Energy bulls are rejoicing over the recent rally in oil prices, but crude is still more than 50% off its highs.
The rout has taken a major toll on most energy companies’ profits. Earnings for the sector are expected to decline more than 65% in the third quarter compared to a year ago.
The prescient analysts at Goldman Sachs forecast oil prices will remain around $45 a barrel in 2016. In fact, they say we could even see crude hit $20 a barrel before rallying.
Given this, it might seem logical to avoid the sector altogether. But not all energy companies are created equal, because not all of them lose money when crude prices fall.
One subsector actually benefits greatly from lower oil prices — the pure refiners — and my favorite in the group is Tesoro (NYSE: TSO).
Tesoro Thriving While Other Oil Companies Struggle
Unlike Exxon Mobil (NYSE: XOM), BP (NYSE: BP) and other big oil conglomerates, Tesoro is a pure oil refiner that sells petroleum-based products like gasoline and diesel fuel. It focuses all of its attention on refining, distribution and marketing, with no involvement in the exploration and production side of the industry.
Tesoro operates six refineries in the Western U.S. with the combined ability to process more than 850,000 barrels per day. Its petrol marketing system runs more than 2,200 retail locations across America under the ARCO, Shell, Exxon, Mobil, USA Gasoline and Tesoro brands.
What makes Tesoro unique is that, as a pure oil refiner, the company has been able to exploit low oil prices to generate record profits.
One of the byproducts of cheap oil is cheap gasoline, and one of the byproducts of cheap gasoline is increased consumption by consumers.
According to the U.S. Energy Information Administration (EIA), while the average price for conventional gasoline has dropped about 30% since January 2014, retail sales of gasoline by refiners have increased 45%.
There’s another key statistic that’s even more bullish for refiners.
While the price of gasoline is down roughly 30% since the beginning of last year, crude oil is down about 50%. In short, refiners like Tesero are getting a bigger discount on crude oil than they have to discount their end product — and they’re raking in profits on the difference.
In its most recently reported quarter, Tesoro deliver record earnings per share (EPS) of $4.62, up 172% from the same period last year.
Since Tesoro’s Aug. 5 report, we have seen substantial upward revisions to analysts’ full-year earnings estimates and price targets. In the past two months, the consensus EPS estimate for 2015 has increased 22% to $13.05 per share, while analysts’ average price target now stands at about $119.
TSO is currently trading more than 12% below that target at around $104. I think now is a great time to own shares of the company, but given what is sure to be continued volatility in the oil sector, there is an even better strategy.
The strategy I have in mind can greatly reduce your risk and has the potential to generate a profit whether TSO rallies, stays flat or even falls slightly. Specifically, as long as TSO stays above $95 through Nov. 20, which I firmly believe it will, we can book a 37% return.
Make a Potential 37% on Tesoro in 43 Days
The strategy is known as a bull call spread and it involves simultaneously buying one call option and selling another with the same expiration date but a higher strike price. The option premium from the call sold decreases the cost of buying the long call.
For this trade, I am interested in buying one TSO Nov 90 Call and selling one TSO Nov 95 Call for a net debit of $3.50 or less ($350 per pair of contracts).
Note: Be sure to use limit orders when entering and exiting a bull call spread to get the desired prices.
The most the trade can be worth is the difference in the strikes. This is achieved as long as TSO stays above the strike of the long call ($95) through expiration in November.
Therefore, the maximum profit equals $5 ($95-$90) for a return of 43% over the $3.50 net debit paid to enter the trade.
However, I like to set my profit target slightly below the maximum profit to automate the trade and allow for an early exit if the stock continues to rally. When you enter the trade, place a good ’til canceled (GTC) limit order to sell (close) the spread at $4.80. This will result in a 37% profit in 43 days, or an annualized gain of 315%.
The breakeven for a bull call spread is the strike price of the long call ($90) plus the net debit paid ($3.50), or $93.50, which is 10% below TSO’s current price.
If the stock is below this level on Nov. 20, we will experience a loss. However, no matter how low TSO goes, the maximum loss is limited to the amount paid to initiate the trade, or $3.50 in this case.
A bull call spread is the perfect strategy to reduce risk while still benefitting from potential strength in this pure oil refiner play.
Recommended Trade Setup:
— Buy one TSO Nov 90 Call
— Sell one TSO Nov 95 Call
— Enter trade for a net debit of $3.50 or less
— Set GTC sell limit order at $4.80
Note: We hope you liked today’s trade from options expert Jared Levy. While it’s not the typical trade we’ve featured on Profitable Trading in the past, it’s an incredibly lucrative strategy that you’ll likely be seeing much more of in the future.