The economy received great news late last September when oil prices surged to an all-time record hi

October 22, 2007 10:43 AM

The economy received great news late last September when oil prices surged to an all-time record high. That’s right, it was great news. The move was a welcome relief to traders who were mired in a period of uncertainty about a potential cancer in the economy. The subprime crisis in the housing sector hit traders’ psyche with a force they had not experienced in many years. Many feared that this crisis would spread and sink the economy as the credit markets dried up.

Think of where oil and the stock market were before the crisis broke. Stocks were soaring, commodity funds held a near- record amount of oil contracts and the world was a place of optimism. After the crisis broke there was an aversion to risk as traders shed positions. Stocks plummeted and oil broke hard. The entire outlook for the future was shaken and many feared the worst.

While the notion that higher oil prices is good for equities may seem counterintuitive, recent evidence contradicts this as throughout the past decade the fortunes of oil and the stock market are going hand and hand (see “Quite a pair”). Looking at crude oil and the Dow Jones during the last decade shows a pretty high correlation.

The bull move in crude oil has not been a drag on the market but a strong economic indicator. Industry needs energy and the more it is willing to pay for oil the greater potential economic growth. That is only part of it though. Higher oil prices were not a bad thing as long as they reflected growth in the economy and not some catastrophic event. If oil prices rise due to increased demand because of a robust economy, that is a good thing. However, if oil prices rise because of a supply cutoff due to a geo-political event or a hurricane, then that is a bad thing.

But the price of oil also may be indicating something even more important than just the outlook on the economy. Crude oil recently has moved from contango (when further out contracts are priced higher than the nearby) to backwardation. The market was paying people to store oil for fear that refiners might not be able to secure supply. One reason was fear that a terrorist may blow up a refinery. This could be a sign that the risk premium in oil, stemming from the myriad geopolitical threats to supply and speculated to be anywhere from $10 to $15 per barrel, is coming down.

Now some may argue that this is also a sign that the market may expect a future slowdown in energy demand growth, but the stock market has remained strong. If the backwardation was just about slowing demand then why did we hit record highs even with the front months trading at a premium to the back months?

However, oil prices this year may be more determined by the weather than all of the deeper macro economic forces that we have been taking about. Supplies of heating fuels should be tight and if we get an early taste of winter, prices could set new highs. If it’s warm then we probably will see oil stay fairly range-bound and could go back to the mid $70 level.

But next year the target for oil is $95. Crude oil and equities did deviate when winter was late to arrive last year. Oil had traded as high as $64 in late December before it plummeted to just below $50 in January 2007 as 70 degree temperatures hit much of the country on Jan. 1. This year the market could be vulnerable for a similar correction. If you are bullish but fear a weather pullback, one way to trade this might be a three-way trade.

A three way trade involves going long the crude futures and at the same time buying an at-the-money or a slightly out-of-the money put to lock in your down side. The risk on the trade is the difference between the strike price and the price of the future and the premium that you paid for the option. You can help pay for the option by selling an out-of- the-money call.

The trade has limited risk but if the futures fall precipitously you may be called upon to monetize the future position. Or you may choose to exercise your put option and buy back your short option. One example of what you could do is to buy a January crude future along with an at-the-money put. If you chose, you can sell a call anywhere from $3 to $8 above your futures entry to help you pay for the cost of the put. That way determining which one to sell comes down to the price you paid for the put.

While crude oil and stocks appear set to make new highs, at these levels even a mild correction could be devastating to an account, so any long position needs to be protected.

Phil Flynn is vice president, energy and general market analyst with Alaron Futures and Options. He has provided energy market analysis for numerous media outlets.

About the Author

Phil Flynn is a senior energy analyst at The PRICE Futures Group and a Fox Business Network contributor. Phil is one of the world's leading market analysts, providing individual investors, professional traders, and institutions with up-to-the-minute investment and risk management insight into global petroleum, gasoline, and energy markets.