Before we provide our final thoughts prior to the OPEC meeting along with our trading/hedging idea, we thought we would first expend a small amount of energy on our soapbox. As we have discussed in the past, we and all of you that have been involved in the international petroleum industry for a while have had, with respect, to “dumb down” to a degree in observing, analyzing, and trading the paper oil market. We fully acknowledge there are a substantial number of hedge funds and CTAs who are serious students of the industry and create wealth for their investors. Fortunately, this group helps comprise our client base.
However, at the margin these days there are also a significant number of players who call themselves “hedge” funds but are merely playing with daddy’s money, and often their buying and selling can distort the market. While this often can provide hedging opportunities for our producer friends, sometimes it defies the imagination. Yesterday’s intraday oil price decline before the recovery was partially attributed to “risk off” selling due to the unfolding developments in Washington. Again, with respect, we doubt consumers will be driving less in response to the appointment of Mr. Mueller.
Back to reality. In our “OPEC Pre-Mortem, Part Un” we laid out some scenarios for the meeting outcomes, and at this juncture we are not inclined to amend our thoughts. While it would be nice to call the meeting outcome precisely and pontificate on our OPEC “guru” status, from a practical standpoint we would prefer to offer some risk-weighted ideas that can either make money or help avoid losing it. As we indicated in yesterday morning’s report, “as we all realize, however, the pre-meeting minister verbiage is likely to emerge before the 25th, and could even start this weekend, which is why we wish to provide our trading ideas tomorrow morning. Since they will involve NYMEX crude oil options, there is the risk that putting any positions on tomorrow may be adversely impacted by a few days of time decay. By the same token, as we have seen over the last couple days the possible, or even likely increase in volatility as we move toward the meeting may well offset any time decay”. Caveat emptor!
Giving it all our best guess, we would assign 20% odds of a bearish meeting outcome, 30% odds of a bullish meeting outcome, and 50% odds of a neutral meeting outcome. We would define bearish as the inability to agree on an extension of the current deal and everyone goes home. Our bullish outcome would be the bullish “tail” of the probability distribution previously discussed, i.e. Saudi Arabia cuts production by 5% if all others agree to freeze output at current levels. This would imply a more than 7% reduction in Saudi crude oil exports for the summer reflecting domestic refining and seasonal requirements for direct crude oil burning. Thus, we are willing to assign higher odds to a surprise bullish outcome than a bearish outcome. Our neutral outcome, although the market may take it as modestly constructive depending on where the market is prior to the meeting, would be an extension of the deal through the first quarter of next year as previously suggested by H.E. Khalid al-Falih and Russian energy minister Novak.
Putting this all together we would propose the following, with the number of contracts and timing of position initiation a function of your specific needs and/or risk profile, plus bearing in mind there are a number of alternative trading positions that could fit the bill. We would buy 1 July 47 put, buy 2 July 53 calls and sell 1 July 55 call. The net cost as of yesterday’s settlement, $49.66 per barrel and vols is $1.68 (before commissions). The market is moving today but the only “known” right now is yesterday’s close. Assuming for the moment that vols remain the same between now and, say, Tuesday, two days before the meeting, with July NYMEX crude at yesterday’s settlement the net cost (before commissions) would be $1.39, so one may wish to wait, unless vols in fact rise between now and then as discussed. If vols rise 2% between now and next Tuesday and the underlying remains constant, the net cost (before commissions) would rise to $1.58.
In any event, if the position is put on next Tuesday at the $1.39 net cost, if the meeting outcome is neutral and vols stay the same since they are much lower now than before last November’s meeting, the total loss on the trade (per one 47 put, two 53 calls and one 55 call) would be $193 before commissions, due purely to time decay between Tuesday and Friday. If the outcome is surprisingly bullish and the July contract jumps by $3.00 per barrel, one would make $840 on the trade, before commissions, despite the time decay. If the outcome is bearish and the market drops $2.00 per barrel, one would make $10 on the trade, before commissions. We believe the magnitude of the market move is skewed to the upside because few if any are assuming our bullish Saudi scenario. A probability-weighted outcome would yield a profit of about $158 before commissions. Obviously between now and next Tuesday NYMEX crude prices could be higher, lower, with vols higher, lower or unchanged with an endless possibility of combinations. We wanted to provide one example that made sense to us while illustrating where our biases lie.
Since we are dealing with options we would emphasize that if the meeting is a non-event the entire position should be closed out, with powder kept dry for the next move, if there is one. If the outcome is in fact one of simply extending the current deal through the first quarter, as we are seeing today the market may largely discount the outcome and subsequently “sell on the news”. A more aggressive pre-meeting positon with less adverse exposure to a drop in post-meeting vols would be to buy 1 July crude oil future and buy 2 July 47 puts. Once again, we would emphasize that our primary concern right now is the meeting outcome. Whether it will be the “correct” decision” from the consensus view of market balancing or in the context of our forecast global demand and supply outlook, the market will decide one way or another as we move through summer. Last November most funds and most of Wall Street thought OPEC made the right decision and they were dead wrong. Ludi incipient!