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Deal Making Could Be a Casualty of Higher Interest Rates

Deal Making Could Be a Casualty of Higher Interest Rates

Higher interest rates will have a number of impacts on the economy. Analysts are already concerned that higher rates will result in a slowdown in the housing market. There are also concerns consumer spending on big ticket items like cars and appliances will slow.

Businesses may also feel the impact of higher interest rates as the cost of borrowing rises. This will make many projects that were feasible just a few months ago less attractive. An extreme example of this was detailed by Ben Bernanke, the former Chair of the Federal Reserve.

Bernanke wrote, “…if the real interest rate were expected to be negative indefinitely, almost any investment is profitable. For example, at a negative (or even zero) interest rate, it would pay to level the Rocky Mountains to save even the small amount of fuel expended by trains and cars that currently must climb steep grades.”

Changes in Projects May Be Subtle

Higher rates may mean some deals are not announced and other long standing agreements may be wound down.

GlobeNewswire confirmed that Occidental Petroleum Corporation (NYSE: OXY) will no longer pursue the extension of the Idd El-Sharghi North Dome (ISND) offshore field in Qatar, which expires in October 2019.

“We have been honored to partner with Qatar Petroleum for more than 20 years on the development of the ISND field. During our operatorship, we have significantly increased production while being recognized as a leader in safety performance and the lowest-cost offshore oil operator in the country,” said President and Chief Executive Officer Vicki Hollub.

“Consistent with our strategy, our intent is to redeploy our capital and human resources to projects where we can deliver the highest returns for our shareholders.”

2018 Free Cash Flow (FCF) for ISND is estimated to be less than $300 million with production of 51,000 barrels of oil equivalent per day, prior to adjustment for foreign tax barrels.

Occidental intends to have the production and cash flow from the ISND contract replaced in 2020 from its ongoing development program and reallocation of 2019 capital from ISND. Due to the major infrastructure investments that would have been required under an extension, the company’s estimate for FCF was approximately $70 million annually for the first five years.

A Changing Environment Could Drive Stocks

The recent weakness in the stock market has pushed a number of stocks down, including shares of OXY.

OXY daily chart

The selling comes as the stock encountered resistance. The uptrend in price had stalled in May and after several pull backs, the stock has been unable to make new highs. This is potentially bearish.

The long term chart shows that prices fell below an important support level in the recent sell off and the down side risk in the stock is now significant.

OXY weekly chart

A Trading Strategy to Benefit from Weakness

A price decline often results in higher than average options premiums. That means option buyers will be forced to pay higher than average prices for trades, But, sellers could benefit from the higher premiums.

In this case, with a bearish outlook for the short term, a call option should be sold. The call should decline in value if the stock declines and sellers of calls benefit from this decline.

Selling options can involve a great deal of risk. A spread options strategy can be used to limit the potential risk of the trade.

One strategy that traders can consider is the bear call spread. This is a trade that uses two calls with the same expiration date but different exercise prices.

Traders buy one call and sell another call. The exercise price of the call you sell will be below the exercise price of the long call. The call is sold to limit the risk of the trade. So, this strategy will always generate a credit when it is opened and will always have limited risk.

The risk profile of this trading strategy is summarized in the diagram below which shows the limited risk and reward.

bear call spread

Source: The Options Industry Council

While risks and rewards are limited, this strategy will allow traders to generate potential gains in a stock they might otherwise find too risky to trade. Many individuals ignore bearish strategies because of the risks.

You’ll know the maximum potential gain with this strategy as soon as it’s opened. It is equal to the amount of premium received when the trade is opened. The maximum loss is equal to the difference between the exercise price of the options contracts less the premium received and is also known.

A Bear Call Spread in OXY

For OXY, we could sell an October 19 $73 call for about $0.81 and buy an October 19 $75 call for about $0.15. This trade generates a credit of $0.66, which is the difference in the amount of premium for the call that is sold and the call.

Remember that each contract covers 100 shares, opening this position results in immediate income of $66. The credit received when the trade is opened, $17 in this case, is also the maximum potential profit on the trade.

The maximum risk on the trade is about $134. The risk can be found by subtracting the difference in the strike prices ($200 or $2.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($66).

This trade offers a potential return of about 49% of the amount risked for a holding period that is about one week. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if OXY is below $73 when the options expire, a likely event given the stock’s trend.

Call spreads can be used to generate high returns on small amounts of capital several times a year, offering larger percentage gains for small investors willing to accept the risks of this strategy. Those risks, in dollar terms, are relatively small, about $134 for this trade in OXY.

These are the type of strategies that are explained and used in our TradingTips.com’s Options Insider service. To learn more about how options can be used to meet your income and wealth building goals, click here for details on Options Insider.