I certainly don’t need to tell you how much crude oil has dropped over the past six months, from above $147 a barrel to near $40 currently. In the short-term, I think there is a good possibility crude oil could continue to fall, even though it’s already 75 percent off its highs. However, in the longer-term, I think there are forces that should drive the price much higher.
Stocks and commodities are down across the board, and economies around the world have switched into low gear. We have seen demand for crude oil and gasoline fall off a cliff. Hedge funds and investment banks were responsible for a big part of crude oil’s climb, and as the U.S. economy started to fail and subprime issues came to light, we watched as those market participants scrambled to free up cash to save their companies.
They did this by unwinding positions in the commodity markets and running for cover. We have watched investors seek safety by pouring money into Treasury bonds and U.S. dollars. This has caused a bull market in the U.S. dollar and since oil is priced in dollars, it has pushed the price of crude oil lower.
I believe the U.S. dollar is overbought and it is due for a major pullback. The cost of bailing out our country’s financial institutions alone will be at least $5 trillion, and that’s just the beginning. We’ve already committed trillions more in additional loans, grants, guarantees and other programs to try and boost the economy. In addition to a weaker dollar, OPEC is beginning another round of cutbacks that are expected to fall somewhere between 3 – 4.2 million barrels a day. If OPEC is able to continue with planned cuts, crude oil should find a bottom and begin to recover. OPEC may not have the power to actually boost the price of oil, but should be a supportive factor. They can only do so much and other factors will be needed to get prices moving upward significantly.
Eventually, I believe the combination of the proposed stimulus plan, previous TARP spending, a weaker dollar and a return of inflation could light a fire under crude oil prices. We could see the highs of the summer of 2008 revisited. There are so many factors that could come into play as we head into the summer driving season that could be bullish for crude oil. The hurricane season could bring refinery disruptions, and there is always the prospect of geopolitical turmoil. Eventually, we’ll start seeing signs of an economic recovery that will light a fire under the market.
These are incredibly volatile times in commodity markets, and I believe this painful pullback will eventually lead to some amazing opportunities and clear the way for the next leg up. Because of the volatility, I recommend buying calls or using a bull call spread to take advantage of the decline in crude oil. A bull call spread is a debit spread created by purchasing a lower-strike call and selling a higher-strike call with the same expiration dates. The strategy has both limited profit potential and limited downside risk. It does not require margin if you want to purchase options, because your risk is defined by the price of the option. I’d recommend considering a 60-70 call spread at this time. I believe the decline in crude will lead to amazing opportunities and it’s time to take advantage of them.
Tom Power is a Senior Market Strategist with Lind Plus, Lind-Waldock’s broker-assisted trading division. He can be reached at 866-231-7811 or via email at tpower@lind-waldock.com.
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