Has Oil Bottomed?

Trading in the first quarter of 2015 will center on oil for good reasons. Not only has oil’s fall created one of the largest tax cuts since Reaganomics, the fallout has far reaching implications across a broad spectrum of industries.

Interestingly, at US $105 per barrel, it was obvious to anyone who understood supply and demand that oil was overvalued and demand will not likely drive oil prices higher as it is at best, stable with a slow bias to the upside.

Supply on the other hand has been rising at an almost exponential pace. Particularly as fracking technology has allowed the US to get at supplies that were previously unattainable. There is a view that U.S. and Canadian operations may be taken off stream as prices continue to decline. At present, most of the major wells remain in play likely because the estimated cost of production is somewhere between US $30 and US $45 per barrel. This is not as profitable based on recent prices, but margins that are sufficient to maintain current drilling operations.

The question is where do we find a bottom? My best guess is that we may have already put in a bottom and will likely trade in a range between US $40 and US $60 per barrel throughout 2015.

The one view everyone seems to share is that oil price declines benefit consumers. Perhaps, but those benefits seem to have been misplaced as consumers were reluctant to spend over the holiday season. Is it possible that consumers in the US and Canada have developed a savings habit?

We also know that a disruption within any sector leads to a domino effect across the economy often with unpredictable consequences! For example, we know that the Russian economy is imploding. That’s a dangerous environment when you have powerful politicians seeking to retain power in a declining economy that has no safety nets.

Veteran traders may recall April 2nd, 1982 when Argentina laid claim to the Falkland Islands, ultimately sparking a ten week war with the United Kingdom. The Falkland War was not about claiming territory in the South Atlantic, it was about deflecting attention away from the hyper-inflation that lead to rioting and civil unrest within Argentina. In the end, Argentina suffered a major defeat on the battlefield but got its desired result by focusing the country’s attention on the war effort and away from domestic problems. I am not suggesting that Russia will engage in the same kind of mind games,but you have to think that Ukraine is a potential pawn should things worsen.

The same story is true in Venezuela, that has already imploded and will most certainly face civil uprisings. More importantly, the Middle East, where major producers like Saudi Arabia have enormous fixed costs that cannot be honored unless the country continues its current output regardless of the longer term consequences!

On the positive side, we have seen movements in Iran away from their nuclear ambitions, which is clearly driven by their desire to further the domestic agenda in an environment of lower oil prices. In fact, we may see a politically motivated agreement forged in the months ahead that only six months ago would have been impossible.

On an economic level, there is no doubt that oil producing regions of the US will suffer as will the Canadian economy given oil’s roles as one of the three pillars that drive Canadian GDP. However, it may not matter much when you consider the power that oil wields on the political stage.

Oil is one of the world’s great equalizers. Long employed by oil producing countries to influence their political agenda, I suspect the US will be reluctant to ratchet down production for fear of losing a big stick.

When you think about it in those terms, it is clear that the US has been wielding a big oil stick with some clear results. As mentioned, Russia is imploding based on the fall of the Ruble, Venezuela’s economy is on the verge of collapse and the OPEC countries no longer have any real influence on the world markets.

Same goes for the US fight against terrorism. The best way to stop a radicalized fringe groups is to stop funding them. As North America becomes less dependent on foreign oil, it creates an interesting political backdrop to enact these types of policies.

If we accept the twin premise that oil has 1) put in a bottom and 2) is unlikely to rise sharply during 2015, traders may want to look closely at covered call writing on some of the larger energy names. The recent volatility that has sent option premiums higher across the energy sector make this strategy especially appealing.

Some stocks to consider as covered writing candidates; Crescent Point Energy (Symbol: CPQ, Friday’s close $30.07). Selling the April $32 calls at $1.65, Canadian Natural Resources (CNQ, $35.51), selling the May $36 calls at $2.90 and Imperial Oil (IMO, $47.43) selling the May $48 calls at $3.20.