Since establishing seasonal lows back in January, unleaded gasoline prices have been in a relentless uptrend. Reformulated gasoline Blendstock for Oxygenate Blending (RBOB) prices at the New York Mercantile Exchange (Nymex) have increased more than 32% since the beginning of the year and the fundamentals driving it show no signs of abating anytime soon. In the United State, the auto fuel industry has a problem and there appears to be no quick fix (See Selling Unleaded Puts Looks Like a Great Play for Summer Months, 3/9/07 on our website www.optionsellers.com )
Yet, while gasoline fundamentals remain bullish, many traders are getting a little skittish about buying in at current prices, feeling that from a technical standpoint, the market is overbought and due for a correction. This may or may not be true, but for the trader seeking a more stable route to profits, the crude oil market may offer the better opportunity at this time. While unleaded gasoline may have more potential on the upside, crude oil probably has the better chance of not falling substantially. For option sellers, there is a big difference.
As a seller of puts, one does not necessarily need the market to move higher. He simply needs it not to move substantially lower. Whether, the market has moved sharply higher, stayed the same, or even moved moderately lower does not matter to the put seller at expiration. As long as the underlying contract’s price has not reached his option’s strike price, he makes the same amount – the premium he collected.
Therefore, while selling crude or unleaded puts could both be profitable if the energy markets continues to trek higher, it is our opinion that crude oil stands a better chance of turning a profit with less risk should the market move into a corrective phase.
We base our opinion on these factors:
Increased refinery runs should begin to eat into crude stocks and build gasoline supply in the coming weeks. Much has been made of the discrepancy between gasoline stocks vs. crude stocks this month and it is a valid point. As of the May 16 EIA report, U.S. gasoline stocks remain at historically low levels for this time of year, with 195.2 million barrels reported in storage, a 17-year low and a full 6% below 2006 levels. Yet at the same time, crude oil stocks in the United States rose to 342.2 million barrels, approximately 5% above the 13-year average for this time of year. There are two reasons for this discrepancy. First, U.S. refineries got a late start switching production over to gasoline this year as a late-winter cold snap in March forced increased heating oil production to take precedence. And second, the aging U.S. refinery infrastructure is showing signs of wear and tear and the newest U.S. refinery is 30 years old. U.S. refineries seem to suffer more maintenance problems and downtime each year, resulting in slower builds of products. As of last week, U.S. refineries were operating at 89.5% of capacity, a full 4% below the average operating rate for this time of year. This has trimmed gasoline supplies and allowed crude stocks to build. Prices have reacted accordingly. The spread between gasoline prices and crude prices, known as the crack spread, is now at a multi-year high. (See chart). However, this is typically the time of year when refineries make a push for maximum production given that driving season in the United States begins in less than two weeks. Expect both operating capacity and gasoline production to increase in the coming weeks, especially with the media-led concern that U.S. gasoline supplies will not be adequate to meet summer needs, as well as the usual seasonal government posturing towards runaway gas prices. Increased refinery rates should begin to whittle away at excess crude stocks while continuing to add to gasoline supplies.
Speculative traders have built a massive long position in unleaded gasoline, making it vulnerable to sharp pullbacks. As of the May 8, commitment of traders report with options, combined fund and spec net long position was listed at 35,180 contracts and is expected by many to break a record net long position by the next report. This could mean many longs covering quickly should a few decide to take profits at the same time, causing the market to trigger stop orders. While a figure such as this may have contrarians licking their lips, it is impossible to predict a correction. We make the point only to demonstrate that crude oil is not nearly as overbought, nor has it rallied as far and fast as unleaded gas, and thus is less susceptible to a dramatic downturn in prices.
Though gasoline is leading the energy complex now, crude answers to many other fundamentals that should continue to support prices even if gasoline corrects. While gasoline supply is the story this year, Chinese and world demand drove crude prices to record levels last year. This demand has not gone away. In fact, the IEA is projecting a large jump in world demand in the coming months and has expressed concerns that global crude supplies could come under pressure by July or August of 2007. OPEC is keeping supply flow tight. And as the U.S. and world economies continue to show a surprising tilt towards growth, demand from the industrial sector should continue to expand. Globally, 2007 world oil demand is expected to increase 1.2% over 2006. Chinese April crude imports were up more than 23% from the previous year. U.S. April Industrial production was up .7% (more than double the increase analysts had expected) hints that demand from the U.S. commercial sector should add support to crude prices as well.
Geopolitical events will always be a factor in crude oil. Last month it was the terror plot to hit Saudi production facilities. This month, its rebels in Nigeria are responsible for shut ins of roughly 1/3 of the country’s oil production. Next month it could be Iran, Oman or Venezuela. The constant threat of supply disruption seems always to be enough to keep a floor under crude prices these days.
To summarize, although unleaded gasoline seems have more of a potential upside in underlying price movement at this time, it also has more of a downside risk than crude oil. Not only does crude have more dimension to its supportive fundamentals, but we feel ramped up refinery production of gasoline in the coming weeks will soon help close the gap between crude and unleaded prices. Unleaded has moved up further and faster than crude and therefore has the potential for a more extreme downside.
Based on core fundamentals, we see crude oil maintaining current price levels for at least the next eight to 12 weeks, with a price range of roughly $62 to $70 basis the August contract. An unforeseen geopolitical event, however, could drive prices beyond the upper band of this estimated range, posing an increased risk for call sellers. Therefore, we favor a put selling approach to crude and would look to initiate positions when the market moves towards the lower end of this projected price range. As is always our strategy, we favor strike prices far beneath the market.
If you would like more information about selling options in the energy markets or building a portfolio based on the option selling approach, please call or visit us on the web at www.optionsellers.com.
James Cordier and Michael Gross
Liberty Trading Group
(800) 346-1949
www.optionsellers.com
James Cordier is head trader and president of Liberty Trading Group, an investment firm specializing exclusively in option writing on commodities. James’ market comments are featured by several international financial publications and worldwide news services including The Wall Street Journal, Yahoo Finance, CNBC and Bloomberg Television News. Michael Gross is an analyst with Liberty Trading Group. Mr. Cordier’s and Mr. Gross’ book, The Complete Guide to Option Selling (McGraw-Hill 2005) is available at bookstores and online retailers now.
***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.
