More Pleasure, Less Pain

A 1951 advertisement for a Buick Riviera Special promises
that the "rakish beauty" will deliver "high thrills" while
riding "serenely level over rough roads"…If only oil
stocks would do the same thing.

To be sure, oil stocks deliver no lack of thrills, but the
ride is hardly serene. Maybe there’s a way to make the ride
just a little more comfy…without sacrificing the
exhilaration.

"Take a good look at the jaunty beauty pictured here,"
begins an advertisement in ‘The American Weekly’ of August
12, 1951, "then listen to the good news that goes with it.
This racy automobile is a ’51 Buick Special that’s newer
than new – it’s a Riviera…

"You’ll find it delivers the high thrill and high mileage
of Buick valve-in-head power – from the highest powered
Fireball Engine in Special history. You’ll find it sweeps
through all speed ranges with the velevety surge of
Dynaflow Drive…You’ll find it rides serenely level over
rough roads and smooth – because soft coil springs cushion
all four wheels…

"Better drop in soon," the ad concludes, "and look into
this rakish beauty that’s such a boon to tight budgets."
Your editor stumbled upon the tattered, decaying copy of
the American Weekly when crawling through his attic over
the weekend. (If only we had seen the ad a little earlier,
we might well have purchased one of these "rakish
beauties." But alas, they’re sold out). For no particular
reason, the ad’s marketing copy reminded him of investment
strategies that try to capture most of a stock’s power,
while also taking bumps out of the road.

Such strategies seem particularly worthwhile in today’s
volatile energy stock sector.

Most investors, for example, would love to have captured
the big gains these stocks have delivered over the last few
years. But very few of us possessed the conviction or
chutzpah…or, perhaps, stupidity, to stick with them
through thick and thin.

Consider Valero Energy (NYSE: VLO), one of the brightest of
the oil sector’s bright lights. Since the fall of 2002,
Valero’s share price has soared 600%. Yet, on six separate
occasions during that spectacular run the stock tumbled 15%
or more. In other words, the ride has been anything but
serene.

Oil stocks are as volatile as refined oil itself. In
controlled environments – like a V-8 engine – refined oil
produces locomotion. But when mishandled, this same
volatile compound can blow apart refineries. Oil stocks are
no different. If properly controlled, they can propel a
portfolio to impressive returns, but this same "rocket
fuel" can also blow portfolios apart.

The trick is to achieve the locomotion without the
unintended volatility. We know of no perfect means of
containing volatility, but we have stumbled upon a two-part
tactic that may advance the cause:

1) Favor the least volatile sectors of the oil-share
market and;
2) Favor the least volatile securities.

A little bit of volatility is sexy – like the type that
sometimes rips a button off a shirt. But the type that
smashes wine glasses at "Le Bernardin" is much less sexy.
Indeed, it is unnerving. Many oil stocks have become wine-
glass-throwers, which is why we would suggest emphasizing
the "facilitators" over the producers. At current
valuations, the stocks of companies that facilitate the
production of crude oil seem to offer a better risk-reward
proposition than those that track down oil and pull it out
of the ground – the so-called exploration and production
(E&P) companies.

The share prices of some "facilitators" have already soared
dramatically, Valero being a prime example. But some have
not, at least relative to other stocks in the sector. Most
oil-drilling and oil services companies have merely kept
pace with the oil sector in general. Yet, the longer-term
investment prospects for these companies seem superior to
the E&Ps…or at least more certain.

"Evidence from the last sustained energy bull market,"
Barron’s observes, "suggests that a long period of high
[oil] prices creates disproportionate gains for drilling
and service companies, not just relative to the broader
market, but also to oil and gas producers…While energy
producers are flush with cash from record-high prices, the
scramble to develop new fields and maximize output from
existing ones has forced them to sharply raise spending on
services."

Because most oil companies are just beginning to ramp their
exploration and development spending, this new investment
cycle will not likely end soon…even if oil prices slump
somewhat. That means that oil service stocks should begin
to exhibit less sensitivity to daily oil price volatility
than E&P companies.

"While a short-term dip in oil prices would translate into
an immediate hit to producers, it would have to be severe
to affect service companies," Barron’s asserts. "According
to a recent spending survey by analysts at Citigroup, oil
prices would have to drop to $32 a barrel to trigger a 10%
reduction in drilling programs."

Over the last two years, XLE (the ETF that holds mostly
integrated oil stocks like Exxon and Chevron) and OIH (the
ETF that holds oil services stocks) have produced nearly
identical returns. But during the most recent rally in oil
stocks off their mid-May lows, OIH outperformed XLE.
Interestingly, the price of OIH call options relative to
the price of XLE call options has been falling since mid-
May, despite OIH’s superior performance. Indeed, the
relative pricing of OIH call options has been dropping for
two years.

To use the parlance of the options trade, the implied
volatilities of call options on OIH have dropped
dramatically over the last two years compared to the
implied volatility of call options on XLE. Two years ago,
OIH call options cost almost twice as much as comparable
options on XLE. Today, the prices are nearly identical.

These observations lead directly to our second tactic:
Emphasizing less volatile securities. To wit, we would
suggest buying OIH itself, rather than any of the
individual oil services companies that OIH holds. But a
better idea still, might be to buy one of the relatively
cheap OIH call options. The January 105 call option, for
example, seems relatively inexpensive at $8.00. (This
option, for example, is about 33% cheaper than a similar
call option on Valero Energy).

OIH calls might expire worthless, of course. That’s the
risk every option-buyer takes. But at least the potential
loss would be limited to the cost of the option. Sometimes,
in the context of a larger portfolio, that’s a good bet to
make. On the other hand, long-date OIH calls might deliver
as much power as a "Fireball Engine," while also cushioning
the ride along the way.

While we are examining option volatilities, let’s turn our
attention to the VIX Index, also known as the "fear gauge."
The VIX measures the implied volatilities of various
options on the S&P 500 Index.

Because the VIX is based on real-time option prices, it
reflects investors’ consensus view of future expected stock
market volatility. "During periods of financial stress,
which are often accompanied by steep market declines," the
CBOE Website explains, "option prices – and VIX – tend to
rise. The greater the fear, the higher the VIX level. As
investor fear subsides, option prices tend to decline,
which in turn causes VIX to decline."

Yesterday, the index dropped to 10.81, the lowest closing
price in the 18-year history of the VIX.