• Share
  • Email
  • Embed
  • Like
  • Save
  • Private Content
Option Strategies - Natural Gas Trading Opportunities
 

Option Strategies - Natural Gas Trading Opportunities

on

  • 653 views

Actionable trade ideas for stock market investors and traders seeking alpha by overlaying their portfolios with options, other derivatives, ETFs, and disciplined and applied Game Theory for hedge fund ...

Actionable trade ideas for stock market investors and traders seeking alpha by overlaying their portfolios with options, other derivatives, ETFs, and disciplined and applied Game Theory for hedge fund managers and other active fund managers worldwide. Ryan Renicker, CFA

Statistics

Views

Total Views
653
Views on SlideShare
653
Embed Views
0

Actions

Likes
0
Downloads
7
Comments
0

0 Embeds 0

No embeds

Accessibility

Upload Details

Uploaded via as Adobe PDF

Usage Rights

© All Rights Reserved

Report content

Flagged as inappropriate Flag as inappropriate
Flag as inappropriate

Select your reason for flagging this presentation as inappropriate.

Cancel
  • Full Name Full Name Comment goes here.
    Are you sure you want to
    Your message goes here
    Processing…
Post Comment
Edit your comment

    Option Strategies - Natural Gas Trading Opportunities Option Strategies - Natural Gas Trading Opportunities Document Transcript

