Executive summary

Given the recent headlines about the supply and demand of oil, Rich uses WTI Crude Oil weekly options to express a directional view that could benefit from an upside move and provide protection on the downside.

Image 1: Headlines on the fire in Mexico’s Cantarell field

There are no shortage of headlines impacting the daily discourse on the supply vs. demand discussion. Has OPEC+ cut enough? Will the U.S. continue to drawdown the SPR? What about China demand and Russian supply? What is the North American rig count telling us? These questions can get quite confusing and daunting for traders. After seeing the Reuters headline about Mexico’s Pemex losing 100,000 barrels per day of crude this month after fire, I had to explore further. I found that the Mexican oil output is decaying slowly not just because of the fire’s output loss but also due to the lack of energy sector expertise.

Are OPEC+ cuts enough?

Below is an exert from Moneycontrol’s “Production cuts by OPEC+ may keep crude oil prices high: Reliance” article published on July 24, 2023:

Reliance Industries Limited (RIL) stated that voluntary oil production cuts by Organisation of Petroleum Exporting Countries and its allies (OPEC+) might keep crude prices elevated and impact demand. “Other factors to impact demand could be higher inflation [and] higher supply from China.” RIL CFO V Srikanth said. In May, OPEC+ had cut oil production by 1.6 million barrels/day for 2023.

It is not just the reduction in supply from Mexico that is the topic. The big questions seem to be whether OPEC+ has cut enough, whether the OPEC partners will stick to these cuts, and whether this will make a difference if demand falls. Now traders and industry experts are discussing whether there have been enough cuts to support the price of oil. 

Image 3: IEA World oil consumption and supply

The price of oil is affected when the supply and demand difference goes beyond the 2% band (white line) of over or under supply. The current rate is 0.677%, showing improvement from last fall, but supply cuts are still insufficient to raise oil prices relative to demand. In fact, the aggregate supply (orange line) shows minimal change from last summer to now. The differential that has provided support to the price comes from the demand (blue line), which is not only not falling as many expected, but is now breaking out above pre-Covid levels.

Image 4: China crude oil demand

The demand in China is rapidly increasing, as shown in the graph above. The most recent reading is the highest in several years. Despite some fluctuations on a monthly basis, I believe the trend in demand throughout this year suggests higher, not lower, demand.

Image 5: Demand for U.S. crude from Asia

It is not just China buying Russian oil either. There is demand for U.S. crude from other parts of Asia. While the most recent reading was not as large as this past April, there still appears to be a strong, steady demand coming from that part of the world.

Summary of global oil demand and supply data

Below is an exert from Rory Johnston’s analysis from the Commodity Context on July 21, 2023:

Flat Prices rose a dollar per barrel to around $81/bbl trying their best to finally consolidate above $81/bbl before exploring the rest of early-2023’s price range.

Calendar Spreads were uninspiring, moving more-or-less inline with flat prices, but they did end the week less backwardated on both a prompt and Dec23/Dec24 basis; prompt WTI spreads are now trading steeper than Brent.

Inventories data were modestly yet consistently bullish with draws across all major tracked hubs; inventories in Singapore, in particular, are getting quite low as the rapid depletion of light distillate stocks pushes overall volumes to the very bottom of their typical seasonal range.

Refined Products outperformed crude, with both gasoline and diesel crack spreads gaining about $5/bbl in New York Harbor as global product invitatories continue to ease.

Positioning data revealed that speculators were small net-buyers of crude, with the biggest move coming between benchmarks as speculative length Brent and dove into WTI, with the net spec position not at ~7.3% of total open interest, positioning doesn’t present any clear directional risk to current prices.

In his inventories analysis, he highlighted that the data was “modestly yet consistently bullish across all major tracked hubs,” with Singapore’s inventory particularly low. This reinforces the demand for oil from Asia and suggests that demand remains strong, with only modest cuts potentially needed to support prices. 

Image 6: U.S. Strategic Petroleum Reserve

Regarding the supply side, while the U.S. says it’s buying oil to refill the SPR and has been awarded contracts, the oil hasn’t reached the SPR yet. Some oil is scheduled to arrive in August, and additional quantities are expected in September. The biggest bearish piece that shifted the supply/demand balance in late 2022 may be starting to diminish.

Image 7: North American rig count and oil price four months out

The North American rig count is another crucial factor in the supply puzzle. As we are in earnings season, the commentary from oil services firms is about the falling rig count. This count (white line) tends to lag and follows the recent decline in oil prices, indicating a potential further decrease. This would likely reduce supply in North America and lend support to the price of oil. We may already be seeing this impact in the front-month crude oil contract, which has risen in recent weeks.

Image 8: Daily Ichimoku Cloud chart for the active front-month WTI contract

This recent rally in crude has led the short-term crude contract to breakout above the Ichimoku Cloud. We can see the MACD turning higher further adding to the bullish story. In addition, the RSI in the lower panel appears to show no signs of being overbought. While the cloud trend are still very flat, which suggests there is no medium-term bullish impulse, the short-term view looks positive.

