A Small Bet On Oil's Rebound Could Land Traders Big Profits

Joseph Hogue's picture

Tuesday, May 12, 2015 - 7:30am

by Joseph Hogue

Spotting emerging trends in the market is the best way I have found to make oversized returns in equities. By getting ahead of market sentiment for a particular sector, idea or theme, you can take advantage of the herd mentality without being part of the herd.

This quarter, and potentially for much of the year, I am looking for two major themes to develop. 

The first is a cooling or even reversal of the U.S. dollar's rally, which began in force late last year and continued through March. 

The second theme, which is indirectly related to the first, is a stabilization of oil prices and improved sentiment in the space. Oil prices have bounced off their March lows, and near-term catalysts could help support them and bring investors back into the space.

If even one of these two themes plays out, it could mean strong upside for today's pick. If both themes develop, as they should, it could mean up to 56% returns for traders.

Oil's Rebound and Europe's Turn for Growth

The European Central Bank (ECB) was slow to adopt quantitative easing, the kind of bond-buying program that spurred growth in the United States, instead opting for strict cuts to deficits.

Stronger economic growth in the United States while the European economy stagnated led to a gradual weakening of the euro over the past several years. The announcement of a 19-month program to pump more than $1 trillion into the European economy was a big factor in the dollar's rise last year. Bond rates in Europe plunged, sending investors overseas to buy American assets and heightening demand for U.S. dollars. 

But the macroeconomic backdrop is changing. While first-quarter GDP growth in the United States was disappointing, recent manufacturing data out of Europe shows growth. The eurozone manufacturing purchasing managers' index (PMI) for April came in at 52, above the 50 demarcation for growth, and just under March's 52.2, which was a 10-month high. 

The ECB's QE program looks to be jump-starting growth, and the region could be on track to meet its 1.5% GDP target this year, for the fastest growth since 2011. The euro has already jumped almost 7% from its mid-March low.

The dollar's slide against the euro and other currencies since March has contributed to the rebound in oil prices. Since oil is priced in dollars, the commodity typically falls with a strengthening dollar and rises with a weakening one, among other fundamental factors. 

Besides help from a weaker dollar, oil may have several upside catalysts over the coming month. The plunge in crude prices has led to steep cuts at exploration and production (E&P) companies with the number of drilling rigs falling to the lowest since 2010. 

Crude storage inventories have started to come down as refineries ramp up demand for the summer driving season, and the U.S. Energy Information Administration (EIA) is already reporting a decline in crude production in some major shale basins.

Then there is the next scheduled OPEC meeting on June 5. The oil cartel is not expected to cut production, but prices could get a boost if they acknowledge declining U.S. production and the effect lower prices have had on the market. This could signal a production cut and higher prices later in the year.

Get Ahead of the Herd With This Oil Play

Total S.A. (NYSE: TOT) is the world's fifth-largest integrated oil company. The Paris-based company operates in 130 countries with about 80% of net income coming from E&P, and the rest from refining and chemicals, marketing and transportation, and alternative fuels. Operations in Europe account for 74% of net sales, while North American operations contribute just under 10%. 

Not only will Total benefit from a stabilization in oil prices and higher European growth, but ADR shares, priced in dollars, should also get a boost if the euro strengthens relative to the dollar. Dividends and other cash fundamentals will look stronger in dollar terms as the greenback weakens. 

Total is scheduled to report earnings on July 29, with analysts expecting $0.80 per share. This is likely conservative considering the developing oil and currency themes, and four analysts have upgraded their estimates over the past month. The company beat expectations by an average of 13.6% over the past four quarters, and a similar beat would bring results close to my EPS estimate of $0.90 a share. 

Amplify a 6% Stock Move Into a 56% Return

I see TOT running to at least $57 by late summer, which is about 6% above current prices. Given the volatility in energy prices, though, this target could be reached much sooner.

In early March, my colleague, Jared Levy, predicted Valero Energy (NYSE: VLO) would make a run from its then price of $57.30 to about $65 by June. The stock took off immediately, hitting a high of $64.49 just 15 days later.

A 13% move in just over two weeks is nothing to scoff at, but those who followed Jared's advice actually made a 90.5% return in that time using call options.

I want to provide you with a similar trade that could make you 56% if TOT hits my target.

The TOT Aug 50 Calls are trading for about $4.50 a share. Since each option contract controls 100 shares, you will end up paying $450 per contract. So you can make a bet on an oil rebound for less than $500 compared with the more than $5,300 it would currently cost you to purchase 100 TOT shares.

The breakeven on this trade is $54.50 ($50 strike price plus $4.50 options premium), which is 1.4% above the current price. 

If TOT hits my target of $57, the call option will be worth at least $7 ($57 stock price minus $50 strike price), for a return of 56% in just over three months. 

If you're interested in using options to magnify your portfolio returns, I highly recommend checking out Jared's Profit Amplifier service. If you have just a few minutes, there are five things I really think you should know about him.

This article was originally published on ProfitableTrading.com: A Small Bet on Oil's Rebound Could Land Traders Big Profits

Joseph Hogue does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.