    • September 18, 2006 Natural Gas Trade Opportunities Derivatives Strategy Ryan Renicker, CFA • We expect near-term downside for utilities names exposed to natural gas prices - EXC, D, TXU, 1.212.526.9425 and NRG. However, we are fundamentally bullish on these names over the medium term, on theryan.renicker@lehman.com basis of tightening U.S. power markets and Q406 shareholder events. Devapriya Mallick 1.212.526.5429 • We suggest two derivatives strategies that efficiently express this fundamental view with different dmallik@lehman.com risk-reward characteristics. Power & Utilities Daniel Ford, CFA • Purchasing Oct puts and Jan call spreads lets investors gain from any near-term lows and provides 1.212.526.0836 participation to any upside in the fourth quarter and early next year. daford@lehman.com Gregg Orrill 1.212.526.0865 • An alternative strategy involving higher risk would buy Oct puts and 1x2 call spreads expiring in gorrill@lehman.com January. This reduces the initial premium and provides greater leverage, but leaves investors short the upside beyond the interim target price.Lehman Brothers does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict ofinterest that could affect the objectivity of this report.Customers of Lehman Brothers in the United States can receive independent, third-party research on the company or companies covered in this report, at no cost to them,where such research is available. Customers can access this independent research at www.lehmanlive.com or can call 1-800-2LEHMAN to request a copy of this research.Investors should consider this report as only a single factor in making their investment decision.PLEASE SEE ANALYST(S) CERTIFICATION AND IMPORTANT DISCLOSURES BEGINNING ON PAGE 6.
    • Equity Derivatives Strategy | Natural Gas Trade Opportunities Investment Conclusion We expect near-term downside for utilities names exposed to natural gas prices - EXC, D, TXU, and NRG. However, we are fundamentally bullish over the medium term based on expected catalysts. We explore two derivatives strategies for expressing this view using relatively cheap options on these names. The first strategy is to buy Oct puts and Jan 07 call spreads. A higher risk alternative is purchasing Oct puts and Jan 1x2 call spreads, with the higher strike close to the interim target. Fundamental View – Daniel Ford/Gregg Orrill Our fundamental view is that these 4 companies are advantaged by tightening U.S. power markets coupled with shareholder events in Q406 that should propel them at least halfway to our 12 month price targets by January. These catalysts include: EXC: a 12/12 analyst meeting where we expect a dividend hike, share repurchase and 2007/2008 EPS guidance. Our 12 month target is $71 is premised upon applying a 15% premium to the integrated utilities group, or 14.3x our $4.97 estimate for ‘08. However, our interim target is $65 which reflects ½ of the potential upside to our 12 month target. D: completion of strategic business review, potential structural changes announced. Our 12 month D price target of $79 reflects an integrated multiple of 11.2x our 2008 EPS estimate of $7.12. However, our interim target is $78 which reflects ½ of the potential upside to our 12 month target. Our long-term rating on D is a 2-Equal weight as we are skeptical on the timeliness of recognizing the strategic upside of the assets, however, we believe that within the derivatives context detailed herein, particularly due to the near-term weakness in gas prices, there is a buying opportunity. TXU: the likely air permit for a major power plant in Texas in mid-October followed by development company debt and equity financing in Q406. Our 12 month TXU price target is $69, however, our interim target is $65 which reflects ½ of the potential upside to our 12 month target. More specifically, our 12 month target is premised upon the average of three valuation methodologies, which are: 14.9x the Utility business and 17.7x the Energy Business plus a value of the retail business of $1,178 per customer which yeilds $63; 7.4x 07E EBITDA of $5.4B less $12.4B in debt which is $63; and a free cash yield of 7.9% on $2.8B in 07 which is $80. NRG: investor meeting on 10/17 to review a generation development program. Our 12 month target is $59, however, our interim target is $53 which reflects ½ of the potential upside to our 12 month target. More specifically, our 12 month target for NRG reflects the average of four valuation methodologies following and $2/share of NOLs NPV including: IPP average 7.5x 2008 EBITDA of $1.72B less $5.9B of net debt and 144M diluted shares; free cash yield of 10.5% on $846M or $56; asset based values of $53 and Open EBITDA average of $2.35B 2008 EBITDA of 6.6x less $6.0B of net debt. Near-term this fundamental view is challenged by collapsing natural gas prices due to unprecedented storage levels, coupled with lack of supply disruptions (hurricanes) and normal seasonal declines in usage. In similar past periods these stocks have tracked gas down and corrected 10-15% notably in 10/05 and 5/06. We believe this trough could last until winter heating season begins to ramp-up in November. September 18, 2006 2
