Staying alive in this topsy-turvy market

It has been a week since I last posted, and what a week it has been. We witnessed Hurricane Gustav and its less than disatrous landfall, the postponement and then spectacular conclusion of the Republican convention where we were not disappointed by Gov. Palin (really, better than hoped for) and Sen. McCain. And we saw another week of violent whipsawing in the stock market.

What to do?

I have been successful playing the whipsaw. I don't see any other way to go, other than to hunker down in cash and take a long nap. In my trading account (my retirement accounts are full of conservative high dividend, buy-and-hold stocks and funds) I continue to play the trading range of the Financial index. UYG and SKF are the two bookends of the trade, SKF being short and UYG being long. They are both based on the XLF S&P index for Financials, but levered by 2X. The XLF range is oscillating between 20 and 23 since mid-July with a round trip every 10 days (which is very volatile).

In the latest cycle, I closed out my UYG Sept 25 sold puts contracts on Wednesday for around $3 (with the XLF around 22.00). Then I sold puts on the SKF October 125 for $20. On Thursday, at the open, the XLF moved to 22.50 and I could have sold more SKF puts at $23, but I held on as I was in the red. By Thursday close, the XLF had dropped 6% and was at 21.50. My SKF puts were in the black.

Today, on Friday, the XLF continues to drop and is now close to $20. The SKF which was at $110 on Thursday at the open, is now at $123. UYG has gone from $23.50 to $20 as of now. As mentioned, $19 or just a little less, is the low end of its 7 week range. I have a "buy to close" order on the SKF puts at $10.50 and a "sell to open" order on another round of UYG sold puts (Sept 25) for $7 (which will execute when UYG gets close to 19). I expect to close out the SKF today or Monday, depending on how quickly the market drops, and then get back in for the ride back up on the UYGs next week. I will continue playing this cycle until I can't.

Another trade on the horizon is selling more PWE canroy puts short. PWE is approaching its 24 month weekly low of $25. (it did hit 23.50 for one day on Jan. 24). It has corrected back to the level it was at when Nat Gas was $5.50 and oil was $70. But they are not at those low levels. PWE gets sold down hard by speculators even though it is not a speculative stock with its 15% dividend. It will always bounce back based on solid cash flow for the forseeable future.

The PWE Dec 30 put is at $5 as of today. I have orders in to sell puts at $5.50 and $6, giving me prices of $24.50 and $24 on the underlying stock if assigned. I will take that price on PWE any and every day.

PWE vs. XOM: Followup

A few days ago I wrote Jake Schmidt about what I saw was the problem with the large integrated oil companies like Exxon (XOM), Conoco (COP) and Chevron (CVX). Namely, the integrated oils are saddled with both diminishing reserves in more politically dangerous and expensive locations, and alternately, generate much of their income from refining and retail operations which have been squeezed by tight crude supplies and decreasing crack spreads.

This week's earning news has backed up that assertion as XOM on Thursday and CVX today, have disappointed the Street and have been sold off as a result. I had suggested that instead, we should just buy more Pennwest (PWE) or other favorite Canroys. They continue to be a great bargain as shown by the yield and cash flow multiples. Or, if a little more leverage and return is desired, sell the puts short.

Today (August 1), the PWE September $30 put (PWEUF) has a premium of $1.65. This generates a return of over 5% on the premium, but with the leverage of a margined short put (20% margin), the actual return is over 25%. When the 42 days to expiration is annualized, that simple return is around 250%. High return, high risk, so what is the risk? Getting PWE assigned at $30 a share if the price drops further before expiration on September 20. That PWE stock price is based on the cash flow generated by an average crude oil price of $80 a barrel, with the PWE hedge program that is in place. What is the risk of oil going below $80 in the next 12 or 24 months? I think pretty low. And if the stock is "put" to you the option seller, it is returning 12% on dividend yield right now, while retaining almost 50% of its cash flow for reinvestment and acquisition.

I continue to think the Canroys are the way to play the energy market. If not PWE, take a look at Daylight (DAYYF), Harvest Energy (HTE), Provident (PVX), Baytex (BTE), or Pengrowth (PGH).

The Trouble with Canroys

Brian, I have one question that keeps coming up on all the boards about CANROYS. The comments are that since the CANROYS pay out such a large dividend, and if they are not able to increase their production capabilites that the stocks will reduce in price over time as all the dividends are paid out. (or something close to this). Do they have a point or is this true for all oil and gas companies.

Jake, It is true that Canroys (and REITS and Master limited partnerships or MLPs in the States) are valued based on their dividend payout which is closely related to cash flow. In the States, REITs and MLPs must pay out 95% of income by law. In Canada, it is left to the royalty trust what percent to pay out.

This is an important distinction in my mind. The additional flexibility in Canada allows the Canroys to use a larger percent of income to make acquisitions to replace or expand production. You will see this is happening with the better trusts we invest in when you read the quarterly and annual reports of the trusts. PWE reinvests about 40% of its income in production, either making acquisitions (like the recent C1 Energy acquisition) or investing in additional wells on existing leases or rehabbing old wells. American trusts (MLPs and REITs) do have a problem with reinvesting in production and must issue more shares (diluting current owners) to raise money for acquisitions or expansions.

The metric that is used to measure how likely Canroys are to keep producing is Reserve Life. I look for a reserve life of at least 10 years. This doesn't mean the trust becomes worthless in 10 years, but that is how much "proven reserves" are available to last at current production rates. Each trust also has "probable reserves" which are normally many times the proven reserves. Probables are on leases that have yet to be tested, but are known to have oil and/or gas. So, as long as the trust doesn't run out of oil / gas, it will continue to produce and pay dividends.

The only other thing that can go wrong is a collapse in the price of oil and gas. Most of the trusts have a business model that generates current dividends well below current prices. (PWE's dividend model is around $40 a barrel). If the price of energy goes below that level, then profitability declines and they may start "shutting in" wells to eliminate marginally profitable pumping. But I am betting againsts that happening anytime soon. It would require a lengthy global recession to significantly reduce global energy demand.

So, in short, if we stick with the big trusts like PWE or PGH, I don't think there is much to worry about. If the trusts are acquired by a private company, then we will get a nice one time appreciation, but will lose the long term dividend. So, I am hoping the trusts remain independent and the Canadian gov't backs off on the tax change.