“Perfect Storm” of Bearish Fundamentals Could Sink Crude Oil Soon

“Perfect Storm” of Bearish Fundamentals Could Sink Crude Oil Soon
Apr

19

2017

“Perfect Storm” of Bearish Fundamentals Could Sink Crude Oil Soon

Selling Distant Calls Far Above the Market Appears to offer High Probability Cash Flow for Investors

Martin Conrad, chief investment strategist at C.I.G. made a disturbing observation for stock traders in the March 13th edition of 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.” I’m no stock trader. I count coffee beans and bushels of corn. But if I see ice on a pond with a few wet spots on top, I know enough not to skate on it. No matter how much fun it looks, sooner or later, it’s going to give way. If you’re seeking cover from stocks this month, potentially into some other diversified asset classes, the crude oil market is a place that could be offering some high probability cash flow to option writers this Spring. 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 option sellers, tumbles can be very profitable.

“Perfect Storm” of Bearish Fundamentals

Like the crew of the Andrea Gail, the crude oil market could be headed into a perfect storm. By that, I mean a storm of market fundamentals that could sink the ship of support crude oil has been riding on since last November.

Rough Waters ahead

Rough waters ahead for Crude Oil Prices?


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. But news stories fade with time and it may now be time for crude oil’s chickens to come home to roost. Although the price of oil has recently fallen more than $7 per barrel, our opinion is that price could have another leg down into the low $40s by late summer. There are 3 primary reasons for this:
  1. OPEC Price 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 of 2017. 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 questionable. 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.
  2. Record US Oil Supply: At 528 million barrels, US Oil Stockpiles as of March 10th are at their highest levels ever, at any time in history. Current levels are 27% over the 5 year average for this time of year. 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.

    Graph EIA weekly crude oil 04-19-2017

    Crude Oil Inventories have surged to all time highs


    We expect supplies to continue to build because…
  3. US producers hedged at $60 and above, will continue to pump, even if crude prices fall: When oil surged after the OPEC announcement, US frackers used the opportunity to lock in back month futures contracts at $60-$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, “low prices curing low prices” might be out the window in 2017. Indeed, since the late 2016 price surge in crude, US production has gradually been increasing again – after falling for most of the 2 prior years.

EIA Weekly Crude Oil Production Chart

US Crude Production has been rising since the price surge in late 2016.

Seasonal Factors Turn Against

Seasonal factors typically support crude prices in the winter and early Spring. While we have not seen a price rally this year, 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?

Dec 2017 Crude Oil Chart

Conclusion and Strategy

While the media continues to tout what is a very shaky OPEC deal, a near perfect storm of bearish fundamentals are aligning against crude oil prices. Record US supplies of crude oil coupled with an unwillingness of US 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 “bet” on that to generate a good return from this market. As an option seller, all you have to position against is that crude prices do not stage a spectacular rally in such an environment. In my opinion, that’s a safe bet. While we will utilize our own proprietary strategies for managed portfolios, investors wishing to go this trade on their own can consider selling the December Crude Oil 65.00 call for premiums of $600+. A mid-spring rally in crude prices may afford the opportunity to sell the December 70.00 calls for similar premium.
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