Report highlights

Rich Excell's latest report examines the impact of supply and demand on oil prices, focusing on the current market balance and potential disruptions from an early hurricane season. Rich looks at a short straddle with a butterfly spread as one possible scenario using WTI Crude Oil Weekly options.

EIA oil supply vs. demand overlaid with generic first WTI future

It goes without saying that all commodities are going to be impacted by the changing perception of supply and demand. However, I have always found two things when it comes to the oil market. First, consumption has trended higher over the last 20 years with the exception of drops during the Great Financial Crisis and Covid-19. Second, the changes in supply will tend to have more of an impact, particularly in the short term, for the price of oil. Unless, of course, we are in the midst of a bad recession. Given none of the data suggests we are in the midst of a bad recession, the focus on supply should be our key focus. To show you this visually, I have plotted the difference between supply and demand as measured by the EIA in white, then versus this difference, I plotted the generic first WTI futures. I have put bands around this at +/- 1.5%. We can see that when supply outstrips demand by more than 1.5% (i.e., the white line is falling) the price of oil is negatively impacted. Yet when supply is less than demand by 1.5%, the white line rises above the band, which means this is positive for oil prices. The impact of the extra supply coming from the draining of the U.S. SPR in 2023 is seen pressuring the price of oil. In 2024, there have been some concerns that supply would be disrupted by the various global conflicts, as well as concerns that OPEC+ would grow the amount produced. However, when all is said and done, I can see that supply and demand is largely in balance, which is why the futures price has largely been in a range this year.

Extreme weather events and the impact on price of oil

With that said, there can be exogenous shocks that impact the supply of oil in the short term. News in the past few days reports that we have the earliest ever Category 5 hurricane developing in the Atlantic, Hurricane Beryl, has added intrigue and uncertainty into the outlook for supply. This is about a month earlier than we typically see storms develop, which tends to happen in August. While this storm may not directly impact supply, the notion that we have had three measurable storms develop in June, instead of August, points to a potentially more active hurricane season this year, which has the risk of negatively impacting supplies in the Gulf of Mexico as we move throughout the year. This is uncertainty that traders will have to wrestle with, which has the potential to put upward pressure on prices.

Commitment of Traders report for WTI Crude Oil

Traders may already be positioning for this. The charts above show two different views from the Commitment of Traders reports that traders can find on CME Group’s website or via their QuikStrike tool. The top view looks at the positioning for managed money. Other than a brief spike at the end of last summer, this is the longest managed money has been of the oil complex since 2022. In the bottom picture, it shows the length across several different portions of the market, and I’ve plotted it versus the futures price. One can see that when managed money has been long, there have been moves higher in the price of oil, back in 2022, and briefly at the end of last summer. Is this set to be another period of higher prices in oil, forecasted by the length seen from managed money?

Generic front month WTI Ichimoku cloud chart

I now turn to technical analysis and assess what the chart patterns look like for the generic front month contract. My favorite is the Ichimoku cloud chart. In the top panel, it appears that futures prices are breaking above the cloud – the area at which bulls and bears have largely committed. I can see the cloud has been relatively horizontal, suggesting that bulls and bears are in a fight to establish dominance. However, prices are starting to break out to the upside, telling me that bulls might be establishing some control here. In addition, you can see the lagging span (red line) also breaking above the cloud. The lagging span is the measure of prices 26 periods in the past. When it breaks above the cloud, this suggests a new trend is developing. The middle panel is the MACD and here I see that the lines have crossed higher, and it is also pointing to a new trend higher. Finally, in the bottom panel there’s the RSI, which indicates that prices are not yet over-extended. All signs point to potentially positive price action, with the bulls in control, in spite of the fact that the market is clearly long.

