Energy Remains No.1 Investment In 2021

Summary

• The energy renaissance continues apace for 2021 - both traditional O&G and Green stocks.
• Both still have incredible potential for 2021 upside.
• Call option selling is uniquely profitable right now, and particularly for small individual investors.

Both traditional fossil fuel and green energy stocks have been the investment story of 2021, and are likely to continue in my view at the top of sector opportunities throughout the rest of the year. But we know as investors that the job of finding good investments is not limited to figuring out the sector trends that are working. Sure, oil and gas are making a great comeback in 2021 compared to the previous five years. And yes, green stocks, led by Tesla (TSLA), have been an even longer darling of the markets, combining the hype of renewable energy with the sexiness of technology stocks.

But knowing all this is hardly enough. First, there is the fundamental job of weeding out the real opportunities from the hundreds of potential energy plays out there, then comes the job of timing the entry and finally, and this may be the most important, using the right strategy in managing the investment – the timeline, the limits for exit and the added importance of adding or subtracting from positions while they are being held.

That’s a lot for any individual investor, never mind for a professional manager. But there’s one strategy that’s available right now that’s particularly useful for us as individual investors with relatively small portfolios that’s not available to larger managers and funds: covered call selling.

I want to talk about covered calls as a perfect strategy for taking advantage of the particular situation that faces us today with both traditional and green energy stocks, poised as they are for a very good 2021.

Why am I complicating our trades with options? Three reasons: First, the historical volatility of options for many energy issues are very, very high right now, making the opportunity of premium selling particularly profitable. Second, the ability of small investors to put on option positions, is far easier than for larger-scale managed funds.

Because individual month/strike options markets are often illiquid, only small orders can be handled without destroying the prices in those markets – a small investor with 10 or 20 options to sell can get filled at a reasonable price, while a similar order for 1000 or 2000 of those options would completely disrupt the pricing.

Finally, the strategy with options, while more complex to initiate, actually removes much of the timing and decision-making for entry, exit and adding or subtracting from positions. With covered options strategies, you’re almost always committed until the expiration of the option, or until those options are prematurely exercised. This can simplify strategy (and the panicked mistake factor!) enormously.

Let me take two examples in the current energy markets, one from the traditional oil and gas side and one from the more hyped green side and show how both would work using covered calls. Both of these are a part of my portfolio and have been recommended in the past to subscribers of my Energy Word service.

EOG Resources

EOG Resources (EOG) is a prototypical US independent E&P shale player, although it has a far better formula for production guidelines than many others in the space. Their discipline (and superior acreage) has helped them achieve far better production results and return on invested capital than many other shale specialists, and they have earned my respect as one of the few leveraged Permian and Eagle Ford shale E&Ps I’m willing to invest in for the long haul. But despite the relative ‘conservative’ nature of their activity, their share price is directly tethered to the price of crude oil, and the gamma of their options reflects that, with greater than 50% volatility.

That’s a pretty nice premium to collect, particularly if I want to be invested in EOG Resources anyway – and I do. Let’s look at a hypothetical trade, using numbers I took from Tuesday 3/2:

Price is $65.40 – we want to have a position that runs through the summer, so let’s use the October 65 Call with a 58% volatility, priced at @$10.50. Choosing the “right” month and strike is a bit of black magic, but generally, we’ll pick strikes that are closer to settlement prices when we feel the stock price is relatively high and the volatility is relatively low, and move further away from the strike the lower we feel the stock price is and the higher we see the relative volatility. EOG at $65 and 58% vol would seem like it is neither pricey nor with cheap volatility - but historically, it is actually both here.

What are our return possibilities? Our premium is $10.10 over 7 months, or $17.30 annualized or 17.30/65.40 x100 = 26.5% annualized – if EOG remains above $65 until October. If it doesn’t, our returns will go down, although we won’t lose money until EOG drops below $65.40 - $10.50 = $54.90 by October. That’s a nice buffer to have on downside risk, considering I’m happy to own EOG today. On the downside of return possibilities, I am giving up any additional gains should EOG rally above $65.40 + 10.50 = $75.90 by October.

But the trade becomes fundamentally easier to manage because at no point do you need to consider what to do with shares between today and October's expiration. As the expiration approaches, you can finally make one decision whether to buy back options or re-initiate positions upon assignment should the stock rally above the strike, or abandon the position or re-initiate options should the price be below the strike. Until then, you're more or less "locked-in," which can help avoid a panicked misstep with the trade.

FuelCell

Let’s take one more, this time from the green side: FuelCell (FCEL), a hydrogen-exchanger manufacturing company. This one has caught a lot of hype and is, at least fundamentally speaking, overpriced – as are many of the green energy stocks. Still, I believe hydrogen to be an under-weighted green technology (compared to electric cars, for example) – and FCEL actually has been making money, with contracts from some big organizations, like Amazon (AMZN) for example. Recently, the stock has been taken down from very big heights because of the exercise of warrants by Amazon and other partners – and this seems to me a good time to take advantage of that slack in the hype – using options, of course.

Price is $18.70 – we’ll use the October 22 call at $5.90 – a further away strike because we think that FCEL is currently relatively low while its volatility (130% +) is, well, extraordinarily high.

Here are the return possibilities. Collected premium: $5.90 + stock appreciation of $3.30 provided FCEL settles above $22 in October, which equates to a 122% annualized return (!). If FCEL settles below $22, we don’t lose money until the stock drifts below $18.70 - $5.90 = $12.80, again a pretty nice buffer to have on the downside if you’re considering owning FuelCell shares.

All of these return possibilities only look this promising because of the currently very unusually high volatility of the options on energy shares of all kinds these days, combined with the advantage of small individual positions that are capable of executing small volume orders in the very illiquid stock options markets. If you’re looking to take advantage of a continuing renaissance in energy stocks this year, I can think of no better strategy to put to use.

Analyst’s Disclosure: I am/we are long FCEL, EOG. 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.

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