BP Ripe for an Option Combination

BP ADRs [NYSE:BP $48.28] have taken a major hit due to their Gulf of Mexico offshore oil leak. No doubt this is both a financial and a public relations setback for this massive (about $300 billion revenues) company.                    

That said, the shares fell from a January 19, 2010 high of $62.38 to this afternoon’s $48.28 – a reduction in market cap of approximately $44 billion. It appears very unlikely the ultimate damages will approach that magnitude.

BP went ex-dividend for $0.84 at the opening today and the shares are likely to trade down as many investors may have been waiting to lock in one more dividend  before bailing out due to the bad news headlines.

Current estimates for BP now run from $6.10 – $6.70 for this year and between $7.15 – $8.11 for 2011 although the spill and its ramifications make these subject to a large degree of uncertainty. Even the low-end estimates make the P/E less than 8x this year’s and 6.8x next year’s expectations. Both those numbers are well below BP’s typical multiple (10-year median P/E = 13x).

Spill related costs will probably restrain any near-term dividend growth but the present $0.84 quarterly payout represents a generous 6.96% current yield, especially attractive in today’s ultra-low interest rate environment.

This combination of BP’s well-below normal P/E and its higher than typical dividend should provide a floor for BP ADRs barring a much worse than expected final outcome when the damage from the Gulf is tallied up.

If the recent sell-off appeals to your contrarian sensibilities here is a LEAP option buy/write that could provide a fine 21-month total return even if these shares do virtually nothing from now through January of 2012.

If BP rises to at least $55 or better (+14%) by the January 21, 2012 expiration date:

·         The $55 calls will be exercised.

·         You will sell your shares for $55,000 in cash.

·         The $55 puts will expire worthless.

·         You will likely have collected $5,040 in dividends (assuming no increase or decrease)

·         You will have no further option obligations.

·         You will end up with no shares and $60,040 in cash.

This best-case scenario would result in a net profit of $60,040 -$30,280 = $29,760 cash-on-cash.

$29,760/$30,280 = 98.2%

achieved on any move up of at least 14% over the approximately 21 months before the trade’s expiration date. That should leave plenty of time to see the headlines recede along with the uncertainty about the ultimate financial costs of the spill.

What’s the risk?

If BP remains below $55 on the January 21, 2012 expiration date:

·         The $55 calls will expire worthless.

·         The $55 puts will be exercised.

·         You will be forced to buy another 1000 BP ADRs.

·         You will need to lay out an additional $55,000 in cash.

·         You will likely have collected $5,040 in dividends (assuming no increase or decrease)

·         You will have no further option obligations.

·         You will end up with 2000 BP and $5,040 in cash.

What’s the break-even on the whole trade?

On the original 1000 BP ADRs it’s their $48.28 purchase price less the $4 /share call premium = $44.28 /share.

On the ‘put’ shares it’s the $55 /share strike price less the $14 /share put premium = $41 /share.

Your overall break-even will be $42.64 /share (excluding dividends) and $40.12 /share (including the yield assuming no change in payout).

BP ADRs could drop by as much as 11.6% – 16.9% from their already depressed price without causing a loss on this trade.

Summary:

 BP has already had $44 billion clipped from its  market capitalization in anticipation of huge financial costs due to the Gulf of Mexico oil spill. Unless you feel this is fully justified the shares appear to be bargain priced based on investor over-reaction to the bad news.

Buying shares today while writing $55 calls and puts for the January 2012 expiration allows for an outstanding cash-on-cash return if BP merely bounces back by 14% over the next 21 months. In a best case you’ll net 98% total returns on the actual cash outlay (assuming you write the puts against paid-up marginable equity already held in your margin-type account).

In a worst case scenario you’ll end up with twice the number of BP ADRs at an average cost of $42.64 or less. That’s lower than the annual lows for BP during the entire period 2004 right through 2007.

With oil prices in an uptrend and the dollar likely to worsen versus other currencies I think it’s unlikely BP will stay that low over the period to January 2012.

Dr. Paul Price

www.BeatingBuffett.com

Disclosure: Author is long BP ADRs and short BP options.