Oil Speculation
The price of crude oil has been in freefall recently on fears of less demand due to the recession. Prices on the January 2009 futures contract dropped to $36 a barrel today, down from a high of $147 per barrel earlier in the year. At $36, this is less than half of Saudi oil minister Ali al-Naimi's $75 target fair price for crude, a price needed to support investment in new fields.
This is just bizarre. It's almost enough to make one believe that oil is plentiful and cheap. OPEC on Wednesday announced production cuts of 2.2 million barrels per day, and non-OPEC producers like Russia and Azerbaijan have announced plans to cut production as well.
While the world's economic woes cannot be ignored, I don't believe that the demand issues are likely to go away. There have been no fundamental changes to warrant the decline: economies are still dependent on oil for growth, no major new oil supplies have been discovered, and no alternative energy source is anywhere near in a position to substitute for oil. While growth may be delayed for a time, developing economies like China and India will continue to have huge demands for oil. A prolonged spell of cheap oil also delays the development of alternative energies as well as the search for new oil fields, as it no longer becomes economically feasible to pursue those options. Ultimately, it's all a matter of supply and demand. Coupled with the fact that crude prices remain denominated in the ever-weakening dollar, it seems to me nearly a sure bet that prices must rise.
How to Exploit the Mispricing
The most straightforward method is to buy securities that are correlated with the price of oil, such as oil companies or an ETF that tracks crude oil like USO. A quick check shows that USO does a reasonably decent job of tracking crude prices. If crude rebounds to OPEC's $75 target, that makes for an easy double.
Buying Call Spreads
One play whose risk/return proposition appears very attractive to me is to buy a call spread on USO. USO tends to trade at about 75%-80% of the price of crude and closed at $32.73 today, versus the January 2009 futures contract which closed at $36.20.
Here is a list of USO options expiring in January 2011, over two years from today.
You can buy an in-the-money call option (OLLAX)for about $13.60 with a $30 strike price. Thus, if USO trades above $43.60, or roughly $50-$55 per barrel for crude, by January 2011, you will break even. Anything above $43.60 is pure profit.
You can offset the price of the call option by selling another call option with a higher strike - the classic bull call spread. I did this for a January 2011 call option (ZVKAH) with a $60 strike, at a premium of about $6. By doing this, I basically sell off any upside in USO above $60, which is about $75 in terms of the cost of a barrel of crude. This reduces the cost of my spread to $13.60 less $6, or about $7.60.
You can choose to construct wider/narrower call spreads at different strike price points, which will impact the net cost of the spread. I chose to buy a spread at the $30 range so that my $30 call was already in-the-money.
In this case, I will profit if USO trades above $37.60 by January 2011. I can potentially make up to ($60 - $37.60) or $22.40, assuming USO trades above $60 at expiration. I am basically betting $7.60 for a potential return of up to $22.40, which is almost a 3:1 or 300% gain.
Additionally, I can unwind the position at any point over the next two years, as the prices of the options will change depending on how USO and crude prices change. The only drawback is that the bid/ask spread to unwind the position can be costly.
I believe there is a better than 50/50 chance that crude oil will rise above $75 per barrel over the next 2 years, and I can get a return of up to 300% if that actually happens. That's a bet I'm quite willing to make. Even today, a crude oil futures contract for delivery in January 2011 is trading at $62.09. The U.S. government outlook is for $51 crude oil for 2009.
There is probably an even more lucrative opportunity to be had trading futures here, but I don't have an account set up for that currently. In any event, buying the call spread seems like a solid speculative play to me. I normally refrain from speculation, but the risk/reward was too enticing to ignore.
And What if Oil Prices Stay Low?
Somehow, I wouldn't count on the price of crude to stay this low. But if it does, that's fine by me. If oil prices continue to stay low, that should bring good news at the gas pump and to the economy overall. We can return to our profligate habits of McMansions and Hummers. You can probably pick up both now for pennies on the dollar.
Disclosure: The author is long USO.
This is just bizarre. It's almost enough to make one believe that oil is plentiful and cheap. OPEC on Wednesday announced production cuts of 2.2 million barrels per day, and non-OPEC producers like Russia and Azerbaijan have announced plans to cut production as well.
While the world's economic woes cannot be ignored, I don't believe that the demand issues are likely to go away. There have been no fundamental changes to warrant the decline: economies are still dependent on oil for growth, no major new oil supplies have been discovered, and no alternative energy source is anywhere near in a position to substitute for oil. While growth may be delayed for a time, developing economies like China and India will continue to have huge demands for oil. A prolonged spell of cheap oil also delays the development of alternative energies as well as the search for new oil fields, as it no longer becomes economically feasible to pursue those options. Ultimately, it's all a matter of supply and demand. Coupled with the fact that crude prices remain denominated in the ever-weakening dollar, it seems to me nearly a sure bet that prices must rise.
