Whither Oil? Don't Guess.

Here's what we do know:
· Crude Oil is trading at a 12 year high of around $40 a barrel.
· The last peak the in crude price was October 1990 at $41.15
· US oil inventories are at their lowest point since 1975.
· War is imminent.
· Baby, it's cold outside- heating oil demand up 20 percent from 2002.

Here's what we don't know:
· Is a release of US strategic oil reserves coming?
· Will a war be fast and surgical?
· Where crude prices will settle?
· Will OPEC raise supply at the March 11th meeting?
· What if there's no war or the US et al wait until the fall?

Here's the deal. Oil prices have virtually doubled in the last year. We are on the knife-edge of the price breaking significantly one way or the other.  About the only certainty is that it won't stay at this level for long. If it seems too easy to buy into this run, it probably is. The smart money was in a long time ago and is now likely looking to hedge gains. 

Oil: Bubbling or Bubble?

So can you. Going long or short at this point is a mug's game. Can you really say without doubt that oil will go to $60 a barrel? Or $20? Or stay right here? I thought not.

There are several ways to play this situation. First is to buy a bombed out top quality international oil company such as Shell (SC: NYSE). The ADR's (American Depository Receipts) have dropped from $47 last July to $34 currently, courtesy of a couple of crummy quarters last year. But it beat the street in the first quarter and things look interesting for the rest of the year. Consensus earnings projections at First Call for fiscal 2003 and 2004 are $2.62 and $2.63 respectively. That's a projected price/earnings ratio of about 13 times for both years. And, there's a 4 percent yield.

You are, of course, free to pick the oil company of your choice. For those who want to own naked stock, Shell is a good representation of a potentially profitable situation and you would receive a 4 percent dividend yield (currently) while you own it.

Be smart. There are options.

Carrying on with Shell, for those who wish to protect their downside, a share purchase might be combined with a put option. Perhaps the Shell August 30 put which currently trades at about $1.55. (Each put price represents a contract for the equivalent of 100 shares. Therefore, one August 30 put would cost $155 before commission.) Simply, if you buy the put, you have the right to sell the underlying shares at $30 until the option's expiration date in August. Think of it as a stop loss limit order-remember you bought your 100 shares of Shell at $34. If the stock were to drop to $25, the option would have a value of at least $5, offsetting-to a degree-the loss in the stock. 

If you were to purchase the stock at $34 plus an August 30 put; your total risk per share (exclusive of commissions) would be $5.55, or 16 percent. If the shares rise to $40, the put price was merely insurance that you didn't use. Your gain would be reduced by $1.55, but that's better than the alternative if you're wrong. If the shares happen to drop precipitously prior to the August expiry, the gain in the option's price may even further mitigate the loss on the shares. A put needn't be held until expiry. It can be traded in the same fashion as a stock.

There are many versions of this strategy and some may appeal to risk averse investors. The point is to explore the hedging options to determine whether the reduction of volatility is worth the 'insurance' premium paid.

Get Shorty.

The reverse strategy can also be employed if an investor chooses to short a stock. Purchasing a call option alongside a short sale can mitigate the damage if the shares take off. The investor knows exactly the maximum potential loss on the position during the life of the option.

In the current environment-whether you go long or short Shell or another optionable oil stock-- the comfort alone should be worth the slightly higher outlay.

Other ways to play the oil market, albeit long or short include: futures, options on futures, indices through vehicles such as Exchange Traded Funds (ETF's)-and their attendant options-- or energy Mutual Funds. 

You don't have a clue.

The bottom line is that oil has had a hell of a rise in recent months and getting in now is a crapshoot. However, the oil companies' shares have yet to respond in force to the move, and therein could lie an opportunity. 

Our fondest hope is that should you wish to play oil-no matter the vehicle-in this environment, bear in mind the caveat that you may quite likely be wrong if you simply pick a direction.

Never buy on emotion or with a "the train's leaving the station without me" mentality. This train's already a fair way down the track. Make sure you have some insurance in case it derails. 

Trader's Tip

Options are volatile. They are a wasting asset. You could lose all the money you paid for an option if the shares don't move during the option's life. As time passes, so does any time value they may have had initially even if the stock moves. Check the number of contracts outstanding-known as the open interest. The higher that number, the greater the liquidity. Whenever you buy an option, you have the right to decide what happens to it-you can trade it, exercise it or let it expire.

Next time we'll talk about the sell side of options, where you are obliged to do what ever the buyer wants. But that may be OK. And I promise it won't be complicated. Much.

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