Synthetic Short On ConocoPhilips (NYSE: COP)

Short ConocoPhillips

Initiate synthetic short position on ConocoPhillips (NYSE: COP) using February 2015 Puts striking at $75; contingent on COP reaching short term level of $72.

Key points:

  • Short to medium term play backed by favorable technicals and sector fundamentals
  • Assumes crude oil remains in its range (worst case) or continues to the downside (base case)
  • Continue to expect sectorial rotation out of oil and gas (energy) and into transports within US markets
  • COP remains profitable despite $50-60 oil prices but top and bottom lines expected to be significantly affected
  • Prices have staged a corrective advance to key technical levels, offering potentially attractive entries on a risk-to-reward basis

Narrative

Bottom line:

  • Oil prices will remain suppressed
  • Relatively steady supply into waning demand
  • OPEC's new strategy of crowding out new American entrants
  • Saudi Arabia will do all it takes to stave off the Shale Revolution; protect market share
  • Entire energy industry has been hit; giants not spared
  • Profitability has dropped and will remain lower in new paradigm of low crude prices
  • Producers with high breakeven costs risk being wiped out; those highly leveraged face risk of bankruptcy
  • Outlook on sector remains bleak, bottom picking extremely risk business
  • Bear trend is our friend

The weak oil price story isn't a new one; North Sea Brent crude oil has fallen from $116.13 on June 22, to $58.16 on December 14, a 50% decline in half a year. Global oil prices are firmly in bear territory and the outlook doesn't seem bright; definitely not a canary in a coal mine.

As I wrote previously, there are 2 sides to the current climate of cheaper oil: Steady supply by OPEC, and waning demand

The IEA (international Energy Association) cuts global oil demand forecast for fourth time in 5 months as OPEC refuses to blink and global growth forecasts dim to a twinkle. This has sent WTI prices below $60 and printed a low of $57.31, the weakest since July 2009. Across the board, Brent and Canadian Heavy prices are also crashing through the floor. Corporate credit and equity of companies in the energy sector continue to take relentless beatings as analysts continue to predict ever lower prices. The contagion effect has major oil producing countries all over the world scurrying to prevent their respective economic meltdowns as revenues are clawed back by the markets for every additional cent oil prices decline.
— Business of Finance

The negative contagion stemming from weak energy prices has negatively impacted the American energy sector, which has been the stoic focus as of late. The entire energy industry in America has been hit hard. A number of analysts covering the American energy sector have commented that the strategy of OPEC remains that of crowding out the new entrants to the shale oil revolution in America; small to medium cap names especially those whose production is heavily weighted on drilling into pockets of shale oil have higher breakeven prices/bbl. OPEC, especially Saudi Arabia, cannot afford to cede market share to America and Canada via the Sale Oil Revolution; what was once North Sea oil is not Shale oil.

One thing remains clear: The Saudis will not cut production, because doping so means the Americans have won. Oil is the only thing the Saudis are known for, they will not give up without a good fight, and they have proven that with oil being at $60.

 The broader energy complex in America has seen no dearth of selling and mass liquidations as giants like Exxon and Chevron are not spared. XLE (Energy Sector ETF) is down 28.7% since June's highs but has recently seen a strong rebound following some respite in crude oil prices

The broader energy complex in America has seen no dearth of selling and mass liquidations as giants like Exxon and Chevron are not spared. XLE (Energy Sector ETF) is down 28.7% since June's highs but has recently seen a strong rebound following some respite in crude oil prices

With Brent oil underneath $70/bbl, many smaller drillers with higher breakeven costs will bleed cash with every marginal barrel produced. They have 2 choices: Stop production, or lower production. Even giants like Exxon (NYSE: XOM) and Chevron (NYSE: CVX) have not been spared from the bloodbath.

With this in mind, we look for low risk and high probability entries seeking to capitalize on the bear trend in energy. Although the risk of a short squeeze remains, the baseline scenario rests on a continuation to the downside in crude oil prices. Recent has shown that there is a high positive correlation between crude oil prices and market performance of oil producers.

Trade Details

This short is a synthetic position utilizing derivatives to attain a short exposure to the underlying security, COP stock. In this case we utilize put options on COP to gain short exposure within risk parameters of out propriety metric-based system.

  • Long 75 Feb 2015 Puts on COP (expiring 2/20/15)
  • Last asking price was $6 (as of 12/23/14 close)
  • Trade contingent on COP reaching $72, inline with risk metrics
  • Non-linear payoff and drawdown
  • Position to be exited discretionarily for a loss if COP trades above $75
  • Interim target for COP is $62
  • Potential risk-to-reward of at least 2.32 (linear expectations on spot price)

Options remain the instrument of choice as implied volatility is anticipated to flare if COP stages another fierce decline. The inherent leverage inside the puts gives us a higher geared position to potentially profit from a further selloff. Although volatility levels remained fairly heightened, there should be little concern as this is an indication that protection is still bid on COP, and probably other energy names.

We go 2 months out to provide a margin for timing miscalculations which often occurs. The favorable chain according to our framework is 4 months out, however options on COP kink after Feb to May, which makes it too expensive for consideration.

Slightly ITM puts were selected for this trade partially to mitigate some of the higher costs associated with the slightly unfavorable volatility premiums, and partially to ride on a higher delta since we move on spot we are betting on is just slightly north of 10%.


Technicals

Bottom line:

  • Trend is down, trade with the trend
  • Broken 2-year trendline
  • Staged corrective advance to system-mandated resistance area, providing favorable entry to short
  • Objectively defined stop loss level on COP
  • Highly plausible and realistic target on COP
  • Brent oil prices consolidating within 1.5 & 2 STD ranges, downside breakout anticipated

Business of Finance utilizes a metric-based system to provide setups and entries that are inline with our risk profile. By synergizing the best of fundamental and technical analyses, we are able to justify our trades with a sound fundamental basis, as well as being superior in market timing and risk and expectations management.

As for COP, the trend remains bearish. Our trend-based indicators continue to indicate COP could still trade lower. Technically, COP is weaker than XOM but slightly stronger than CVX; however COP fits in best with out system and offers the clearest entry and exit points.

 COP has broken under a 2-year long up trendline, signaling a shift in both sentiment and momentum. Trend-based indicators continue to point down

COP has broken under a 2-year long up trendline, signaling a shift in both sentiment and momentum. Trend-based indicators continue to point down

 Illustration of short COP trade. Upper pane shows the extend of the selloff in COP and the ensuing correction. Lower pane plots historical prices of the 75 Feb 2015 Puts on COP; puts remain a good way to gear up on a bearish bet

Illustration of short COP trade. Upper pane shows the extend of the selloff in COP and the ensuing correction. Lower pane plots historical prices of the 75 Feb 2015 Puts on COP; puts remain a good way to gear up on a bearish bet

 The baseline scenario posits crude oil prices (Brent used here) to head lower, breaking out of the current consolidation. Worst case scenario is crude prices continue to trade within this range, bleeding the premium on the puts

The baseline scenario posits crude oil prices (Brent used here) to head lower, breaking out of the current consolidation. Worst case scenario is crude prices continue to trade within this range, bleeding the premium on the puts


Permutations

While we do not anticipate an extension to the time frame of this trade, if future prevailing circumstances permit, we would consider rolling to farther dated series of puts or even legging up into a vertical spread to lock in the delta in premiums.

Look for more updates to this trade as market develops further. Meanwhile, Merry Christmas and happy shorting!