Outlook for Crude Oil: Limited Downside From Here

Includes: DBO, OIL, USO
by: Ananthan Thangavel

The crude oil market remains volatile and closely watched in the wake of unrest in Egypt. The possibility of disruption at the Suez canal sent oil prices surging off of the 100 day moving average, from $85.28/barrel to $92.19. However, since peaking out one week ago, crude has fallen all the way back to $87.45, only slightly above where it began the fear-induced rally. It would seem that the risk premium associated with the Middle East protests has largely come out of the market, but crude oil remains elevated.

As we commented last week, the crude oil VIX broke out in a significant way. As can be seen from the chart below, despite crude's fall back to pre-protest levels, the oil VIX has remained elevated. Selling options when volatility is at an unsustainably high level is a hallmark of our Global Macro portfolio, and the strategy contributed the lion's share of our 67% return in 2010. We examine here whether such a strategy could work in today's crude market.


Crude Oil VIX Chart

Breakouts of this nature in implied volatility of securities are almost always false indicators. Consider that the oil VIX has moved up 12.69% since January 28th but that crude oil itself has only moved up 2.58% in the same time period. Since the oil VIX measures the value of crude oil options (with a skew towards put options), the oil VIX is showing a significant increase in fear even though crude oil is actually up over that time span. We expect this situation to converge as crude oil put options decline in value, bringing the oil VIX down, and crude oil itself to either rally or move sideways.

Crude Oil Futures Chart

Falling volume during crude's selloff indicates seller conviction is not high, and that the rally could be intact. The chart above shows crude oil prices in the top panel and volume on crude oil futures on the bottom panel. As can be seen, since volume spiked during crude's surge, volume has been trending downwards, even falling below the 45 day moving average today even though crude sold off 2%. We believe this lack of volume coincides with seller conviction waning as crude returns to the prices it traded at before Middle Eastern fears caused the spike.

Especially considering that other commodities such as precious metals have already begun to rally after a significant correction, crude seems to have very limited downside from here. The 100 day moving average, currently at the 85 level, should serve as significant support. If prices break below this level, the selloff may intensify. However, with gold and silver having advanced significantly in the same time period, it is unlikely that commodity buyers would let crude slip this much, as it is an excellent hedge against inflation.

From the fundamental picture, we can see that manufacturing in the US is picking up. Last week's employment numbers were disappointing on almost all fronts except manufacturing. While analysts expected the economy to add 10k manufacturing jobs, they instead added 49k, and even upwardly revised the previous month's numbers to +14k. The increase in manufacturing jobs is directly attributable to currency debasement, as our export continue to gain attractiveness to foreign buyers whose currencies continue to appreciate against the dollar (Australia, Canada, Brazil, etc.). As manufacturing continues to gain steam, US energy demand should continue to increase.

The twin boons of industrial demand and inflation-hedging should give crude oil prices a bid for the forseeable future. While the short-term view remains cloudy and volatile, aggressive traders can profit in such a situation.

Our recommendation is to sell a short strangle on crude oil, a strategy we described implementing for natural gas 2 weeks ago. In such a strategy, a trader could simultaneously sell the April 80.5 put and 103 call for a net credit of 99 cents, or $990 per short strangle. The trader would keep the entire credit amount if crude trades between 80.5 and 103 on March 17, and the trade retains some degree of profitability if crude is between 79.51 and 103.99. If crude oil moves outside this range, the trader could buy or sell one futures contract to cover the uncovered call or put option, respectively. Such a strategy entails significant risk given that crude oil is a volatile commodity and moves either way could occur with little warning, but we feel that the amount collected is satisfactorily paying for the risks undertaken.

Disclosure: I am long crude oil futures, short strangling crude oil futures options