How to Exploit the Mispricing
The most straightforward method is to buy securities that are correlated with the price of oil, such as oil companies or an ETF that tracks crude oil like USO. A quick check shows that USO does a reasonably decent job of tracking crude prices. If crude rebounds to OPEC's $75 target, that makes for an easy double.
Buying Call Spreads
One play whose risk/return proposition appears very attractive to me is to buy a call spread on USO. USO tends to trade at about 75%-80% of the price of crude and closed at $32.73 today, versus the January 2009 futures contract which closed at $36.20.
Here is a list of USO options expiring in January 2011, over two years from today.
You can buy an in-the-money call option (OLLAX)for about $13.60 with a $30 strike price. Thus, if USO trades above $43.60, or roughly $50-$55 per barrel for crude, by January 2011, you will break even. Anything above $43.60 is pure profit.
You can offset the price of the call option by selling another call option with a higher strike - the classic bull call spread. I did this for a January 2011 call option (ZVKAH) with a $60 strike, at a premium of about $6. By doing this, I basically sell off any upside in USO above $60, which is about $75 in terms of the cost of a barrel of crude. This reduces the cost of my spread to $13.60 less $6, or about $7.60.
You can choose to construct wider/narrower call spreads at different strike price points, which will impact the net cost of the spread. I chose to buy a spread at the $30 range so that my $30 call was already in-the-money.
In this case, I will profit if USO trades above $37.60 by January 2011. I can potentially make up to ($60 - $37.60) or $22.40, assuming USO trades above $60 at expiration. I am basically betting $7.60 for a potential return of up to $22.40, which is almost a 3:1 or 300% gain.
Additionally, I can unwind the position at any point over the next two years, as the prices of the options will change depending on how USO and crude prices change. The only drawback is that the bid/ask spread to unwind the position can be costly.
I believe there is a better than 50/50 chance that crude oil will rise above $75 per barrel over the next 2 years, and I can get a return of up to 300% if that actually happens. That's a bet I'm quite willing to make. Even today, a crude oil futures contract for delivery in January 2011 is trading at $62.09. The U.S. government outlook is for $51 crude oil for 2009.
There is probably an even more lucrative opportunity to be had trading futures here, but I don't have an account set up for that currently. In any event, buying the call spread seems like a solid speculative play to me. I normally refrain from speculation, but the risk/reward was too enticing to ignore.
And What if Oil Prices Stay Low?
Somehow, I wouldn't count on the price of crude to stay this low. But if it does, that's fine by me. If oil prices continue to stay low, that should bring good news at the gas pump and to the economy overall. We can return to our profligate habits of McMansions and Hummers. You can probably pick up both now for pennies on the dollar.
Disclosure: The author is long USO.
posted by Henry at
1:19 AM
6 Comments:
While oil consumption is likely to rise at a faster rate than supplies, I'm not convinced that the market tracks reality. It seems these days it's tracking more on fears than anything else. I mean, they have stock prices of companies that are ridiculously low like C at $4 and YHOO at $9. I guess my question is whether it's better to by oil now or a year from now when the economy starts rebounding.
I'd agree about the market mispricings. Visinomics has an interesting post comparing the price of crude with gold and dollars. While crude hasn't been this cheap since 2004 when you price it in terms of dollars, it hasn't been this cheap since 1999 when you price it in terms of gold.
As for timing, who knows? Ultimately, the question I ask myself is if I had the chance to buy crude at ~$35/barrel and gas at <$2 gallon today, would I regret it 5 years or 10 years from now? If you posed this question to me over the summer, the answer would have been most definitely no. It's more important to me to catch a good price rather than to catch the exact bottom.
I guess the question isn't whether this is a good stock but what is the best stock for the long term game. Also, if you are tracking stocks regularly (once/several times a day) and willing to make trade monthly or whatever, then you're real time horizon is the next trade, not the 5-10 years right?
well, looks like I was wrong about USO, man, up 15% in a week!
It's just short term swings. As for time horizon, the USO ETF is a bit different than your typical common stock, as it tracks a commodity and not an actual business. The purchase of the USO ETF is intended as a rough hedge on future gasoline purchases - essentially locking in ~$3,600 in gas at today's prices. Consequently, I don't intend to sell this.
The $30-$60 call spread trade is indeed speculative, as the safety of my principal is not guaranteed if oil prices stay at its current levels for the next two years. The trade is limited by the life of the options, which expire in January 2011. I've intentionally constructed a position that cuts off my upside at USO equal to $60 in order to reduce the cost of the trade, but still offers a potential ~3:1 payoff. There's a possibility that USO may go way above $60 before Jan 2011, in which case I may choose to close the trade before then as most of the value would already have been gained.
USO at $25 but gas prices still high, worst of both worlds?
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