Oil Prices: What Should Investors Expect to See This Week

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April 27, 2020 12:08pm NYSE:USO

NYSE:USO | News, Ratings, and Charts

 

  • Brent is different than WTI- Landlocked Oil
  • The May NYMEX contract taught us a lesson for options risk
  • June- wild swings likely- the upside would be the biggest shock

 

Crude oil was the first shoe to drop in markets as the price of the energy commodity reached its high for 2020 on January 8 and began to decline. After trading at $65.65, the price was already down below $55 on February 19, the day the stock market hit its record high. The outbreak of Coronavirus and OPEC’s decision to flood the market with the energy commodity pushed crude oil down to below $20 per barrel in March, exacerbating selling in the stock market.

The agreement between OPEC, Russia, and other leading oil-producing nations to cut production by 9.7 million barrels per day did nothing to balance the fundamental equation for the energy commodity in an environment of plunging demand. Last week, crude oil was in the headlines as the price of the expiring May contract drew the chart line down to a low of negative $40.32 per barrel.  With storage at capacity levels, there is nowhere left to put crude oil, which has become a bearish hot potato. On April 21, the day after May futures fell into negative territory for the first time in modern history, June crude oil traded down to a low of $6.50 per barrel. The previous day, even though the May contract fell to under negative $40, the June futures only reached a low of $20.19. The carnage shifted from May to the new active month futures contract on April 21. On Friday, April 24, the price of June futures recovered to around the $17 per barrel level.

We should expect wild price action in the oil market to continue. The United States Oil Fund (USO) and the United States Brent Oil Fund (BNO) replicate the price action in the actively traded futures contract. USO had already rolled its risk from May to the June and July contracts by April 20, which prevented the ETF from imploding.

Brent is different than WTI- Landlocked Oil

The now active month June futures contract on NYMEX experience a week of unprecedented price variance.

(Source: CQG)

The daily chart illustrates that the price traded in a range from $6.50 to $24.92 per barrel and wound up just above the midpoint of its trading range at the $17 level on Friday, April 24. Daily historical volatility was at over 237% after the $18.42 per barrel trading range.  

(Source: CQG)

Meanwhile, the other pricing benchmark, Brent crude oil, traded in a range from $16.00 to $28.24 per barrel last week and was trading at around the $21.85 level, just below the midpoint of the week’s trading band. The range from low to high was $12.24 in Brent crude oil, over $6 per barrel narrower than the NYMEX WTI futures.

The reason for the narrower spread in Brent is that it is the pricing mechanism for two-thirds of the world’s petroleum and is a seaborne crude oil.  West Texas Intermediate is a landlocked crude oil. Therefore, there are many more storage options for Brent than WTI. With storage at capacity in the US, the spread in Brent was narrower, and the lack of options for storage as May WTI futures contract expired caused it to drop into negative territory and June futures to fall to the low of $6.50 per barrel, $9.50 below the low in June Brent futures.

The May NYMEX contract taught us a lesson for options risk

One of the many lessons that the price action in the May WTI futures market taught market participants is that the risk-reward profile for a put option is not limited to zero. The potential profit for a market participant holding a long put option is not limited to a zero price. When it comes to risk, there is no implied put at zero, and anyone holding a short put position could lose a lot more than the difference between the strike price and zero.

The unprecedented move to negative $40.32 per barrel in the May WTI crude oil futures contract likely caused many option traders, and those managing leveraged ETF and ETN products to adjust their models to allow for below zero values.

June- wild swings likely- the upside would be the biggest shock

The unprecedented price volatility in the oil market is far from over as the impact of Coronavirus and a self-induced coma in the global economy has caused demand to drop dramatically. The move by OPEC, Russia, and other oil-producing nations to cut production by 9.7 million barrels per day fell far short of the supply reduction necessary to balance supply and demand. The price action last week told us that an output cut triple that level or more would be required to offset the current level of demand.

Meanwhile, the price action taught us not to take anything for granted on the downside, but the potential for a dramatic spike to the upside remains a clear and present danger for the oil market. The Middle East is the home to over half the world’s oil reserves. Tensions between the US and Iran in the region have not disappeared, and last week the two sides were trading threats.

(Source: Twitter)

On April 22, US President Trump issued a warning to the Iranians that could lead to hostilities over the coming days, weeks, or months. Any actions that interfere with the flow of petroleum from the Middle East to consumers around the world could cause a dramatic move to the upside after the unprecedented move lower on April 20. Moreover, with the market’s sentiment bearish and reeling after the move to under negative $40 per barrel, the trajectory of a price spike to the upside could be far more dramatic than in early January when the faceoff between the US and Iran sent nearby WTI and Brent futures to highs of $65.65 and $71.99 per barrel, respectively.

It is not a time to be complacent in the crude oil market. The weakest demand in history and rumblings in the Middle East is a prescription for continued price variance. Last week, inventories in the US rose by 13.226 million and 15 million barrels according to the API and EIA for the week ending on April 17. However, daily US output dropped to 12.2 million barrels per day. The number of rigs operating was at the lowest level since July 2016 at the end of last week, according to Baker Hughes.

Expect lots of volatility in the oil markets and expect the unexpected.

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The United States Oil Fund LP (USO) was trading at $2.13 per share on Monday morning, down $0.44 (-17.12%). Year-to-date, USO has declined -82.26%, versus a 7.99% rise in the benchmark S&P 500 index during the same period.

USO currently has an ETF Daily News SMART Grade of F (Strong Sell), and is ranked #65 of 109 ETFs in the Commodity ETFs category.


About the Author: Andrew Hecht

andrew-hechtAndrew Hecht is a sought-after commodity and futures trader, an options expert and analyst. He is a top ranked author on Seeking Alpha in various categories. Andy spent nearly 35 years on Wall Street, including two decades on the trading desk of Phillip Brothers, which became Salomon Brothers and ultimately part of Citigroup. Over the past decades, he has researched, structured and executed some of the largest trades ever made, involving massive quantities of precious metals and bulk commodities. Aside from contributing to a variety of sites, Andy is the Editor-in-Chief at Option Hotline.


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