Energy Could Offer Income Even in a Bear Market
Oil is one of those markets where good news can be bad news. This was a point raised in a recent article from The Street, which said that “the only certainty about global energy is that the markets will continue to surprise in 2019.
The energy business has always been notorious for its ups and downs. This is even more true today when the energy landscape is evolving rapidly. The old order is changing fast as new trade routes emerge, driven by the resurgence of US energy production.”
That said, there are a few key trends that emerged in 2018 that are likely to set the tone for the year ahead. Some, like oil independence seem to be good news but could be bad news for bulls in the market.
U.S. Oil Independence
The United States was a net exporter of oil and refined products for one week in late November for the first time in 75 years. The shale revolution has seen domestic U.S. crude oil production surge to around 11.7 million barrels per day.
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Plentiful supplies of crude oil are also making U.S. refiners more competitive, encouraging them to boost output of refined products like gasoline, diesel and jet fuel.
This net export status is unlikely to be a regular occurrence in 2019. But the U.S. is likely to continue its path towards energy independence, reshaping the global markets. In 2016, 47 percent of the crude oil run in U.S. refineries was from abroad.
This fell to almost 41 percent during 2018 and could well ease lower still in 2019.
The U.S. is becoming an important supplier of crude oil to the world. U.S. crude exports increased by more than 80 percent year-on-year, according to the latest EIA data.
This trend towards increased exports is likely to continue in 2019, boosted by infrastructure developments on the U.S. Gulf Coast and new market mechanisms such as CME Group’s WTI Houston Crude Oil Futures.
Source: The Street
The United States, Saudi Arabia and Russia
The new status of the U.S. as a major oil producer as well as consumer has changed the dynamics of the global market. A presidential tweet can now move the oil markets up or down. The U.S. has joined Saudi Arabia and Russia as the “big three” most influential oil producers.
The diplomatic relationship between the big three now matters deeply to the oil markets. Geopolitics is always one of the most significant drivers of oil prices and the politically-charged relationship between these three major players will be a key determinant of oil prices in 2019.
For now, investors seem to expect a benign environment. That has led to pressure on stocks in the sector and even income plays like MPLX LP (NYSE: MPLX) with a yield of more than 8% is feeling the pressure.
MPLX is a master limited partnership (MLP) formed by Marathon Petroleum Corporation (MPC) to own, operate, develop and acquire midstream energy infrastructure assets. The share price recently broke important support and could be headed lower.
A Trading Strategy To Benefit From Weakness
A price decline often results in higher than average options premiums. That means option buyers will be forced to pay higher than average prices for trades, But sellers could benefit from the higher premiums.
In this case, with a bearish outlook for the short term, a call option should be sold. The call should decline in value if the stock declines and sellers of calls benefit from this decline.
Selling options can involve a great deal of risk. A spread options strategy can be used to limit the potential risk of the trade.
One strategy that traders can consider is the bear call spread. This is a trade that uses two calls with the same expiration date but different exercise prices.
Traders buy one call and sell another call. The exercise price of the call you sell will be below the exercise price of the long call. The call is sold to limit the risk of the trade. So, this strategy will always generate a credit when it is opened and will always have limited risk.
The risk profile of this trading strategy is summarized in the diagram below which shows the limited risk and reward.
Source: The Options Industry Council
While risks and rewards are limited, this strategy will allow traders to generate potential gains in a stock they might otherwise find too risky to trade. Many individuals ignore bearish strategies because of the risks.
You’ll know the maximum potential gain with this strategy as soon as it’s opened. It is equal to the amount of premium received when the trade is opened. The maximum loss is equal to the difference between the exercise price of the options contracts less the premium received and is also known.
A Bear Call Spread in MPLX
For MPLX, we could sell a February 15 $29 call for about $1.30 and buy a February 15 $32 call for about $0.42. This trade generates a credit of $0.88, which is the difference in the amount of premium for the call that is sold and the call.
Remember that each contract covers 100 shares, opening this position results in immediate income of $88. The credit received when the trade is opened, $88 in this case, is also the maximum potential profit on the trade.
The maximum risk on the trade is about $212. The risk can be found by subtracting the difference in the strike prices ($300 or $3.00 times 100 since each contract covers 100 shares) and then subtracting the premium received ($88).
This trade offers a potential return of about 41% of the amount risked for a holding period that is relatively brief. This is a significant return on the amount of money at risk. This trade delivers the maximum gain if MPLX is below $29 when the options expire, a likely event given the stock’s trend.
Call spreads can be used to generate high returns on small amounts of capital several times a year, offering larger percentage gains for small investors willing to accept the risks of this strategy. Those risks, in dollar terms, are relatively small, about $212 for this trade in MPLX.
These are the type of strategies that are explained and used in our TradingTips.com’s Options Insider service. To learn more about how options can be used to meet your income and wealth building goals, click here for details on Options Insider.