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Thursday, January 9, 2014 - 14:30

Generate A 22% Return -- By Betting Against Buffett's #1 Energy Stock?

Thursday, January 09, 2014 2:30 PM

Wicked winter weather has been rocking the entire country. According to the National Weather Service, the Northeast and Midwest have been experiencing "life-threatening" wind chill, with temperatures hitting multi-decade lows.

But while these extreme conditions have led to school closures, government shutdowns and massive traffic jams, they've also supported one of my favorite long-term investments.

With the country suffering through a deep freeze, demand for natural gas has been surging. The United States Natural Gas (NYSE: UNG) exchange-traded fund is up 17% in the past three months and back within striking distance of the 52-week high just above $24. That strong finish helped natural gas gain 32% in 2013, making it the year's top-performing commodity.

Cold weather has been a great short-term catalyst for natural gas. But the long-term outlook is even better: The natural gas boom is expected to last for decades. According to the U.S. Energy Information Administration, natural gas is on pace to become the country's leading source of energy by the end of the decade.


Source: U.S. Energy Information Administration

That bullish trend is great news for energy investors operating ahead of the curve. But with that growth potential comes volatility. Energy companies are capital intensive, which makes them more sensitive to economic growth. A hiccup in the global economy can scare a lot of hot money out of the energy sector in a hurry.

To find the steadiest energy stocks, I built a screen starting with the S&P 500 and focusing on large-caps with global operations. From there, I screened for a price-to-earnings (P/E) ratio of 13 or lower. And since dividend stocks are typically more stable than non-dividend payers, I looked for stocks with a yield of more than 2.5% and a five-year dividend growth rate better than 10.5%.

A total of 15 companies from the entire S&P 500 passed. That comes out to just 3%, already rare territory.

From that list of 15, only three energy companies emerged. From those three, I have chosen Warren Buffett's favorite new energy stock as our options trade of the week.

Buffett's New Favorite Energy Stock
Exxon Mobil (NYSE: XOM) is a great way to cash in on the natural gas boom.

In the past few years, Exxon has been aggressively transforming itself into one of the largest natural gas companies in the world. In 2010, it bought natural gas producer XTO Energy for a record $41 billion.

Exxon has also been making big investments in liquefied natural gas (LNG) projects worldwide, including a $52 billion LNG complex in Australia that will serve as a crucial supplier to high-growth Asian markets.

In Qatar, Exxon recently began building four of the biggest LNG trains in the world.

It's clear that Exxon is making big moves right now to position itself as a key supplier of natural gas to high-growth emerging markets. Those moves have attracted the attention of one of the most successful investors of all time.

In November, Buffett revealed he had exited a long-standing investment in ConocoPhillips (NYSE: COP) and initiated a $3.7 billion stake in Exxon -- his seventh-largest holding and his largest new holding since 2011.

As one of the most shareholder-friendly companies in the world, Exxon fits right into Buffett's classic investment style. It has a current dividend yield of 2.5% and a five-year dividend growth rate of 10.6%. Despite those robust dividend hikes, the company's payout ratio has held steady between 32% and 22% for the past four years. That bodes well for future dividend increases. Exxon's strong financial profile also makes it one of just four S&P 500 companies with a AAA credit rating.

Buffett probably also found Exxon's valuation attractive. Its forward P/E of 12.5 times is in line with its 10-year average of 11.5 and a nice discount to the S&P 500's 15.5. That helps protect shares from short-term market or economic volatility.

But despite the bullish outlook and Buffett's stake, Exxon looks a bit extended in the short run.

That's why the time is right to employ one of my favorite options strategies to give us a chance to buy shares at a 10% discount. If that doesn't happen, we'll collect a solid stream of income totaling more than 22% annually.

Earn Money For A Chance To Buy XOM At A Discount
I think Exxon will produce great returns in the long run. But shares have run up in the past few months. With the market trading near all-time highs, I'm looking to be a little more conservative with new positions.

So instead of buying shares of Exxon at its 52-week high, I am going to sell puts.

Selling a put option is like selling an insurance policy to another investor. This provides us with two potentially beneficial outcomes.

The first is the ability to generate income. When we sell a put option, we get paid for it. The premium you receive for selling a put is deposited directly into your brokerage account as instant income.

If Exxon continues to move higher, these options will expire worthless. That's good for us because it means we profited from Exxon's bullish trend without having to buy a single share.

The second is the ability to buy a desirable stock at a discount. If Exxon falls below our strike price on the day our options expire, we'll be able to buy Exxon at a 10% discount from current levels. And since I'm bullish on Exxon's long-term outlook, that would be fine with me.

On Friday, Exxon closed at $99.50. This week, I recommend selling XOM Jan $90 Puts for $0.35.

Selling these puts will generate immediate income of about $37 (each option controls 100 shares), but we would be obligated to buy 100 shares of Exxon at $90 if prices fall below that level on Feb. 14.

A strike price of $90 is far enough out of the money to support a respectable premium while also carrying a low probability we will actually be put shares.

Although it's possible to buy long-dated options that expire in years, I like to focus on short-dated options with expiration between 45 and 60 days because that increases the probability that the options will expire worthless.

Think about it like this: A lot of unexpected things can happen to a stock in a few years. Share prices can zoom all over the place. That makes it risky to commit to buying at a certain price with a put option dating years into the future. But in six to eight weeks? There is a much lower chance for volatility and extreme price movement.

We won't be rewarded with as large a premium because we're taking less risk with short-dated expiration -- but wouldn't you rather have lots of smaller winners than a mix of big winners and big losers?

Action to Take -- > Being put 100 shares of Exxon at a strike price of $90 would require a $9,000 investment. But to initiate this trade, you won't need the full amount. Most brokerage firms require a 20% deposit to control the position. That puts our margin deposit for the Exxon trade at $1,800.

Here's how the trade looks if the options expire worthless. As you can see, this is a high-probability trade, with an 81% chance of our options expiring worthless. A potential 2.1% return might not jump off the page -- but that comes out to more than 22% annually when compounded over 12 months.

Here's how the trade looks if the unlikely happens and we are put shares of Exxon:

P.S. My colleague Amber Hestla executed her own options strategy to perfection last year, with 35 consecutive profitable closed trades -- good for an average annual return of 66%. How did she do it? Click here to learn more.

Michael Vodicka 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.