Oil Market Trade Setup

Inventory Report

Today we had another bad inventory report [11], and this is to be expected as we are in the weak period for the oil market, from a seasonal demand and refining demand standpoint. I am not looking for much relief on this front until around the second week of February as spring starts to get on people`s radar. I was asked about this statement that I made to provide some color regarding a couple of issues “let us say the next 11 months of the year I believe Oil prices will be higher than they are now.”

Price Target

The first question is how much higher? Well, let us assume oil is going down to $25 a barrel, $20 in an extreme case scenario. This would be good for oil markets actually. The problem is that the oil market has a lot of guys like Harold Hamm who need to retire from the industry, these people are just archaic dinosaurs who don’t understand the value of a good market intelligence program. If he had one at Continental Resources he never would have taken off his oil hedges when oil was in the $65-$75 area, this fact alone cost his company and shareholders a fortune. There are just too many clueless idiots with no finance background in the shale space. A decent drop in the $20s for oil would be a good thing, it would force people out of the business, lock, stock and barrel.

Market Intelligence

You wouldn`t believe how many major oil companies in Houston do not have a basic market intelligence department, that is how clueless they were in being prepared for this pullback in oil prices. Some of the biggest firms have one person in this role that isn`t even a real market intelligence qualified individual. The point here is that the oil industry has been fat and happy and out of touch with reality for some time. There is too much dead wood in the industry that needs a good house cleaning. 

In listening to Harold Hamm today on Bloomberg, he still doesn`t get it. It is this Harold Hamm Mentality of I don`t need any hedges here, and Oil prices will recover that has led to oil prices falling so much. Shale Production should have stopped a year ago, we should be producing around 6 Million barrels per day, and dropping fast. Consequently it actually would be a good thing for oil markets if oil took this next leg down, there are just that many stupid, clueless idiots in the industry. 

Sorry if I am being overly blunt here as some of my colleagues have suggested a more diplomatic approach. However, I find that vulgar language cuts through the euphemistic bullshit, and the oil market needs to ‘awaken from its slumber’ and get its act together real fast. The euphemistic language just placates the current status quo of ineptitude that runs through corporate management at the oil companies this past year. Management at oil firms has been behind the curve for years.

Thus if oil goes down to $20, the short covering rally would take it back to $35 a barrel. I am assuming that additional production gets knocked offline in this $20-$35 price range, and knowing how oil markets are binary. By this I mean fund flows either flow in or out from the short or long side so price is either a 1 or a 0 there is no in between. Thus if you get to $45 a barrel in the futures market, then you get to $52 a barrel – it just is how the oil market moves. 

Therefore, conservatively I see the price of oil for WTI at $52 a barrel sometime over the next 11 months’ time period. I would evaluate the trade based upon market dynamics if US Production starts to really decline I am staying long oil and my next target would be the $65 a barrel area on an overshoot in the futures market. But who is to say with 15-20% depletion rates for shale wells, the lag in rig counts versus production effects, how much U.S. Production could come in here.

Downside Risk for Price

Subsequently the next question asked is from what base? And I have just given my worst case scenario of a base in the $20-$25 area. But like Jeffrey Gundlach who believes we are close enough to the bottom for government work, i.e., you can make money from the long side if you get in here, regardless if oil prices take the next leg down. And we traders like to make sure we get in a trade, even if we are too early, but we have to be in it to make money. And given my downside risk of $20 a barrel, effectively I have a long term call option on the oil market by getting in around $30 a barrel over the next two years’ time horizon.

Preferred Oil Instrument

The next question is what is the best way to play this expected higher move in oil? The best way is to buy outright futures in WTI, and just roll these over each month. You never know when oil will spike, I have been doing this too long, and futures markets move at some of the least expected times, in extended hours, Fridays, in the midst of 10 million inventory builds which happened last year. The point is with the oil markets you just never know. The big players could be buying right now, and building a huge position. After all, in yesterday’s oil trading there were over 600,000 contracts trading hands on the Globex exchange Tuesday with over 1 million in estimated total volume at settlement.

