COMMODITIES ROUNDUP: Crude Oil
August 22, 2007
It has been a tumultuous month for equities, interest rate products, and the US economy in general. The commodities markets have not been immune to this volatility as markets across several sectors experienced sharp sell-offs last week.
While equities and/or futures traders may have had a hair pulling week, these are the times for which option sellers strive. Volatility suddenly entering the markets can skew fair option values, creating opportunities for investors true to the fundamentals. Volatility is a temporary condition that will eventually fade from the market as prices drift back towards underlying fundamental values.
This is even truer for the commodities markets. As stocks react to the subprime issue, the economic outlook becomes influenced by stock prices. And commodities prices, in turn, react (or overreact) to the economic outlook. Much of this reaction however, is based on perceptions, currency values and fund manager decisions. These factors, however, tend to be external in nature and must be viewed in light of the existing supply/demand fundamentals in order to gain a complete price picture for the commodity.
There is no better example of this than the crude oil market. Crude prices were initially able to withstand the plunging US stock market as crude traders eyed the approaching Hurricane Dean as a potential disruption to US production from the Gulf of Mexico. Short covering and fear buying drove near month prices back above $74 per barrel. As it became more apparent that Dean would miss US production areas, however, speculators and funds liquidated with a vengeance. Crude prices were not only discounting Dean, they were forced to react to bearish demand perceptions as falling world equity markets cast a negative light on US and world economic growth.
While the ultimate fallout of the US sub-prime debacle remains to be seen, it is almost a certainty that if the US economy begins to deflate, the rest of the world will feel the pinch. In a true slowdown, oil will be one of the first commodities affected as industrial production in the US, China and the rest of the world will decrease, meaning less demand for energy to fuel factories and ship goods. Traders and investors are well aware of this effect. This concern should be an obstacle for higher crude prices as long as the US credit markets remain in the news.
It may take months before we know if we are truly headed for an economic slowdown or if this is just a proverbial “blip” in a longer term cycle of growth. Either way, it is our opinion that the petroleum markets will have a hard time putting together any type of sustained rally with the lingering fear hanging over the market in the coming months. The mortgage issue in the US is one that is likely to linger for through 2007 – regardless of it’s longer term consequence (if there is any). Our point is that it is the fear of slowing growth that should keep a lid on crude prices – not necessarily slowing growth. We are commodity analysts, not professional economists. Our purpose is not to predict the future of world economies but to determine how crude prices will react (or in the case of option sellers - not react) to existing conditions.
Aside from Macroeconomic issues, crude oil will also be affected by seasonal factors as the US heads into Autumn. With the US driving season in the home stretch, demand for gasoline will begin to wane after August. Labor Day weekend (for non-US citizens, this is the first weekend in September) is traditionally the last hurrah for gasoline demand bulls. Refineries are already switching over to heating oil production in order to meet winter demand needs. However, as storage objectives are attained, production of heating oil tends to scale back in late September/early October. This tends to crimp demand for crude and thus, crude prices have a seasonal tendency to begin trekking lower during the September-October time period. Now the disclaimer – past performance is not indicative of future results. Just because crude prices have tended to trend lower in autumn in past years, this does not guarantee it will do so this year.
That being said, we have every reason to believe that it will. This weeks DOE report shows US crude stocks at a burdensome 337.1 million barrels (mb) – still well above the five year average. We also find it interesting that crude stocks managed to increase by 1.9 million barrels over last week with both gasoline (9.3 mb per day) and heating oil (4.2 mb per day) production increasing over prior week’s figures. With this much supply and heading into slack demand period, oil over $70 a barrel looks overvalued – economic slowdown or not.
From a technical standpoint, hedge funds continue to hold a historically high net long position in the crude market. But funds tend to be trend followers. Should the trend in crude begin to drift lower, funds could begin to liquidate rapidly as sell signals are triggered.
To summarize, we see crude prices drifting back towards the low $60’s through the 4th quarter of 2007 based on the following factors.
- Fear of slowing world economies and weakening oil demand fueled by the US “sub-prime/credit issue”
- Seasonal tendencies for crude prices to trend lower into autumn as the US driving season concludes
- A continuing over supply of crude in US storage facilities
Sure there are always geopolitical risks present in the crude market. Hurricane risks will also be a factor over the next 6-8 weeks. But the market has grown weary of reacting to the latest violence in Nigeria or the newest threat from Iran. Hurricane rallies, while headline grabbing, are usually temporary in nature. The market could also show strength resulting from late season drawdowns in crude stocks as refineries make a push to finish off the gasoline production season. We would view any of the above as high percentage opportunities for selling calls at strikes well above the 2007 highs.
Remember that when selling calls, the market does not necessarily need to decline for the call seller to profit. The futures price only needs to remain below the option’s strike price. It is for this reason that we feel comfortable selling premium at strikes upwards of $100 with crude trading at near $70. We do this with the expectation of crude prices ultimately declining, yet giving the market plenty of room to move higher if we are wrong or if our timing is off.
Recent volatility has made option values in the energy markets quite attractive to sellers. We stress that sellers of calls should be patient. The energy markets can rally quickly from storm forecasts this time of year and calls sellers should take advantage of the volatility such rallies create instead of positioning ahead of them and “riding it out.”
Figure 1: Sept 07 Crude Oil
We will be working closely with clients in identifying and selling call premium for their portfolios in the coming weeks.
Note: The opinions presented here are that of Liberty Trading and not necessarily shared by Optionetics and/or its instructors.
James Cordier & Michael Gross
Contributing Writers, Liberty Trading Group
Optionetics.com ~ Your Options Education Site
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