OPEC has had its way with prices. But demand season looms.
Selling Puts as a High Odds Play
Guest Post by James Cordier co-author of The Complete Guide to Option Selling.
If dissecting crude oil prices were the same today as it was 15 years ago, we would be discussing ISIS, Ukraine and the mood of Iran in todays market piece.
But its 2014 and crude prices arent as susceptible to geopolitical shock as in years past. This is due in large part to production from the United States and its revolutionary fracking industry. Its an old story and we all know it well by now.
OPEC knows it too. Which is why some oil analysts are baffled as to why OPEC continues to crank out production on top of rising US output. The combination has swollen US and global supply reserves and sent crude prices tumbling to their lowest levels in three years.
APRIL 2015 CRUDE OIL
Oil Prices have collapsed to their lowest levels in 3 years as OPEC continues to let the spigot run.
OPEC Power Play?
While prices flirted with multi-year lows, OPEC production surged to a new 2 year high in September of 2014 according the latest Reuters survey. September OPEC production averaged 30.84 barrels per day (bpd) on September and approached those levels in October hitting 30.72 bpd.
Meanwhile, US production is higher than at any time since J.R. Ewing roamed the oil fields of Texas (at least on TV) back in the roaring 80s. The last week in October saw US output climb to 8.97 million barrels per day a 28 year high.
While the US is a rising player in the global oil markets, OPEC is still the King of the Jungle. So why flood the market? Why not cut back production to lift prices and generate more profit?
The cover story is that competing interests within OPEC are driving prices lower in order to grab market share (read: Saudis). While this may be at least partially true, there is another dynamic at work.
OPEC and Saudi Arabia in particular, are quick studies on the US oil industry. With the US now a viable competitor and a threat to longer term OPEC profits, slowing down the industry here would certainly be on the to do list of any nation member.
- Ramping up production does two things for OPEC.
It sends the message We are still in charge here and shows the rest of the world who still runs the show
- It gives US producers, speculators and oilmen pause in starting and pursuing new ventures, wells, and production. It can even put some existing ones out of business. This is especially true for smaller, marginal players whos cost to produce a barrel of oil can reach $75. At a price of $100 per barrel, they get rich. At $70, they go bankrupt.
While this muscle flexing may have little effect on long term US oil production, OPEC hopes the short term psychological effects will slow industry growth in the US for a bit. It is no coincidence that OPEC output levels reached peaks in September and October a weak demand season for crude in the US therefore making prices most susceptible to a tumble.
OPEC members, of course, are not going to stand for weakened profit margins forever. OPECs endorsed oil price is $100 per barrel. And in fact, several members are demanding production cuts in the upcoming November 27th meeting. Dont count on it .yet. But if OPEC members are squeamish with prices under $80, their eyes will be watering if prices approach $70. Another $3-$5 per barrel swing lower and OPEC leaders will come under extreme pressure to take their foot off the gas (so to speak). For this reason, while were not predicting a raging bull market in crude oil tomorrow, we do feel the downside could be somewhat limited at this point.
For his part, OPEC General Abdullah al-Badri told oil markets this week not to panic and that the situation would resolve itself.
Indeed it may.
For while the latest price collapse was due as much to weak seasonal demand as it was to OPEC supply, that situation seems set to reverse.
Demand to the Rescue
Oil markets lend themselves very well to seasonal analysis the practice of studying historical price flows based on fundamentals that happen at certain times each year. Examples are planting and harvest cycles in grains and agricultural commodities. In energy markets, the focus is on seasonal demand cycles. Seasonals are a key fundamental factor that many inexperienced analysts overlook. They shouldnt. If you are unfamiliar with seasonals in commodities, you will find two full chapters devoted to the subject in The Complete Guide to Option Selling 3rd Edition (McGraw-Hill 2014).
The period between summer driving season and winter heating season is known as shoulder season here in the US. This period is often characterized by weak demand for crude oil.