Consequently somebody sure is buying, while everyone and their brother is selling the futures market in oil. Trading volumes have been well above average for the WTI contract to start this trading year. Thus from a positional trade standpoint you just want to be in the trade if you think it is a good long term value, and be able to stay in the trade.

Trade Scale & Sizing

Here is what I propose with a minimum $400,000 account and just scale up accordingly. Buy 8 futures contracts per $400,000 at the current price, and assuming oil goes down to $22 a barrel – the downside risk is 8x$1000x$8 from current $30 price= $64,000 drawdown. First upside target is $52 a barrel which is $22 higher than the $30 a barrel entry price for the trade setup. Given this scenario playing out we have 8 contracts at $1000 each point up or dollar move up in the oil price, so 8x$1000x$22=$176,000 profit on the trade minus rolling associated costs. Hence the risk reward profile is $64,000/$176,000 or for every 1 unit of Risk, the trade setup nets 2.75 units of Reward. This is a decent ratio, and can go much high through trade management if the market really starts moving your way.

Most Likely Trade Catalyst: Drop in U.S. Production

And the most certain and easy way for the trade to move your way is a reduction in U.S. Production, and the greater the drop in U.S. Production the greater the upside profit potential there is on the trade. The beauty of the trade is that the lower it goes against you, the better longer term it is for your position to the upside. Secondly, there is some kind of floor, even if its $15 a barrel, which I would welcome if I was in the trade which is only an additional $56,000 worth of heat on the trade from the $22 a barrel price level, and yes you can stay in this trade with a small $400,000 account, and not be at risk of margin liquidations on the trade. This would put your total downside exposure at $120,000 at the $15 a price level which is about a 30% drawdown, which seems like a lot until you factor in what you’re your profit percentage is on the trade when the market does rebalance and rationalize to the economics of more normalized oil economics. Shale cannot stay in business at $15 a barrel, price is not staying there long before the market economics play out and rebalance the supply market – it just is how economics work.

Cannot be afraid of Risk – Go be a School Teacher

Now if oil goes to $2 a barrel, ok I am just going to lose a lot of money on the trade. It happens and every single market asset has some sort of risk involved in it, and often proportional to the rewards to the upside if the trade breaks in your favor. There is no such thing as risk free trading, as even the so called risk free trading strategies have opportunity risks associated with them. The bottom line is that you cannot be afraid of risk in financial markets or you’re in the wrong business – investment and trading by definition involves risk. Trust me there is going to be a major move up in oil sometime this year, and large position traders are going to make the most money on the trade. They are identifying their levels right now.

Conclusion

Thus, I like that basic 8 futures contracts per $400,000 account sizing, and just scale up according to account size. If the reader doesn`t have $400,000, access to futures trading, or just doesn`t want the stress of a futures drawdown, then the USO ETF is the next best option for playing this expected rebalancing in the oil market as supply rationalizes with a much lower price than most of these shale projects budgeted for their operations. There is no way these shale projects and operations got into the game for $30 oil prices, there just isn`t enough profit at these levels to justify producing over the long term. Either prices rise or they go out of business, and it is probably a combination of both playing out in the oil market over the next six months.

Therefore this is the trade setup that I have configured to take advantage of the current price dynamics in the oil market. In effect, oil prices are so low it offers up a long term call option on the commodity. Sure prices may go $10 lower, but this is a trading expense similar to premium paid on options dated into the future, and as opposed to options, your futures contracts are never going to expire worthless, you just continue to roll them over each month until you ultimately close out the trade. I like the strategy, it meets my risk profile, is supported by economic theory, and actually benefits from the market going against me in the short term. The downside is that it may require a certain level of rationality in the market that just isn`t there, and I could be forced to be more patient than forecast which means capital is tied up with lost opportunity costs associated with it.