Tim Bovee, Private Trader: ERF: A growth and income hydrocarbons play

Update 6/9/2015: I sold my shares in ERF and have calculated results. The stock was hit hard by sharp decline in a oil prices this year, and I have better uses for the funds.

Shares declined by 60.2% over 372 days. The position -- shares, hedges and dividends -- produced a 33.7% loss on debit, for a -190% annual rate.

Update 12/1/2014: I was unable to structure a new hedge on ERF because of unfavorable open interest distribution and a resulting overly high risk/reward ratio. I'll keep working on the problem and, with luck, eventually succeed.

Update 11/22/2014: My November options spread hedging ERF expired out of the money on Nov. 22 for maximum (100%) profit. I'll calculate profit or loss when the ERF series of trades is complete.

ERF shares remain below the 12-month moving average and so I shall attempt to roll the hedge forward to a new position on Monday, Nov. 24.

Update 10/17/2014: My October options spread hedging ERF has expired out of the money. It was a short position, sold for a credit, and OTM expiration means I get to keep the proceeds of that sale.

I've rolled it forward to a similar position, structuring it as a bear call spread, short the $16 calls and long the $17 calls, sold for credit and expiring Nov. 21.

I won't calculate profit or loss until the entire roll series has ended.

Update 9/10/2014: ERF has again moved below the 55-day price channel and I've re-opened a fresh bearish hedge, structuring it as a bear call spread sold for a credit and expiring Oct. 17. Short-term chart analysis shows ERF in the 5th wave, the final one, of a downtrend.

Click on chart to enlarge.

ERF 2 months hourly bars

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Update 8/29/2014: ERF moved above its 10-day price channel and I've closed my bear hedge on my shares position. Elliott wave analysis places in the 5th wave to the upside. I expect it to move beyond $24.30, perhaps considerably so.

Click on chart to enlarge.

ERF 30 days hourly bars

Update 8/4/2014: ERF dropped sharply below its 20-day price channel on Aug 1, signalling that I should hedge my long-shares position managed under my longer-term rule set. ERF confirmed the signal in trading the next day.

ERF's implied volatility is in the upper percentiles of the one-year range, so I structured the hedge as a bear call options vertical spread, short the $23 calls and short the $25 calls, sold for a credit and expiring in October. Under my standard guidelines for entry I would have used options expiring in September, but open interest in that month was low, so I moved a month out.

Click on chart to enlarge.

ERF 2 years daily bars

Elliott wave analysis suggests that ERF completed wave 3 {+1} to the upside on July 2 and will now correct a portion of that rise, which began Oct. 9, 2013 from $15.53. The major Fibonacci retracement levels are 38.2% at $21.61, 50% at $20.45 and $61.8% at $19.29.

The end of the correction will be followed by by an upward push that will move above $25.37, perhaps significantly so.

Enerplus Corp. (ERF) is an oil and natural gas exploration and development company. But I suspect its attraction has less to do with hydrocarbons and more with a monthly dividend that provides a paycheck to investors, combined with a rise in the markets that has doubled ERF's price since 2012.

Income plus capital gains are the surest formula for popularity, among stocks at least. And growth and income is considered by financial advisers to be a conservative formula. But dividends can shrink when business or the broader economy stumbles, and growth evaporates quickly once the income takes a dive.

However conservative a play might be, the smart trader always looks for a hedge.

The Chart

ERF hit a low of $11.35 in June 2012 after falling in a three-wave corrective pattern from its pre-recession peak of $59.45 in August 2006. From that point it has begun a rise that I count as wave 1 {+4} to the upside under the Elliott wave rules.

Within the {+4} degree, ERF began to really show its exuberance in June 2013, when it entered a third wave within a third wave the {+2} and {+3} degrees.

The count within wave 3 {+2} is difficult because there is so little difference in magnitude to distinguish the lower degrees. That's a sure sign of an extended wave, and it is still going on.

Click on chart to enlarge.

ERF 2 years 35 months daily bars (left), 9 months daily bars (right)

Elliott provides no way to estimate how long the rise might continue. Wave 3 {+2} will followed by a downward correction of a portion of the rise from $13.57 beginning June 24. Since it will be a 4th wave and the 2nd wave was a zig-zag, it is more likely to be a flat, which is a shallower correction although sometimes more time-consuming.

The subsequent wave 5 {+2} to the upside will begin wave 3 {+3} to an end and usher in another correction, this time of the rise from $11.47 beginning Nov. 16, 2012.

That is a lot of upside potential and makes this chart extremely attractive as a long-term bull play with an income component.

Options are pricing in confidence that 68.2% of trades will fall between $18.60 and $27.76 over the next year, for a potential gain or loss of 19.7%. I've marked those levels on the left-hand chart in blue.

Odds and Yields

ERF has completed four bull signals since wave 3 {+2} began a year ago. Three were successful, on average yielding 4.4% over 37 days. One was unsuccessful, losing half a percent over 22 days. The resulting 3.9% win/lose yield spread is quite adequate for what is primarily a dividend play.

