The Risks of Prolonged Commodity Weakness

The Bank of Canada released its semi-annual Financial Systems Review on December 2015. Click to download the Report.    While the report was comprehensive in looking at Global Macro Risks, we wanted to focus on their comments on the global commodity markets.

Here is an excerpt from the report (p.27):

Risk 4: Prolonged Weakness in Commodity Prices

“There is a risk that strong global supply continues to exceed demand, leading to prolonged weakness in commodity prices at current or somewhat lower levels, with adverse implications for the Canadian financial system. This risk is rated as “moderate.” The probability of the risk occurring is medium, and the severity of the impact on the Canadian financial system if it were to materialize is assessed as relatively low.”

While I agree that the risk of prolonged weakness in commodity prices has a destabilizing effect on the Canadian financial system is low, its impact would be far more reaching to Canadian investors that have been watching their beloved resource stocks suffer greatly in what can now clearly be labelled as the worst commodity bear market this century.

Normally when commodity prices decline in this magnitude (think 2008), the natural instinct for investors is to buy the dip or dollar cost average. The problem this time around is that if Stephen Poloz and the BoC’s risks come to fruition, investors may find themselves too early and risk prolonged inactivity.

So what can an investor do if they find themselves down considerably on a number of these resource names?  One can consider selling cash covered puts at lower prices as a way to reduce your cost base and potentially average down at more favourable prices.

Let’s use an example using Canadian Natural Resources (TSX:CNQ).

  • Investor originally purchased 300 shares at $40.00 or $12,000
  • The stock had a high of $49.57 in June 2014 and a low of $25.01 in August 2015
  • The investor still likes the company and would like to dollar cost average his position, but fears that the stock may remained challenged for at least 6 months or a year.
  • The stock is trading at $29.67 at the time of writing

Rather than purchasing the shares at the prevailing ask or placing a limit order at a lower price, the investor chooses to sell a cash covered put.

The investor sells 5 contracts of the May $25 put for $1.30 or $650.00 gross.  This obligates them to potentially have to buy 500 shares at $25.00 ($12,500) over the next 6 months.  Having collected a fixed $1.30 cash flow income, if the investor is assigned they would be buying the additional shares at an average cost base of $23.70.

Let’s review the possible outcomes for our investor at the May expiration:

Scenario 1: CNQ is trading at, or above $25.00.  In this scenario the investor simply continues to own the original 300 shares and has made an income of $650 or 5.41% from the puts profitably expiring.

Scenario 2: CNQ is trading below $25.00. In this scenario the investor is assigned on the put option and must honour their obligation to buy 500 shares at the $25.00 strike price. Considering the investor still owns the 300 shares at $40.00 and has made $1.30 a share in income, the investor now has a total of 800 shares at the new adjusted cost base of $31.44.

Any investor that accepts the risk of prolonged weakness in commodities can consider using put options as one of the alternative methods to average down at more favourable prices.

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