Back in mid-April, we forecast a $124 price objective for Valero Energy Corporation. At the time, the oil refiner’s stock was trading at the $105 level.
I’m happy to say that our target was hit on May 31. That’s actually a “good news, bad news” story. The stock hit our target—and actually overshot it by nearly $3—much sooner than we anticipated. That sounds like good news, doesn’t it? Well, an 18 percent gain in just six weeks ain’t chicken feed, that’s for sure. But the speed at which the stock raced upward has now become the speed of its descent. VLO’s slumped more than 7 percent in just seven trading days.
We’ve often discussed the relationship between VLO’s price and that of crude oil. You can readily get a sense of VLO’s relative value by tracking the stock’s price multiple over the cost of West Texas Intermediate crude. It’s pictured in the chart below.
VLO got way ahead of the oil market on its ascent. As the Texas-based company’s stock raced to its zenith, spot crude gained but 10 percent. The VLO/WTI ratio ended up topping out above 1.95. As a point of reference, the ratio had been trading on either side of 1.50 for months before our forecast.
Now oil’s leading the way down. WTI shed nearly 12 percent of its peak value before it found a recent foothold. And there’s likely more weakness to come. This month’s price action sets up another 8 or 9 percent give-up, putting an objective of $57 to $58 in view.
And what of VLO? Well, if our ratio reverts to its current mean, VLO could trade down to the $86 level.
Seems like quite a drop, doesn’t it? I mean, the last time VLO changed hands at that price was back in December.
So what do you do if you own VLO now? Well, you could sell out. The wisdom of this move will be determined by your cost basis and your comfort with abandoning your position and its potential for a recovery. It may be a taxable event as well.
An alternative strategy would be to “collar” your stock. By purchasing a protective put together with writing a covered call, you could obtain downside protection for very little or even no cash upfront. And no margin requirement, meaning you need a very low level of option account approval. The put’s exercise price becomes your worst case exit price from the position while the call’s strike price sets the cap on your upside during the life of the hedge. This cap is the real cost of the strategy. If VLO decides to scream upward, you’ll likely need to buy back the call to avoid the risk of being lifted out of your stock.
TV actor and model Sean Faris, known for his fashion sense, once remarked, “I hate the polo collar.” Nobody’s yet sought his opinion on the VLO collar, but I reckon he wouldn’t mind it so much if he owned the stock in a slippery market.
Brad Zigler is WealthManagement’s Alternative Investments Editor. Previously, he was the head of Marketing, Research and Education for the Pacific Exchange’s (now NYSE Arca) option market and the iShares complex of exchange traded funds.