Volume 8, Issue 25
Saudi Oil Summit
Trade selection using volatility as the primary criteria. Different trades for different volatility opportunities.
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The big event is scheduled to begin on Sunday June 22, 2008 in Jeddah, Saudi Arabia. No doubt there will be several opinions presented in an attempt to establish the reasons for the current high price of crude oil but there seems to be agreement among most of the participants that they share the common objective of lower crude oil prices. A number of recent events suggest that there may be a coordinated effort underway to lower crude oil prices and the Saudi Summit may mark the beginning of more coordinated actions designed to curb prices. Several emerging market countries including China have announced the lifting of subsidies that have precluded demand from falling as crude prices rose. The “London loophole” is being blamed for obfuscating the reporting relationship between speculators and commercials in the crude oil futures markets. The US Congress will debate these issues and legislative action seems likely to follow. The value of the US dollar and OPEC production levels will also be a part of the discussion.
This meeting looks like to beginning of a process that is likely to continue for several months and we think it is prudent to look once again at some hedges and/or shorts for the sector. In addition, we will offer some suggestions for the likely beneficiaries of greater crude oil production and lower crude oil cost. First a few brief comments about the markets.
Market Review
S&P 500 Index (SPX) 1317.93. The SPX closed lower on the week, now trading at about 16 times forward earnings. We expect the SPX to decline further reaching the downside-measuring objective at 1300 from the complex Head & Shoulders Top created by the May 19, 2008 high of 1440.24. This decline could be part of a larger bottoming pattern and with the expected decline back down to 1300 it would then have the look of a large Head & Shoulders Bottom.
The CBOE Volatility Index ( VIX) 22.87. With this week’s market decline the VIX turned higher and appears to be in an uptrend. The call open interest declined to 643K with the June options expiration diminishing the value of our 800K call open interest indicator.
The US Dollar Index (DX) 73.03. After closing above 74 last week the DX turned downward once again. Last week we established 75.50 as the operative measuring objective, but it looks as if it could continue to be one week up followed by one week down.
NYSE McClellan Summation Index. Our market breadth indicator also continued lower but at a slightly slower pace declining 179.94 points and ending the week, at –194.71 confirming the market weakness.
Strategy
If the Saudi Oil Summit marks the beginning of a concentrated and coordinated effort to bring down the current high price of crude oil as we suggest in the section above we should expect to see selling begin in the oil and gas sectors. If a decline in the crude oil price is conditioned upon an increase in production it will need to be transported and the ocean tanker group would be a beneficiary. Further the airline sector would see some relief from higher fuel prices. If the US dollar is part of the package then we could see wekness in other commodity-related groups that have benefited from the dollar weakness.
IVOLopps™
United States Oil. (USO) 109.14. This ETF seeks to reflect the performance of the spot price of West Texas Intermediate (WTI) light, sweet crude oil. The fund invests in futures contracts for WTI light, sweet crude oil, other types of crude oil, heating oil, gasoline, natural gas and other petroleum based-fuels that are traded on exchanges. It may also invest in other oil interests such as cash-settled options on oil futures contracts, forward contracts for oil, and OTC transactions that are based on the price of oil.
In IVolatility Trading Digest™ Volume 8, Issue 22, Contango, dated June 2, 2008 we suggested an October put ratio backspread for USO when it was priced at 103.06.
We now return with another suggestion for a potential decline in crude oil prices. The put open interest has risen from 300K contracts to 550K in the last three months while the put/call open interest ratio is 1.83. Put volume regularly exceeds call volume as USO is being used for hedging by the longs in crude oil. With the current Historical Volatility at 41.63 consider this bear put spread.
- Buy USO Oct 105 put IYSVA 9.20 IV 47.68 Delta -.3781
- Sell USO Oct 102 put IYSVX 7.85 IV 47.81 Delta .3383
Debit 1.35 Position net delta -.0398
The maximum value of the spread is 3 points and the 1.35 debit represents a reasonable and defined risk for a longer-term position.
UltraShort Oil & Gas ProShares. (DUG) 28.70. This ETF is the inverse of the long Ultra Oil & Gas ProShares (DIG) and will increase in value if the share prices of the companies that comprise the DJ US Oil and Gas Index decline. With a Historical Volatility of 46.31 consider this bull call spread as a hedge against long oil & gas positions.
In IVolatility Trading Digest™ Volume 8, Issue 21, Crude Oil Bubble, dated May 26, 2008 we suggested bull spread that would gain in value with a decline in the shares of the oil & gas producers.
With the current Historical Volatility of 52.93, here are two more ideas.
DR: If the Saudi Oil Summit represents a coordinated effort to reduce crude oil prices then this ETF should rise in value with a decline in value of the oil company shares. The sector appears overbought and this is a seasonally weak period.
