How to make 100% on the Gulf spill without buying BP (or any other stock)

Let's talk about BP… Some of the world's top value investors have begun to buy shares of BP based on their estimates of what the Gulf cleanup will cost compared to the enormous cash flows of the company (roughly $30 billion annually, pre-tax). Our friend Whitney Tilson, one of the most respected value-oriented hedge fund managers in New York, even says that BP won't have to cut its dividend. We doubt Tilson is correct about the dividend, but he makes a few excellent points about the scope of the disaster in contrast to the media hype about the spill:

• It's a horrible accident, but unlike what Matthew Simmons says, you don't really have to clean up the entire Gulf of Mexico. "The Gulf of Mexico is huge, covering 615,000 square miles and containing 660 quadrillion gallons of water," Tilson wrote in an e-mail to me this morning. "Let's compare this to the amount of oil Deepwater Horizon has been leaking. Most estimates are in the 12,000-20,000 barrels per day range, so let's take the high end and also assume that this continues until mid-August, meaning four months since the accident.

"Let's also assume that the cap captures no oil (the latest reports are that it may be capturing most of the oil, but let's be conservative). 20,000 barrels/day x 120 days x 42 gallons/barrel = 100.8 million gallons of oil released. 100.8 million divided by 660 quadrillion is one gallon of oil for every 6.6 billion gallons of water in the Gulf. That's the equivalent of roughly one-millionth of an ounce of oil in a typical bathtub full of water."

• It has happened before, and it wasn't the end of the world. "PeMex's Ixtoc oil well [1979] was far worse than the Deepwater Horizon well: 140 million gallons of oil poured out of the Mexican well… After four months, an oil slick had covered about half of Texas's 370-mile gulf shoreline, devastating tourism."

• It's nothing compared to Kuwait. During the first Gulf War, 10 times as much oil spilled into the Persian Gulf, which is one-sixth the size of the Gulf of Mexico. And what were the long-term consequences? Tilson cites a 1993 UNESCO study that reported "little" long-term damage was done to the environment. "Half the oil evaporated, a million barrels were recovered and 2 million to 3 million barrels washed ashore, mainly in Saudi Arabia," he said.

Should you buy BP, down almost 50% from its high? It is now trading at roughly six times earnings. If the dividend isn't cut you'll make 9% a year in yield buying the stock at its current price. Several of the smartest guys we know well in the investment business and in the oil business have said they're buying the stock. So… what do we think you ought to do?

We won't share our opinion on BP. It's not that we don't care… or that we don't feel compelled to give you our best advice. But our best advice in this situation isn't to buy the companies most likely to be caught up in direct liabilities from the accident. BP, Transocean, and Halliburton are very likely to spend the next 20 years wrapped up in litigation from this accident. Anyone who tells you they know how it will turn out is a liar. That can't be known.

But… we simply believe all of these things are beside the point. You don't need to know whether or not to buy BP. What you need to know is that one of the world's best oil exploration companies has seen its stock fall more than BP. This stock has been implicated in the spill. But unlike BP, Transocean, or Halliburton, it actually has zero liability. It was not an operator of the well. It merely had a passive ownership stake. We don't think this firm will pay even a penny in damages.

Here's the best part. All of the hype about the spill and fears about a moratorium on deep-water drilling have not only caused the stock price of this world-class oil company to fall by more than 40%, it has also sent the premiums on its stock options soaring. That sets up an opportunity for us to make quite a bit of money selling puts on this stock.

Instead of buying the stock where it's trading right now, you could simply promise to buy the stock at its current price. Making this promise normally requires you to put up only 20% of the stock price, instead of the full amount. Why would you merely want to promise to buy the stock? Because doing so would earn you a fee (a put premium) of nearly $9 a share. Compared to the amount of capital you'd have to put up for this trade, that equals a return of more than 100%. Yes, those numbers are right. Right now, you can earn more than 100% on your margin by simply promising to buy this world-class drilling company.

