex development zone.

While there is risk with every oil stock, Encana's sub $5 price is too low to ignore in my opinion. The company has added a dividend, quickly raised it and promises to raise it more.

I like selling the January $4 puts for about 35 cents. That's a 7.5% return on cash secured for purchase of the stock. I would sell this put in addition to buying a small stake now. If you already own the stock from higher prices, then selling this put to reduce cost basis I think is a good transaction if it fits with your asset allocation.

Parsley Energy Inc (PE)

Parsley just acquired Jagged Peak Energy, Inc (JAG). Do you see a pattern in the companies I like. I believe that consolidation in the oil space will be very good for the survivors in the industry as we enter the "peak oil plateau" (updated report imminent). I have described the peak oil plateau as a period lasting roughly a decade where oil demand and supply remain roughly balanced as oil demand finally plateaus around 100-110mbd before falling in the 2030s.

Peak Oil PlateauParsley is a leading Permian producer that is widely rumored takeover target. I believe the Jagged Peak acquisition makes them very attractive to an oil major such as Chevron (CVX). Goldman Sachs (GS) points out that the company should realize significant cost savings from the acquisition and is a major player in water that is considering monetizing those assets.

Money flow on the weekly chart just turned up after having an extended flat bottoming on the monthly. The money flow coincides with the merger announcement:

Parsley Energy Technical ChartWith Parsley trading under $20 per share, I believe is also a good buy here and well suited to be paired with a cash-secured put sale. If you already own the stock, but could hold more in your asset allocation, I would strongly consider selling a cash-secured put.

Two puts to consider are the January $17.50 and $15 puts. if you already own the stock, I would look to sell the $15 and take the smaller premium, which is still solid. If you do not own the stock, I would look to sell the $17.50 with the idea that you want the stock, but at a lower cost basis than it is trading today. Selling both puts if you do not own the stock is also a solid idea.

Devon Energy (DVN)

Devon has not engaged in a strategic transaction... yet. Rumors have been circulating all year that the company is in talks to merge with another shale producer. I have speculated, with some insights from other industry followers, that Marathon Oil (MRO) could be that company.

Devon also makes a lot of sense as takeover target for the majors as it has operations in the Permian, STACK, Eagle Ford and Powder River Basin. Exxon (XOM) seems to make the most sense based on overlap for bolt-on operations.

Devon presents an interesting value proposition. While growth is low, earnings are rising on cost savings and non-core asset sales. The asset sales will run their course, however, will leave the company very low debt for an exploration and production company. Debt to equity has already been plunging as debt has been pared in half the past 3 years.

Devon Energy DVN Debt to EquityMoney flow has just started to return to Devon. Why? A PE of 3? M&A speculation? Just too cheap to ignore? I think all of the above.

As with the other stocks, consider your asset allocation, but I believe selling any or some combination of the January $19, $20 and $21 puts makes quite a bit of sense. Buying a starter position in Devon, if you do not have one, also makes quite a bit of sense to me as it now pays a dividend that is growing.

Pioneer Natural Resources (PXD)

Pioneer has also long been a rumored takeover target of the majors. The CEO seems rough around the edges and has side the company is going to go it alone. To that end, he is pushing a monumental efficiency campaign. We'll see if a bid develops for the stock.

What we know is that debt has plunged to make the Pioneer one of the least leveraged out there. This was accomplished by selling off all non-core assets as the company has become a Permian pure play.

The company produces out of cash flow and is continuing to pound down debt. It is not unlikely this is a debt free, cash flow machine soon, that further ratchets up buybacks and dividends. Then again, Chevron, after losing Anadarko and the CEO saying it's still looking, might just look at the current stock price which is 40% off its peak and make an offer somewhere in between.

Pioneer is in a bottoming process for money flow on the weekly and monthly charts. It is also hitting and holding major technical support with a nice consolidating pattern.

Pioneer Natural Resources technical chartPXD shares certainly carry risk in the short-term, but buying a starter position at this point makes a lot of sense for those who believe there's another bull market in oil stocks coming. I would be setting buy limit orders in the $100-120 zone.

Given the price of the stock, it is difficult to sell cash-secured puts on for most investors, however, if you can sell puts with strike prices in the $100-120 range those look very attractive in my opinion. Again, consider your asset allocation and risk tolerance.

Final Risk Management Thought

In general, selling cash-secured puts are a risk management tool because you are creating premium income and an entry price below today's price. You should be bullish on the stock to make this work. There is no sense in selling puts on stocks you believe have significant downside or that you don't want. You well puts to accumulate at better prices. The analogy is setting a limit buy order, but getting paid to do it.

Regarding the oil industry. I do believe, as I have discussed, that we are at "the beginning of the end of the oil age." But, I also believe the 2020s will be good for efficient, low debt, shareholder friendly shale stocks as the "peak oil plateau" plays out.

Oil stocks have crashed for a lot of reasons. Not the least of which is that Millennials don't have a lot of interest in these stocks so far. What I know about Millennial traders though is that most will go where the money is. So, we'll see how their oil stock demand plays out.

Also, financial advisors have grabbed onto what they perceive as a marketing opportunity to declare themselves "sustainable" or ESG investors. Certainly, some, like me, believe that is the future, however, many are just looking to make a buck. That flood of advisors into that arena is playing out as well, which means, less impact soon.

Finally, the divestiture movement took off with a bang. Well over 1000 institutions have divested oil and gas stocks so far. Again, I think that is about played out as first movers have moved and other institutions are moving more slowly trying to avoid selling at the bottom (that doesn't mean they won't exit eventually). Even Norway is divesting oil stocks after making virtually all of that nation's wealth in oil.

In my opinion, oil stocks are priced for Armageddon. I don't think Armageddon is quite here yet, even though it certainly "feels" that way. Take a look at my article Here's Why Oil Stocks Are Priced For Armageddon to really consider the risks you are willing to take in order to take part in the large rally I see coming to certain shale producers in the early to mid 2020s.

Disclosure: I am/we are long ECA, DVN, PXD, PE, OXY. 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 own a Registered Investment Advisor, but publish separately from that entity for self-directed investors. See relevant terms and disclaimers at the website of Bluemound Asset Management, LLC. Any information, opinions, research or thoughts presented are not specific advice as I do not have full knowledge of your circumstances. All investors ought to take special care to consider risk, as all investments carry the potential for loss. Consulting an investment advisor might be in your best interest before proceeding on any trade or investment.