Image 9: Daily candle chart for generic front-month crude

Those who may be inclined to fade this move will likely point out that the futures have yet to break above the 200-day moving average. I use the 252-day, which represents one year of trading, but the level just below $80 is essentially in the same place. I believe only when and if we move above this moving average, some traders will be convinced that we may be on the cusp of a bigger move higher.

Image 10: Commitment of Traders report for WTI

We see in the graph above that managed money seems to be sensing a bigger move higher as the recent Commitment of Traders reports show an increase in the net positioning that is coming from managed money accounts. This indicates that professional traders are starting to sense a bigger move higher and are positioning for it.

Image 11: CVOL chart for energy products

As we sit at or near the one-year lows for the CVOL in all products, a quick look at the CVOL chart for all energy products shows us that implied volatility is inexpensive across the board. In particular, WTI has low volatility relative to other products and relative to its history.

Image 12: WTI CVOL, UpVar, DownVar, and Skew

Digging into the numbers a bit, in the graph above I look at the CVOL level relative to the underlying. I also look at UpVar, DownVar, and the difference between them (Skew) to see where traders’ preference for convexity is at. I can see that as the underlying price has materially corrected since the summer of last year, not only has overall volatility come under pressure, but so has both the demand for convexity in either direction or also the skew in the market. Skew shot up sharply in early 2022 when prices moved rapidly higher. It hit a difference of greater than 30. Right now, the skew is zero if not even negative in some cases. This suggests to me that upside options look relatively inexpensive.

Image 13: QuikStrike volatility matrix for WTI options

Next, I go to the QuikStrike volatility matrix so I can see how the skew looks in different expirations, but also how the term structure looks across expirations. I can see that the very short-dated options have a slightly higher implied volatility, but then the curve gets very flat quickly. In addition, I can see that the skew is steepest (favoring puts, not calls) the further out one goes (December or into next year). If I wanted to do a pure skew trade, where I took advantage of the preference for puts over calls, this is where I would look to do my trade, as these options have more vega thus the impact to trading the skew would be more important. However, I can also use this inexpensive skew to express a directional view using weekly options. This directional view with options should give me the opportunity to put on a more favorable reward to risk idea than the futures themselves.

Image 14: Volatility by strike for LO2Q23 weekly options

Looking at the matrix, I focus on the weekly options that expire on Friday, August 11. CME Group recently launched Monday and Wednesday Weekly options, providing more opportunities for traders to customize their option strategy to the exact date and strikes that fit their portfolio and their view the best. Looking at the Friday weeklies, what stands out is the discount to the at-the-money options I get in the upside strikes, while the downside still has a slight premium. Mentioned earlier, overall volatility was on the low end relative to other products and to their own history, so I have a bias to lean long optionality, but this helps me decide where I might want to position.

Image 15: Expected return for short 1 LO2QU3 75 call vs. long 3 LO2QU3 81 calls

Thinking of how I wanted to structure my idea, I wanted to focus on three things. First, I wanted to lean long optionality overall given the relatively low levels. Second, I wanted leverage to a move higher, so I wanted to be long upside options, not only for direction, but also because I feel that on a move higher implied volatility for the upside strikes will tick higher. From a trading standpoint I can win from both the directional move in futures as well as the directional move in volatility. Third, I wanted some protection in case futures run into the 200-day moving average and are rejected. Without any imminent catalysts outside of company earnings reports, there is enough uncertainty that I want to be protected in case my view is wrong. 

Then I decided to sell an in-the-money call option where the volatility was higher. I chose the 75 calls with an implied volatility of almost 33. I was then able to deploy the proceeds to buy three times the number of 81 calls that trade at an implied volatility of less than 31. I am long upside skew and long delta. The biggest gains for me will come if the futures, which is currently at 78 and change,  moves above 83.50 where my upside breakeven is. However, if the move happens quickly, I can gain from a mark-to-market basis, at least over the next week and a half. The risk to the idea comes if there is a slow drift higher and theta, or time decay, starts to kick in. We can see that in a couple weeks, at higher prices, I could start to lose on this idea. Thus, this is an instant gratification idea, and if we do not get a move in the short-term, I may want to look to trade out of the idea. 

The nice thing about this idea relative to futures is on the downside, but because I take in premium net when I do the trade (100 ticks), I will also make money on any move below 76. Therefore, if futures reject the 200-day moving average and move a couple handles lower from the current level, I can still make money on my idea. I have leverage to a sharp upside move and protection on the downside. My enemy then becomes Inactivity or the failure to make a move in either direction in the near-term. When anyone is long optionally, particularly in short-dated options, it becomes a risk. 

The flexibility afforded to traders with the weekly options that have been on the board, as well as the new Monday and Wednesday weeklies, allow traders to position for catalysts that are on the horizon – earnings commentary, Chinese economic data, and U.S. government press conferences. The flexibility of weekly options plus a thoughtful look at what the market is pricing in can give a trader a potentially more appealing reward to risk idea that can help improve overall performance. That is the beauty of the options market. 

Stay Vigilant and good luck trading! 

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