Excell with Options: Where’s crude going this year?
Executive summary
Veteran institutional trader Rich Excell reviews two Crude Oil option strategies for managing risk and capturing opportunities in the crude oil market, including:
- Geopolitical and other factors that may impact the price of oil in 2022
- Ways to use CME Group QuikStrike tools to help evaluate potential hedging strategies
- How to use an LO short put spread to finance a bullish long call strategy
- How to use LO options to hedge a bearish futures position
The story of 2021, which has continued into this year, has been the move in oil. There are multiple potential catalysts for black gold (oil) this year, so let’s talk through some of the things that may happen and how Crude Oil options could be used to manage risk.
Politics
Intuitively, politicians know that higher oil prices mean higher gas prices, both of which could combine for trouble at the polls. A very quick Google search about whether higher oil prices matter to voters yields a slew of headlines from all major media outlets which suggest voters do in fact care.
The Biden Administration, showing its concern, has acted a couple of different times to stem the tide of higher prices, reaching out to OPEC last fall in a search for more supply and deciding at Thanksgiving time to release oil from the Strategic Petroleum Reserve. In a mid-term election year, we can expect oil prices and politics to be a big theme this year.
Kazakhstan
While the unrest in Kazakhstan may seem like troubles in a distant location to many, it is important to note that this country produces about 2% of world oil supply and is a top 5 supplier of oil to the European union. In addition, Kazakhstan has 12% of the world’s uranium resources and is the world’s largest producer.1 Thus, one should expect that the events in the country are going to have an impact on energy prices in the near term.
China
China is going through its own internal issues, with struggles in the property market at the forefront right now, particularly as the world prepares to focus on the country during the Winter Olympics. The Chinese PMI dipped below the 50 level (but moved back above last month), which is typically viewed as the cut-off between expansion and contraction of the economy. As the largest consumer of most commodities in the world, your outlook and view of the Chinese economy clearly impacts your view of major commodity prices like oil.
ESG
Environment, Social and Governance (ESG) is a major investment theme going through all markets. As a CFA charter holder, I can tell you ESG is a primary focus of the CFA Institute, with a certification specifically on the topic, and more of the CFA charter testing devoted to it. Active and passive managers alike are shifting to the subject. According to the United Nations Principles of Responsible Investing website, more than 50% of global assets under management have some form of ESG mandate. This is important because investors are urging companies to make commitments to achieve carbon neutrality. Even investors in energy companies are pushing toward this and we have seen many (led by European majors) make commitments to carbon neutrality. This has the potential to impact the global supply of energy, not so much in the near term, but in when and how much capital expenditure is going into the exploration and production of energy reserves.
Supply/Demand
Putting all this together, we can see that there are potential impacts on both the supply and demand sides of oil. As with any commodity, the price will be impacted by the supply and demand of the product over every time horizon. Using U.S. Department of Energy data that measures world consumption and world supply, I created a custom index in Bloomberg to measure this supply and demand imbalance in percentage terms. We can see that whenever we get more than 2% out of balance (areas I have circled) there is an impact on price. The 2014-2016 bear market for oil was a period when the supply of oil was outstripping demand. Independent oil producers, using the new fracking technology, oversupplied the product. Fast forward to the end of 2020 and all of 2021. Demand levels have returned to pre-COVID levels, yet supply has not kept pace. Perhaps this is due to disruptions in U.S. pipelines, challenges in Middle East shipping lanes, or unrest in countries like Kazakhstan.
Figure 1: Crude oil supply and demand imbalance
Without giving a forecast for the direction of price, as I will leave that to each of you, I merely want to point out that there is a slew of potential catalysts that could impact supply and demand. It is the imbalance between these that likely will drive the price of oil. Thus, I will walk through two option strategies for either a bullish or bearish view.
Bullish energy view strategy
What if you are an investor who is weighing the different outputs and takes above? You know there is an OPEC meeting on February 2, 2022. Your sense is that OPEC is going to do nothing about supply at that time. In addition, in spite of the problems in China, you also feel that ahead of and into the Beijing Winter Olympics (starting February 4), which coincides with the Lunar New Year (February 1), near term demand will remain firm, and as we see above, out of balance. I have drawn a few important technical lines on the front month crude futures (CL) contract. This may help us think about the critical levels in the market. The shorter red line is drawn to identify the highs we saw in the future in 2021. These were the highest levels in several years. In addition, there is an upward-sloping trend line from the COVID 2020 low which has defined the move higher in oil. One could argue that the trend looks higher, and a breach of the 2021 highs will point to levels not seen since 2014, when the fracking over-supply hit the market. This level (in green) comes in about $108.