Boom Or Bubble? The Best Oil Trading Strategy For 2008

Along with the falling dollar, it bears the single most responsibility for the bull market in commodities. It possesses formidable fundamentals as demand for it is at an all time high while production capability is or already has reached its peak.  Traders use it as currency. Terrorists use it as a target. We all use it most every day of our lives. The commodity is crude oil and it is in one of the most recklessly ascending bull markets ever seen in the history of bull markets.

The question is, is now the time to buy in or is this market setting up for a big fall? Is this a boom that will continue or a bubble that is about to burst?

In an attempt to answer this question, we must first understand the macroeconomic reasons why prices are at current levels.

While worldwide oil demand may not be fully to blame for the most recent spike in crude prices, it most certainly continues to provide a favorable environment for the bull market in crude. 10 years ago, world oil demand was about 70 million barrels per day. In 2008, that figure is close to 87 million barrels per day. This figure is expected to increase about 1 million barrels per year for the next 5 years largely as a result of growing industrial use in China and India.  Worldwide producers seem to be reaching maximum production capacity with major producer Russia indicating that its production may have "peaked out" in 2007.

Crude Oil, however, answers to many different price determinates in addition to supply and demand. With billions of new dollars pouring into commodities each year, commodity and hedge funds need a place to put it. Funds tend to be trend followers and they tend to favor the long side of the market (commodity index funds are always long the market). Thus, a solid uptrend with a good fundamental demand story and massive open interest makes a perfect market for funds to "place" equity. Any bullish tidbit of news becomes an excuse to buy. This is why oil markets have been hypersensitive to any type of bullish news story in recent months. These waves of capital flowing into energy markets create more buyers than sellers. If oil producers were eager to lock in profits at these levels, hedge selling would have curbed price gains weeks or even months ago. But at this point, producers seem content to let prices go where they may.

Probably more influential, however, is the collapsing US dollar. With the Euro near all time highs against the US dollar, the price increase for imported oil has not been as extreme for Europeans as it has been for Americans meaning there is less incentive to curb European or Asian demand. Therefore, while the US has seen a slight decrease in demand for gasoline, the rest of the world is more than picking up the demand slack.

These are mostly known factors however. For investment decisions, we must examine what is happening now in order to project market conditions in going forward.

For crude oil prices to begin a long term decline, one of three things will need to happen.

1.       Consumer demand will need to decline

2.       Investor demand will need to decline

3.       Global production will need to grow

We must then examine each of these and determine the likelihood of any of these occurring in the near future to determine if prices can reverse in any meaningful way.

Consumer Demand

Oil Bears often cite the fact that the US consumer is "cutting back" on gasoline consumption due to higher prices. While this may be true, the cut back is minimal at best. The latest EIA report shows the US consuming 9.343 million barrels of gasoline a day, down from last year's 9.404 figure. That's a whopping 0.65 %.  Crude oil demand is expected to drop slightly in the US in 2008 by about 190,000 barrels per day (the US currently consumes over 21 million barrels of oil per day). However, this decrease has been more than offset by increased demand outside of North America. Chinese demand alone has increased by 400,000 barrels per day in 2008. Overall, global demand for oil is projected to rise 1.2 million barrels per day in 2008.  

Investor Demand

The hedge fund industry currently controls more than $1.8 trillion in investor capital. And while the growth rate of hedge fund inflows slowed in Q1 of 2008, the industry continues to grow as a whole.  Yet, while hedge funds are typically for the wealthy, the average investor now has access to the oil markets through the new Oil ETF's, possibly the fastest growing segment of investor demand. Add to that the traditional oil futures trader and one has an army of hungry investors ready to pounce on the slightest bullish news story relating to oil. Gold and Silver have been the traditional choice for a hedge against a falling dollar and rising inflation. But with crude possessing the news headlines and a solid fundamental story, it has equaled or surpassed precious metals as the top choice for an inflation hedge. Europe's bullish announcement on GDP growth in Q1 this week lent fresh strength to the Euro and should be one factor continuing to pressure the dollar in Q2. Crude should remain a top choice for investors in Q2 and Q3 2008.

Global Production

It can be argued that the entire bull case of crude oil is based on production. Crude demand is at a record and continues to rise. But demand for crude has steadily risen for the last 50 years, albeit not as rapidly as within the last 10. Rising demand is not a problem, as long as supplies rise in unison. In the US, production has fallen from 6.5 million barrels per day to 5.1 million barrels per day in 2008, a drop off of nearly 21%. The US has made up the difference in imports. However, with global demand jumping by nearly 20% in that same time period, producers have ramped up production to near maximum capacity. Yet, Russia, the world's largest oil producer and second largest exporter saw production decline in Q1 2008.

OPEC production has hovered between 31-33 million barrels per day for the last four years. Yet oil prices have increased by nearly 200% during that same time period. Saudi Arabia, thought to be the only country left with any spare production capacity, has refused to increase production, even at the second request of President Bush this week. OPEC has kept output targets unchanged during its past three meetings despite oil surging $25 per barrel of the course of the meetings. Saudi Oil minister Ali al-Naimi blames "market turbulence" not demand for higher prices. 

Yes, you read that correctly.

If the product you are selling has increased in price by 200% in 4 years and you have not increased your output of that product during the same time, economics lead to only one explanation: You don't have the product to provide.  Economic sense would dictate that with oil at $125 a barrel, Saudi Arabia and OPEC would be pumping all the oil and using all of the excess capacity they have in order to capitalize on the higher prices.  It lends a load of credibility to the argument that Saudi excess capacity has been exaggerated and that there is a reason they are not operating at maximum capacity. It could be because they are already operating at maximum capacity.

STRATEGY

Despite bullish fundamentals that do not appear to be changing anytime soon, oil prices have raced up dramatically which will leave the market prone to sharp waves of speculator liquidation. Nonetheless, Goldman Sachs this week raised it's forecast for crude oil to $141 per barrel in the second half of 2008 and forecast $148 oil for 2009.

Do you buy it now?

Maybe so, but we are more inclined to side with Sanford C. Bernstein's statement this week that "the potential for significant price weakness is unlikely due to the onset of the high demand period associated with the US and European driving seasons."

In other words, we're not going to predict where prices are going. As option sellers, we don't have to. In the current environment, as Bernstein says, it is unlikely that prices will fall substantially. As sellers of puts, that is all we need to profit.

Rather than buy crude and risk a correction, we advise selling put options in crude oil. Buy crude at $125? Why not just sell the $95 put options and collect $700 for each one? If crude prices are anywhere above $95 per barrel at option expiration, the seller keeps all premium as profit.

In our opinion, it's a common sense way to play bullish fundamentals in crude, without trying to guess the mood of the speculators each day. 

If you would like more information about selling options in crude oil or gaining exposure to the commodities markets through the option selling approach, please feel free call or visit us on the web at www.OptionSellers.com.