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It is no secret that energies are in a bull market. Crude oil grabs headlines daily and the price of gasoline at the pump is a favorite subject of local news media around the country (and the globe).  And while the mainstream media loves to blame speculators for high prices (and they could be partially correct), speculators don’t buy markets that have hoards of supply and little demand. Oil and gasoline are demand stories, pure and simple. They are markets where relentless global demand is steadily outpacing supply and our resources for producing supply. As such, the days of $50, $60 and $70 oil are probably over.

This is not to say that oil prices will always go up or that trading it gets any easier. It is still like any other market. It is just that there happens to be a new price range that is considered “normal.”  There are some analyst that are calling the energy markets a “bubble” and expect that prices will come crashing down any day now. 

While we at Liberty Trading respect these opinions and understand the reasons behind these views, we happen to disagree. Of course, energy prices could and probably will experience price corrections in the coming weeks and months. However, global consumption will not wane enough, even in a US economic slowdown, to drastically change the demand picture anytime soon.  For that reason, we see the longer term bull continuing for the foreseeable future.  Timing trades, however, remains a challenge – even for option sellers.

For trading opportunities, then, one must look for the subplots in these markets to identify opportunities. One of these subplots is the subject of this week’s option selling focus – Unleaded Gasoline (RBOB).

With all the talk of slowing economies and consumers cutting back on consumption, Gasoline prices have continued to soar. We outlined our case for selling puts in the unleaded gas bull market back in January in The Option Seller Newsletter. (See Unleaded Gasoline Special 1/7/08 in the newsletter archive).

1. The macro-economic outlook has not changed. Short-term fundamentals, however, have changed. Short term, fundamentals for unleaded gasoline appear to be more bullish and could support a run to the $3.10 -$3.15 range basis the July NYMEX contract. This would translate into prices near $3.80 at the pump.  We see this continued uptrend for several reasons. Presented below are three issues highlighting the overall bull market in oil and gasoline and a fourth explaining a key subplot that makes unleaded gasoline look like the best option selling opportunity over the short term.

1. While past performance is not indicative of future results, gasoline prices tend to rise in the Northern Hemisphere springtime as wholesalers accumulate inventory to meet summer “driving season” demand.  Regardless of prices at the pump, US drivers are unlikely to cancel vacations because they have to pay a few more dollars for gasoline. Gasoline demand will almost certainly surge during the June through August time period. Distributors have to be ready which means forward purchases will continue, regardless of absolute price. As we discuss in The Complete Guide to Option Selling (McGraw-Hill 2005), pairing seasonal tendencies with selling far out of the money options can be a powerful combination.  

1. The “slowing economy/slowing demand” theory may be fading. The EIA reported this week that US gasoline demand is up .8% over the last 4 weeks compared to year ago levels. Concerns over international demand were also eased as China continues to aggressively import oil despite it’s price tag. Chinese refinery processing rates were up 6.8% last month. The IEA expects global oil demand to rise by nearly 1.3 million barrels per day or 1.5% over 2007. Global oil demand remains robust as oil is not as expensive (on a relative scale) as in the US due to the falling dollar and rising values of other currencies.

1. Oil and Gasoline continue to be fund favorites as the dollar continues to plunge.  The latest Commitment of Traders report shows funds again building a long position in Gasoline.  The COT with options report has large and small spec net long positions back to 59,010 contracts, just shy of the October record of 61,763. As the dollar’s value declines, physical commodities are worth more and thus serve as an effective inflation hedge for investors. With the Federal Reserve expected to cut rates at least 2 more times this year, expect the dollar’s plight to continue – despite this week’s rally.  But while some US speculators can buy gasoline contracts, the big money flows into crude contracts. This could have an even larger impact on the price of gasoline (see #4).

1. KEY FUNDAMENTAL:  This week’s EIA report was enlightening to say the least. US refinery operating rates fell 1.6% to 81.4% of capacity. Read that again. With gasoline prices at record levels, consumers screaming for relief, congressional hearings, and an economy in or heading for recession, refineries are producing gasoline at only 81.4% of their total capacity. That is down more than 10% from just a few months ago. There are several reasons cited for this: An aging (some call antiquated) and inefficient US refinery system, a shortage of MTB (the additive refiners must include in summer gasoline) and shut downs due to seasonal maintenance.  All of these could be contributing to US refineries operating at 9% lower capacity than is normal for this time of year. But they are not the main reason. The main reason is that US refineries are deliberately scaling back operations.

Why would US refiners do this? The answer is, of course, is money.

As international hedge funds and sovereign wealth funds plow billions into the energy markets to hedge against the falling dollar, their market of choice is crude oil. It is the only petroleum market with enough open interest to handle the volume these funds provide. Therefore, investor demand for crude oil is greater than that for the products (unleaded gas and heating oil.)  In other words, a fund from Dubai trading $100 billion in equity does not buy US heating oil or gasoline contracts. They buy crude oil.

This has pushed the price of crude oil up faster than that of gasoline.  Therefore, while US drivers cry for mercy, gasoline still appears underpriced relative to its main ingredient, crude oil. It also means that refinery profit margins have shrunk dramatically. Exacerbating the problem is that US unleaded gasoline stocks are at 15 year highs for this time of year at 215.8 million barrels.

To solve the problem, refiners are attempting to “correct” the situation by cutting back on gasoline production.  In theory, this will lower gasoline supplies while allowing crude supplies to build (as it will not be used for gasoline production), thus bringing the price balance back in line and restoring profit margins to desired levels.

Thus far, it appears to be working. This week’s report showed US gasoline inventories fell by a staggering 5.5 million barrels or 2.5% - the largest drop since August 2007 and well in excess of the average analyst projection of 1.7 million barrels.  The problem is that crude oil stocks dropped too, by 2.3 million barrels largely as a result of lower imports.  Our guess is that they’ll have to keep trying.

Therefore, within the overall story of bullish oil and gas fundamentals, we have our subplot. US refineries are scaling back gasoline production in order to lower inventories – while heading into peak demand season. 

In light of this fact, look for gasoline to outperform crude oil over the next 4-8 weeks. It should rally more in bullish conditions and fall less if the market corrects. We see it as a strong set up for put selling.

Recent volatility makes it possible to sell inflated put premiums far below the market. Technically, this market is due for a correction in the near term. We would see any such weakness in unleaded gasoline as opportunities for writing puts.

Figure 1: June 08 RBOB Gasoline

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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