The Crude Oil Rally is Only Temporary: Here’s How to Profit
Crude oil traded sharply higher on Thursday thanks to a surprise drop in U.S. inventories. Unfortunately for energy bulls, this crude oil rally is likely to be just a temporary blip. Over the next few weeks, I expect oil prices to give back their gains and possibly test the lows hit at the beginning of last month.
The good news is that we can actually profit from a pullback following Thursday’s crude oil rally. Today, I want to talk about one particular trade you should consider for capitalizing on this situation.
Supply and Demand Dynamics for Crude Oil
Basic laws of supply and demand tell us that when there is an abundance of supply, prices naturally move lower. And when supplies drop, prices naturally rebound.
On Wednesday, the Energy Information Administration reported a 14.5 million barrel drop in U.S. crude oil inventories. This, in stark contrast to economist expectations for a 905,000 barrel increase.
On the surface, it makes sense that oil prices would trade higher on that news. After all, a surprisingly low inventory level should naturally lead to higher prices.
But the devil is in the details. And in this case, there is one big detail that needs to be considered.
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That detail is Hurricane Hermine which disrupted oil imports for the past week. According to Bill O’Grady (quoted in Bloomberg), imports dropped by 1.9 million barrels per day last week. This accounts for the majority of the difference between the expected inventory levels and what was actually reported.
Meanwhile, there are plenty of catalysts on the horizon that could dampen traders’ enthusiasm for oil
Potential Catalysts to Stall the Crude Oil Rally
While Thursday’s crude oil rally made headlines, there are three key reasons why I believe oil will trade lower over the next few weeks.
First, the majority of delayed imports will eventually find their way to the U.S.. Tanker ships avoided unloading imported oil during the storm. But those ships will likely deliver their crude oil over the next few weeks.
This will likely lead to an import increase over the next few weeks. Higher imports will naturally push inventories higher (and prices lower).
Second, Iran is likely to continue to increase crude oil production. The country is coming back online after the U.S. lifted sanctions on the country. Iran has stated its intention to reach production of 4 million barrels per day, which is what the country was producing before being sanctioned.
Today, Iran is producing near 3.8 million barrels per day (as reported by CNBC). As the country continues to add more production to the global oil market, prices will naturally come under pressure.
Finally, weakness in emerging markets could weigh heavily on crude oil. That’s because weak emerging market economies will use less fuel, hurting global demand for crude oil.
At the same time, many of these countries are net exporters of crude oil. This means that the countries must sell oil to meet their local budgets. With oil trading much lower than in previous years, these countries have more incentive to export as much oil as possible. That way they can increase revenue to pay for government services.
Here’s How to Profit From Crude Oil Trading Lower
If you believe (as I do) that the crude oil rally is only temporary, then you should consider a bear call spread to profit from a pullback.
Remember, a bear call spread involves selling one call contract and buying a second call contract for a lower price. We collect instant income from the difference in price between the two contracts, and our risk is always limited.
For a refresher on how these trades work, check out my writeup on bear call spreads here.
For this income opportunity, we’re going to use the United States Oil Fund (USO). This ETF trades on U.S. stock exchanges just like a normal stock. And USO tracks the price action of crude oil. USO closed on Thursday at $10.96
To set up a bear call spread on USO, I suggest entering these two trades simultaneously:
- Sell the USO October $11 calls near $0.52 per share
- Buy the USO October $12 calls near $0.19 per share
- You should receive a net credit near $0.33 per share
Remember, each option contract represents 100 shares. So if you enter this trade for a credit of $0.33, then you’ll receive $33 for each unit.
Also, remember that you can use your brokers spread trade platform to enter the trade. This way you’ll be able to get a fair price when you enter the trade.
Here’s What Can Happen…
Once you have entered the USO $11 / $12 bear call spread, there are three different ways the trade could turn out.
First, USO could remain below $11. If USO closes below $11 on October 21 when our calls expire, you’ll get to keep your income from the trade. Both of our call contracts will expire and they will disappear from your account.
This is the best scenario for our trade and the one that I think is most likely.
Second, USO could trade higher and close above $12. If this happens, you’ll still get to keep the $0.33 per share that you received from the spread trade. But you’ll be required to buy 100 shares of USO at $12, and sell them at $11.
This is the worst-case scenario for us. In this case, you’ll lose $1.00 per share (or $100 per contract). But that loss will be offset by the $33 per contract that you received when setting this trade up. In other words, your potential loss is capped at $67 per contract.
The third scenario would be if USO closed between $11 and $12.
If this were to happen, you would be required to sell 100 shares of USO at $11. Your broker would automatically borrow the shares and “sell them short” in your account.
Rather than letting this happen, I would advise closing the spread trade before October 21 if it looks like USO will hover between $11 and $12. You may be able to lock in a small profit – or a small loss – but this way you won’t be required to take a short position on USO.
I hope you’ll take this opportunity to profit from what should be a temporary crude oil rally.