A Simple Option Strategy for Trading Oil

Crude oil futures have been on the move, and if you’d like to get involved in this market, options enhance the variety of strategies you can employ, no matter which way the market is headed next. I think fundamental factors for oil look strong over the next few years, and I will outline a long-term trading strategy using options to take advantage of bullish trends.

The NYMEX January futures contract peaked just above $90 a barrel on Monday, December 13, 2010. I am extremely long-term bullish on oil and think there are further gains to come, although it might not be straight up.

Demand from Asia

Growing Asian demand for commodities has been a driving market force and doesn’t look to be slowing. China has been buying and hoarding commodities and is thirsty for oil. While China has been on the defensive lately as inflation has begun to accelerate, I don’t think they are going to stop needing oil anytime soon. The People’s Bank of China raised its key short-term interest rate in a surprise move in October, although it held rates steady at its most recent meeting in early December. According to a Chinese statistics bureau, consumer prices in China have risen 5.1% in November. Speculation that China will enact more tightening could create some short-term commodity corrections. However, China’s growth is an amazing story, and India and South America are growing their economies, too. More and more consumers are able to afford cars, which as of today, still rely primarily on oil.

Offshore Drilling Freeze

In the wake of the BP oil disaster, drilling in the Gulf of Mexico has been affected by a government freeze, which, if it stands, will impact production. The Department of Interior recently announced that new areas of the Atlantic and Pacific coasts, and Eastern Gulf of Mexico will no longer be considered for potential new lease sales and offshore oil drilling through 2017. What this ultimately does is increase our dependence on foreign oil.

As permits for rigs located in the US Gulf are not currently being renewed, some are relocating to foreign locations. The Energy Information Administration estimates that US output will be lowered by 170,000 barrels per day in 2011 as a result.

Quantitative Easing

The Federal Reserve has maintained easy monetary policy to try and get the US back on a growth track. Many analysts speculate the second wave of Chairman Bernanke’s quantitative easing regime (known as the US) has been monetizing debt for several years now, and Bernanke has said the Fed would do whatever it takes to get the economy growing again. As the largest consumer of oil, any pickup in US demand should be reflected in prices.

Technical Picture

Several commodity markets have seen similar action as crude oil from a technical perspective. We’ve seen higher highs and higher lows in silver, for example, which you can see on the chart below. Crude oil (top chart) has been coiling for some time, and we see a triangle pattern similar to the pattern seen in silver, which recently broke out to above $30 an ounce.

Oil may not see a strong breakout in such a short period of time, but in my view, the conditions look good for a move significantly higher in several months or a year. Geopolitical events often trigger strong emotional reactions in crude oil prices. I don’t know what the trigger will be—it could be Iran or North Korea or some other global crisis that creates political tensions.

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NEXT: A Potential Strategy for Trading Long-Term Oil Growth

Just the Facts

As mentioned, the US is the world’s largest consumer of crude oil, at 7.1 billion barrels per year. More than 50% is imported. Most of our foreign oil comes from Canada and Mexico. In Mexico, oil production had been nationalized, but now private companies have been given the green light to drill. Some say this action will cause a drop in oil prices, which could be the case. However, Mexico’s oil output has been dropping over the past ten years and the US and China still need more oil from other global sources. World demand is 31.3 billion barrels per year and growing, and roughly 80% of the world’s oil comes from just ten countries. Some of those countries are not friendly toward the US.

Estimates and Expectations

Some reputable firms and analysts have been putting out bullish oil targets for 2011 and 2012. JPMorgan Chase predicts oil will rise to $100 in 2011 and $120 in 2012. Goldman Sachs likewise expects oil to reach $100 next year, but is slightly more conservative for 2012, with an estimate of $110.

Auto demand is a driving force in oil use, as we still don’t have widespread use of alternative energy sources. In the US, there are 765 cars for every thousand people. In China, there are 17 cars per thousand people. In India, there are 12 cars for every thousand people. If China and India’s auto demand increases just by even a small amount, it could shock the oil market. Safety standards are lower in China and India than in the US, and therefore, manufacturers can cut prices dramatically to allow more citizens to afford small, inexpensive vehicles.

Global growth demand is expected to increase by 2% per year. In 2011, that equates to 88.7 barrels per day; in 2012, 90.5 million barrels per day; and in 2013, 92.3 million barrels per day. You can see the trend. The wild card in the growth picture is the US economy.

Trading Strategy

If you are looking to capitalize on long-term bullish oil trends without the need to monitor an outright futures position, you might want to consider an options strategy. This strategy allows you to stay in the position even if the market faces some corrections before the options expire.

Buy the December 2014 crude oil $115 call
Sell the December 2014 crude oil $125 call

This trade would cost approximately $1,900 (subject to change) plus commission costs. The risk-to-reward ratio looks attractive (4:1), and I think this is a good strategy for a long-term bullish investor who wishes to have a less expensive and/or lower-risk strategy than an outright futures position. These options expire on November 17, 2014.

Please feel free to contact me with any questions you have about the markets and to develop a customized trading and investing approach based on your unique goals and risk tolerance.

By Phil Streible of Lind-Waldock

Phil Streible is a Senior Market Strategist with Lind-Waldock. He can be reached at 800-803-8037 or via email pstreible@lind-waldock.com. Futures trading involves substantial risk of loss and is not suitable for all investors. Past performance is not necessarily indicative of future trading results. Trading advice is based on information taken from trade and statistical services and other sources which Lind-Waldock believes are reliable. We do not guarantee that such information is accurate or complete and it should not be relied upon as such. Trading advice reflects our good faith judgment at a specific time and is subject to change without notice. There is no guarantee that the advice we give will result in profitable trades. All trading decisions will be made by the account holder.