Last Thursday's decision by the Organization of Petroleum Exporting Countries to keep its production quotas in place not only sparked a rally in crude prices but lit a fire under the shares of oil and gas companies. In the past two weeks, the Philadelphia Stock Exchange Oil Service index, or OSX, has surged some 10%. Although the move was certainly impressive, it also seems a bit late, given the fact that crude oil has been averaging above $30 per barrel for nearly a year now.
"I think the reality of sustainable $30 crude prices is finally settling into the market," says Al Kaplan, an energy industry consultant with Kaplan Resources. He notes that is some $15 per barrel, or 100%, higher than the average price for crude in 1999-2000. However, oil stocks, as measured by sector indices, are still trading some 10% below their year-ago levels.
An OPEC meeting scheduled for Feb. 10 -- as well as the cartel's past experience with noncompliance -- leaves room for more production in coming months. Nonetheless, it's becoming safer to assume that oil prices should hold above $25 until at least the beginning of March. This should help underpin the prices of oil company stocks, allowing them to consolidate recent gains and possibly work higher over the next few months.
energy guru Chris Edmonds provided a list of oil-services companies that are poised to move higher. But because I can't pretend to have the ability to pick the "right one," I'll instead use the
Oil Service HOLDRs
to establish a model position in the sector. The OIH is made up of 18 stocks, with
together representing nearly 60%.
Using a ratio call spread might be an appropriate strategy for taking advantage of steady to higher oil-stock prices. A ratio call spread involves buying one call option and selling multiple call options that are further out of the money but have the same expiration period. For example, you could buy one January $40 call and simultaneously sell three January $50 calls. The maximum profit of a ratio call spread is realized if the underlying equity (or commodity) settles at the higher strike price ($50 in this case) at the time of expiration. Risk comes into play if the underlying share price rises too far too quickly, pushing the short calls into the money. The losses can be unlimited and mount quickly in a rapidly rising market.
So why, given the possibility of higher oil prices, would anyone consider a position that not only bets against an increase in volatility but also could turn delta-negative and incur losses if prices move above a certain level? First, remember that the ratio writing will be applied to oil stocks, not the actual commodity.
Who's Scared of Higher Prices?
Unlike equity options, which typically see implied volatility rise as prices fall, a byproduct of the "fear factor" of put protection, many commodity options exhibit the inverse behavior. As the price of the underlying product increases, so does the implied volatility of its options. This makes sense intuitively: Whereas stocks suffer from uncertainty, commodity prices tend to rise when faced with the unknown, whether it's a drought, embargo or war.
But when we look at stocks that are leveraged to commodity prices, we are presented with a paradox. Even though they typically benefit as the price of the product they produce rises, their options behave much like ordinary equity options: Their implied volatility declines as prices rise.
"The volatilities of physical commodities, such as energy, tend to have a forward skew as buyers are more anxious and volatility jumps on the way up," says Howard Simons, a fellow
contributor. "Oil prices really trade off what is currently available, not what is in the ground, making it difficult to monetize future capacity at current prices," he said, explaining why oil and gas prices have a higher front-month price than further out in the future. January crude oil is now at $32, trading some $3, or 10%, above July crude prices.
Rising prices allow producers to secure a certain price level, making profits more predictable for a measurable period. That is a definitive way of removing volatility from stocks' prices. Given that the suggested strategy involves oil stocks, not the physical commodity, concerns that rising oil prices will lead to an increase in volatility should be alleviated.
Just how far can this group of stocks run? That's a tougher question to answer, but the options position can be adjusted to accommodate a variety of scenarios. The main goal is to choose strikes that provide ample room to profit from steady to higher prices, as well as a break-even point that represents a price level you'd be comfortable selling.
According to the OIH chart blow, the first level of resistance is at $60. More substantial resistance exists at the $65 level and at what appears to be insurmountable, last June's price spike to $67.50. Strong support is in place along the $55 level, where OIH has bounced several times over the past year.
Let's assume I don't think OIH will clear $65 in the near term, and I'd be comfortable shorting above $70. My setup would be to buy one April $55 call and sell three April $65 calls. With OIH now trading at $59, I could establish the ratio spread for a net debit (or total cost) of about $1.50.
The maximum profit of $8.50 would be realized if OIH settles at $65 on the April 16 expiration. The maximum loss of $1.50 would be incurred if OIH ended up below $55 on expiration. Losses would start to mount if OIH rose above the $69.25 break-even point.
The ratio spread can be adjusted by using higher or lower strikes, narrowing or expanding the spread and increasing or decreasing the ratio to make the position match your predictions and comfort level.
Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to