Profiting from Crude Oil
The Smart Profits Report: Issue #174
Tuesday, January 11, 2005
Profiting from Crude Oil: In the Age of "Perpetual Shock"
By Steve Belmont
Research Specialist, Mt. Vernon Research
Profiting from crude oil is big news. But crude oil hasn’t always been the center of attention. A few years ago, it barely rated a mention on CNBC, never mind a spot on the ticker. Americans used to take cheap oil for granted.
Those days are over…
Crude has always been vulnerable to political price shocks, but the rules have changed. Consider these factors that have changed the dynamics of the crude oil market…
- War in the Mideast
- Depletion of cheap, easily recoverable supplies worldwide
- The phenomenal growth of Asia
Asia’s 3.6 billion people consume 20 million BPD. Now consider that America’s 293 million people already consume 22 million barrels of oil per day.
Asia has over twelve times the U.S. population but consumes 9% less oil than the U.S. Imagine the increase in demand if Asian per capita usage grows by just a few percentage points.
Welcome to the age of perpetual shock…
Existing global supplies are being depleted at a rate of 4-5% per year. New demand is increasing by 2% per year. That means new supplies must increase at least 6% per year in order to keep the market on an even keel.
Plenty of Crude Oil Remains… But It’ll Be Expensive
The trouble is, all the inexpensive oil has already been found. What remains is hard-to-get, expensive oil - most of it in unstable nations. In order to make it worthwhile for oil companies to invest the capital necessary to get at the remaining oil, prices need to rise. This is how capitalism works.
In this sense, the world isn’t necessarily running out of oil; however, it may be running out of cheap oil.
Not surprisingly, crude oil has been in a rip-snorting bull market for the past two years. However, like most bull markets, it got crowded near a top.
Fears of a pre-election terrorist attack in the U.S. sent prices skyrocketing as high as $55 per barrel in October. Since then, crude futures have corrected, getting as low as low as $40.25 per barrel - a drop of 27% - before bouncing back above $45.
How High Might Crude Oil Really Go?
Despite the drop, crude oil remains in a powerful uptrend. The fact that crude was able to test its intermediate-term uptrend and bounce significantly is positive.
How high could crude go? Barring a global slowdown, supply/demand fundamentals could have crude re-testing $55 per barrel by the end of the year. Throw in a successful terrorist attack and $70 per barrel is not out of the question. This is still well short of the inflation-adjusted $83-per-barrel highs made back in 1977.
The question is: Is it time to jump back in? Our answer would be a qualified yes - "qualified" because crude may continue to test the staying power of the late-to-the-party bulls until their spirit is finally broken.
This would probably happen below $40 per barrel.
Crude could dip as low as $35 without negating its long-term uptrend. Should this happen, we believe it would be a huge buying opportunity. Yes, because in an uptrend you want to be long the market. Crude may not get back to $35 per barrel. It may not dip below $40. In the event it doesn’t, we want to jump back in, but not necessarily with both feet.
Crude oil futures are extremely volatile, so we would not recommend trading them directly for most investors. However, most energy stocks don’t keep pace with gains in crude oil. Crude rose 157% from 2002 to 2004 while Chevron Texaco rose just 16% in the same time frame. There are loads of other examples just like this.
An Options Play on the Crude Boom
Consequently, we are looking at the NYMEX crude oil call options instead - more specifically NYMEX bull call spreads.
NYMEX crude calls enable investors to make limited risk bets on crude oil directly. Big volatility means the calls are currently expensive. Bull spreads are a way to remove the bulk of this volatility premium in exchange for a cap on potential gains.
Here’s a quick example of how bull spreads work….
On Friday, Jan. 7, December 2005 $50 NYMEX crude oil calls closed at a price of $2.74 each. Each option covers 1,000 barrels of crude oil, so buying one option would require a total cash outlay of $2,740. (1,000 barrels times $2.74) Each call gives the holder the right but not the obligation to be long a crude oil futures contract at a price of $50 per barrel. This right is good until option expiration on Nov. 15, 2005.
The key phrase here is, "not the obligation." Since the call buyer has no obligation to buy - all he or she has at risk is the $2,740 paid for the option.
Still, $2,740 is a lot to pay for an option that is currently 16% out-of-the-money…
Lowering Cost and Risk Simultaneously
In order to lower our cost and our risk we want to simultaneously SELL a December 2005 $60 crude oil call. The $60 calls closed at $1.19 on Friday or $1,190 per option. We receive $1,190 into our account in exchange for our obligation to sell a crude futures contract at $60 per barrel.
We can now use the $1,190 we receive for our obligation to sell crude at $60 to offset part of the $2,740 we paid for our right to buy crude at $50. What we get is a trade that costs us $2,740 minus $1,190 or $1,550. (Note: we place the trade as a "spread" order making sure we get both sides of the transaction.)
We have now paired the right to buy 1,000 barrels of crude at $50 per barrel with a corresponding obligation to sell 1,000 barrels of crude at $60 per barrel. That means we can make the $10 per barrel difference but no more. Since each spread covers 1,000 barrels, this makes our net potential return the $10,000 difference between strike prices minus the $1,550 net cost of our spread or $8,450. The downside is we will not participate in gains over $60 per barrel.
Right now we’ll take the cap and the lower risk that goes along with it.
Good trading,
Steve Belmont
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Today’s Smart Profits Cribsheet
- Visit our Smart Profits Glossary for more on the option terms used in today’s report, like "strike prices" or "exercise price."
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You should be aware that options are not for everyone and, in general, should only be traded with "risk capital" or money you can afford to lose. Prices may have changed by the time you read this but the basic technique described above remains the same.
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For more information about commodities you can contact Sue Rutsen at Rutsen Meier Belmont Group LLC, A Division of Man Financial Inc: toll-free 800.345.7026 and 312.528.3494 direct.
Related Articles:
- Crude Oil Prices: Here’s What An Industry Insider Says Is Next For The Runaway Oil Market
- Bear Spreads - Totally Risk-Free Profits Shorting Crude Oil
- Crude Oil Prices Per Barrel: Former Market Maker Reveals Where Oil Prices May Be Headed
