TAMPA, Fla. (Liberty Trading Group) -- Our view is that the price of any market will eventually have to reflect is core supply/demand fundamentals. Yet, there is another factor that can push prices around quite a bit in the meantime. That factor is emotion.
Emotional trading is often triggered by news stories and events. And there are few markets more affected by world news events than Crude Oil.
Crude oil prices spiked to new all time highs this year as fears of supply disruptions have continually gripped the market. Terror threats, rebels in Nigeria, the beginning of the US hurricane season and of course, Iran's persistent drive to enrich uranium and vague threats to cut supply have all contributed to recent price spikes. This all comes at a time of record world demand, especially from the growing US and Chinese economies.
But the luster has come off of crude prices in recent weeks and there is reason to believe the weakness could continue, at least in the short term.
We should establish that the viewpoint of this article is not that we believe crude prices will come crashing down. Rather, that they could be vulnerable to a corrective phase that will take prices moderately south of $70. At the very least, we feel the chances for a violent price spike to new highs has decreased and this can often mean fertile ground for astute call sellers.
Our reasons for this viewpoint are numerous. First, from a technical perspective, crude appears to have entered an intermediate term downtrend that began in the first week of August. This week's close below key support near $70 hints at more downside to come.
But what is the fundamental catalyst? What has changed since early August when October crude was trading near $78 a barrel? Answer: Fundamentally, nothing. Emotions have changed. This is a case of a market that is beginning to discount outside news stories and focus on core fundamentals - supply and demand.
Traders appear to have grown weary of the Iran story as it now appears that any action or solution will be a process that could drag on for months. There have been no hurricanes to speak of. More importantly, the US economy appears to be slowing and traders are starting to turn attention to the actual supplies of crude in storage. And the more focus turns away from perceived threats to supply and keys on actual supply on hand, the lower prices are going to go.
While energy traders had expected a decline in US crude stocks this week, the DOE reported crude stocks increased 2.4 million barrels for the week ending August 25th, pegging US commercial crude oil inventories at 332.8 million barrels. This not only flies in the face of a seasonal tendency of stock declines for this time of year but also means current supplies are approximately 7% higher than the 14 year average for this time of year. Gasoline and distillate stocks also increased indicating that refinery snags are not to blame for excess crude.
While this is normally the time when distributors are accumulating crude oil supplies as heating oil production shifts into full swing, the tendency has not been as pronounced this year (as indicated by the last several DOE and API reports). An initial assumption for this could be to assume that gasoline demand had slackened, allowing crude inventories to build in August. But this is not the case. US Gasoline demand in August was 1.6% higher than August of 2005. Distillate demand was 2.8% higher than last year at this time.
Our inclination is to believe that distributors are postponing forward purchases of crude in the expectation that prices will be lower in September. This could be something for spec traders to take note of. Commercials generally follow core fundamentals and place less emphasis on news stories and emotion. With indications that the US economy is slowing, commercials could be anticipating a slowing of demand. And while speculators have been focusing on Iran, Lebanon and Ernesto, US crude stockpiles have quietly crept up to their highest levels in four years.
Of course there are plenty of catalyst that could spark another rally in crude and there are many longer term factors that should keep the market from experiencing any drastic declines. However, we believe this market is going to have to come to terms with it's base fundamentals in the near term, now that traders are starting to recognize what they are. This should mean crude prices at least stabilizing and possibly needing to adjust lower in the coming weeks.
Yet with spec traders still looking for the big pop, there are very attractive call premiums available at strikes well above the all time highs in crude. It is our opinion that calls written at these levels will be high probability writes for traders looking 30-60 days out. We would recommend writing covered positions to protect ones downside, just in case one of the situations mentioned above takes an unexpected turn for the worse.
On the other side, an additional $3-$4 drop in crude prices would look like an opportunity to write some put premium well below the market.
Either way, the crude oil market should provide fertile ground for option sellers looking to generate income through the month of September.
Copyright (c) Liberty Trading Group 2006
James Cordier is head trader and president of Liberty Trading Group, a futures brokerage firm specializing in option writing on commodities. Michael Gross is an analyst with Liberty Trading Group. If you would like more information about the option selling philosophy or building a portfolio based on the option selling approach, please feel free to call (800-346-1949), e-mail or visit us on the web.