    • Equity Derivatives Strategy | Natural Gas Trade OpportunitiesFigure 1: Nat Gas Trade Milestones Figure 2: Average Implied Vol for EXC, D, TXU andNRG Interim 30% Current RecoveryStock 9/18/06 Downside Positive Catalysts Target 28%D $76.87 $72-$68 Strategic review announcements $78EXC $58.73 $57-$54 Dividend hike, stock buyback, 07/08 guidance $65 26%NRG $48.08 $46-$43 10/17 investor meeting in TX. $53 24%TXU $62.29 $59-$57 Air permit for TX plant and devco financing. $65 22% 20% Avg 3m Implied Vol 18% Avg 1m Implied Vol 16% 6 06 06 6 06 6 06 06 06 -0 l-0 -0 p- n- n- b- g- r- ay ar Ju Ja Ju Fe Ap Se Au M MSource: Bloomberg, Lehman Brothers Source: Lehman Brothers, OptionMetrics Based upon past patterns, we posit that the stocks could see lows of $59-$57 for TXU, $46-$43 for NRG, $57-$54 for EXC, and $72-$68 for D. Figure 1 summarizes the potential key catalysts along with the expected downside and recovery target for each of these stocks. We would begin buying these stocks at the high end of the correction range and aggressively purchase at the bottom end. Our point of view is backed by a long-term view of gas and power prices outlined in "Just the Beginning" 8/21/06. Implied Vols Still Fairly Low Implied volatility for Utilities names has been rising concurrently with the sell-off over the last two weeks. Figure 2 shows that average implied vols for these 4 stocks have been on the ascent over this period. However, these options are still trading cheap relative to their vols since the beginning of the year. In the event of a near-term trough being attained, volatility could rise even further, hence biasing us towards long option strategies. We suggest two possible options strategies with different risk-reward profiles that efficiently express our fundamental view. September 18, 2006 3
    • Equity Derivatives Strategy | Natural Gas Trade Opportunities Strategy I: Oct Puts vs Jan Call Spreads • Expectations of a near-term pullback merit purchasing short-dated puts expiring in October. • Long call spreads expiring in January give participation to any potential upside in the later part of the fourth quarter and early next year. • We show the payoff from a strategy of buying TXU Oct 60 puts and TXU Jan 07 62.5-65 call spreads (Figure 3). • The trade benefits from any downside below $60 as of the October expiration and gains from TXU rising to $65 by the January expiration. • The up-front premium is $2.15, or approximately 3.5% of TXU’s closing price last night. This represents the maximum downside from the trade. • Figure 4 shows the expiration payoff of the strategy for TXU, for different underlying prices as th th of the October 20 and January 19 expirations. • Per our fundamental expectations, if TXU retreats to $57 by October 20 and rallies back to $65 by January 19, the trade stands to pay off $5.5 at expiration, over 250% of the initial premium.Figure 3: Puts vs Call Spreads Payoff – TXU Figure 4: Strategy I P/L for TXU Under Different Scenarios 6 Maximum downside limited to Max gain if TXU retracts in near-term premium paid and rallies before Jan 5 Payoff (9/18/06) 4 Benefit from Payoff (10/20/06) TXU Price as of Jan 07 Expiration 50 52 54 56 58 60 62 64 66 68 70 pullback till Oct Payoff (1/19/07) 7.9 7.9 7.9 7.9 7.9 7.9 7.9 9.4 10.4 10.4 10.4 3 50 Strategy Payoff TXU Price as of Oct Expiration 52 5.9 5.9 5.9 5.9 5.9 5.9 5.9 7.4 8.4 8.4 8.4 2 54 3.9 3.9 3.9 3.9 3.9 3.9 3.9 5.4 6.4 6.4 6.4 56 1.9 1.9 1.9 1.9 1.9 1.9 1.9 3.4 4.4 4.4 4.4 1 58 -0.2 -0.2 -0.2 -0.2 -0.2 -0.2 -0.2 1.4 2.4 2.4 2.4 0 60 -2.2 -2.2 -2.2 -2.2 -2.2 -2.2 -2.2 -0.7 0.4 0.4 0.4 62 -2.2 -2.2 -2.2 -2.2 -2.2 -2.2 -2.2 -0.7 0.4 0.4 0.4 -1 64 -2.2 -2.2 -2.2 -2.2 -2.2 -2.2 -2.2 -0.7 0.4 0.4 0.4 -2 66 -2.2 -2.2 -2.2 -2.2 -2.2 -2.2 -2.2 -0.7 0.4 0.4 0.4 68 -2.2 -2.2 -2.2 -2.2 -2.2 -2.2 -2.2 -0.7 0.4 0.4 0.4 -3 70 -2.2 -2.2 -2.2 -2.2 -2.2 -2.2 -2.2 -0.7 0.4 0.4 0.4 50 52 54 56 58 60 62 64 66 68 70 72 74 76 78 80 TXU PriceSource: Lehman Brothers, Bloomberg Source: Lehman Brothers, Bloomberg September 18, 2006 4
    • Equity Derivatives Strategy | Natural Gas Trade Opportunities Strategy II: Oct Puts vs Jan 1x2 Call Spreads • A higher risk alternative to the previous strategy would be to purchase 1x2 call spreads expiring in January. • This reduces the initial premium and provides greater leverage but leaves the investor short the upside beyond the near-term target price. • The strategy makes more sense for stocks with an upward sloping term structure of implied volatility, such as NRG. • Figure 5 shows the payoff on different dates from a long position in NRG Oct 45 puts and NRG Jan 07 50-55 1x2 call spreads. • The initial cost of setting up the trade is $1.5, or about 3.1% of NRG’s closing price last night. • Figure 6 shows the suggested strikes and breakevens for the other stocks. The upper is the price above which the stock has to finish in order for the 1x2 call spreads to start losing.Figure 5: Puts vs 1x2 Call Spreads Payoff - NRG Figure 6: Puts vs 1x2 Call Spreads Payoff – Suggested Strikes 10 8 1x2 call spreads start losing 6 beyond upper breakeven 4 Lower Upper Net Strategy Payoff 2 Ticker Oct Leg Jan Leg Breakeven Breakeven Premium (Oct 06) (Jan 07) 0 -2 D B 75 Put B 75-80 1x2 Call Spread 1.7 74.3 81.6 -4 Payoff (9/18/06) EXC B 60 Put B 60-65 1x2 Call Spread 3.05 58.1 71.35 -6 Payoff (10/20/06) NRG B 45 Put B 50-55 1x2 Call Spread 1.5 44.4 58.1 Payoff (1/19/07) TXU B 60 Put B 60-65 1x2 Call Spread 0.9 59.1 66.3 -8 -10 35 37 39 41 43 45 47 49 51 53 55 57 59 61 63 65 NRG PriceSource: Lehman Brothers, Bloomberg Source: Lehman Brothers, Bloomberg September 18, 2006 5
