Pavel Hála Pavel Hála

What strategy to choose for oil & gas in 2019

Crude oil is undergoing a bounce, but should remain under pressure for the rest of 2019…this is what we have predicted in the last issue of the Spread report our premium subscribers received on the New Year’s Eve.

Today, I will take a closer look at the situation in crude oil and also mention natural gas briefly. I will describe the fundamental or rather geopolitical forces behind this outlook and outline the strategies suitable for this environment.

 

Crude oil

We may get strong relief rallies like the one we witness right now. Nevertheless, the market has fundamentally changed and we don’t expect the bull market to resume anytime soon. Our key prediction is that oil will stay in contango for most of 2019 as this is the best indicator reflecting conditions in the physical market.

I think so because of these reasons:

  • Political system in the US – although rising oil price contributes positively to the overall US economy, the drilling is concentrated mainly in just two states (Texas and North Dakota). Economies of these states heavily depend on crude prices and they profit from high price. On the other hand, the rest of the states benefit from low oil prices. President Trump desperately needs to be reelected in 2020 and would put a great effort into keeping the oil price low. The electoral system in the US is based on federalist principle where each state elects the appropriate number of electors out of the total 538 members of the Electoral College which then elects the President. The voting system varies among the states. Most of the states, however, employs the majority voting system, meaning that winner in such a state takes all the electors. Because of this, the so-called swing states, where both republicans and democrats are head-to-head, usually decide the outcome of the elections. While Texas and North Dakota are deep red states and Trump will likely win there anyway, people in the swing states are sensitive to the oil price and rising oil and gasoline prices would hurt Trump in these states.
  • Trump’s leverage on the Saudis – Saudi king Salman and especially his powerful son, crown prince Muhammad bin Salman built their domestic political influence on the close alliance with Donald Trump. Although the succession to the throne is clearly set, it doesn’t automatically secure position of the future king. The Allegiance Council of the senior members of all the royal family branches plays a big role in the confirmation of new king. The murder of Jamal Khashoggi in Turkey greatly weakened the position of the crown prince. Despite his control of the armed forces, he can no longer be absolutely certain someone wouldn’t attempt to steal the throne from him after his father dies. The greatest threat seems to come from the sons of the previous king Abdullah. The US support can play a key role in such a delicate situation. President Trump has so far embraced Muhammad bin Salman and this support won’t come cheap. He has publicly pressured the kingdom to pump enough oil to prevent prices from rising too high.
  • Slowing global economy – significant slowdown of the global economy would most likely be the event that will push the oil into a bear market. And this is exactly the scenario we witness right now. Although the developed economies are still doing well, the emerging markets are already decelerating. In fact, the emerging markets were responsible for most of the growth in oil consumption over the years. Their weakness has therefore profound impact on the crude oil market.
  • Rising production – USA is the world’s largest crude oil producer and has recently become a net exporter. That’s an unbelievable change compared to the fundamentals (and sentiment) just a decade ago. Moreover, production in Saudi Arabia and Russia has also gone higher over the months. And the situation in Iraq and Libya has stabilized.

 

Every prediction has its risks and there is always an alternative scenario. My base case scenario can be threatened by:

  • War in the Middle East – any conflict in this part of the world would likely push the oil price much higher, as we have seen several times in the history. The greatest risk lies in the escalation between Israel an Hezbollah or the Iranian proxies in Syria. The second Lebanon war showed us how a miscalculation can lead to a full-blown war. Both Israel and Hezbollah publicly state they’re not interested in the war right now. On the other hand, they admit the war is not a matter of if but when.
  • Massive stimulus to the global economy – a 180° turn in the FED policy would be necessary. Just slowing down the pace of rate hikes wouldn’t be enough. I’m talking about reversing the rate outlook and ending the quantitative tightening. Such an aggressive change in the FED policy is very unlikely, especially in the short term. Another way would be a loose fiscal policy. However, there doesn’t seem to be enough political will in the US to pass another stimulus like Trump’s tax cut.
    The administration is unlikely to get it through Congress after the Democrats have taken control of the House. Such obstacles don’t exist in China. Nevertheless, the current path of gradually loosening monetary policy is a safer bet. Fiscal stimulus is unlikely due to the reduced marginal utility of any new debt which is common in heavily indebted economies.
  •  

    Natural gas

    I expect the volatility in NatGas to calm down at the end of winter. We may get some more upside till then. The $3.5 level looks certainly possible. The short term price action depends on the weather. Longer term, however, the strong production in the US will likely prevail and cause contango expansion. This makes bear spreads a suitable strategy for 2019.

     

    Strategic takeaway

    Futures bear spreads would likely work well in both oil & gas, especially in favorable seasonal or COT environment. It is also tempting to make use of high volatility for short strangles or naked put/call writing. However, make sure to properly understand the volatility environment. The truth is, credit option strategies are profitable in the periods of increased volatility, not the high volatility. That’s a subtle, but very important distinction.

    When the volatility becomes extremely high, it usually persists for some time. This phenomenon is known as volatility clustering. Although there are fat premiums in such times, the realized volatility may turn out to be even higher than the implied one. And that’s deadly for any credit strategies. A better idea is to sell options when the volatility increases in generally low or medium volatility regimes. In such a situation it will inevitably fall back from the elevated level sooner or later which would push credit strategies into profit. These events usually happen in corrections during major trends or in a sideways market.

3 articles you must read before you lose your trading account

Pavel Hála
Pavel Hála
Pavel is the founder and CEO of SpreadCharts.