Another High Risk, High Reward, Short Term Trade

Now that oil, as represented by WTI, has jumped above $50 and trades such as the Petrobras (PBR) purchase that I recommended a couple of weeks ago are showing a tidy profit (+ 41.4% in that case), it is time to trim positions such as that and look around for others with potential for the same kind of pop. It is not that PBR couldn’t go higher; of course it could, if oil continues to climb. It’s just that the pace of increase is likely to slow from here, so taking some profit and looking around for something that could show a similar short term performance makes sense.

The problem, of course, is that most stocks in the energy sector have tracked WTI’s upward move. Value and potential are a little harder to find in light of this dynamic. The answer could lie in the hardest hit area of the oil industry, deepwater drilling. Stocks in companies that specialize in that area have been hit particularly hard and have been slower to react to the recent bounce. There are very good reasons for that; oil recovered by deepwater drilling is relatively expensive, so the sustained drop represents an existential problem for some companies in the field.

Given the level of volatility in oil prices recently, the market can be forgiven for not rushing to buy deepwater drilling stocks on this jump, but now that the $50 level has been breached, there are several significant support levels in close proximity, so a dramatic drop back looks less likely than it did just a few short days ago. That makes a risk controlled play on a deepwater specialist a tempting proposition right now.

The first thing to look for is a company that has a reasonably solid balance sheet and a decent cash position. Many companies in the deepwater field have been bleeding cash and have had to cut exploration plans to the bone for an extended period, with no prospect of reinstating those plans, even if oil were to continue upwards. They are focused on survival rather than growth.

For Cobalt International Energy (CIE), though, the threat to survival doesn’t come from cash flow issues. The company recently sold its interest in the deepwater play off of the coast of Angola. That leaves them with a cash position that it is estimated will be close to $3 Billion at year’s end. One would think that disposing of a valuable asset such as that would hurt a company’s value, but exiting that particular project, given the corruption scandals that have dogged it, could be seen as a positive in this case. The possible negative effects of that scandal still linger though. The U.S. Department of Justice is still investigating, but the fact that the SEC has dropped its investigation can be seen as a positive sign, and the remaining risk looks to be fully priced into the stock.

During the time that PBR has gained its 40 percent or so, CIE has also bounced, but is up only around 10 percent, for all of the reasons stated. If WTI does stay above the $49-50 level though, the longer that goes on the more confident the market will feel about CIE’s prospects given their remaining assets and cash position. The $20+ levels of a couple of years ago look way out of reach, but in the short term, a recovery to around $10 is distinctly possible. When that target level is weighed against the logical stop loss level just below the recent $6.73 low the risk/reward of the trade is in your favor.

There are a lot of reasons not to buy CIE at the moment, just as there were a lot of reasons not to buy PBR a couple of weeks ago, but that is usually the case for a trade worth taking. Trading, however, is about embracing risk when the risk/reward ratio works in your favor, and in this case it does so. As worrying as some of those reasons sound right now, buying CIE with a reasonable stop loss level makes sense.