    • Equity Derivatives Strategy | Natural Gas Trade OpportunitiesAnalyst Certification:We, Ryan Renicker, Daniel Ford and Gregg Orrill, hereby certify (1) that the views expressed in this research email accurately reflect our personal views about anyor all of the subject securities or issuers referred to in this email and (2) no part of our compensation was, is or will be directly or indirectly related to the specificrecommendations or views expressed in this email.To the extent that any of the conclusions are based on a quantitative model, Lehman Brothers hereby certifies (1) that the views expressed in this research emailaccurately reflect the firms quantitative research model (2) no part of the firms compensation was, is or will be directly or indirectly related to the specificrecommendations or views expressed in this research report.Important DisclosuresLehman Brothers does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have aconflict of interest that could affect the objectivity of this email communication.Customers of Lehman Brothers in the United States can receive independent, third-party research on the company or companies covered in this report, at no cost tothem, where such research is available. Customers can access this independent research at www.lehmanlive.com or can call 1-800-2-LEHMAN to request a copy ofthis research.Investors should consider this communication as only a single factor in making their investment decision.The analysts responsible for preparing this report have received compensation based upon various factors including the Firm’s total revenues, a portion of which isgenerated by investment banking activities.Stock price and ratings history charts along with other important disclosures are available on our disclosure website at www.lehman.com/disclosuresAnd may also be obtained by sending a written request to: LEHMAN BROTHERS CONTROL ROOM , 745 SEVENTH AVENUE, 19TH FLOOR NEW YORK, NY10019Mentioned StocksDominion Resources (D - USD77.16) 2-Equal weight / Negative A/D/E/J/K/L/MRisks Which May Impede the Achievement of the Price Target: Dominion is exposed to the electricity, natural gas, and oil commodity markets which can createearnings volatility.Other Material Conflicts: Lehman Brothers is acting as financial advisor to Equitable Resources in connection with the potential acquisition of Dominion Peoples andDominion Hope from Dominion ResourcesExelon Corp (EXC - USD59.21) 1-Overweight / Negative D/J/LRisks Which May Impede the Achievement of the Price Target: Risks to the outlook include wholesale commodity prices, generation development market conditions,the outcome of regulatory proceedings, rating agency actions, interest rates, and access to the capital markets.Other Material Conflicts: Lehman Brothers is currently acting as a financial advisor to Exelon Corp. with respect to its restructuring of Commonwealth Edison.NRG Energy (NRG - USD47.30) 1-Overweight / Negative D/F/J/LRisks Which May Impede the Achievement of the Price Target: Key risks include power and gas prices, weather volatility, higher interest rates and wider creditspreads, and power markets regulation.TXU Corp (TXU - USD61.45) 1-Overweight / Negative A/D/E/F/J/LRisks Which May Impede the Achievement of the Price Target: Key risks are Texas regulation, U.S. power and gas prices, interest rates, and credit ratingdowngrades. September 18, 2006 6
    • Equity Derivatives Strategy | Natural Gas Trade OpportunitiesDisclosure Legend:A: Lehman Brothers Inc. and /or an affiliate managed or co-managed within the past 12 months a 144A and/or public offering of securities for this company.D: Lehman Brothers Inc. or an affiliate has received compensation for investment banking services from the subject company within the past 12 months.E: Lehman Brothers Inc. or an affiliate expects to receive or intends to seek compensation for investment banking services from the subject company within the nextthree months.F: Lehman Brothers Inc. and/or its affiliates beneficially own(s) 1% or more of any class of common equity securities of the subject company as of the end of the lastmonth.J: Lehman Brothers Inc. or an affiliate trade(s) regularly in the shares of the subject company.K: Lehman Brothers Inc. has received non-investment banking related compensation from the subject company within the last 12 months.L: The subject company is or during the past 12 months has been an investment banking client of Lehman Brothers Inc. and/or an affiliate.M: The subject company is or during the last 12 months has been a non-investment banking client (securities related services) of Lehman Brothers Inc.Options are not suitable for all investors and the risks of option trading should be weighed against the potential rewards.Supporting documents that form the basis of the recommendations are available on request. Please note that the trade ideas withinthis report in no way relate to the fundamental ratings applied to European stocks by Lehman Brothers Equity Research.Guide to Lehman Brothers Equity Research Rating SystemOur coverage analysts use a relative rating system in which they rate stocks as 1-Overweight, 2- Equal weight or 3-Underweight (see definitions below) relative to othercompanies covered by the analyst or a team of analysts that are deemed to be in the same industry sector (“the sector coverage universe”). To see a list of companies thatcomprise a particular sector coverage universe, please go to www.lehman.com/disclosures.In addition to the stock rating, we provide sector views which rate the outlook for the sector coverage universe as 1-Positive, 2-Neutral or 3-Negative (see definitions below).A rating system using terms such as buy, hold and sell is not the equivalent of our rating system. Investors should carefully read the entire research report including thedefinitions of all ratings and not infer its contents from ratings alone.Stock Rating1-Overweight - The stock is expected to outperform the unweighted expected total return of the sector coverage universe over a 12-month investment horizon.2-Equal weight - The stock is expected to perform in line with the unweighted expected total return of the sector coverage universe over a 12-month investment horizon.3-Underweight - The stock is expected to underperform the unweighted expected total return of the sector coverage universe over a 12-month investment horizon.RS-Rating Suspended - The rating and target price have been suspended temporarily to comply with applicable regulations and/or firm policies in certain circumstancesincluding when Lehman Brothers is acting in an advisory capacity on a merger or strategic transaction involving the company.Sector View1-Positive - sector coverage universe fundamentals are improving.2-Neutral - sector coverage universe fundamentals are steady, neither improving nor deteriorating.3-Negative - sector coverage universe fundamentals are deteriorating. September 18, 2006 7