CVOL for the Energy market (top) and the time series for WTI CVOL (bottom)

I next turn my attention to the volatility markets. For this I use the CVOL measures that I get from CME Group. The top panel gives me an overview of where implied volatility sits for all Energy products over the past three years. This gives me a sense of whether it is higher or low versus the past year, are traders more nervous or complacent, and if any one product stands out from the others. I don’t want to look at the full history because that will bring in periods like early 2022 where oil prices shot higher and implied volatility followed it. I can see that over the past year implied volatility is in the bottom half of readings, but it is still a fair bit from the lows that we have seen. This suggests that traders acknowledge we are in a bit of a range trade, but are not too complacent that we are not going to move again.  Now I look to the bottom panel for WTI CVOL, looking not only at the level of CVOL through time, but also the skew ratio, which is the upside variance divided by the downside variance. This measure of skew ratio gives me an indication for the directionality of option interest. Here, I see on the far right that the skew ratio has recently spiked higher, telling me there has been higher than normal relative demand for upside options vs. downside options. If I look back over the past few years, I can see that when we have these spikes in skew ratio, we actually subsequently see a move lower in the price of oil (dotted line). Does this mean that by the time we are seeing potentially levered bets on the upside of oil and all of this news is now in the price, there is nowhere to go but lower? I find this particularly interesting given the length that we see in the oil market from the COT data.

Implied volatility surface by delta for all expirations of CL options

The CVOL gives me a broad overview of the CL options market. However, to dig into the actual contracts I want to go to QuikStrike and look at the Vol Tools tab. From here I can click on the volatility surface and sort it by delta. This allows me to look at each expiration and assess where the options market is pricing one expiration vs. another expiration, and also where it is pricing calls and puts not only versus each other but also versus the at the money options. The first thing that comes clear to me is that the Weekly options in the CL market give a trader quite a few choices to narrow in their bet to particular periods. In fact, on July 22, CME Group will list Tuesday and Thursday WTI Weekly options, so traders will have an option that expires every day of the week. This increased flexibility will allow traders to pinpoint exactly, by expiration and strike, where they want to express their long or short directional or volatility view.

As I look at this grid, I notice that near the front part of the curve, call options are trading at a premium to put options and at the money options. However, as I look further out, implied volatility reverts to puts trading higher than both at-the-money and out-of-the money call options, and call options being the same, or even slightly lower than at the money. This suggests to me that there is some near-term exuberance for upside in the CL market, which we also saw in the skew ratio for CVOL and in the net positioning for Managed Money in the COT report. While the technical charts and potential supply disruptions sound bullish, is the market positioned for this already? Could this be a case of “buy the rumor, sell the news?”

Expected return and breakeven for LO2N4 weekly 81-82.5-84 iron butterfly

Putting this information together, I have decided that it might be a good idea to fade the move in CL futures. While the news looks bullish, we have seen before that if the market is too long in anticipation, it can end up being a non-event. There is potentially still some room lower in implied volatility, but since I am looking at shorter-dated weekly options, this becomes more of a breakeven play for me. Futures are at 83.40 and I am betting that futures will stay in a range or drift a bit lower as the market is too long in spite of bullish news. However, I want to make sure that I cover the tails of this short straddle position in case there is a breakout to the upside or in case the news changes materially and the length in the market is purged. So, while I sell a slightly downside 82.50 straddle, hoping futures move a little lower and sit, I decide to buy the 81-84 strangle to cover the wings and turn this idea into a butterfly. You can see that the maximum gain for this position is 1.23, which occurs at strike of 82.50. The maximum loss is limited to 0.27 which is the premium I take in (1.23) less the difference in strikes (81-82.50, 82.50-84 or 1.50). I have a defined reward to risk position of gain of 1.23 vs. loss of 0.27, a 4.55 to 1 bet that futures stay in a range or hopefully drift a little lower to my strike in the next 10 days. I have not looked further out for this bet because it is one that is focused on near-term length vs. news, and not on the actual developments of supply disruption, that would occur more as the events transpire. It is more about expectation vs. reality. The butterfly allows me to put on a defined reward to risk idea, which I always prefer but particularly prefer when we move into less liquidity holiday or summer markets, which we are seeing right now.

The flexibility of weekly, and soon daily, options on CL futures give the trader the ultimate flexibility to tailor make their trade to fit the exact timeframe for their view in my opinion. My viewpoint is that this extra nuance has the potential to aid a trader’s profitability in the longer-term.

Good luck trading!

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