Exploiting crude oil volatility

January 24, 2016 01:00 PM

In August 2015, near-month crude oil prices hit $37.75 per barrel, the lowest level since the 2008 financial crisis. 

By now, even if you’re not a commodities trader, you’re likely familiar with the reasons why: The emergence of the United States as an oil superpower, the excess pumping from OPEC and the concerns over the broader global economy.

But are those factors still valid? And how can investors make money on crude oil now? 

You can, of course, trade the outright crude oil futures or energy exchange-traded funds. There’s money to be made there if you can pick and time the direction of oil prices correctly. If that’s you, best of luck. Most traders don’t have the skill needed to make reliable money timing trades. There have been close to double-digit 10% swings in crude oil since the market first tanked in the second half of 2014. This volatility may have produced losing trades on either side of the market. 

An alternative approach is to build an option-selling strategy that allows you to take premium from both sides of the market over a long period of time, and potentially profit regardless of what direction prices are moving. As long as the price remains in a defined range there is a good chance to profit. That’s high-probability investing. 

But before we talk premium, let’s first understand the fundamentals and how they will likely effect prices over the near- and intermediate-term. 

The bulls say...

Oil bulls are making an argument for higher oil prices into 2016. They cite several reasons.

The Russian “intervention” in Syria and the potential for a regional conflict near two of the world’s largest oil producers (Iran and Iraq) has the oil market on edge. The prospect of an accidental encounter with U.S. or NATO forces is adding additional concern for the oil market. The chance of a U.S./Russian military encounter, or the conflict spilling over into oil-rich Iraq, Iran or even Saudi Arabia, has bulls talking rally.

Another reason is the prospect of U.S. oil production falling. The combination of new U.S. production and Saudi, Middle Eastern and Russian oil producers turning the spigots up to “full blast” has flooded the world with oil. However, the excess supply has caused U.S. producers to scale back. U.S. production, which is now the largest in the world, has dropped 500,000 barrels per day since peaking at 9.6 million barrels per day in April (see “Production dip,” below).

The U.S. Energy Information Administration (EIA) projects U.S. production dipping by another 500,000 barrels per day by August 2016. Now the world’s largest producer of oil, the United States and its production cutbacks are at the core of the bull argument.

It is not unusual for slack seasonal demand to weigh on oil prices in autumn. However, as early as December, refineries tend to switch back to gasoline production to start building inventories for the summer demand season. This historically resulted in rising crude demand and often has corresponding price increases beginning in December. This demand effect can last deep into the spring. Bulls argue that demand will start supporting prices in the near future. They also point to continued growth in global demand for emphasis. Despite concerns about the global economy, demand for crude has jumped sharply in 2015. The International Energy Agency (IEA) expects global demand growth of 1.7 barrels a day in 2015, the fastest pace in five years.

The bears say...

Bears counter the bullish arguments with a number of points of their own.

First, the United States and the world are awash in cheap oil. Global oil supplies in both the United States and the world currently classify as a “glut” and are at record highs. At the time of this writing, U.S. weekly ending stocks sat at 460 million barrels, or 28% above the five-year average (see “Stocked up,” above).
Perhaps even more important is that global stocks are likely to keep growing. Even as U.S. producers pull back on production, the rest of the world is not doing so (see “World total oil supply,” below). The oil market is a global game. 

That point became abundantly clear last March when OPEC rattled oil markets with its announcement that it would not only not cut production, but it would increase it. In August, OPEC production hit 31.5 million barrels per day (bpd), which was above its target of 30 million bpd. OPEC producers refuse to scale back as each member fears doing so would result in loss of market share to others that would not.

Even if OPEC did scale back, it’s likely that U.S. producers would ramp up output to take advantage of any price increases. As a result, global oil supplies were expected to hit 93 million bpd in 2015—
an all-time record. The International Energy Agency (IEA) forecasts an oversupplied global oil market well into 2016. In addition, the finalization of the Iran nuclear deal is expected to result in Iran doubling its oil exports to 2.3 million bpd. The bear takeaway is this: OPEC’s production surge is more than offsetting 
U.S. cutbacks and growing oil demand on the global stage.

Economic factors also strengthen the bears’ hand. Despite bullish hopes for a “soft landing” in China’s economy, the data continue to paint a more sinister picture. Through August 2015, Chinese exports were reported down 6.1% on the year. September exports fell 8% from a year earlier. China is the world’s second largest oil consumer. Russia is in a severe recession with its economy expected to contract by 3.3% in 2015. An interest rate hike in the United States would further support the U.S. dollar. A strong dollar hurts oil prices by adding price pressure to all commodities (because commodities traded on U.S. exchanges are priced in dollars).

Outlook & strategy

Despite the bearish global supply picture, U.S. production cutbacks and refineries ramping up gasoline production will get more attention in the United States where the New York Mercantile Exchange WTI crude contract is traded. That should help support crude prices, especially into the first quarter of 2016. At the same time, burdensome global supplies and a shaky global economy will keep rallies in check.
In September 2015, a wave of producer hedge orders flooded the market when the price of oil hit $50 per barrel, knocking prices right back down. If the guys that pump this stuff are so eager to lock in a price of $50 per barrel, traders shouldn’t be too eager to buy above that level. 

Outside of some dramatic development, expect crude prices to remain range bound between $35 and $60 per barrel through the first quarter of 2016. Should prices pull back to the lower part of that range, take advantage of the weakness to sell puts with strikes in the $20 range. A rally to the higher end of the range should be viewed as an opportunity to sell overpriced calls with strikes at $70 and above. Look to take premiums of $600 to $700 per option (see “Safety zone,” below). April options will offer the fastest time decay but May or June will offer deeper out-of-the-money strikes. 

Overall fundamentals remain bearish for crude oil. Yet, the market has already priced in much of the over-supply situation. Short-term, seasonal strength could fuel a price rally into early 2016, but global supply will continue to check rallies. Option sellers can take advantage of the increased volatility to extract premium from both sides of this market by selling puts on weakness and calls on strength.

About the Author

James Cordier is the founder of www.OptionsSellers.com, an investment firm specializing in writing commodities options for high net-worth investors. He is the author of The Complete Guide to Option Selling 3rd Edition (McGraw-Hill 2014).