Crude Fundamentals Bearish Despite Noise

November 28, 2017 11:44 AM
Despite recent natural disasters and a spike in geopolitical concerns, the crude market remains deliciously ripe for the right short.

North Korea
The media has had a field day with the North Korea story. While its relation to oil prices took a back seat, some bullish analyst did try to use the story to bolster their case. Crude prices, they argue, would surge on an outbreak of hostilities with North Korea. Rationing would begin, they argue, to support military efforts on the Korean peninsula.

While military action in North Korea remains unlikely, any such action would likely be a boon to call sellers in oil. In the first place, despite the media coverage, military action against or from North Korea remains highly unlikely. Intensified posturing on both sides does not change that fact. Both the United States and North Korea (who in no way would act without the blessing of China) know what is at stake.

However, in the unlikely event that a military action would take place, oil prices, along with stocks and many other asset classes would likely decline, perhaps drastically, off of concerns for the U.S. and world economy. For call sellers, this would be a boon.

Despite media hype, the real story in crude is less dramatic. It’s simply old fashioned supply and demand. In energy markets, that often means seasonal supply and demand. Labor Day marks the official end of driving season in the United States.  With the official end of driving season, crude oil now enters what is known as “shoulder season.” This is a lower demand period of the year when crude inventories begin to build again as refinery rates slow in response to weaker demand.

This weaker demand and rising supply has, in the past, often led to lower prices into early winter (see “Crude seasonals,” above).

While we fully expect this seasonal phenomenon to once again begin pulling prices lower, there are a couple of factors that could exacerbate the trend this year. They are soaring production and OPEC cheating.

U.S. production is soaring, adding to already near-record supply levels. With oil prices hovering near the $50 level again, U.S. producers have ramped up production. U.S. rig counts numbered 768 in August, more than double the 372 rigs in production this time last year. Why? Higher prices.

Oil at $50 per barrel makes U.S. fracking a lucrative endeavor. In addition, many producers used price strength this spring and summer to establish hedges in oil at the $55 even $60 level. Thus, maximizing output can be quite profitable, regardless of what the spot price does. Currently at 9.43 million barrel-per-day, its possible U.S. production will top 10 million by the end of the year, adding to already burdensome supply levels (see “Pump it up,” above).

Production agreements are largely based on the honor system, and some members of OPEC do not always behave honorably. In fact, the one anomaly with the most recent production cuts agreed to by OPEC and non-OPEC members is that compliance had been strong. However, there is evidence building that Russia is exceeding quotas, which will likely lead to OPEC member Iran, exceeding limits as well. Should prices begin a seasonal decline in the fall, members could simply choose to ignore the agreement in an “every man for himself” grab for market share. This could potentially tip the market, potentially back into the $30-range.

What’s the Plan?
While media types focus on sensational headlines, the real forces driving crude prices are high supplies and the beginning of a weaker demand season for crude. We feel the highest odds scenario is for a steady drift to the low $40-range by December with an outside chance of a roll into the $30s.

Regardless, the least likely scenario would appear to be a severe and sudden spike higher in crude prices. Still mammoth supplies and tumbling seasonal demand should prove too much of a weight to allow oil prices to rally too far. Rallies are possible but strong resistance remains at about $60.

Option sellers do not try to predict the market but only bet against the least likely scenarios. Selling calls would seem to be the ideal strategy in the crude market at this time.

We’ll be deploying a number of call selling strategies throughout the fall to capitalize on the crude situation for our managed clients.

Self-directed traders can consider selling the May crude oil 63.00 calls on limited winter rallies. Rallies will result in potential premiums of $500 or greater. With current margin requirements, a worthless option expiration would produce an approximate 35% rate-of-return (see “Calling out opportunity,” above).

All this being the case, crude oil’s seasonal tendency tends to reverse sometime in mid-winter, which could help support prices this spring. This could create an opportunity to turn this trade into an option strangle at some point later this year or early next.

While headlines can lead to price spikes, it’s old fashioned fundamentals that most often win the day in commodities. Use hard facts – not try to predict the direction of prices, but rather, only bet against the sensational and extremely unlikely.  It’s a trusted way used by many to make a living in the markets. 

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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).