OPEC Deal Creates a Trading Opportunity
Last week, the group of oil producing nations that make up the Organization of the Petroleum Exporting Countries (OPEC) cartel agreed to extend production cuts through the end of 2018. The production limits are an effort to increase the price of oil and generate badly needed revenue for the OPEC nations.
According to Bloomberg, the meeting of OPEC nations was a success. The news service noted that the growing global economy and production cuts have helped push up oil prices. But the problem now is how to keep prices high without stimulating further growth in US shale oil production.
Many analysts believe shale production will increase when oil tops $60 a barrel since that is the level where the wells are profitable. These analysts also believe there are a number of well heads ready to be turned on whenever prices are high.
OPEC officials seem to be in agreement with that analysis. Khalid Al-Falih, Saudi Arabia’s energy minister and OPEC’s most powerful member, acknowledged a “number of variables that we cannot fix with certainty going into the new year.”
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But, at least in the short term, OPEC officials and Russia presented a united front, contrary to the expectations of major Wall Street investment firms including Goldman Sachs Group and Citigroup, which had bet that Moscow would sink any deal.
“You can’t find light between us, we have been united shoulder-to-shoulder,” Al-Falih said, referring to Russian counterpart Alexander Novak.
Or as an oil analyst with the Boston Consulting Group, said, “For now, the OPEC-Russia bromance continues.”
Analysts also noted that Libya and Nigeria, which had been exempt from the previous deals limiting production due to economic hardships in those countries, now agreed not to lift their production above their peak 2017 levels.
While saying he was “very bullish” about oil demand for next year, Al-Falih said the group had not yet defined exactly when it would start unwinding the cuts, or how. That is a problem that might be addressed at OPEC’s next meeting in June.
Shale Producers Now a Part of the Equation
Analysts also noted that US shale oil producers and OPEC “appear to have called a truce of sorts even though there is no sign the US industry will do anything to help reduce the global oil supply glut.”
Texas and North Dakota, the two largest shale oil and gas producing states, described it as a boon for their producers. “Now that it seems prices are looking to stabilise with this OPEC deal around $60 (per barrel), I think that’s going to be a very nice price environment for folks around the state,” Ryan Sitton, one of three commissioners on the Texas Railroad Commission, told Reuters.
The commission regulates the Texas oil industry, which pumps over 3 million barrels per day, more than some OPEC members. Sitton forecast output would grow by an additional 2 million barrels per day within a decade.
This might have led to the resignation of OPEC officials. “Shale is an important parameter, and complementing to the production of the world,” United Arab Emirates Energy Minister Suhail al-Mazroui told reporters on the sidelines of the talks.
“We cannot ignore it, but we need to apply the right weight for that contributor without exaggerating the effect if it.”
The outlook for oil now is that prices are likely to remain in a range. This is the pattern that has existed for nearly two years now.
That means we are likely to see a similar pattern in US shale producers since oil and gas companies tend to show a high degree of correlation with the price of oil.
Among the large cap shale producers is Hess Corporation (NYSE: HES). Hess has made significant investments in these unconventional oil and gas plays. The company first moved into the Bakken Formation in North Dakota, one of the premier U.S. tight oil plays.
More recently, Hess has expanded into the Utica Formation in Ohio, an emerging shale gas play. Oil and gas from these plays now constitutes about 45% of Hess’ total operated production.
One options strategy that benefits from a stock in a trading range is an iron condor. This strategy has the added benefit of carrying limited risk.
To open an iron condor trade, the investor sells one call while buying another call with a higher exercise price and sells one put while buying another put with a lower exercise price. Typically, the exercise prices of the calls are above the market price of the stock and the exercise prices of the put options are below the current price of the underlying stock.
In an iron condor, the difference between the exercise prices of the two call options will be equal to the difference between the exercise prices of the two put options. The final requirement for this strategy is that all of the options must have the same expiration date.
The risks and potential rewards of the iron condor strategy are shown in the following diagram.
Source: The Options Industry Council
The maximum gain on this trade is equal to the premiums received when the position is open. The maximum risk is equal to the difference in the two exercise prices less the amount of the premium received when the trade was opened.
Opening an Iron Condor in Hess
For Hess, the trade can be opened using the following four options contracts:
As you see, all of the options expire on the same day, Friday, December 15.
The difference in the exercise prices of the calls or puts is equal to $2.50. Since each contract covers 100 shares of stock, this means the maximum risk on the trade is equal to $250 less the premium received when the trade was opened.
Selling the options will generate $2.05 in income ($1.50 from the call and $0.55 from the put). Buying the options will cost $0.70 ($0.55 for the call and $0.15 for the put). This means opening the trade will result in a credit of $1.35, or $135 for each contract since each contract covers 100 shares.
The maximum risk on the trade is equal to the difference in strike prices ($2.50) minus the premium received ($1.35). This is equal to $1.15, or $115 since each contract covers 100 shares. Many brokers will require a margin deposit equal to the amount of risk. That means this trade may require just $115 in capital.
The maximum gain on the trade is the amount of premium received when the trade is opened. In this case, that is $1.35 or $135 per contract.
The potential reward on the trade ($135) is about 117% of the amount risked, a high potential return on investment for a trade that will be open for less than one month. If a trade like this is entered every month, a small trader could quickly increase the amount of capital in their trading account.
The iron condor is an example of how options are a versatile tool and could meet many of your trading objectives. In this trade, options provide income and defined risk that should be lower than owning the stock.
These are the type of strategies that are explained and used in TradingTips.com’s Options Insider service. To learn more about how options can be used to meet your goals, click here for details on Options Insider.