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Executive summary

In this report, Rich Excell looks at market forces impacting crude oil supply and demand to help formulate a trade strategy around WTI volatility.

In March 2023 we will mark the 40th anniversary of the WTI contract. This contract has become a bellwether and the benchmark future for getting a quick gauge of global economic activity. One can see the increased volatility in the contract over the last 20 years vs. the first 20 years. As I write this today, the price sits in the mid-70s, which is just above the average price we have seen over the 20 years. This level is near the lows of the last one year, which saw a move from 85 to 130 and back down to 70.

Image 1: Monthly chart of Crude futures

In the last half of 2022, a big driver of the performance of crude came from the release of the Strategic Petroleum Reserve (SPR). The Biden Administration released 180 million barrels between April and November of last year. This release was meant to offset the loss of Russian supply from the market and aimed at helping consumers struggling with inflation. Just when the market was thinking the Administration may begin refilling the SPR below $80, the Administration has authorized a further release of 26 mm barrels. We can see that the level of the SPR is now projected to go from the current 372 million barrels down to 346 million barrels, a 40-year low and a level last seen when the WTI contracts first began.

Image 2: Strategic Petroleum Reserve through time

Trying to counteract some of this pressure, OPEC+ met in October of last year and agreed to cut output by two million barrels per day from November 2022 all through 2023.

Two weeks ago, OPEC released a press release reaffirming the schedule to cut output this year saying:

“The Committee reviewed the crude oil production data for the months of November and December 2022 and noted the overall conformity for participating OPEC and non-OPEC countries of the Declaration of Cooperation (DoC).

The members of the Joint Ministerial Monitoring Committee (JMMC) reaffirmed their commitment to the DoC which extends to the end of 2023 as agreed in the 33rd OPEC and non-OPEC Ministerial Meeting (ONOMM) on 5th of October 2022, and urged all participating countries to achieve full conformity and adhere to the compensation mechanism.”

Image 3: OPEC press release on February 1, 2023

These different moving parts are leading to changes in the supply and demand outlook for product. I have created a custom index that looks at the difference between EIA supply and demand. I have noticed through time that when this imbalance gets to be more than 2% or about two million barrels a day, we see an impact on price. I have circled those times in green and shown the direction of price with the arrows. The increase in supply from U.S. fracking caused the downtrend in price from 2014-2016. This moved to a demand excess in 2017-2018 that saw a recovery in price. After the Covid-19 exogenous shock caused a dramatic plunge in demand and price, we saw the excess demand of late 2020 all the way through early 2022 led to a recovery in prices. Now, with major releases from the SPR bringing in excess supply, the market is again below the 2% threshold. Will we see the reaction in prices to the downside then?

Image 4: EIA Global supply vs. demand compared to CL1 futures

Complicating the supply and demand outlook is the potential for a strong re-opening in China, which is one of the biggest commodity importers in the world. The recent China PMI moved back above the 50 threshold which is typically seen as the expansion/contraction level. While it has been volatile the past few years, there is some hope that a re-opening and economic recovery in China will lead to more demand that may help support WTI prices in the U.S.

Image 5: China PMI

However, the picture in China is far from clear. While the PMI is a good measure of economic activity, there are many other measures that market watchers prefer because they may give a better picture. The blue line is the Li Keqiang Index, named for the outgoing Premier of China, and is based on what the Premier himself feels are the best measures of growth – rail freight, bank lending, and electricity consumption. You can see that it has not yet given the all-clear that we will see stronger activity. In addition, the yellow line is the Bloomberg Chinese Credit Impulse, which is measuring the demand and supply of lending activity in the country. It will lead economic activity and it is still heading lower. Finally, the orange line is the hot rolled coil steel price, which has perked up a bit but remains far from a strong indication of better economic times ahead.

Image 6: Chinese economic activity: Credit Impulse, steel prices, and Li Keqiang Index

As a result of the increased supply and inconsistent view on potential demand growth, oil prices have been under pressure. We can see from the daily Ichimoku Chart that the price has struggled to get above the cloud – the region where the majority of traders are long or short from. This waterfall like decline from $120 down to $75 would seem to suggest the bears are still in control of this tape. It would take a strong move above $82 to clear this zone and re-establish control for the bulls.

Image 7: Daily Ichimoku Cloud Chart for CL1 futures

Trying to assess how I should think about this set up with options, the first place I usually turn is the CVOL tool to get an idea of whether implied volatility is largely inexpensive or expensive. In WTI, the recent level of about 38 is very close to the lowest levels of the past year, suggesting I might want to consider being on the long side of an options trade.

Image 8: CME Group CVOL tool

Next, I like to look at the skew in the market to potentially get an idea for where the more nervous side of the market may be. What I see in the chart below is not only the implied volatility premium for downside strikes, but the implied volatility discount in upside strikes. This may seem to suggest option collars were put on either to protect speculative long futures positions or from a corporate hedging perspective.

Image 9: WTI April implied volatility skew

I want to be long gamma and vega because there are many potential events that will add to the supply and demand outlook. The biggest potential for change would be on the Chinese economic activity, but U.S. and EU economic activity has held up better than expected through the winter. Will that continue? The market has been consolidating and has the potential to resolve this consolidation in either direction, which is another reason I like being long gamma. Finally, implied volatility is near a one year low and so I am not paying elevated prices. Instead of buying a straddle, I have bought a strangle to reduce the premium outlay. This also allows me to take advantage of lower implied volatility for upside strikes. By skewing my strikes slightly to the upside, I have started with a slight negative delta bias. With the future near 77, my downside breakeven is near 72 and my upside breakeven is about 84. I think if futures can move above and hold the 82 level, that would be a breakout, which would see it move past my breakeven. However, I am fully cognizant that the supply and demand picture, as well as options activity, is pointing lower.

One can tell from the breakeven graphs that the sooner a move happens, the better I am. The closer the expiration, the deeper my graph gets, showing the time decay that would have accumulated at that point. Getting long gamma is not for everyone and requires the trader to watch and manage the position actively. However, when there is a consolidating pattern with many supply and demand catalysts, it can prove to be a reward potential opportunity.

Image 10: Expected return and breakeven for an April 76-79 strangle

As the volatility of the market begins to reduce and futures prices consolidate around a level, we can often see implied volatility lowered to reflect the difficulty in making back the daily time decay. If a trader can spot the possibility that there are catalysts or events that can potentially lead to higher future volatility (e.g., technical breakout/breakdown from a pattern, geopolitical catalysts, economic catalysts) one may be able to benefit by adding long convexity to the portfolio. A trader may want to look at this from a breakeven perspective or from the perspective of trying to buy low implied volatility with the hope of selling it higher. It may not be a strategy for everyone, but convex positions like long straddles can be successful tactical additions to one’s portfolio.

Good luck trading.

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