Approaching Price Ceiling on Crude?

Includes: USO
by: Ananthan Thangavel

The crude market continues to be tugged in multiple directions. Seemingly alternating days there is an economic recovery rally in crude oil, only for it to fall back on worse-than-expected economic data. Masquerading among this “risk-on, risk-off” volatility is the supply/demand fundamentals surrounding crude oil.

Posted below is a chart of crude vs. managed money net long positions.

[Click to enlarge]

As can be seen, the entire upward move in crude during the Middle East unrest period beginning in February was due to increased speculative activity (a point we have driven home numerous times). At present, the speculative interest has fallen to more reasonable levels but remains considerably elevated. We believe the risk in crude is absolutely to the downside, with upside moves being tempered by a host of reasons.

The first reason that crude has more downside than upside is that the recent data has shown that speculators need to be the primary driver for crude to go higher. With the unexpected release of oil from the strategic reserves breaking speculators’ backs, speculators will be wary of bidding up the price of oil beyond $100/barrel. The most important point from the strategic draw was that it was a multilateral decision, not just a US one. This indicates that many governments are on board with keeping oil prices in check.

Secondly, in keeping with the above theme, OPEC also does not want $100/barrel oil. As we have discussed before, OPEC would like the price of oil somewhere in the $70-90 range. This is because that range offers OPEC producers a very healthy profit margin, but also keeps US alternative energy vigilantes sidelined. With the cost of gasoline at a reasonable level, the environmental buffs do not have nearly as much sympathy from the US population, and consequently Capitol Hill. OPEC knows that, in the long run, having the US devote sustained resources to alternative energy research spells certain doom for it. This is why it would much rather quietly collect its profits instead of risk the wrath of US voters turning hostile towards gasoline forever. It knows that the oil age will come to an end eventually, and has no interest in quickening the pace.

The third reason that crude has a fairly hard ceiling is that the cure for higher prices is simply higher prices. In the US, drivers simply stop driving or curtail driving activity to a minimum if gasoline prices rise too far. This causes demand to fall, which in turn causes prices to fall back to equilibrium. Making matters even more efficient is that gasoline prices are reset on a daily basis, so drivers adjust their behavior to price very quickly.

The US cannot support $150/barrel oil. If the cost of oil was to rise 50% from current levels, a view championed by the cover story in Barron’s last week, US drivers would drastically cut back their activity and the most popular political topic would shift from the national debt to foreign oil independence. It is in the best interest of numerous active, interested, and controlling parties for this not to happen. While the supply constraints of crude have been well-noted, we believe the demand side of the story to be more palatable and measurable. The Barron’s belief that Saudi supply is already at max level is nothing more than a guess based on some offhand commentary.

Trade Recommendation
In order to profit from a perceived ceiling on crude oil prices, we recommend selling the September 104 calls for 0.98 or $980 per contract. This trade would be profitable as long as September delivery crude does not close above 104.98 on August 17, a little over a month from now. This is an aggressive trade, as crude would only have to rally about 8% from current levels for this call to be in-the-money, but we view the upside on crude oil to be limited for all the aforementioned reasons. We would view a rally in crude as an opportunity to sell more calls, possibly for longer maturities and higher strike prices.

In order to effect this trade using the USO, an investor could sell the USO August 41 calls for ~$0.38.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: Short crude calls

Disclaimer: All information included herein is the opinion of the firm and should not be considered investment advice. Past performance is not necessarily indicative of future results.