From the August 01, 2009 issue of Futures Magazine • Subscribe!

Crude can't ignore fundamentals

The bulls are at it again this summer. However, unlike 2008 when a falling dollar and insatiable demand lifted crude oil prices to all-time highs, this year’s rally is missing one critical component — consumption.

While the media has been busy playing up summer gas prices and green shoots, energy bulls may want to peek under the covers and realize that we’re still in a recession. Demand is off. And while speculators may still be buying and refiners are churning out gasoline like it’s 2008, it could all come to an end in the second half of 2009 for energy bulls.

The Energy Department in June reported gasoline inventories increased 3.87 million barrels during the week ended June 19. That was in stark contrast to a one-million barrel draw on supplies that analysts were expecting. This marked a 1.9% rise in gasoline stocks over the prior week, and the biggest gain in stocks since Jan. 16. By July, U.S. gasoline stocks sat at 7% above the five-year average for this time of year.

More telling, however, was that motor-fuel demand, usually peaking at mid summer, was relatively weak. AAA estimates that U.S. travel during the July 4 holiday weekend declined 1.9% from last year. At the same time, refineries have increased production into “peak” season as refinery operating rates rose in June to the highest levels since December of 2008.

Crude prices tend to take their direction from gasoline this time of year. This combination of low demand, building gasoline stocks and higher refinery output does not paint a bullish picture for prices.

What should be further concern to energy bulls is crude oil inventories still remain near 20-year highs. With this type of supply hanging over the energy markets, bulls looking for an extended energy rally could be sorely disappointed.

While it is true that much of the run-up in crude oil in the first half of 2009 (more than doubling its January low of $33.20) occurred along with bearish supply/demand fundamentals amid the worst of the recession, prices were, to a large degree, responding to 1) An extremely oversold condition in the energy sector, 2) An “irrational exuberance” after the election that seemed to create a feeling that economic conditions were, or would soon be, improving and 3) A weakening U.S. dollar which supported the commodity sector to some degree. These may have been enough to rally prices at the $40 or $50 level. We doubt they are enough to carry prices at the $70 level.

The same thing goes for geopolitical concerns. Conflicts in Nigeria and Iran are causes for concern but are somewhat priced in at the early July levels around $70. Yet, the rally in crude oil alone has brought with it a key benefit for option traders. It has allowed option premiums to remain high, even for strikes considerably out of the money.

For example, at the time of this writing, December $105 crude calls were trading at $750, 110 calls at $500, and 115 calls were pulling $375 each.

We look for prices in both crude oil and gasoline to begin to fade into August as the trade begins to realize this is not 2008. Slacking demand and rising inventories can only be ignored for so long. The dog days of summer will have many investors refocusing on supply figures which are suggesting an overpriced market.

We see crude oil prices working back towards the $50 area into September. We like the idea of taking advantage of the higher strike prices and premiums made available by the recent rally and would look to sell calls in either crude oil and/or unleaded gasoline on price strength in the dog days of August.

James Cordier is the founder of Liberty Trading Group/OptionSellers.com, an investment firm specializing exclusively in selling options. Michael Gross is an analyst with Liberty Trading Group/OptionSellers.com. Mr. Cordier’s and Mr. Gross’ book, “The Complete Guide to Option Selling: 2nd Edition” (McGraw-Hill 2009) is available at bookstores and online retailers. More information is available at www.OptionSellers.com

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