Oil Prices at $114 unsustainable...or is this just a stopping point to $150 per barrel?
Utilizing Synthetic Options to profit on a downward trend with no money down
"The price of oil can't move any higher" - How many times have you heard that one before? At $60 per barrel, then at $80, then at $100. Well, there will be a near term top and I believe we've hit it. Given that oil is denominated in US Dollar terms, our weakening economy's certainly given a boost to the price of oil, but even in terms of stronger currencies, oil is at or approaching historical highs in real terms.
Global Recession - The Party's Over
The US and hence, the global economy is teetering on recession (we're not as "de-coupled" as the talking heads would have you believe as evidenced by the crash of the emerging markets with the US indices). If history and logic are any barometer, as the global slowdown ensues, demand for goods and services declines, leading to a reduction in overall consumption and hence oil consumption. This decline in oil demand/consumption complex lowers the price of oil to the point that it is no longer as profitable to extract it and companies start to invest capital in other sources of energy (i.e. how the tar sands and green energy sectors were born) and the whole cycle repeats itself again as economies return to robust growth and the lack of capacity creates a pinch point for oil production. To think that oil at these prices is sustainable is to assume that US home prices would continue to climb 10%+ for years to come and the internet bubble would never burst. That's not to say oil is due for a precipitous decline (don't miss the poll on the left), but markets overreact and with commodities in general, we're clearly seeing that. Gold and other metals have retreated; why is oil at new highs?
Counter Argument - Gold to $150 by Summer
You haven't seen anything yet. As Chavez continues to nationalize oil interests, Nigerian kidnappings present continued supply interruptions and oil pipelines in Iraq remain an Al-Qaeda target, the current prices you're seeing are a mere bump in the road for oil prices. Many industry experts have conceded that the replacement rate of oil by the majors can no longer keep pace with consumption. Some of the top wells in the world have breached their theoretical maximum output rate and will only decline from here.
Oil at over $100 per barrel is the new reality. Why, you might ask? Well, it's just too damn cheap compared to everything else out there and the world's insatiable appetite for oil cannot be quelled. Extracting energy from the tar sands in Canada is a dirty business and only now becoming attractive at these high prices. Solar is terribly expensive and ethanol is the biggest scam pulled on the US public in decades. Notice that the primaries begin in Ohio, where the greatest concentration of farmers benefit from this sham? Until our politicians decide to remove the tariffs on ethanol imports from Brazil, there's no way we'll break our dependence on oil as a primary energy source. In my humble opinion, in the absence of a major attitude adjustment from the economy where 5% of the world's population consumes 25% of the world's energy, nuclear's the only viable option, but "not in my backyard", so you won't see any new plants coming on line any time soon.
A Synthetic What?
A Synthetic Option is a a way to synthetically mimic the return of an underlying stock without actually shelling out any money. How is this possible? On the long side, you can buy a put and sell a call for the same premium and have a net neutral cash outlay in your trading account. If the stock rises, you benefit from the upward movement of the call and the decrease in value of the put and can roughly duplicate ownership of 100 shares of the underlying stock. Of course, if things go the wrong direction, you're on the hook for the downside move. There are variations on a theme here. If you don't want to risk loss for a small move, you can buy and out of the money call and sell an out of the money put and still realize the same net neutral outlay as long as the premiums are equivalent.
Here's an example of the trade I executed today (obviously, I chose the former, not the latter argument and took a net short position on oil, banking on a return of USO to $80 as we've seen twice in the past month):
USO is the ETF that tracks spot price of West Texas Intermediate (WTI) light, sweet crude oil and roughly matches the moves in the quoted oil prices you see in the mainstream press. My belief is that we've reached a peak and will not see a move much past $115 per barrel before we see a nice drop like the one that occurred a few weeks ago.Since USO was valued at 90.8 today when the oil price was $113.4 per barrel, I decided to executed a synthetic option with action at the 5% move level in the May expiry contracts:
I bought 2 USO 86 strike PUT options at 2.20 each
I sold 2 USO 95 strike CALL options at 2.35 each
My net out of pocket cost was zero considering commissions.
Here's how this will play out:
If oil spikes say, 10% to $128 per barrel, USO will move to ~$100. My 95 calls will be $500 out of the money each for a net loss of $1000.
If oil drops 10% to ~$101 per barrel, USO will move to ~$82 per share and the puts will be in the money $400 each for a net gain of $800.
If oil remains range bound and USO is somewhere between $86 and $95 at expiry in May, there is no transaction and both sets of options expire worthless. If trading close to $86, I could sell the put for a small profit based on the remaining time value.
The risk here is obvious, a major spike in oil will trigger a loss. However, given where oil's at now and with only 2 options contracts, I don't face catastrophic loss and I can sleep at night. If this sort of thing does keep you up at night, but you like the prospect of synthetic options, you could always cap your liability by buying an additional 2 out of the money calls at say, $100 to cap your losses to $500 per contract. This insurance somewhat negates the allure of the net neutral play, but that far out of the money, the options are cheaper at ~1.20. I don't recommend this play unless you fully understand your risk-adjusted return and you can handle the maximum liability.
Don't miss the poll in the sidebar this week to register your thoughts on where oil's headed!
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