Why Crude Oil Should Be A Staple In Your Option Selling Portfolio In 2018

by: James Cordier

Lifted Regulations on US Crude Exports have Oil Prices in the Headlines Again. Here's Why Option Sellers should be licking their lips.

Despite the latest round of liquidation, crude oil has embarked on an impressive bull market over the past 6 months, defying both seasonal tendencies and burdensome US supply. How? A perfect storm of mitigating "outside" influences. Some of these will continue into 2018.

So is it time to buy now and hold on for $80 or $100 crude? Or is the recent selling in crude an indication prices are headed back to the $40s?

As an option seller, you don't have to decide. Crude oil may move up or down in the coming month. But as you'll see in the following paragraphs, fundamentals are now beginning to balance out. This means prices could now settle into a new (albeit higher) trading range for much of 2018. This month, we'll show you how to put together an ideal option selling strategy to target high profits from these new fundamentals - a strategy you can utilize all year long.

Before we do that, you must first understand the factors that have been driving crude prices - and what could continue to support them through 2018.

Bullish Change: What is Driving Crude Prices?

1. OPEC Supply Cuts: After a year of data, it is clear that OPEC and Non-OPEC oil producers are serious about cutting production to raise prices. It was speculated that widespread cheating amongst the21 nation-effort would render it useless - as had happened with some past agreements. But top producers Saudi Arabia and Russia get a large percentage of their GDP from oil revenue. At $40-50 per barrel they were suffering and ready to take some short-term pain for long-term gain. That trade has paid off. October 2017 marked the first month that both OPEC and Non-OPEC groups hit cutback targets. For the year, the group will come pretty close to the target of a 1.8 million barrel per day production cutback. Top producers Saudi Arabia, Venezuela and Kuwait are now exceeding targets while Russia is nearly meeting it. Supply and prices are responding with WTI crude hitting 2-year highs last month. (Sources: OPEC secondary source estimates; Bloomberg, IEA preliminary estimates for non-OPEC nations.) The extension of the agreement in November means production cutbacks could stay in place through the end of 2018 (more on this later.)

2. Surging US Crude Exports: The US lifted its ban on exporting crude oil (other than token amounts to Canada) at the end of 2015. But it has taken nearly 2 years for that action to have a real impact on price. Now it is happening. With OPEC cutting production, global supplies are coming back into balance. But higher prices saw US producers, especially those in West Texas, ramp up production. This helped WTI (West Texas Intermediate) crude trade at a discount to Brent (global) crude. Currently, WTI traded at a $6 discount to Brent. Thus, major crude importers such as China and India went shopping for a better bargain and got in with the US. The first four months of 2017 saw theUS exporting 3 times more crude than in the same period in 2016.

US Crude Oil Exports steadily increased in 2017 before surging at year's end.

US exports hit an apex in October 2017 at near2 million barrels per day before backing off into January. However, the increased export figures are helping bring US supply tables back into balance. The latest EIA data shows US crude inventoriesdown 63.59 million barrels from this same time last year and approaching 5-year averages (after last year's burdensome levels.)

US Crude Supplies are moving back towards 5-year averages

3. Seasonal Demand Tendencies: Crude Oil prices have a seasonal tendency to decline into the end of the year, then rally into the Spring. This is a function of waning demand at the wholesale level at year's end followed by refineries ramping up gasoline production in mid-winter to meet summer demand needs. The chart below illustrates this tendency.

Crude Oil Has Historically tended to Strengthen into Spring and peak during driving season.

The seasonal decline in December did not happen this year. Why? The massive US exports (a brand new avenue of demand) superceded weaker US domestic demand. Seasonal demand will remain a supportive factor for prices into the Spring. However, a case can be made that the bulk of the move may have already taken place by January.

Extended Rally in 2018? Not So Fast

Until recently, financial media was abuzz with the "how high can it go" conversation as of late. Price estimates in the 80s are already being floated by the talking heads.

In our opinion, this is not likely.

Here's why:

1. US Production is Soaring. With OPEC turning back the spigots, US producers have been more than happy to step in a ratchet up production. The latest US rig count shows a staggering increase in US oil rigs in just the last year. At 939 rigs as of early January, the US rig count has grown by a staggering 42% since just last year(source Baker Hughes). The latest EIA data shows US production jumping to 10.3 million barrels per day by year end 2018 - a full million barrels higher than the same estimate this time last year. Thus in the "sheiks vs. shale" rivalry, shale is putting much of OPEC's1.8 million barrel per day cutback right back on the market - at a lower price.

US Crude Production has jumped by 1 million barrels per day in just over a year. It is expected to surge to 10.3 million barrels per day by year-end 2018.

2. Crude Oil is still Overbought: Speculative long positions in crude oil reached a record level in January. Large speculators (read hedge funds) werenet long 809,730 contracts while small speculators (the public) also held a massive net long position over 51,000 contracts. This shows overconfidence and often marks a turning point in trends. Conversely, commercials (those actually in the oil industry) hold a gigantic short position at 861,500 contracts and are adding to it. The stock sell-off in early February brought a "risk off" vibe into crude, causing funds to liquidate a portion of these longs. However, the market still appears to be holding a sizable net long position by specs.

3. Producers could begin abandoning production cuts if prices rebound to the high 60's. Should crude rebound slightly with BRENT crude testing the $70 level again, both OPEC and non-OPEC nations can be extremely profitable. If prices remain at these levels through Spring, an early end to the cutback agreement seems likely.

Conclusion and Option Strategy

OPEC production cuts and increasing US exports have gone a long way towards rectifying the global supply glut. At the same time, the US is ramping up production and OPEC could begin easing cuts if prices remain near current levels.

Crude prices have surged as the market prices the lower supply. But the market was already showing signs that those cuts could be nearly priced into the market - even prior to the February sell-off. Seasonal demand could help spur a further leg higher in crude while continually heavy US production or a further macro sell-off of risk assets could pressure prices.

We believe the crude market may be hitting a point of equilibrium. We see WTI crude prices in a new trading range (most likely between $50 and $70) - and probably staying there through 2018.

Thus an option writer would seek profit by selling options well outside of that projected trading range. This would mean selling calls high above the market and selling puts well below. This strategy is called an option strangle.

We have a series of months and strikes on the table forclient portfolios this month. The recent bout of volatility has opened up a variety of strikes at attractive premiums. However, self-directed traders can consider selling the December Crude Oil 76.00 call/40.00 put strangle. That trade sets up like this:

December 2018 Crude Oil

This chart shows a December Crude Oil 76.00 Call Strike and 40.00 put strike - the $36 price range in between the strikes is known as the "profit zone."

Total Premium Collected: $1,000

Estimated Minimum Margin Requirement: $2400

ROI if Successful: 41.6%

Analysis: While a number of scenarios could play out in crude prices this Spring, we see the least likely scenario as a break below $40 per barrel or a break above $76 per barrel. This is due to the factors previously described. Writing options at this level gives you a large($36 per barrel) profit zone. Should neither level be reached prior to expiration, both options expire worthless and you keep all premium collected as profit.

Analysts remain split on which way crude prices move next. With a little analysis and a lot of common sense, you don't need to pick a side to be profitable.

The good news is crude is a market that one can layer options on in different strikes and months throughout the year. Slow changing fundamentals make it an ideal market for building positions for potentially sizable income flow each month. For this reason, the crude market should be considered a staple market for any serious option seller this year.