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Crude Prices Could have Floor in Place

With Demand Rising Again, Crude Prices Could have Floor in Place

James Cordier, Michael Gross, OptionSellers.com
January 14, 2011

Cordier Tells FOX Business "Odds favor Put Sellers"

Unlike gold or some of the "exotics" like coffee or sugar, Crude oil prices remained relatively stable through the dollar related volatility that roiled markets in the second half of 2010. While a falling dollar and various weather issues caused supply worried bulls to bid up agriculture and metals, concerns over global demand kept a bullish reaction in crude prices largely in check. However, as we stated in our December client newsletter, crude oil appears to have all the right fundamentals alligning at the right time. This could make crude oil a leader in the commodities markets in 2011. It could also make the crude oil options market fertile ground for investors that make their living collecting premium.

The bears have been vocal lately in regard to crude prices. They point out that with the threat of Chinese interest rate hikes, rising US refinery rates, ongoing turmoil in the Euro Zone, and the nagging unemployment issue in the US, crude oil prices will stall at current levels, possibly falling back to the mid to low $80 range. As put sellers, this would be just fine with us.

However, our opinion is that the bears have lost sight of the bigger picture. Oil prices are poised to experience another surge in demand in 2011. Producers, OPEC and otherwise, will be under pressure to ramp up output. This week, the EIA announced that total world oil consumption will rise by 1.4 million barrels per day in 2011 and by an additional 1.6 million barrels per day in 2010. This would bring global oil consumption to 89.6 barrels per day - above 2008's pre-recession levels. This is largely the result of the economic factors we highlighted in last month's letter, including:

1. The US Economy is finally beginning to turn the corner in earnest – a big positive for oil prices. US productivity posted a larger than expected rise in the 3rd quarter. US private sector jobs jumped by 93,000 in November, the largest monthly gain in three years. This week's manufacturing numbers painted an outright rosy picture for US industrial firms. The extension of the Bush tax cuts was a shot in the arm for investor sentiment. Unemployment numbers dipped unexpectedly this month. Yes, the recovery is uneven and erratic. But the unmistakable trend is there. US GDP is expected to grow by 3.5% this year.

2. Despite efforts to cool it’s raging economy, China continues to expand and thus demand for crude oil continue to build. China is the world’s second largest consumer of crude oil but it’s demand growth rate is far outpacing the US. Despite recent increases in the value of the yuan, the Chinese economy will grow by another 9.5% this year.

Demand could come Sooner rather than Later

US demand for crude could get a boost earlier rather than later if past year's are any indication. Late January to early March marks the time of year when US refineries shut down for maintaince and perform their annual switch over from heating oil to gasoline production. This not only can support energy prices from a short term supply angle (lost production and falling inventories due to production shut downs) but from a demand viewpoint.

The US and most of the northern hemisphere experiences a surge in retail gasoline demand from June through September as "driving season" takes vacationers to the road during the warm summer months. This demand skew shows up at the wholesale level as early as January as distributors begin to stockpile gasoline inventories to meet summer demand. This ramps up demand for production, which in turn ramps up demand for oil.

This "one-two" effect of refinery maintenance and seasonal demand can often produce late winter/ early spring price rallies in the energy markets.

At the very least, it should be one more pillar supporting crude prices over the next several months.

Conclusion and Investment Strategy:

We remain of the opinion that the risk of a move in crude prices appears to be more weighted to the upside. However, we do not expect a "blow off" rally either. Rather a scenario where crude prices trade comfortably in a range of $85 to $100 seems like the most likely scenario for the coming months.

We are advising selling puts near the $60 level for conservative minded bulls and strangle plays (adding a $130 or $140 call) for higher premium minded investors. Look to get at least $1,000 per strangle.

While these premiums are still available, the oil VIX has been on the decline as of late. We advise entering these trades earlier rather than waiting as premiums could dry up quickly (this is a good thing if you are already positioned).

We would not be shy about going out to late summer contracts as these premiums could go quickly as well if oil settles into a defined range. Remember, as an option seller, all prices have to do is stay above or below your strike price. If it does, you keep the premium. Crude appears to be an optimum market for this strategy at this time.

Note: The opinions presented here are that of Liberty Trading and not necessarily shared by Optionetics and/or its instructors.

James Cordier & Michael Gross
Contributing Writers, Liberty Trading Group/Optionsellers.com
Optionetics.com ~ Your Options Education Site

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Crude Prices Could have Floor in Place