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    Thursday, August 14, 2003

    The Oil Trade

    Having made a relatively good call on interest rates using the Profunds rising rates opportunity funds (up 13% in 36 days) I decided to investigate the other economic factor that appears historically mis-priced to me. Oil.

    It turns out that there are many different types of Oil and different prices for them. The type that I have analyzed is called light sweet crude. Futures and options on futures are sold on Light Sweet Crude at the New York Mercantile Exchange (NYMEX).

    Considering daily data from April 4th 1983 to yesterday, we are 1.5 standard deviations from the mean price of $22. Today’s close was $30.78. There have only been 366 days (7%) with equal or higher prices out of the 5108 in the period. If you exclude the two gulf wars by taking out the 1990 and December 2002 – August 2003 prices we are 1.7 standard deviations from the mean and there are only 5% of days that exceed today’s price.

    Historical oil prices have been even lower. From 1947-1998 the average price was 19.27 and from 1867-1997 it was 18.63. The 83-now data is closer to an average of $22.

    Additionally one of the significant problems with the economy right now is the additional “tax” that high oil prices create. This affects earnings and GDP. A similar presidential election was lost by the senior Bush due to the economy. This one is not going to make the same mistake. The tax cuts were a component as cheap oil will be shown to be. Looking back from the November 2004 election you will see at least 6 if not 9 months of much lower oil prices.

    The question is how can we formulate a trade to take advantage of this. You can trade both futures and options on futures on the NYMEX. A futures contract is one in which you agree to deliver to a contract (such as 1000 barrels of oil) at a set date in the future. The price, however, is agreed today. It is different to buying an option as delivery is not optional.

    There are then options contracts that are derivatives of the shortest duration futures contract on expiry. For example you can trade April ’04 options on the May ’04 futures. In April ’04 the options settle with delivery of the May ‘04 futures contract and then in May the futures settle with delivery of Oil. In reality the options are usually closed out before futures contracts are delivered and the futures are almost always closed out before actual oil delivery is required. To close out you either sell your contract if long or buy back your contract if short.

    On to the numbers. The March 04 futures are trading at 28.45. That reflects an expectation that in February the spot price for oil will be 28.93. Importantly in the statistical analysis, 130 days was the longest period between a price above $30.78 and $26 (the $26 will become important in a moment).

    You can buy options on the March 04 futures. As we believe the price will decrease we would buy a Put option. The March 04 Futures Contract Put at a strike of $28.5 costs $2.33 and expires in February 2004. That means we need the price of oil to be less than $26.17 for us to make money. That occurs 74% of the time (excluding gulf war times or 71% including). To double your money the March 04 future would need to trade at $23.84 between now and February ’04. 69% of trading days were below $23.84 (or 66% including wars).

    Iraq also plays into this. 75.7 Million Barrels of oil are consumed daily. Iraq can currently produce 2M barrels under the oil for food program. If this gets doubled to 4M then you could expect a 10% decrease in prices simply as a result. Additionally OPEC’s target is in the range of $22 to $28 a barrel. Again I think Bush is going to make sure that is at the lower end of the range for a while leading up to the election.

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    Disclaimer and Disclosure Analyses are prepared from sources and data believed to be reliable, but no representation is made as to their accuracy or completeness. I am not paid by covered companies. Strategies or ideas are presented for informational purposes and should not be used as a basis for any financial decisions.
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