Back Derivatives Strategy

Use XOP Options to Add Upside Energy Exposure Following Sharp Pullback and Underperformance to Oil

Published on December 22, 2024

Jeff Jacobson

We believe the weakness in the energy stocks over the past month, especially relative to the price of crude, has created a very attractive opportunity to add upside exposure via options to position for a rebound as we head into the new year. The main E&P etf (XOP) is down nearly 16% from the highs it hit at the end of November, and is now trading just above the lowest levels of the year (back in September when recession fears were much higher and oil was trading ~ $64 vs a current $70). Since November 25^th XOP has declined by ~ 13.5% and oil is UP 1.28%. This dislocation between energy stocks and oil has now brought the XOP/Oil relative spread back to the January lows. What is of note about this level for the relative spread is XOP also bottomed back in January when this level was hit last time and then proceeded to rally by 28% between the end of Jan thru the middle of April. Colin Fenton, the head of commodity strategy for 22V, just put out a bullish oil note this week (here) citing low US inventories and rising demand. Dennis also mentioned energy as a sector that should also do well if financial conditions continue to tighten and value starts to outperform growth (here). So given the sharp decline in the E&P names, on both an absolute and relative (to crude) basis, we could be setting up for another sharp rebound trade in the sector much like we saw in Q1 of this year.

XOP declined by as much as 17% from the November highs and is back to the Sept lows (when oil was ~ 10% lower from where it trades today)

The XOP/Oil relative spread also dropped sharply and is back to EXACTLY where the spread bottomed in January

XOP had a massive rally between end of Jan thru mid-April last time XOP/Oil spread was here and also from the same mid 120’s price area

We favor using XOP, over say XLE, when looking at adding upside exposure with options for several reasons. First, XOP is far more diversified than XLE with no one name having a weighting of more than 4%. XLE has 3 stocks (XOM, CVX and COP) that comprise ~ 45% of the entire etf. When we have had such a selloff in the sector over a short period of time, we prefer to use the more diversified XOP when looking at positioning for a rebound. Second, the XOP/XLE relative spread is also trading near 2-year lows (chart below). If we are right about a sharp rebound for energy names, we believe the higher beta XOP etf is the “better” vehicle to use. Lastly, natural gas is quietly trying to breakout here after a prolonged period of weakness. Rising natural gas should favor the E&P names more than the larger integrated names that are top-heavy in XLE.

Looking at XOP options and volatility we see that XOP 3-month (March) implied vol now trades just below the 1-year highs and is up ~ 50% from the May lows. Therefore, we want to be mindful of this “expensive” volatility when considering adding upside structures. Given the sharp pullback, combined with the large underperformance to oil, we favor selling a downside put to buy an upside call spread at this time to offset the rich volatility.

XOP 3-month (March) implied volatility is just below the 1-year highs and up ~ 50% from the May lows

Trade:

Sell XOP March 115 put
Buy XOP March 135/155 call spread
Costs ~ .25 (XOP 126.26 ref)

Either own XOP down 9% at the 2-year lows of $115 or participate on any upside between $135 and $155 by March expiration

Trade Details:

Selling the 9% downside March puts to buy the 20-point wide upside call spread that starts 7% above current levels. The 115 level (put we are selling) is also the 2-year low for XOP
Have seen a sharp correction in most energy names, even though oil has remained well bid (perhaps a year-end positioning move given energy stocks underperformance?)
XOP/Oil relative spread back to the Jan ’24 lows – we saw a quick rebound in the spread as XOP rallied more than 25% over the next 3 months
XOP 3-month implied volatility trading just below the 1-year highs – why we favor selling the put to own the wide upside call spread for nearly even cost
Call spread is capped to the upside above the July and November highs and is just below the April ’24 highs
Structure is a great add-on trade to an existing long/bullish energy position, or as an attractive entry-point trade into the beaten down sector (with a decided cushion to the downside in case of further weakness)
Please contact me or the trading desk for updated pricing and/or execution

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