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As crude oil prices reached an all-time record of $145 per barrel this summer, oil “analysts” and media pundits across the globe speculated on how high prices could go. Many spoke as though $200 per barrel was assured and some speculated aloud as to whether $300 per barrel was in the cards. But while traders in New York and London continued to chase the spiraling price of crude, the consumer was mounting a counteroffensive which would ultimately harness the bull.

“High prices cure high prices” is an economic truism that will eventually take hold in any market. While the threshold for curbing crude demand was higher than most of us thought, we eventually did reach a tipping point where global consumers began to curb usage. And while the consumer himself may be responsible for the immediate drop in oil prices, the longer term impact of government policies and manufacturing shifts could help to hinder future uptrends in the price of oil.

Crude oil, however, is a resilient market with an almost inelastic global demand structure. While near term demand may have waned slightly, do not expect crude prices to go back to the “normal” levels of $40-$50 or even $80 per barrel. Before exploring future price potentials however, we should first understand what brought us to current price levels.

Geopolitical events have played their usual role in the rise and fall of crude prices as well. Crude prices spiked to all time highs in July as Israeli jets made a series of “practice runs” in what was believed by many to be a prelude to an airstrike on Iranian nuclear facilities. Tensions cooled off a bit in August as US and Iranian rhetoric began to take on a more diplomatic tone. This has certainly helped to take some of the risk premium out of prices and sidetrack the bull.

It is demand, however, that is most responsible for reversing the relentless trek higher in prices. Demand destruction in the US has been present in the market for most of 2007. The United States EIA report dated August 1^st shows US gasoline demand down 3.4% over the same period last year – a trend that has been pervasive for much of the year. In May of 2008, Americans drove 9.6 billion miles (or 3.7%) less than the year before.

Many have sighted emerging economies such as China to blame for the run up in gas prices. They may very well have been right as Chinese demand for crude has and does continue to grow. Chinese crude demand is expected to grow by 5.6% in 2008. However, Chinese demand for oil may have been allowed to grow artificially in recent years. Consider that as of June 2008, China has held the retail price of gasoline near 5.34 yuan or about $2.60 per gallon a 9% increase over January 2007. The average price of US gasoline during this same time period jumped by nearly 80% to $4.00 per gallon.

These Chinese government price controls have helped keep the price of Chinese gasoline cheap and has kept demand humming along. Therefore while demand is waning in the US and Europe, demand in China and other Asian nations was cited as a reason that price continued to rise. In June, however, China abrubtly decided that gasoline prices would be raised by 16% to $6.20 yuan per liter. While this is still not comparable to prices being paid in the US and Europe, it has helped to curb demand and thus become a factor in pressuring oil prices.

Yet despite slowing economies and a general liquidation trend in commodities, oil prices may have a limited downside. The US dollar is showing signs of recovery as many other industrialized nations begin to slow along with the US. This will make oil cheaper in the US and thus help to encourage demand again. Despite all of the talk of Asian demand, the US remains by far the world’s largest consumer of oil, burning over 20 million barrels per day. Fluctuations in the dollar can and do have an impact on world oil prices.

Oil has corrected by nearly $35 per barrel off of it’s mid-summer highs and is now in a slack demand period in the US, at least from a wholesale standpoint. Seasonally however, wholesale demand begins to pick up in the Northern Hemisphere in the late summer and early fall which can have a major impact on oil prices.

The beginning of August is typically the time when distributors of heating oil begin accumulating inventory in order to have enough on hand to meet winter demand needs. This will generally increase demand for distillates and their primary ingredient, crude oil. Crude oil inventories tend to build through July and then begin to decline through the end of the year as excess demand for heating fuel from the wholesale sector uses up the excess inventories. This year, however, finds oil stocks well below typical levels for this time of year as inventories began to decline in May. As of the EIA stocks report for August 1, the US had 296.9 million barrels of oil in storage – over 7% below the 16 year average and more than 12% lower than last year at the same time. This is could very well be a cornerstone fundamental for aspiring bulls hoping the see the uptrend reestablish itself.

Potential Investment Opportunities

Although a reduction in global demand may have taken the luster off of the bull market in crude oil, we think that prices should remain above $100 per barrel given the low level of US supplies, the approach of a peak demand season, the heart of US hurricane season and the fact that prices have already corrected in dramatic fashion. While that may seem to be a very general price projection, for  the strategy we are about to recommend, it is all we need.

Volatility in oil should remain high, making it an ideal market for selling options. As our long-term outlook for crude remains bullish (or at least not overly bearish), we at Liberty Trading believe that 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, $70 per barrel. He collects a cash premium for doing this. If crude oil is anywhere above $70 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 approximately 80% of the time. It is our opinion that putting a little fundamental knowledge behind this figure can increase the percentages even greater.

Liberty Trading''s gut feeling is that crude prices will begin to gradually increase in the September/October time period and puts sold below the $80 should be solid investments.  

Figure 1: December Crude, Aug 18, 2008

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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