Crude Topping Out... Or Just Starting Its Run?

 |  About: The United States Oil ETF, LP (USO)
by: Ananthan Thangavel

The last month has seen incredible volatility in WTI crude oil prices due to geopolitical uncertainty. Political upheaval began in Tunisa and Egypt, and is now being digested in Libya where Gaddafi refuses to yield to both domestic protesters and international rebuke.

However, the real risk premium being built in to crude prices stems from the possible spread of instability to Saudi Arabia, the number 2 crude oil producer in the world at about 10 million barrels per day. By comparison Libya and Egypt combined produce about 2.5 million barrels per day. In addition to the obvious supply disruption, significant unrest in Saudi Arabia would leave the door open to regime change in neighboring countries such as Iraq and Iran, which could threaten the bulk of OPEC oil production and cause a catastrophic supply dislocation.

To illustrate the extent that the market is discounting this risk, let's take a look at last week's Commitment of Traders Report.

The below chart (click to enlarge) shows Managed Money net longs in white and the price of crude in amber.

CFTC Crude Oil Managed Money Net Long Chart

As can be seen, from February 15 - March 1, Managed Money net long positions increased 64%. In the same period, the price of crude jumped about 24%. The huge outpacing of speculative positions relative to the price of crude indicates that there is massive speculation occurring in crude oil. The current net long exposure for Managed Money is the highest in history.

Usually, extreme highs or lows in Managed Money positions are good contrarian entry points to either be short or long a commodity, respectively. When there is this much speculation to the long side, any positive news coming out of the Middle East or Libya could drop crude oil by 5-10% in a matter of hours as weak long speculators liquidate. We believe that this will become true in this case, but have several important caveats.

If Saudi Arabia and the rest of the Middle East were to experience further instability, the cap on crude prices could be astronomical. With Saudi Arabia's prominence as an oil producer as well as their perceived status as a bedrock of stability in the Middle East, if the kingdom were to fall, crude could easily see between $150-200 almost overnight. Such an event would almost assuredly cause a global depression as energy costs spiral out of control and destroy any fragile sense of recovery.

However, one can take solace in the fact that both the Saudis and the rest of the world know this. No one has any interest in crude spiking to such a high level or a renewed global recession. Even though OPEC producers do collect more money when oil spikes higher, they know that in the long run if crude stays too high, demand destruction will occur and the growing chorus for renewable energy will grow deafening. Furthermore, the rulers of Saudi Arabia have already witnessed the folly of Egypt and Libya, and have had a bit of time to stem discontent. The Saudis have already promised a $40 billion expenditure on a combination of social welfare, education, and other initiatives in a preemptive step to appease the masses.

The "Days of Rage" planned for March 11 and March 20 loom large on the minds of crude oil traders and the world at large, but one wonders whether the hype might outweigh the actual event. With so much time to prepare for such an event, and with extremely limited freedom of speech, the Saudi rulers may have already devised a strategy to deal with the event, but this is merely speculation.

Trade Recommendation

The April calls on crude oil are extremely high-priced even though they expire in just 7 days, largely due to the planned Day of Rage on March 11. We would recommend selling the 113 April call for 46 cents, or $460 per contract. Such a position would be profitable as long as crude oil does not appreciate more than 8.1% in the next week.

However, this is a very risky trade given the unpredictable nature of the situation in the Middle East, so only traders who can withstand a great deal of volatility should look to enter such a position. Traders can also hedge by selling out of the money put options on crude oil simultaneously

We continue to be short crude oil call options and will look to opportunistically add to our position barring major changes in the Middle East.

Disclosure: Short crude oil calls, short USO calls.