The Company

Enerplus, headquartered in Calgary, Alberta, gets 85% of its production from four regions: The Alberta/Saskatchewan and North Dakota/Montana oil fields and the Alberta and Pennsylvania natural gas fields.

The company trades on both the Toronto and New York stock exchanges.

The company is followed by only a handful of analysts, but they are quite optimistic about its prospects, coming down collectively with a 60% enthusiasm rating.

Enerplus reports return on equity of 6% with debt at 49% of equity.

The earnings yield is 1.82%, compared to a 2.56% yield on 10-year U.S. Treasury notes. The company pays a monthly dividend yielding 4.66% annualized at current prices.

Based on growth estimates and taking the dividend into account, ERF's "fair" price is $20.59, implying that the stock is overpriced by 12.5%. I've marked the "fair" price level on the right-hand chart in purple.

The stock is selling for 55 times earnings and also at a premium to sales. It takes $3.55 in shares to control a dollar in sales.

Earnings have been all over the map, as might be expected from the primary extractive enterprise. they were quite high through the 4th quarter of 2012 and have been lower in the five-quarter since. Earnings have surprised to the downside only once in the past three years, in the 3rd quarter of 2013.

Institutions own 26% of shares.

Enerplus next publishes earnings on Aug. 8. The stock goes ex-dividend July 7 for a monthly payout expected to be 9 cents per share.

Liquidity and Volatility

ERF on average trades 539,000 shares a day and supports a wide selection of option strike prices with open interest running at two or three figures near the money.

The options can be used for hedging, but just barely, which is a problem, since my longer-term rules require an options hedge.

The front-month at-the-money bid/ask spread on puts is 18.2%, compared to 0.3% for the most-traded symbol on the U.S. markets, the exchange-traded fund SPY.

The ERF spread, nearly 20%, is quite a bit higher than I'm willing to accept.

Implied volatility stands at 20% and has been declining in a series of lower highs and lows since its one-year peak of 34% in June 2013. The S&P 500 index, by contrast, has 12% volatility.

ERF's volatility stands in the 4th percentile of its one-year range, a very low level indeed.

Options are trading actively today with a strong skew toward calls, which are running at nearly triple their five-day average volume. Puts are running at 57% above average volume.

The Hedging Problem

I'm very picky when it comes to options. I want a front-month at-the-money bid/ask spread in the single digits, and I want front-month near-the-spread open interest to be in the triple digits or better. ERF falls short in both instances.

The options become especially crucial for trades using my longer-term rules, which require me to open bear hedges with options when the price takes a downturn, rather than selling the shares and re-entering later. The goal is to preserve the position for at least a year so I can take advantage of the lower long-term capital gains tax rate.

Possible solutions are to find spreads within the ERF options grid that will have a decent spread and liquidity. Or to find a more liquid avatar to use in hedging; there is no shortage of companies in hydrocarbons business whose charts, most of the time, will resemble ERF's.

The options grid and the broader universe of possible avatars is constantly changing, so there is no single solution. If the price heads declines, then I'll search for a hedge that will match the momentary conditions.

Decision for My Account

I bought shares on June 3, a day before this analysis, based on a preliminary look at the chart. I consider ERF to be a good capital gains and dividend play under my longer-term rules, if I can solve the hedging problem.

-- Tim Bovee, Portland, Oregon, June 3, 2014

References

My shorter-term trading rules can be read here. My longer-term trading rules can be read here. And the classic Turtle Trading rules on which my rules are based can be read here.

I use the number 68.2% in using applied volatility to calculate the expected trading range. This comes from statistics and refers to the one standard deviation boundaries, which are expected to contain 68.2% of whatever is being studied. Putting it another way, given an item (a trade or whatever), there is a 68.2% chance that it will appear within those boundaries.

Elliott wave analysis tracks patterns in price movements. The principal practitioner of Elliott wave analysis is Robert Prechter at Elliott Wave International. His book, Elliott Wave Principle, is a must-read for people interested in this form of analysis, as is his most recent publication, Visual Guide to Elliott Wave Trading.

Several web sites summarize Elliott wave theory, among them, Investopedia, StockCharts and Wikipedia.

See my post "Chart Analysis: Nomenclature" for an explanation of my method for labeling waves on the chart.

By preference I place my shorter-term trades in the last half hour before the closing bell in New York. See my essay "When is the best time to trade" for a discussion of the practice.

Disclaimer

Tim Bovee, Private Trader tracks the analysis and trades of a private trader for his own accounts. Nothing in this blog constitutes a recommendation to buy or sell stocks, options or any other financial instrument. The only purpose of this blog is to provide education and entertainment.

No trader is ever 100 percent successful in his or her trades. Trading in the stock and option markets is risky and uncertain. Each trader must make trading decisions for his or her own account, and take responsibility for the consequences.