Alternative Play May Be The Smartest Way To Trade The Future Of Oil

Joseph Hogue's picture

Tuesday, January 5, 2016 - 7:30am

by Joseph Hogue

Forecasting the price of oil has become the hot topic heading into 2016. There seems to be little consensus on direction, though. Just as many forecasts call for $20 oil as for $50 per barrel. 

There have been record inflows into energy ETFs as investors try to time a bottom. In fact, Bloomberg reports "a wide range of investors collectively spent about $24 billion over the past 18 months trying -- and failing -- to call a bottom in oil."

While other traders franticly try to catch a falling knife, I've uncovered an alternative play that is all but guaranteed to rally if oil rebounds, but should also do well while we wait.

Higher Oil Someday… 

Despite the difficulty in timing a bottom, several factors point to an eventual rebound in oil prices.

More than $68 billion was slashed from capital spending across the energy industry in North America alone this year, with a survey by Barclays showing it could be cut by another 10% to 15% next year. Globally, the bank found capital expenditures were cut by 20% this year and may be reduced by as much as 8% in 2016, marking the first consecutive spending cuts since the mid-80s. 

With this comes a rig count that has been more than halved over the past year. Baker Hughes reported 826 North American rigs in operation as of Dec. 23 -- a 60% decrease from 12 months ago.

The drop in capital investment and rigs could bring the first production decline since 2008 to non-OPEC fields. The U.S. Energy Information Administration is forecasting production will decline by 360,000 barrels a day from non-OPEC suppliers next year. 

Countries across the OPEC group need an average price of $106 per barrel to balance their fiscal budgets. Heavyweight Saudi Arabia said it needs to borrow $98 billion to cover its fiscal deficit even after cutting some subsidy programs. Other countries like Venezuela could be on the verge of default as tumbling oil revenues fail to cover spending. While OPEC has thus far denied a production cut to support prices, the outcry is growing louder for some measures to help member states.

In its 2035 energy outlook, BP shows a strong picture for long-term energy investors. Total oil consumption is projected to increase by a modest 0.85% annually to 5.06 billion tons of oil equivalent a year over the next two decades. This is in contrast to slower production growth, which is forecast to grow by just 0.7% annually to 4.88 billion tons of oil equivalent over the next 20 years. 

In fact, BP is forecasting an annual oil production deficit of 93 million tons by 2020, led by annual consumption demand growth of about 4% in both China and India.

Even if the price of oil doesn't rebound quickly, one oil-producing nation is looking at a strengthening economy next year.

…A Stronger Canadian Economy Tomorrow

The Canadian economy is forecast to see GDP growth jump from just 1% this year to 1.7% in 2016, according to the International Monetary Fund.

Other signs of solid growth include:

-- The private sector in Canada is estimated to grow 2% next year. 

-- The newly elected Liberal government will take office soon and should make good on its promise of tax cuts and $5 billion of infrastructure spending within the first year of its mandate. 

-- The Bank of Canada recently held rates at 0.5% after two cuts on more evidence that the non-energy side of the economy is rebounding. 

-- Consumer spending in Canada is expected to jump 2.8% next year, up from 2.3% in 2015.

The iShares MSCI Canada (NYSE: EWC) is targeted to access 85% of the Canadian stock market with a 20% weight in energy. Shares trade for just 14.2 times trailing earnings of the companies held, a discount of 38% to the 23 P/E multiple on the S&P 500 index.

EWC's performance is very closely correlated to changes in the value of the Canadian dollar and oil prices. While low oil prices will weigh on the value of the Canadian dollar and shares of Canadian companies, the strength in the rest of the nation's economy should be enough to drive corporate profits higher. 

Energy prices will eventually rebound, taking both the Canadian dollar and EWC for the ride higher. It may be late in 2016 -- or even into 2017 -- before this happens, but investors don't have to wait to book solid returns.

Earn An Annualized 21% Even If Oil Doesn't Rebound

Using a covered call strategy, we can lock in a 21% annualized return even if oil prices remain depressed. If you're not familiar with how a covered call works or need a refresher, watch this 90-second training video.

With EWC trading at $21.65 at the time of this writing, we can buy 100 shares and simultaneously sell one EWC March 22 Call, which is trading around $0.62 ($62 per contract), for a net cost of $21.03 per share. This is below the fund's 52-week low and represents a 2.8% discount to the current price. 

If EWC closes above the $22 strike price at expiration on March 18, our shares will be sold for that price. In this case, we will make $0.35 in capital gains, plus the $0.62 we received for selling the call, for a total return of $0.97 per share. This represents a profit of 4.6% over our cost basis of $21.03. Since we'd earn that in 79 days, it works out to an annualized gain of 21%.

If EWC closes below the $22 strike price, we keep the premium and the shares and can sell more calls to generate additional income.

If the shares do not close above the strike price on expiration, I'll write another call option against the position to generate additional income, while also possibly collecting income in the form of the fund's distribution. 

Note: To find out how you could pocket $795 in the next 48 hours -- and earn up to $3,000 a month -- using another covered call strategy, follow this link.

This article was originally published on ProfitableTrading.com:​ Alternative Play May Be The Smartest Way To Trade The Future Of Oil

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.