This morning, we took a position in BP by purchasing deep in-the-money call options and structuring a trade that expires by January of 2012.
Most of you are aware of the natural disaster unfolding in the Northern Hemisphere thanks to a massive oil spill from an out-of-control well owned by British Petroleum.
Wanting to find a way to take advantage of what is clearly a terrible situation, I spent the morning studying the BP mess in the Gulf of Mexico. (As Buffett says, there are always intelligent things to do regardless of what is going on in the world.)
Turns out, the stock actually looks cheap other than the fact no one knows what this oil spill is going to cost. The ADRs (American Depository Receipts – BP is a British company so ADRs are how Americans invest in them) have fallen to above $50 per share, representing a “regular” earnings yield of just shy of 13% in ordinary times.
We structured a rather interesting position by purchasing deep-in-the-money call options that expire in January 2012. In essence, we bought the right to purchase shares of BP at $40 per share. For this right, we paid a fee of $13.63 per share. That means that our break-even point on BP is $53.63 per share. The stock is currently trading at $51.79.
This allowed us to use a form of leverage without some of the drawbacks of debt. In effect, if BP is below $40 per share, we lose the entire $13.63 fee we paid for each share of stock. If BP is at $53.63, which is barely above where it is now, we can break-even on our position. If BP goes back to where it was before this mess, and reaches $67.26 per share, we earn a 100% return on our money because the $13.63 options we purchased will have a liquidation intrinsic value of $27.26 each.
That means that the stock only has to rise 26.3% any time between now and mid-January 2012 for us to earn 100% on our position. Since our businesses are privately owned, I don’t need to worry about the volatility – these options could lose 90% of their value tomorrow and there is no one who can walk in the door and fire me if I still think they will work out roughly two years from now.
We like the odds and feel the price we paid is fair given the probable range of outcomes. Still, we aren’t playing with a lot of capital as a percentage of our collective balance sheets. There is certainly risk – we could lose the entire amount – but given how we have put together the terms, I feel okay with our reward trade-off. This isn’t the sort of position you’d buy for your grandmother, who can’t afford to take losses.
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