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Bull markets are demand led. Bear Markets are supply led. It’s and old and surprisingly true axiom.

Nowhere has it been truer than in crude oil prices. While oil worldwide demand may not be fully to blame for the most recent spike in crude prices, it most certainly continues to provide a favorable environment for the bull market in crude. 10 years ago, world oil demand was about 70 million barrels per day. In 2007, that figure is close to 83 million barrels per day. This figure is expected to increase about 1 million barrels per year for the next 5 years largely as a result of growing industrial use in China and India.

But this is old news. We’ve all heard the China/India demand story for years. But are China and India to blame for the “rush to $100” mania gripping the US financial media?

Again, growing East Asian demand has provided the backdrop. But it was largely spec and fund led buying that is responsible for the most recent spike in oil prices. Unlike markets in less wealthy nations such as Brazil or the Ivory Coast where producers must sell their product to secure capital, the oil markets are not as subject to producer hedging. Saudi Arabia can produce a barrel of oil for $10. It doesn’t matter if they sell it for $80 or $100, they are generally willing to let the market do what it will and sell it as prices dictate.

A cocoa farmer in Africa or a coffee farmer in Brazil does not have this luxury. His harvest must be sold at a certain price within a specified time frame in order to secure capital to continue his farming operations. Thus, with spec led rallies in markets such as these, producer selling is likely to come into play much sooner, often hindering upside price momentum. Farmers are generally willing to lock in a price that is “good enough” rather than take the risk that prices will decline. They are willing to pass this risk to the speculator.

Of course, weather related problems can still produce sudden rallies in these markets and prices will always need to move to serve the function of balancing supply and demand. But demand for these commodities remains relatively stable, growing at slow predictable rates each year. Runaway spec led rallies, like the one in crude oil, are less likely in commodities where a large percentage of supply comes from less developed, agricultural nations. Producer selling will often be there to keep the specs from running things too far out of line.

Crude Oil, however, is a different animal. With billions of new dollars pouring into commodities each year, commodity and hedge funds need a place to put it. Funds tend to be trend followers and they tend to favor the long side of the market (commodity index funds are always long the market). Thus, a solid uptrend with a good fundamental demand story and massive open interest makes a perfect market for funds to “place” equity. Any bullish tidbit of news becomes an excuse to buy. This is why oil markets have been hypersensitive to any type of bullish news story in recent weeks. These waves of capital flowing into energy markets create more buyers than sellers. If oil producers were eager to lock in profits at these levels, hedge selling would have curbed price gains weeks or even months ago. But at this point, producers seem content to let prices go where they may.

Producers have tended to take an alternative route to hedging anyway. Adjusting production has been OPEC’s method of controlling price in the past. However, seeing the world suck up $90 per barrel oil without as much as blinking an eye has provided OPEC with little incentive to raise production. In the past, OPEC was often willing to ramp up output in order to keep oil prices at levels that would not hurt the economies of its best customers. The logic being that as long as these economies remained healthy, they could continue to pay up for crude oil. OPEC was willing to sacrifice a little short term profit to secure its longer-term gains. In other words, they did not want to kill the goose that laid the golden egg.

But the goose is turning out to be a lot heartier that even OPEC had thought and there appears little incentive for them to do anything to curb prices.

This leaves crude prices largely in the hands of speculators and traders.

The New Fundamental

Despite the soaring price of petroleum and the media’s coverage of the market, there is no shortage of crude oil in the US.

For the week of November 9^th, EIA crude stocks stood at 314.7 million barrels. While it is true that this figure is about 6% lower than supply levels at this time last year, it is almost exactly in line with the 15 year average supply levels for this time of year (last year’s stocks were well above normal).

There is a conglomerate of other fundamentals, however, that have combined to help drive prices higher. In addition to relentless worldwide demand, there are the usual geopolitical factors such as supply disruptions in Nigeria and the ongoing tensions with Iran (Just this week, Venezuelan present Hugo Chavez suggested that a US/Iran military confrontation would result in $200 a barrel oil). There is the IEA report this month suggesting world oil stocks would reach “worrisome” levels by the first quarter of 2008.

Probably more influential, however, is the collapsing US dollar. With the Euro at all time highs against the US dollar, the price increase for imported oil has not been as extreme for Europeans, meaning there is less incentive to curb demand. However, as the US buys it’s oil in dollars, if the dollar is worth less on the world market, it takes more of them to purchase a barrel of foreign oil. This increase in dollars per barrel has had a sharp impact on prices at the NYMEX in recent months.

While all of these factors have contributed to higher oil prices, we do not feel that they alone can justify oil at current price levels. For oil to ignite on a sustained rally such as the one we have just experienced takes more than just the items listed above. Yes, demand is strong but it has been for some time. The dollar is weak but its decline was not as intense as the rise in oil. Since the beginning of this year, crude prices have increased by an astounding 90%, more than half of which occurred during a particularly torrid 9 week span from late August through early November. Yet, consumption of crude oil did not increase by 90% since January. Nor did supply decline by any level remotely justifying such a price spike. There is something else at work.

What is happening goes back to our opening comments about funds and speculators. Crude oil has become a desirable global investment asset. It has become a currency per se in and of itself. For millennia, investors bought gold and silver, not for any particular consumption use, but to hold as an investment. In the 21^st century, investors are now buying oil, not for consumption, but to hold as an investment.

This is profound in that it adds an entirely new dimension to the demand structure for crude oil. Demand for oil comes not only from suppliers and consumers of the product, but from investors wishing to own the product for different reasons. There are many ways for investors to hold oil through modern investment vehicles. In the end, however, demand is demand and while consumer demand may be the fuel for the bull market fire in crude, investor demand is the accelerant that ignites the blaze.

Potential Investment Opportunities

With these trends in demand seen continuing into the future, we feel it inevitable that crude prices will eclipse $100 a barrel in 2008. That being said, speculators are a fickle bunch and with such a large open spec position in crude, things could get a little volatile if everyone decides to head for the doors at once.

We at Liberty Trading see crude oil as a healthy longer term bull market that will remain vulnerable to sharp corrections on the whims of speculators. As such, volatility in oil should remain high, making it an ideal market for selling options. As our long term outlook for crude remains bullish, selling put options would be the recommended strategy of choice.

For those unfamiliar with selling options, an investor can sell a put on crude oil with a strike price of say, $65 per barrel. He collects a cash premium for doing this. If crude oil is anywhere above $65 per barrel at the option expiration date, the put option expires worthless and the seller of that put keeps the cash premium as profit.

We find put selling to be a high percentage strategy for taking advantage of bull trends without having to pick absolute market direction. It is a fact that options held through expiration will expire 82% of the time. It is our opinion that putting a little fundamental knowledge behind this figure can increase the percentages even greater.

Our gut feel is that crude prices are due for a seasonal correction of at least $5 - $10 per barrel. We would advise against getting short, however, for while a correction may be in the cards, it is impossible to know when it will come. Rather, we would suggest waiting for such a correction and then selling puts in the mid to low $60 range as put premiums increase on the price decline. 

Figure 1: January 08 Crude Oil (NYMEX)

In this demand-led bull market, we’d consider it a solid bet.

[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
Questions for James and Michael? Visit the Optionetics.com Discussion Board

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