Unlike gold or some of the "exotics" like coffee or sugar, crude oil prices remained relatively stable throughout the dollar-related volatility that roiled markets in the second half of 2010. While a falling dollar and various weather issues caused supply worried bulls to bid up agriculture and metals, concerns over global demand kept a bullish reaction in crude prices largely in check. However, crude oil appears to have all the right fundamentals aligning at the right time. This could make crude oil a leader in the commodities markets in 2011. It also could make the crude oil options market fertile ground for investors that make their living collecting premium.
The bears have been vocal lately in regard to crude prices. They point out that with the threat of Chinese interest rate hikes, rising U.S. refinery rates, ongoing turmoil in the Eurozone and stubborn unemployment in the United States, crude oil prices will stall at current levels, possibly falling back to the mid to low $80 range. As put sellers, this would be just fine with us.
However, our opinion is that the bears have lost sight of the bigger picture. Oil prices are poised to experience another surge in demand in 2011. Producers, OPEC and otherwise, will be under pressure to ramp up output. This week, the Energy Information Administration (EIA) announced that total world oil consumption will rise by 1.4 million barrels per day in 2011 and by an additional 1.6 million barrels per day in 2010. This would bring global oil consumption to 89.6 barrels per day — above 2008's pre-recession levels. This is largely the result of a few key economic factors.
- The US Economy is finally beginning to turn the corner in earnest: U.S. productivity posted a larger than expected rise in the third quarter. U.S. private sector jobs jumped by 93,000 in November, the largest monthly gain in three years. The extension of the Bush tax cuts was a shot in the arm for investor sentiment. Unemployment numbers dipped unexpectedly the first few months of 2011. Yes, the recovery is uneven and erratic, but the trend is positive. U.S. GDP is expected to grow by 3.5% this year.
- Despite efforts to cool it’s raging economy, China continues to expand and thus demand for crude oil continue to build. China is the world’s second largest consumer of crude oil, but it’s demand growth rate is far outpacing U.S. demand. Despite recent increases in the value of the yuan, the Chinese economy will grow by another 9.5% this year.
U.S. demand for crude could get a boost earlier rather than later if the past is any indication. Late January to early March marks the time of year when U.S. refineries shut down for maintenance and perform their annual switch over from heating oil to gasoline production. This not only can support energy prices from a short-term supply angle (lost production and falling inventories because of production shut downs) but from a demand viewpoint.
The United States and most of the northern hemisphere experiences a surge in retail gasoline demand from June through September as "driving season" takes vacationers to the road during the warm summer months. This demand skew shows up at the wholesale level as early as January as distributors begin to stockpile gasoline inventories to meet summer demand. This ramps up demand for production, which in turn ramps up demand for oil.
This one-two effect of refinery maintenance and seasonal demand often can produce late winter/ early spring price rallies in the energy markets. At the very least, it should be one more pillar supporting crude prices over the next several months.
Based on all this, we view the risk of a move in crude prices to be weighted to the upside. However, we do not expect a "blow off" rally either. Recent developments in the middle east have brought additional buying support into the crude market on fears of supply disruptions. We have increased our crude oil price target to the $100-$115 range for Q1-Q2 2011.
Conservative minded bulls can sell $60 (or thereabout) puts and higher premium minded investors could add a $130 short call creating a strangle, which would produce roughly a $1,000 premium (see chart).
While these premiums are still available, the oil VIX has been on the decline as of late. We advise entering these trades earlier, rather than waiting as premiums could dry up quickly.
We would not be shy about going out to late summer contracts as these premiums could go quickly if oil settles into a defined range. Remember, as an option seller, all prices have to do is stay above or below your strike price. If it does, you keep the premium. Crude appears to be an optimum market for this strategy at this time.
James Cordier is the founder of Liberty Trading Group/OptionSellers.com. Michael Gross is an analyst with Liberty. They are the authors of "The Complete Guide to Option Selling," 2nd Edition (McGraw-Hill 2009). For more information on selling options, visit their website at www.OptionSellers.com.