Oil - How To Profit From An Uncertain Price Future

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Includes: BNO, DBO, DNO, DTO, DWT, OIL, OILK, OILX, OLEM, OLO, SCO, SZO, UCO, USL, USO, USOI, UWT, WTID, WTIU
by: D. H. Taylor

Summary

The break-even price for oil is $38.00; the market has more downside.

Despite cuts, producers are still pumping more oil than before.

The move lower in the price of oil was significant and the chance of a bounce is high -- here's how to profit from that.

I received a reader email today asking why crude prices are falling. Oil has been moving down sharply since the OPEC meeting, and even I have to agree this is getting to be a bit extreme. The move began on June 25th and the price of oil has dropped from $52.00 down to $43.00 -- a 17% decline in just three weeks. There are two questions this move brings up: How low will oil prices go? And when will crude oil prices go back up?

Regarding the first question, oil prices can still go lower. Regarding the second question, while I believe the move is extreme, as I just mentioned, there is more room for oil to go down. However, being a commodity and FX trader for the number of years that I have been, I also know that markets typically do not move in straight lines such as what we're seeing in the continual move lower in oil.

Ultimately, I am targeting a low of $38 for oil. I came up with that price level simply because I had gotten an email in which someone asked me if it was possible for oil to go that low -- that, and the fact that the break-even point for oil is $38. I am structuring trades that will profit once oil gets to that price, and then I am looking for oil to moderate before heading higher.

The break-even point for oil is just below $40 at roughly $38:


There are really only two factors that affect the price of oil: supply and demand. It's true that a government policy that limits oil production levels, such as OPEC's last meeting, would also affect the price of oil. But that is a factor of supply. The basics boil down to that. Given that, there is too much supply and not enough demand.

From a supply level perspective, take a look at the countries with the biggest oil reserves, the biggest oil producers: Russia, the United States, Saudi Arabia, Iran, and Iraq. If you look at charts on their production levels, you get a sense of what supply looks like. These are the world's largest oil producers, respectively:
Do you notice anything about these charts? They are all moving upward, Saudi Arabia's moves notwithstanding. You will recall that in 2014-15, the world was slowing down economically. And, yet, the oil producing nations found it prudent to step up production at those demand levels.

Or, not really.

If you take a closer look above at the first chart on the break-even price for oil, in 2015 innovation and technology dropped the break-even price for oil enough that companies could be more profitable at lower prices. For some of these oil producers, such as Iran and Iraq, the oil revenue ends up in the country's government coffers. These countries do not necessarily work like a company in the "bottom line" drive. Instead, they only care about revenue and largely do not care what the marginal returns are for pumping one extra barrel of oil. They only care about revenue.

So, the price of oil drops and so did the break-even price for oil. And countries around the world increased their production. This is what prompted OPEC to step in, led by Saudi Arabia, and have member nations agree to production cuts. Mostly, the production cuts were effective -- if you consider not meeting your target goal of cutting 1.2 million bbl/day and having the price largely not affected by what you did cut as effective. So, OPEC was forced to extend the production cuts.

The bottom line on the supply of oil: There are more signs of an oil glut and the price of oil is falling. That is the supply side.

The demand side is largely based on the economies of the world and how fast they are expanding. The bottom line: not very fast. In the United States, GDP came in at a soft 1.2% for the first quarter and the trend is heading lower.
Growth rates are on the lower end, but the economy is still growing. This is the case in many of the industrialized nations: Growth exists, it's just softer than economic growth could be, or that could mop up the excess oil being produced. If aggregate economies of the world cannot expand at a rate that will consume the excess oil being brought to market, then oil prices will continue to move lower.

Looking at the first chart you would think the price of oil is in a free fall. It is not. However, a move of 17% lower is large -- very large. I stated above that I believe the price of oil could hit $38. But I have been wrong before. I was waiting for a move higher to sell into this market again: I went short oil the day before the OPEC meeting on June 24th. That worked out well.

I have been trading in some capacity or another since 1990. Markets do not move like oil prices have been moving. I think a bounce will occur very soon, while at the same time I expect that the price of oil will eventually get to my target of sub-$40.

In order to take advantage of that kind of movement, I am structuring an options trade that will allow the market to move in either direction and allow me to profit both ways. I can pick up a $43 call option on oil for about $1.35, expiring in about six weeks. What I plan on doing is selling spot oil. Then, I will buy 3x my oil position size. Two scenarios will occur: The price of oil either goes up or it goes down. That is not rocket science.

If the price of oil goes down, I will cover my spot trade at $38 for a $5 profit on the spot. I am long three calls at a cost of $4.05. That means I profit $0.95 in total and then I hold the options with no cost.

As I said before, I a believe that the market will move lower to $38. But markets never move in a straight line. That means I'm anticipating that potentially oil could finally get some respite and head higher. Let it. I am long 3x calls on my spot size. If the price moves upward $2, I break even.

Until the demand increases significantly, or until supply decreases significantly, the price of oil will go down. But I do not believe it will go down in a straight line continuously as it has been. I'm taking advantage of having seen enough market movements and experience in the market to know that I can profit from this either way.

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

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am shorting oil spot and going long at-the-money calls simultaneously.