Perfect storm could sink crude oil soon

Martin Conrad, chief investment strategist at C.I.G. made a disturbing observation for stock traders recently in Forbes. He said, “In comparison with the size of the economy and total revenues, stocks have never been this expensive before…With a debt-fueled buyback bubble…and consecutive years of payout ratios well over 100% of profits, nothing can justify these prices.”

You don’t need to be a stock trader to see when there is ice on a pond with a few wet spots on top. If you’re smart, you know not to skate on it. No matter how much fun it looks like, sooner or later,
it’s going to give way.

If you’re seeking cover from stocks this month, potentially into some other diversified asset class, the crude oil market is offering some high probability cash flow to traders this spring and summer. 

This is not because crude is the next hot market to buy. It’s because crude prices could be set for a tumble. And for commodity traders, particularly option sellers, tumbles can be very profitable. 

"Perfect storm" of bearish fundamentals

The crude oil market could be headed into a perfect storm. A storm of market fundamentals that could sink the ship of support crude oil has been riding on since last November. It was then that OPEC announced production cuts that buoyed the otherwise lackluster price of crude, and masked some of the more destructive fundamentals plaguing the market. 

Although the price of oil has recently fallen more than $7 per barrel in March before rebounding, price could have another leg down into the low $40s by late summer. 

There are three primary reasons for this: The OPEC production cut rally was overdone, record U.S. oil supply and producers able to hedge above $60. 

OPEC rally was overdone: The market has continued to see support off of the OPEC production cut through early 2017. But OPEC ramped up production to record levels right before the cut and cuts have not yet had much effect on supply. Saudi Arabia, for instance, cut 486,000 barrels per day – but that represented less than 5% of its record levels in October 2016. This month, the market is beginning to digest the fact that OPEC may need to extend the cuts to have any effect at all on supply. Like any OPEC agreement, however, compliance has been an issue. And while some members support an extension, extending cuts hurts OPEC members’ bottom lines almost as much as lower prices – a prospect many are loathe to continue.

Record U.S. Oil Supply: t 528 million barrels, U.S. oil stockpiles reached record high levels in March. Current levels are 27% above the five-year average for this time of year (see “A lot of oil,” left). With refinery operating rates substantially lower than this time last year, crude supplies are continuing to build at a time when they are typically starting to decline.

We expect supplies to continue to build because U.S. producers are hedged at $60 and above so they will continue to pump, even if crude prices fall. When oil surged after the OPEC announcement, U.S. frackers used the opportunity to lock in back-month futures contracts at $60 to $62 per barrel. This means they can continue to pump at will and net this amount (a level that makes them very profitable). Typically, when prices fall, producers scale back production. But because of heavy hedging in the low $60s, the idea that “low prices cure low prices” might be out the window in 2017. Indeed, since the late 2016 price surge in crude, U.S. production has gradually been increasing again – after falling for most of the two prior years. 

Seasonal factors turn

Seasonal factors typically support crude prices in the winter and early spring. While the 2017 high in crude was set on Jan. 3, we believe seasonal support is the only reason prices have not fallen further thus far. But we now arrive at a time when prices tend to start tapering off. What will happen to the price of crude oil without this seasonal support?

While the media continues to tout what is a very shaky OPEC deal, a near perfect storm of bearish fundamentals is aligning against crude oil prices. Record U.S. supplies of crude oil coupled with an unwillingness of U.S. producers to cut back production paints a bleary picture for near-term prices. With seasonal factors now turning against the bulls, one of the markets’ main pillars of support may now be fading. 

While crude prices may indeed be headed for another leg down, we don’t necessarily have to count on that to generate a good return from this market, especially with so much geopolitical risk. 

By selling premium, all you have to position against is that crude prices do not stage a spectacular rally in such an environment. That’s a safer bet.

Investors can sell the December crude oil 65.00 call for premiums of more than $600. A mid-spring rally in crude prices may afford the opportunity to sell the December 70.00 calls for similar premium. This is an important level as crude oil rebounded to $61.50 in the spring of 2015 following making a low of $45 in January. If we are wrong and crude rallies, resistance at the May 2015 high around $62 will be extremely difficult to take out (see “A high odds play,” below).  

A second leg down in prices could render these strikes nearly worthless by August. A perfect storm of fundamentals aligning in one direction along with this strong technical support is what option sellers wait for.