By late October, heating oil storage levels have often reached points deemed adequate to meet winter demand needs. At the same time, gasoline production has been cut as demand wanes into the winter months. Gasoline stockpiles often hit lows during this time of year.
By December, refineries again begin increasing gasoline production in order to begin accumulating supply to meet summer demand needs.
The EIA chart below confirms that 2014 gasoline supplies have indeed reached a new low for the year. If history is any guide, we can expect refineries to begin ramping up gasoline production in the coming weeks.
Gasoline stocks tend to reach lows near years end and then begin to build as refineries ramp up production. 2014 supply patterns appear to be adhering to seasonal norms.
How does this affect crude oil prices?
Historically, when refineries ramp up production of products, they use more crude oil. This means more demand for crude.
While past performance is not indictive of future results, the chart above illustrates a 30 year seasonal average for crude oil prices. This chart seems to suggest a clear tendency for crude oil prices to rise as winter gasoline production ramps up. Caveat: This chart represents averages only. It is not to suggest that crude oil prices rise every year, or will rise this year only that the averages suggest price strenth in the winter in years past.
With the end of shoulder season and gasoline production expected to begin cranking up next month, crude stockpiles should soon start to drawdown from todays burdonsome levels. This factor alone should begin to shore up crude prices in the coming 4-8 weeks.
In the meantime, a production cut in this months OPEC meeting would be a boon to oil prices. We dont want to bet on that, however, and neither should you. If it happens, great.
But you want to make money whether it happens or not.
To do that, we suggest a put selling strategy.
We see oil prices beginning a steady climb by years end, progressing back towards the mid-80s by Q2, 2015. That may not sound to exciting to a position trader. But to an option seller, that can be sweet music. Remember that as an option seller, youre not trying to hit home runs. You are only looking to take high percentage money off the table. We see that situation setting up in crude oil now.
I stated in my July interview on Fox Business that our downside target for crude prices was $80. We hit that objective and more this month. We still feel $75-80 is fair price for crude at this time with potential to dip to the low $70s if OPEC refuses to reduce output quotas this month. With few expecting a cut, we would think the risk of surprise would be to the upside for prices.
Sentiment in Crude is extremely bearish right now, which is exactly when you want to sell puts.
Nonetheless, if you want options expiring worthless, you want to sell puts at strikes below your lowest projected price level. For us, that would be $70 per barrel.
For conservative option sellers, we suggest selling the March Crude $60 puts. Currently offering a $400 premium, we would wait to take $500 or more on another dip in futures prices. This also gives you a full $10 per barrel cushion if prices fall below our $70 price floor for crude.
More aggressive premium takers can sell the March 62.50 puts for upwards of $600 right now, or look to the February 65 puts for faster time decay (about 60 days).
James Cordier is the founder of OptionSellers.com, an investment firm specializing in writing commodities options for high net-worth investors seeking outsized returns. James market comments are published by several international financial publications and news services including The Wall Street Journal, Reuters World News, Forbes, Bloomberg Television News and CNBC. Michael Gross is an analyst with OptionSellers.com. Mr. Cordiers and Mr. Gross book, The Complete Guide to Option Selling 3rd Edition (McGraw-Hill 2014) is available at bookstores and online retailers now. For more information on managed option selling accounts visit www.OptionSellers.com/Accounts ($250,000 minimum investment).
***The information in this article has been carefully compiled from sources believed to be reliable, but it’s accuracy is not guaranteed. Use it at your own risk. There is risk of loss in all trading. Past performance is not necessarily indicative of future results. Traders should read The Option Disclosure Statement before trading options and should understand the risks in option trading, including the fact that any time an option is sold, there is an unlimited risk of loss, and when an option is purchased, the entire premium is at risk. In addition, any time an option is purchased or sold, transaction costs including brokerage and exchange fees are at risk. No representation is made that any account is likely to achieve profits or losses similar to those shown, or in any amount. An account may experience different results depending on factors such as timing of trades and account size. Before trading, one should be aware that with the potential for profits, there is also potential for losses, which may be very large. All opinions expressed are current opinions and are subject to change without notice.