Consider: benign weather, OPEC production cuts, a slowing economy, large but declining stockpiles, new violence in producing regions. Bullish or bearish?
Dec. 8, 2006 — Crude Oil prices at the NYMEX seem caught in a tug of war between evenly matched fundamentals. Should an investor go long or short? How about both?
For current or prospective option sellers who want to collect premiums on both sides of the market, crude oil could be the market you’ve been waiting for.
Unlike the demand-led advance that drove prices to all time highs in early 2006 or the abrupt decline that occurred shortly afterwards, crude oil prices have settled into a narrow trading range over the last two-and-a-half months. With the market remaining within a $5 price band for such a period, some technical traders contend that the market is “coiling” and preparing to break out in one direction sometime soon.
Don’t count on it. Crude oil may break out of its $5 trading range but don’t expect it to move too far anytime soon. For the first time in a long while, crude oil appears to be priced fairly with an equal amount of bearish factors balancing out any bullish news. To understand how an investor can profit from this, one must first understand these dueling forces and how they are affecting price.
The bull’s argument goes something like the following: We are entering winter heating season, refineries are ramping up production and drawing on crude supply. This is compounded by the fact that OPEC continues to talk about additional production cuts over the next 30 to 60 days. Given the fact that crude prices are still $16 below their 2006 highs and geopolitical threats in Iraq, Iran and Nigeria continue to possess the ability to disrupt supply, the bulls feel higher prices are in the cards.
They may have a point. Seasonal factors have plenty of sway in the energy markets and we are entering the time of year where increased demand is generally expected. Crude is used to produce heating oil, which still heats plenty of homes in the United States, especially in the Northeast and Midwestern states. Refineries are ramping up production as was evident in this week’s inventory report showing U.S. crude stocks fell nearly 1.1 million barrels, well above most analysts’ expectations. OPEC continues to discuss another production cut, possibly coming as early as this month. Most analysts expect this to take another 500,000 to 1 million barrels per day off the world table. This after the organization already cut output last month by 1.2 million barrels per day.
While this may sound impressive, the bears have an equally valid rebuttal. While refineries are ramping up production, the industry begins the heating season with burdensome supplies. Although stocks did fall 1.1 million barrels last week, they remain high at 339.73 million barrels – 17.32 million barrels above last year at this time and 8.3% above the 14-year average. While winter does not officially begin in the Northern Hemisphere until Dec. 21, it has been a warm autumn in the United States with no hurricane related disruptions. This has allowed supplies to build.
This supply build combined with cooling demand has OPEC contemplating another production cut. A cut is not necessarily near-term bullish. Last month’s cut was made to avoid a glut in oil. Another cut is a sign OPEC is still afraid of too much supply on the market.
The Energy Information Administration (EIA) itself stated this week that oil prices would not hit $70 a barrel in the near future. This view is no doubt due to the excess supply currently on hand. Notice they did not say prices would necessarily fall.
The EIA is now projecting average crude oil price in 2007 at $65 per barrel. We think this is an excellent time to sell put and call premium on both sides of the market. Although fundamentals appear to have reached an equilibrium stage, the market is still holding the volatility of the price moves earlier in the year. Therefore selling far out of the money option premium is still possible.
We think that with another OPEC cut and colder weather into January, crude oil prices could approach the high $60’s this winter. Warmer than normal temperatures, combined with OPEC inaction, could easily drop prices back into the mid to high $50’s per barrel.
We do not intend to try to predict the weather, OPEC or rebel strikes in Nigeria. That is for day traders. Our strategy is simply to sell puts and calls well outside of the ranges mentioned above and allow the market to move where it may. There are currently put-option premiums available at $15 below current market price and call-option premiums available at $20 to $25 per barrel above current price. Premiums available on these options are in the $400 to $500 range per option.
It could be that this is not as exciting as swing trading futures, trying to catch $1 to $2 daily moves. Maybe so. But for an investor willing to be patient, this strategy can profit as long as crude prices remain in a $40 wide trading range. That’s close enough for us.
James Cordier and Michael Gross
Liberty Trading Group
401 East Jackson Street
Suite 2340
Tampa, FL 33602
(800) 346-1949
www.optionsellers.com
You can now watch James Cordier’s “Best in Class” appearance on Bloomberg Television, where James is interviewed on the Energy Markets at http://www.libertytradinggroup.com/news.html
***The information in this article has been carefully compiled from sources believed to be reliable, but its accuracy is not guaranteed. Use it at your own risk. There is risk of loss in all trading. Past performance is not necessarily indicative of future results. Traders should read The Option Disclosure Statement before trading options and should understand the risks in option trading, including the fact that any time an option is sold, there is an unlimited risk of loss and when an option is purchased, the entire premium is at risk. In addition, any time an option is purchased or sold, transaction costs including brokerage and exchange fees are at risk. No representation is made that any account is likely to achieve profits or losses similar to those shown, or in any amount. An account may experience different results depending on factors such as timing of trades and account size. Before trading, one should be aware that with the potential for profits, there is also potential for losses, which may be very large. All opinions expressed are current opinions and are subject to change without notice.