So here's my question to you: If I can show you how to make 100% on your capital by merely promising to buy a company that won't have any liability in the Gulf oil spill, why would you bother trading BP? You wouldn't.

All of the details of this recommendation (including the name of the drilling company, the particular put option I'm recommending) can be found in today's edition of Put Strategy Report, an advisory I write that specializes in selling put options. A put is nothing more complicated than a promise to buy 100 shares of stock at a fixed price for a fixed period of time. It's that simple. And assuming you only make such promises on stocks you want to buy at a price you're happy to pay, then selling put options is a risk-free way to make enormous amounts of money. I'm hoping you'll at least try it once. If you do, you'll never buy stocks outright again. You'll only sell puts.

Do these strategies really work? Can you really make so much money, safely? I know you can. We've averaged about 50% gains per recommended put sold in my letter. Says one of our readers, "LB":

Put Strategy Report helped me take the profitability of this strategy to a new level. Since becoming a subscriber, I have sold puts and covered calls 191 times on S&A recommended stocks. Of those, 177 made a profit and only 14 were closed for losses. That's a 93% win rate. Since joining S&A, I have had 18 straight months of profits. The picks have come from virtually every newsletter you publish. My accounts are 24% ahead of the S&P 500 returns over the same period. Thanks for the great recommendations, and keep them coming.

Now, I know that most of you will never trade options. That's fine. You don't have to trade options to be a good investor. But if you're going to trade options, please… make sure you're selling them, not buying them. Studies show 90% of out-of-the-money options that individual investors buy end up never being exercised (they end up worthless). Selling obligations that end up worthless is a lot smarter than buying obligations that end up worthless. For more on my put selling strategy, click here.

Now… on to Prechter. Warning… what follows is mostly a waste of time, but it might help you understand more about the risks of inflation.

Here's the background: Last week, Bob Prechter granted an interview to our sister publication, The Daily Crux. In the interview, he explained why he thinks the world is heading for a serious deflation – a collapse in the money supply that will be catastrophic for the world's equity and commodity markets. Before you build a bomb shelter and start stockpiling dollar bills… keep in mind Prechter has been making the same forecast (more or less) for as long as I can remember. He did so most thoroughly in his book, Conquering the Crash, which was published in 2002, just before a huge wave of inflation swept through the world's stock, commodity, and real estate markets, sending all of them to new highs. He is also perhaps the most widely known "Elliot Wave" analyst – a trading system that incorporates the idea that markets are driven by waves of optimism and pessimism. To me, the two ideas seem related in this way: Anyone who believes in deflation will believe anything – including Elliot Wave analysis.

Let's go through the facts Prechter says support his thesis. First, his basic theory, in his own words: "[I]n the simplest terms, creditors will stop lending, which will keep the credit supply from inflating. And debtors will default, causing the supply of outstanding debt to deflate. This will overwhelm government and central-bank efforts to inflate, and will result in deflation. These trends have already begun."

But actually that's not true. Total new credit in our economy has continued to increase for the most obvious and basic of reasons: The U.S. Treasury is funding a $1.6 trillion annual budget deficit. Increases to government debt far outpace declines in private lending. This is a fact. And it means Prechter is wrong: Credit deflation in the United States has not begun. Nor will it ever, in my view, because our politicians would never allow it. They have a printing press. And they know how to use it. To believe in deflation is to believe in the soundness of the U.S. dollar and in the integrity of our government. Don't laugh. It's not funny. It's sad.

Prechter claims the debts being written off by banks (i.e. mortgages) are too large for the government to paper over. And he says: "The Fed and the Treasury have bailed out or guaranteed another trillion or two of bad debt and promise to do even more."

No, that's simply not true. The government and the Fed have bailed out or guaranteed at least $12 trillion in debt so far. In fact, the guarantees to Fannie and Freddie alone are larger than $10 trillion.