    • Equity Derivatives Strategy | Natural Gas Trade OpportunitiesDistribution of Ratings:Lehman Brothers Equity Research has 1879 companies under coverage.44% have been assigned a 1-Overweight rating which, for purposes of mandatory disclosures, is classified as a Buy rating, 35% of companies with this rating are investmentbanking clients of the Firm.40% have been assigned a 2-Equal weight rating which, for purposes of mandatory disclosures, is classified as a Hold rating, 6% of companies with this rating areinvestment banking clients of the Firm.16% have been assigned a 3-Underweight rating which, for purposes of mandatory disclosures, is classified as a Sell rating, 67% of companies with this rating areinvestment banking clients of the Firm.This material has been prepared and/or issued by Lehman Brothers Inc., member SIPC, and/or one of its affiliates (“Lehman Brothers”) and has been approved byLehman Brothers International (Europe), authorized and regulated by the Financial Services Authority, in connection with its distribution in the European EconomicArea. This material is distributed in Japan by Lehman Brothers Japan Inc., and in Hong Kong by Lehman Brothers Asia Limited. This material is distributed in Australiaby Lehman Brothers Australia Pty Limited, and in Singapore by Lehman Brothers Inc., Singapore Branch. (“LBIS”). Where this material is distributed by LBIS, pleasenote that it is intended for general circulation only and the recommendations contained herein does not take into account the specific investment objectives, financialsituation or particular needs of any particular person. An investor should consult his Lehman Brothers’ representative regarding the suitability of the product and takeinto account his specific investment objectives, financial situation or particular needs before he makes a commitment to purchase the investment product. This materialis distributed in Korea by Lehman Brothers International (Europe) Seoul Branch. This document is for information purposes only and it should not be regarded as anoffer to sell or as a solicitation of an offer to buy the securities or other instruments mentioned in it. No part of this document may be reproduced in any mannerwithout the written permission of Lehman Brothers. With the exception of disclosures relating to Lehman Brothers, this research report is based on current publicinformation that Lehman Brothers considers reliable, but we make no representation that it is accurate or complete, and it should not be relied on as such. In the caseof any disclosure to the effect that Lehman Brothers Inc. or its affiliates beneficially own 1% or more of any class of common equity securities of the subject company,the computation of beneficial ownership of securities is based upon the methodology used to compute ownership under Section 13(d) of the United States SecuritiesExchange Act of 1934. In the case of any disclosure to the effect that Lehman Brothers Inc. and/or its affiliates hold a short position of at least 1% of the outstandingshare capital of a particular company, such disclosure relates solely to the ordinary share capital of the company. Accordingly, while such calculation representsLehman Brothers’ holdings net of any long position in the ordinary share capital of the company, such calculation excludes any rights or obligations that LehmanBrothers may otherwise have, or which may accrue in the future, with respect to such ordinary share capital. Similarly such calculation does not include any sharesheld or owned by Lehman Brothers where such shares are held under a wider agreement or arrangement (be it with a client or a counterparty) concerning the sharesof such company (e.g. prime broking and/or stock lending activity). Any such disclosure represents the position of Lehman Brothers as of the last business day of thecalendar month preceding the date of this report.This material is provided with the understanding that Lehman Brothers is not acting in a fiduciary capacity. Opinions expressed herein reflect the opinion of LehmanBrothers and are subject to change without notice. The products mentioned in this document may not be eligible for sale in some states or countries, and they may notbe suitable for all types of investors. If an investor has any doubts about product suitability, he should consult his Lehman Brothers representative. The value of and theincome produced by products may fluctuate, so that an investor may get back less than he invested. Value and income may be adversely affected by exchange rates,interest rates, or other factors. Past performance is not necessarily indicative of future results. If a product is income producing, part of the capital invested may beused to pay that income. © 2006 Lehman Brothers. All rights reserved. Additional information is available on request. Please contact a Lehman Brothers entity in yourhome jurisdiction.Lehman Brothers policy for managing conflicts of interest in connection with investment research is available at www.lehman.com/researchconflictspolicy. Ratings,earnings per share forecasts and price targets contained in the Firms equity research reports covering U.S. companies are available atwww.lehman.com/disclosures.Complete disclosure information on companies covered by Lehman Brothers Equity Research is available at www.lehman.com/disclosures. September 18, 2006 8