SU: Unwind the position on a close below the downward sloping trendline (now under 25).
- Sell DUG Jul 25 put DZGSY .65 IV 63.56 Delta .2069
Or consider this bull call spread.
- Buy DUG Oct 30 call DZGJD 3.65 IV 64.93 Delta .5252
- Sell DUG Oct 33 call DZGJG 2.825 IV 67.45 Delta -.4313
Debit .825 Position net delta .0939
The maximum value of the spread is 3 points with a debit of .825 for a potential gain of 2.175 or 2.6 times the defined and limited risk.
Other Beneficiaries
If one part of the solution to the high crude oil price is more production then it will need to be transported.
Frontline Ltd. (FRO) 69.70. Hamilton, Bermuda based FRO claims to be the worlds largest Tanker Company with a fleet of 77 oil tankers, including oil/bulk/ore (OBO) carriers ranging in size from 135K dwt to 311K dwt.
In IVolatility Trading Digest™ Volume 8, Issue 18, Ocean Shipping, dated May 5, 2008 we suggested a June bull call spread on FRO when it was trading at 58.24. It closed at 69.70 on Friday and the spread that we suggested at 1.275 closed at 5.00, for a 192% gain in 51 days.
Frontline management recently announced they are contracting for the purchase of four 320,000 dwt VLCC newbuildings to be delivered in 2011. Management says they were ordered because of a positive market outlook and the deal can be executed and financed without significantly reducing their dividend capacity in the short to medium term.
Frontline pays out much of its cash earnings in dividends. The last dividend paid in February for the fourth quarter was 2.00. For the year through February they paid 8.25. Based upon the current price this would be an 11.8 % yield if it can be sustained.
With a current Historical Volatility of 47.61 and with an equal distribution between put and call open interest, consider this bull call spread.
- Buy FRO Nov 70 call FROKN 6.15 IV 38.61 Delta .5497
- Sell FRO Nov 75 call FROKO 4.20 IV 38.20 Delta -.4213
Delta 1.95 Position net delta .1284
SU: Use a close under the last pivot at 60 as the (stop/unwind).
Airlines
The group that would most likely have the most to gain from a significant decline in crude oil prices is the airlines. In the event there is a coordinated effort to lower crude oil prices this group should have the most to gain. Since many of these companies have large short interest positions they could recover several points very quickly. We would not suggest any of these companies without some evidence that there will be a sustainable decline in crude oil prices.
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Northwest Airlines Corp. (NWA) 6.66 operates passenger and cargo airlines worldwide, serving approximately 239 cities in 21 countries principally in North America, Asia, and Europe. It operates hubs at Detroit, Minneapolis/St. Paul, and Memphis with a pacific route system and a hub in Tokyo and a transatlantic joint venture with KLM Royal Dutch Airlines (KLM). As of December 31, 2007, Northwest operated a fleet of 356 aircraft. With a current Historical Volatility of 122.51 consider these ideas.
- Sell NWA Sep 5 put NWAUA .925 IV 145.29 Delta .2193
Or this longer-term out-of- the money bull call spread.
- Buy NWA Dec 10 call NWALB 1.375 IV 118.42 Delta .4844
- Sell NWA Dec 12 ½ call NWALV .975 IV 116.07 Delta -.3713
Debit .425 Position net delta .1131
This position has a maximum value of 2 ½ points with a defined and limited cost of .425. This could produce a good return if crude prices start declining.
Southwest Airlines Co. (LUV) 14.11 operates as a passenger airline providing scheduled air transportation in the United States. As of December 31, 2007, the company operated 520 Boeing 737 aircraft and provided service to 64 cities in 32 states. It is one of the few airline stocks that has risen in the past month. With a current Historical Volatility of 44.63 consider this long-term put sale.
- Sell LUV Dec 12 ½ put LUVXV 1.00 IV 47.06 Delta .2854
The Airlines are obviously contrarian ideas and only valid if the details from the Saudi Oil Summit include a realistic and coordinated plan of action for both producers and consumers.
Previous Issues and Reader Response Request
All previous issues of the Digest can be found by using the small calendar at the top right of the first page of any Digest Issue. Click on any underlined date to see the selected issue. As usual we encourage you to let us know what you think about how we are doing and what you would like to see in future issues. Send us your questions or comments, or if you would like for us to take a look at a specific stock or ETF just let us know. Use the blog response at the bottom of the IVolatility Trading Digest™ page on the IVolatility.com Website.
Posted by Nevil on June 23, 2008 at 08:54 AM EDT
Posted by Jacktrader (66.182.123.195) on June 24, 2008 at 12:51 AM EDT