Prechter claims deflation is all around us. (We wonder who pays for his groceries, his gas, or his lunch… and we bet he'll never win a bidding contest on The Price Is Right.) Says Prechter: "The amount of money and credit in the system is contracting at its fastest pace since the 1930s. Interest rates on Treasury bills are stuck at zero. The CRB index of commodities is at half its value of just two years ago. The stock market is lower than it was 10 years ago. The PPI and CPI (measures of producer and consumer prices) have a zero rate of change."

Again Prechter's facts are simply wrong. Let's take the most obvious point: deflation in commodity prices. When Prechter's book came out in 2002, the CRB index (a big index of basic commodity prices) stood at about 180. By the middle of 2008, it had soared to 480 – an increase of 166%. But Prechter completely ignores this enormous inflation of commodity prices. Instead, he simply says commodity prices have fallen in half. Yes, that's true, too. During the global market crash, the CRB index fell substantially, but not enough to justify any claim of deflation.

Today, it's around 250 – still up 38% since he published his book. Likewise all of his other facts are simply wrong: Interest rates are low because the Fed sets short-term rates and has been buying bonds to force long-term rates down, too. This kind of debt monetization is inherently inflationary. And his claims about the PPI are misleading: They show small rates of change because the government has changed the way they're calculated. If you used the CPI of the 1970s, it would show a 9% annual rate of inflation right now.

But… beyond all of this tit for tat… just ask yourself (or your wife): Are you paying more for groceries, gas, travel, babysitters, etc. than you were 10 years ago? The answer is yes. And guess what… prices are still going up.

Here's my favorite line from the Prechter interview: He says that since his book came out in 2002, "The Fed has offered unlimited credit. It has been injecting money. Yet there has been no runaway inflation."

Those are his words. You have to wonder what planet he has been living on. Did he not witness the enormous inflation in real estate – perhaps the largest credit bubble in history? Did he not witness the price of oil going from $25 to $150 per barrel? Did he not see stocks double by 2008? It seems obvious to me that the only person in the world who didn't see the inflation between 2002 and 2008 was Bob Prechter.

And finally… the coup de grâce… Prechter says he'll admit he's wrong about this deflationary views "if the S&P 500 index, real estate, and the CRB commodity index all take out their price highs of 2006-2008, it would probably be enough to indicate runaway inflation." Ironic isn't it? All of those things happened within four years of his book being published – his book that forecasted a dire deflationary collapse. And yet… now he says they'll have to do it all again before he'll detect the mildest whiff of inflation.

Now… what's my view? How would I explain the massive collapse in stock, bond, real estate, and commodity prices over the last two years if I don't think deflation is possible?

It's simple. The history of paper money is filled with bubbles and crashes. Paper money eliminates the need for sound banking reserves, which allows credit to grow on an almost unlimited basis – up until the minute people begin to doubt asset values. And then they crash. But crashing asset prices doesn't imply that the value of the currency is increasing. In fact, crashing asset prices imply a fundamental weakness in the system of money itself.

Right now, people doubt real estate prices, stock prices, and commodity prices. Sooner or later, they will also begin to doubt the value of the paper bills that delivered them into debt and deprivation. When that happens, we will have a crisis – on that we agree.

Prechter recommends holding Treasury bills to safeguard your wealth. But those are the very instruments that will be destroyed as people finally abandon paper money. If you follow my advice, you'll be holding gold when this final crisis comes. You may notice gold hasn't suffered at all during the crashes of the last two years… and as governments (and their paper money systems) go bankrupt all around the world my bet is gold continues to soar.

New highs: Hilltop Holdings Preferred Shares (HTH-A), The Hershey Co. (HSY), San Juan Basin Royalty Trust (SJT).

In the mailbag… Is it rude to boo a government hack? Let us know what you think: feedback@stansberryresearch.com.

