Investing in Canroys for Long Term Success

From Jake:
Brian I am still not fully invested in the oil group, with the commodity bubble expected to bust I have invested lightly in this area. Any suggestions? Maybe short term? I have CANROYS but wanted to invest more before the run up but did not want to be taken out in a couple of months. I know hard to answer but any thoughts.
Otherwise a great day for me positioned well in all areas! Thank you!


My Response:
I think the Canroys will do very well short term and long term. In the mid term (2 mths to 12 mths) I am expecting a commodities correction. I think there is a lot of hot money in commodities that is parked there while the recession worries play out. I think that hot money (traders and hedgies) will move back to U.S. equities once the all-clear is called for the market. I expect that to happen anytime from June this year to March next year, sooner more likely.

Short term (next 2 months) I think Canroys will benefit from the hotness of the energy market. The Canroys hedge some of the product forward, but not all of it. So, they are benefiting from the higher energy prices on a daily basis, as they sell some production into the spot market. Also, as futures contracts expire, they will write new futures contracts at the current higher prices to lock in this level. So, there cash flow will dramatically increase the next 12 months, way above their budget forecasts, which are mostly in the $60s for oil and around $7 for gas (this info is in their annual reports).

Regardless of market concerns over the Canadian tax consequences, eventually, the value of this cash on the books must be rewarded. There could be a large special dividend, an acquisition which would increase future revenue and cash flow per share, or a takeout, which would result in a large premium on the stock price. I expect a 50% increase in price in the stocks if not taken out. If one of the small Canroys, like Daylight or Baytex for example, are taken out, they could double in value over a couple of days.

So, I think this is a great entry point for the Canroys, though it would have been even better a month or two ago (Daylight has gone from $6 in mid-January to $10 today, for example)

Regarding the Long term, 12 months to 10 years or more in the future, oil and gas will get more and more expensive as demand increases and supply stays flat if we are lucky. After 10 years, I expect alternative technologies to began increasing energy supply in general, shifting demand. I think solar will become a much bigger factor as new technology improvements drive production costs down. Wind, geothermal and wave energy will also be increasingly important. As fuel cell and battery technology improves, more vehicles will operate on electricity which can be produced by solar sources (wind and wave energy is indirectly derived from the sun, as is hydro power from rainfall into reservoirs). I expect biofuels like ethanol to become less and less important. They are very inefficient to produce and compete with the food supply.

I think Solar will be the most immediate winner in alternative energy and I am working in this industry, so can keep an eye on it up close. Today I am buying a small tracking position ($1000) in a new ETF for solar energy called TAN. Solar has had a big run and might pull back quite a bit in the likely coming commodity correction. So, I will buy more gradually looking for a better point to add a big position.

Short Sale - Long Collar: the Perfect Hedge

This may be the perfect hedge: Short Sell a weak stock and then use a long collar to protect against it going higher.  I have been experimenting with this strategy and it is so far working very well. 

 

Here is how it has gone: on January 15 I sold short 300 shares of Radioshack (RSH) at 14.17.  RSH has shown weakness for over a year, though it did have a good spike the middle of 2007.  But lately, it has done poorly along with the rest of specialty retail.  Because the risk on a short sale is unlimited to the upside, I wanted to provide protection, so I bought (3) Feb $15 Call contracts for $0.75 each (each contract covering 100 shares).  To help pay for the Calls I sold (3) Feb $12.50 Put contracts for $0.40.  This left me some room to the downside to profit from continued weakness in RSH (14.17 - 12.50).  If the price of the stock continued to drop below the strike price of the sold put, I would realize a profit of $1.67 + 0.40 - 0.75 = $1.32 per contract (or $396 for all 3) when the put was assigned, taking out the short.  Over the one month time frame, this would provide an annualized gain of over 100% (using only margin, as shorts and sold puts require no capital).

 

But what would happen if the price of RSH rose in the meantime?  I just found out and am pleasantly surprised.  The fear of all short sellers is a rising stock price.  But using the collar, I guaranteed upside protection with the Call contracts.  I sold those contracts yesterday as the price of RSH had risen to $16.80 at the time of the sale.  Here is how the math has worked out on this transaction:  Call price on 15 Feb strike rose to $2  on Feb. 1, 2008 (it was at $2.70 earlier in the day but I have job and wasn't monitoring the contract price).  I closed out the Call contract for $2 and also closed out the short Put contract at $0.05.  My total gain on the Put and Call option contracts was (0.40 - 0.05 + 2.0 - 0.75) $1.60.  In effect, this raised the basis on my short to 14.17 + 1.60 = 15.77.  

 

I turned around and did another collar, though quite a bit higher, with a March expiry sold Put with 17.50 strike for $1.53 and a collaring $20 Call for a paid premium of 0.68.  The worse case scenario is a close below 17.50 on March 22 in which case the put option would be assigned and the Call would expire worthless.  In this case, the total possible loss is $17.50 - 1.53 + .68 = 16.65 - 15.77 (new basis) = 0.88 a share, about the same risk as for the Feb contract, so effectively rolling the strategy forward even in a market with rising prices.  But if it closes above 17.50, the sold put premium will be booked and will again increase the basis on the short position. 

 

Bottom line: this is a reasonable way to put in shorts against weak stocks while mitigating risk.  The weakness of this strategy is limited profits on a dropping stock price.  But it will do very well with flatish prices (renewing the collar will generate profits each month) and will provide protection with rising prices.  It might be possible with this short strategy even to profit with rising prices with good timing (which was not the case here as I gave up 0.70 in profit with bad execution on Friday). 

 

I will keep you posted to performance future months, and may add a couple more candidates, like Washington Mutual (WM), Garmin (GRMN) or CROX.