IRAN, OPEC: What’s Next for Oil Prices? Option Sellers Need Not Decide
Despite the Media Handwringing over Iran, Sky High Crude Oil Prices Could Face Headwinds Soon. The REAL opportunity could be on BOTH Sides of the Market.
President Trump’s withdrawal from the Iran nuclear agreement has the media frothing at the mouth about the potential for yet higher oil prices. What does it mean? Iranian barrels off the market? A budding war in Syria between Israel and Iran? I suppose anything is possible.
However, this is mostly speculation. In some cases, wild speculation. The media loves to speculate because it can be more exciting and entertaining than talking about basic, boring, supply demand fundamentals.
For intelligent investors, however, it can pay to keep your eye on the proverbial ball. While there are many “ifs” in any trading market, it is much more likely that oil prices take their longer term cues from these core fundamentals.
Core Fundamentals in Crude
While stocks have languished since the beginning of the year, crude oil prices have been charging ahead long before Iran was back in the headlines . Crude has not only outperformed stock indexes but also most of its commodity brethren.
Largely the result of its own unique fundamentals.
OPEC production cuts have been effective at raising global oil prices.
For option sellers, the impressive rally has pushed distant option premiums into the clouds. This right at the time when the underlying fundamentals driving the rally may be peaking.
If you’re looking for some inflated premium to sell this month, crude call premium could be your huckleberry. However, because if the balanced nature of its current fundamentals, there may now be an opportunity to take double premium (ie: premium in both put and call options). But to understand the profit opportunity, you must first understand what is and likely will be, driving prices.
What is Really Driving the Current Rally?
The core factors driving crude in 2018 are twofold.
1. The OPEC Supply cuts initiated in January of 2017 are working . Since the cuts were initiated, OPEC production has shrunk by 11.4% since hitting a high of 35.69 barrels per day (bpd) right before the cuts. While many analysts (including this one) doubted OPECs ability to comply with quotas, compliance has registered a startling 138% as of this month – members are actually exceeding the cuts they agreed to.
2. Seasonal Demand has Spurred prices thus far in 2018. Crude prices tend to follow seasonal demand patterns. Springtime is high demand time for crude in the northern hemisphere. Beginning in later winter, refineries begin ramping up gasoline production, building inventories in order to meet summer driving demand needs. This tends to draw down crude inventories, supporting prices. This year, US refineries have been operating at a torrid pace, the last EIA report showing them at 92.4% capacity. This, combined with lower OPEC production, has drawn crude oil US inventories down to427 million barrels as of the last EIA report. This is 3.8% below the 5 year average. Falling US crude stock levels have played a big role in supporting prices this Spring.
In selling options, its important to know what is driving prices now. While the Iranian story may have helped spur on the market, it certainly did not cause the current price strength. However, its more important to know what is likely to direct prices in the next 6-9 months. This is how you generate cashflow. Lets take a look at what is likely to play out in crude prices over that time frame.
Crude Oil Prices – What’s Next?
OPEC cuts have been unquestionably successful in raising prices. $70 per barrel crude is a big win for the cartel. But what happens from here? The most likely path moving forward is one of stabilization. OPECs stated goal at the beginning of the cuts was to bring inventory levels in developed nations back to their 5 year average. That goal has been largely accomplished. Even OPEC itself admits the market is now approaching “balance.” OPEC sees 2018 global demand hitting1.63 mbd with global supplies hitting 1.71 mbd.
US Crude Oil production has soared to 10.5 mbd in Q1 2018.
But US producers have been a pesky rival. US production has soared in Q1 2018, hitting 10.5 million barrels per day . This is a level not even OPEC expected so soon. US drilling has been able to offset some of OPECs cuts thus far, but not enough to keep prices from rising. That could change as seasonal demand begins to level off in Q2 and Q3 , allowing US inventories to once again rebuild. Which brings us to the bigger point.
Seasonal Tendency: A Headwind to Price Gains
As we discussed earlier, oil prices usually tend to strengthen during late winter/early spring . However, as summer approaches and supplies are deemed adequate to meet needs, refineries tend to scale back gasoline production -allowing crude inventories to build again. This cycle often results in crude prices starting to weaken as early as May (see seasonal chart below) in a trend that can last through the summer.
As US refineries reach gasoline inventories deemed adequate to meet summer demand needs, they tend to scale back production as early as May. This allows crude inventories to start to build again – often resulting in lower oil prices into the summer and fall.
In 2018, producers have been so aggressive in building gasoline inventories that “adequate” levels could be hit early. As of the last EIA report, Gasoline inventories stood at 235.9 mb – 4.2% above the 5 year average. If this is the case, refineries could let off the gas pedal (so to speak) at an earlier and faster pace in 2018. This fading of demand could be a stiff headwind to further gains in crude in the months ahead – especially with US production continuing to expand.
Conclusion and Summary
While OPEC supply cuts have been effective in bringing the crude market back into “balance,” the cuts do not expire until the end of 2018 and perhaps further. OPEC is scheduled to meet again to discuss “adjusting the metric” to look at supply averages over a “longer period.” Translation: They like where this is headed and will be loath to end a good thing too soon. The current quotas and talks of “adjusting the metric” (along with periodic Iranian threats) should help keep a floor under prices for the better part of 2018.
On the other hand, with US production rocketing up and the US market probably seeing (wholesale) demand backing off in Q2-Q3, prices will be facing headwinds to further gains in the coming months – especially of an extreme nature.
Our internal calculations see crude trading $5 north or south of $70 for the foreseeable future . Nothing recently happening in the news, Iran or otherwise, changes that. Yet, on the option side, volatility has driven premiums to extreme levels – even moreso with recent media coverage (As in “Honey, we have to get in on this!”) This is a situation that can be exploited richly by the astute investor.
In the case of crude, balanced fundamentals and a recent surge in volatility make it the perfect situation for deployment of an option strangle (the strategy of selling both a put and a call in the same market.)
We’ve been positioning managed portfolios in a number of offsetting strangles this month.
FEBRUARY 2019 CRUDE OIL
Selling the February Crude Oil 90 call/45 put strangle
However, self directed traders can consider selling the February crude 90 call, 45 put strangle for approximate premiums of $600 per side. Margin per trade is approximately $1875. Thus, if worthless at expiration, the options would produce a 64% return on investment.
Strangle writers are NOT trying to predict what prices will do – only pick a price window where prices will likely remain under most foreseeable circumstances. In the case of this example, your profit window is a staggering $45 wide.
Option strangles are a preferred strategy in our portfolios, primarily because of their offsetting nature (one side balancing out the other in an adverse move). IF you are concerned about possible fallout from Iran, you might consider using a covered strategy on the call side. This gives you additional insulation against volatility and the peace of mind of limited risk. Recent volatility has now made such covered spreads viable.
You can use such a strategy this month to target what would appear to behigh probability gains in a market where you never have to pick price direction. As for the availability of these distant strikes, we can all thank Iran and OPEC for that.
Have a great month.
For more information managed option selling accounts with James Cordier and OptionSellers.com, visit www. OptionSellers.com/Discovery . (Recommended opening account deposit US $1MM)