There are multiple fundamentals pulling crude in different directions, which also create opportunities for a strangle trade.
Despite the latest round of liquidation, crude oil has embarked on an impressive bull market during the past six months, defying both seasonal tendencies and burdensome U.S. supply. How? A perfect storm of various outside influences, many of which will continue into 2018.
So is it time to buy now and hold on for $80 or $100 per barrel crude oil? Or is the correction from January highs in crude an indication prices are headed back to the $40 level? There is a strategy that can succeed in either scenario; option writing.
The beauty of option writing is you don’t have to decide on direction. Crude oil may move up or down in the coming month. But as you’ll learn in this article, fundamentals are now beginning to balance out. This means prices could settle into a new (albeit higher) trading range for much of 2018. Here, we’ll show you how to put together an ideal option strategy to target high profits from these new fundamentals – a strategy you can use all year long.
Before we do that, you must first understand the factors that having been driving crude prices – and what could continue to support them through 2018.
OPEC Supply Cuts
After a year of data, it’s clear that OPEC and non-OPEC oil producers are serious about cutting production to raise prices. It was speculated that widespread cheating amongst the 21-nation effort would render it useless — as had happened with some past agreements. But top producers Saudi Arabia and Russia get a large percentage of their GDP from oil revenue. At $40 to $50 per barrel and below, they were suffering and ready to take some short-term pain for long-term gain.
That trade has paid off. October 2017 marked the first month that both OPEC and non-OPEC groups hit cutback targets. For the year, the group will come pretty close to the target of a 1.8 million barrel per day production cutback. Top producers Saudi Arabia, Venezuela and Kuwait are now exceeding targets, while Russia is nearly meeting it, according to OPEC and the Energy Information Administration (EIA). Supply and prices are responding with WTI crude hitting two-year highs last month. The extension of the agreement in November means production cutbacks could stay in place through the end of 2018.
Surging U.S. Crude Exports
The United States lifted its ban on exporting crude oil (other than token amounts to Canada) at the end of 2015. But it’s taken nearly two years for that action to have a real effect on price (see “Exporting ramps up,” left). Now it’s happening. With OPEC cutting production, global supplies are coming back into balance. But higher prices saw U.S. producers, especially those in West Texas, ramp up production. This helped WTI crude trade at a discount to Brent (global) crude. Recently, WTI traded at a $6 discount to Brent. Thus, major crude importers such as China and India went shopping for a better bargain and got it with U.S. exports. The first four months of 2017 saw the United States exporting three times more crude than in the same period in 2016.
U.S. exports hit an apex in October 2017 at near two million barrels per day before backing off into January. However, the increased export figures are helping bring U.S. supply tables back into balance. The latest EIA data shows U.S. crude inventories down 63.59 million barrels from this same time last year and approaching its five-year average after last year’s burdensome levels (see “Draw on stocks,” below).
Seasonal Demand Tendencies
Crude oil prices have a seasonal tendency to decline at the end of the year then rally into the spring. This a function of waning demand at the wholesale level at year’s-end followed by refineries ramping up gasoline production in mid-winter to meet summer demand needs (see “Crude seasonals,” below).
The seasonal decline in December did not happen this year. Why? The massive U.S. exports, which is a brand new avenue of demand, superceded weaker U.S. domestic demand. Seasonal demand will remain a supportive factor for prices into the spring. However, a case can be made that the bulk of the move may have already taken place by January.
Extended Rally in 2018? Until recently, financial media was abuzz with the “how high can it go” conversation as of late. Price estimates in the 80s are already being floated by the talking heads.
This is not likely. Here’s why.
U.S. production is soaring. With OPEC turning back the spigots, U.S. producers have been more than happy to step in to ratchet up production (see “Production rebound,” page 75). The latest U.S. rig count shows a staggering increase in U.S. oil rigs in just the last year. At 939 rigs as of early January, the U.S. rig count has grown by a staggering 42% since just last year, according to Baker Hughes. The latest EIA data shows U.S. production jumping to 10.3 million barrels per day by the end of 2018 – a full million barrels higher than the same estimate this time last year. Thus, shale is putting much of OPEC’s 1.8 million barrel per day cutback right back on the market — at a lower price.
Speculative long positions in crude oil reached a record level in January. Large speculators (hedge funds) were net long 809,730 contracts, while small speculators also held a massive net long position over 51,000 contracts. This shows overconfidence and often marks a turning point in trends. Conversely, commercials (those producing and accepting delivery) hold a gigantic short position at 861,500 contracts and are adding to it. The stock sell-off in early February brought a risk-off vibe into crude, causing funds to liquidate a portion of these longs. However, the market still appears to be holding a sizable net long position by specs.
Producers could begin abandoning production cuts if prices rebound to the high $60s. Should WTI rebound slightly with Brent testing the $70 level again, both OPEC and non-OPEC nations can be extremely profitable. If prices remain at these levels through spring, an early end to the cutback agreement seems likely.
OPEC production cuts and increasing U.S. exports have gone a long way toward rectifying the global supply glut. At the same time, the United States is ramping up production and OPEC could begin easing cuts if prices remain near current levels.
Crude prices have surged as the market prices the lower supply. But the market was already showing signs that those cuts could be nearly priced into the market – even prior to the February sell-off. Seasonal demand could help spur a further leg higher in crude, while continually heavy U.S. production or a further macro sell-off of risk assets could pressure prices.
The crude market may be hitting a point of equilibrium. We see WTI crude prices in a new trading range, most likely between $50 and $70) — and probably staying there through 2018. An options trader can seek profit by selling options well outside of that projected trading range. This strategy is called an option strangle.
The recent bout of volatility has opened up a variety of strikes at attractive premiums. But with the a long-term range apparently in place, the December crude oil 76.00 call/40.00 put strangle is a strong option (see “Profit range,” below).
Dec 2018 Crude Oil strangle
Total Premium Collected: $1,000
Estimated Minimum Margin
Requirement: $2400
Return on investment if
Successful: 41.6%
While a number of scenarios could play out in crude prices this spring, we see the least likely scenario as a break below $40 per barrel or a break above $76 per barrel. This is due to the factors previously described. Writing options at this level gives you a $36 per barrel profit zone. Should neither level be reached prior to expiration, both options expire worthless and you keep all premium collected as profit.
Analysts remain split on which way crude prices will move next. With a little analysis and a lot of common sense, you don’t need to pick a side to be profitable.
The good news is, crude is a market that one can layer options on in different strikes and months throughout the year. Slow changing fundamentals make it an ideal market for building positions for potentially sizable income flows each month.