"I called my broker today to order the bond Mike recommended yesterday [in his newsletter, True Income]. Shortly I got a call back: Who is the guy recommending it? - Why? - Because the bonds desk said they were bombarded with orders. So I gave Porter's and Mike's names with the high regard to both. By the way, my broker told me just before the May correction that I was about 50% better over the year than the average of his clients. I want the folks who are still reluctant to join the Alliance to take notice. I think, S&A as a group stands head and shoulders above others in the industry, not only in their picks, but in their constant (and dangerous) willingness to educate the public about a corruptive nature of the government. Stay on course." – Paid-up subscriber Michael Brailovsky.

Porter comment: Mike Williams does a great job for our subscribers in his bond letter. As I've explained before, I believe bonds should be the foundation of most individual investors portfolios. And yet there are almost no good sources of independent information on corporate bonds. Bought at the right time (at a discount from par) corporate bonds can easily make more money for investors than stocks, with far less risk. Likewise specialized bonds, like convertible bonds, offer investors an equity position in a company, but with the security of a legal obligation to pay.

Most individual investors know nothing about these opportunities. And they never will… simply because they're afraid to learn. It's a shame. On the other hand, we have convinced at least a few people to try our approach to bond investing. Paid-up subscriber Joe E. wrote to us in April 2010 about his first bond trade:

Porter, I have to give you credit. In 2009, you convinced me to buy corporate bonds, something I had not ever bought before… I believed bonds were not appropriate for someone barely 40 years old. I bought two bonds recommended by Mike Williams: Freescale and Rite Aid. The experience has made me a believer for life that bonds can be the best investment you can make, if you buy at the right price and if you buy companies that Mike says are safe… I am up around 120% in less than a year.

I need to thank Porter for convincing me to take a look when bonds were at their most attractive point in many years, and I have to thank Mike for educating me on bonds so that I know what I'm doing. On these two investments alone, I made a profit worth about $26,000 (so far!) with very little risk… By all means, keep beating us on the head when there are incredible opportunities that we simply can't afford to miss, like bonds…

Whether you subscribe to True Income or not, I hope you'll stop to consider this question: If corporate bonds offer investors higher returns with less risk than equities, why don't brokerage firms make bonds easier to buy and why aren't there more sources of information available about bonds? The answer is simple. Bond trading is one of the largest profit centers on Wall Street. Nobody else is going to invite you into this game because it's not in his best interest to make the market more efficient. If you're willing to learn about bonds, you will be a much more successful investor. But… all I can do is point you in the right direction. It's up to you to decide whether or not you'll do it. To find out more about True Income, click here.

As a libertarian myself, I certainly agree with Porter's contempt for anyone [Steve Rattner] exhorting 'share-the-wealth' philosophies. However, if there is one thing I put above such contempt is to never limit free speech by rude behavior. In booing a speaker to even momentary silence undermines respect for libertarian values. – Paid-up subscriber Roger Altman

Porter comment: Yes… I have to agree with you here, Roger. My behavior was rude and not consistent with my personal values. However… there is some justification for my behavior. You see, Rattner was not merely a fellow citizen exercising his right to free speech. He was a high government official bragging about the success of his latest plundering/extortion campaign (ripping off the bondholders of GM and Chrysler), while threatening to confiscate the earnings of the people he was addressing in order to repair what he claimed were the great injustices of the free market. I considered my gentle boo at his income-inequality slide a form of civil disobedience, not rude behavior. And I think our country would be a better place if more of my fellow citizens were slightly less civil to the members of the government who proudly boast of their ability to steal from us. Quite honestly, Rattner has a lot more than just boos coming to him.

"Porter, as Patton reportedly said: 'Rommell, you magnificent bastard!' Shame you did not have some rotten eggs or tomatoes to throw too. What a good laugh… would have loved to have been there. Like your self I am not sure I could have kept my mouth shut either. I often use a phrase of my own making at certain corporate functions: does decorum require me to pretend I believe you when we both know your lying? That would have summed up my feelings on that hubris-laden load of double speak crap he was delivering. Glad some one stood up for common sense." – Paid-up subscriber C. Lee Bruner Jr.

Regards,

Porter Stansberry
Baltimore, Maryland
June 11, 2010