(July 7, 2005) I admit to receiving many calls from subscribers concerning our laddered up crude oil call ratio spreads that have all gone into the money. With eight days until expiration and current volatility, anything can happen. The British subway bombing imploded overnight prices with crude dropping as much as $3 in some markets. By the U.S. opening bell, prices recovered $2.50 and more, but we can see that the propensity for overreaction is a market that has questionable underpinnings.
While flipping between Neil Cavuto on Fox News and Lou Dobbs on CNN, the oil market analysis was virtually identical..."situation tightening, no relief in sight." Neil did raise the question, "If everyone is bullish, isn't there a bear market potential?" My quote is extrapolated from memory, but the gist is the same. We saw the price vulnerability last night and may very well see it before options expire (we hope).
In the meantime, panic is not in order because August, at approximately $60/bbl., is essentially a breakeven after collecting premium. The problem with panic attacks stems from brokerage statements that mark the net ratio spreads to the market without expiration consideration. This tends to overstate losses and increases daily account balance volatility. Hence, I can understand why someone might panic when his statement shows a $12,000 loss, where a breakeven exists upon expiration.
So far, I have heard the explanations given by more than a dozen brokers and it frightens me! If the CFTC and NFA believe their testing is qualifying brokers, they should think again. First, virtually all the calls I received resulted from broker misinterpretation. Second, if the ethics course is to achieve any positive results, it should warn brokers not to panic customers for the sake of a commission. One broker simply stated, "The statement is what it is. I think you need to get out now!"
The math is relatively simple. We bought one August 55 call and sold two 56's. Bought one 57, selling two 58's. Bought one 59, selling two 60's. Obviously, prices blew through all the strikes. So we made 100 points from 55 to 56 on the long 55 call. Made 100 on the 57 call. Made 100 on the 59 call. That's 300 points against which we lost 100 on the short put from 56 to 57, lost 200 on the two short puts from 58 to 59, and lost 300 from 59 to 60 for a total of 600 points, when and if futures expire at 6000. Our net loss is 300 points against which we collected 85, 95, and 115 points in premium, adding to 295 points. Thus, we are out a net 5 points upon expiration based upon yesterday's numbers.
There are some who might argue that we would have been better off selling the outright spreads rather than the ratios. However, the values of the in-the-money calls would have been twice that of the secondary puts. Ratio spreads are a cautious way of playing a particular market bias. Consider that a $1 correction in August crude takes the last put out of the money while leaving the 100 points or less made on the long 59 call. Clearly, if all we were after was the premium, we could have used credit spreads (selling the near and buying the far for protection). Alternatively, we might have done put ratios on the way had we sufficient time.
Examining the fundamentals, the API and government reports showed moderate crude inventory declines up to 3.1 million barrels. This must be offset by the prior increase of more than 1 million barrels. Overall, we remain at a net accumulation. Gasoline consumption is allegedly up, but the statistics are seasonally skewed due to the better weather over the 4th of July weekend...particularly in the Northeast where the greatest usage was recorded. Virtually everyone is bullish and, as Neil Cavuto pointed out, this makes the market extremely tentative as we move beyond $60.
Several months ago, I called attention to the fact that oil in excess of $60 was politically dangerous. Whether you believe the Democrat contention that President Bush is allowing oil to rise so he can foist his energy policy upon Congress--or not, a price above $60 begins to have serious implications at the gasoline pumps and as we approach the heating oil season. This represents a big pop in inflation and a potential drag on the economy. Even Saudi Arabia is becoming concerned that unchecked prices could precipitate a huge conservation response coupled with major alternative energy programs. Once these movements get underway, it is difficult to slow momentum.
Unquestionably, President Clinton's solicitation of Detroit votes during his first and second terms, damaged his very own policy of energy conservation when he fought against the gas-guzzler tax and allowed the fleet mileage standards (CAFÉ) to remain static. Given the demographics reflected by the 2000 Census, we see that timing could not have been more perfect for the rise of the SUV, as Baby Boomers passed through the last phases of moving children from place to place.
The "Next" generation is being wooed by Japanese auto makers with models like the Honda Element and Toyota's Scion. These smaller, cheaper, and versatile vehicles achieve almost 300% better efficiency than even the smaller American SUV models. There is no lying in the numbers. GM and Ford are struggling with their employee discount offer to the general public, while the Lexus hybrid LS300 SUV has a 6-month waiting list at a 40% price premium to most comparable U.S. models. The Toyota Highlander hybrid was released in July and I took delivery of one for my wife after being on the pre-waiting list since December! It is more expensive than the gasoline counterpart and the savings in gasoline are not likely to make up for this price difference before my wife requests another upgrade. It is the convenience of running on a single tank for more than 600 miles that makes the hybrid appealing.
My point is that history proves how quickly we adapt and adopt new technology. From the move away from vinyl records to CD's and the switch from film to digital cameras...from the introduction of Lee Iacocca's K car in the 1970's to the SUV craze of today--we see that modern economic infrastructure has become extremely flexible and nimble. This means that a real conservation movement can change consumption patterns in half a decade. In fact, we could easily cut consumption by 20% within 2 years with simple changes. That, alone, stalls the consumption juggernaut.
I am the lone wolf who does not agree with the cry for $75 and $100 crude oil. Of course, it is not wise to park in front of a moving freight train.
The question is, "How bullish is this chart?" We see a breakout above 5600 in early June to begin the most recent upleg. Measuring from the 4900 low to the 5600 breakout is 700 points. Add 700 to 5600 and we see 6300 as a first objective. Failing to make that suggests an exhaustion whereas a breakout or consolidation at 6300 confirms a bull market remains in tact.
Some chartists may argue that we tested 5600 as support on June 30 with the 5590 low...close enough. The recovery and advance to today's 6210 high, lends confidence to the prospect of a move above 6300 and subsequent 6550 second goal. However, today's failure to sustain a recovery in light of the bullish inventory numbers and a continuing threat of hurricanes in the Gulf of Mexico provides a bearish alternative. A considerable number of longs were forced out of the market when brokers feared the worst based on overnight trading. Bulls sold the rally to take hard-earned money off the table. Essentially, they sold the bullish news. A dip below 5600 sets up a 5300 and 4900 test. If this happens, it is fair to assume a trading range will continue with a wide range from 4900 to 6000.
Crude oil has taken on the complexion of soybeans and corn during the summer when weather changes. Drought means up, rain means down. Admittedly, the reactions have become highly exaggerated by the levels of participation. Oil could easily soar $1 to $2 before expiration. But, if terror in the London subway coupled with declining inventories can't rally the cause, I am inclined to leave the current ratio spread positions. Of course, you can be generous to your broker and buy back short calls as they fall out of the money...just in case.
July 11, 2005
Philip Gotthelf
Commodity Futures Forecast
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