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Oil Is Down Again – Here’s How to Play It

5 | By Shah Gilani

I’ve been trading for very long time. While it’s not rocket science, sometimes it comes close.

Take oil, for example. I can use all kinds of mathematical trading models to trade oil, but I prefer, because it works, to keep my oil trading simple.

Oil is a commodity. That makes it a lot simpler to trade than the stocks of companies.

Commodities mostly trade on supply and demand. It doesn’t get much simpler than that.

We made money in my Short-Side Fortunes investment advisory service when I recommended shorting oil. To me that was an easy call. I saw overproduction in the U.S. shale oil sector adding to global supply, which I knew would result in lower prices.

Since then, oil, as measured by West Texas Intermediate (WTI), dropped from about $100 a barrel to $42 a barrel.

It then bounced off its those, got above $60 where people loaded up as if it was going right back to $100 and hit $63.

Then it started backing off again and is south of $52 today.

Now I’m going to show you how you can make some money here – maybe a lot of money…

The Math

When oil tanked people were surprised. When it popped they were surprised. Now that oil is slipping backward – again – people are surprised.

What they didn’t see… what they don’t see… is the supply side of the equation.

Only, it’s not just the supply of oil I’m talking about. The supply of shares of oil companies is weighing on oil too.

Forget demand.

I don’t even bother with it in my recent oil trading calculations. Demand is too hard to predict. All I need to know is that the global economy isn’t going gangbusters, so demand for oil is mostly flat – and for the purposes of my oil trading I expect demand to remain flat.

If I see demand changing I’ll adjust my trading. But, to keep my oil analysis simple, to trade simply, I don’t dwell on oil demand.

Supply is all I look at lately.

It wasn’t hard to figure that the globe’s supply of oil was increasing

The United States was becoming a huge producer thanks to massive shale oil exploration, development and production, and the rest of the world’s oil producing countries are in desperate need of revenue.

How simple is that? More supply, and prices will go down.

U.S. producers cut back exploration as fast as they could when prices tanked. It costs money to look for oil and drill wells.

So, the number of “rigs” being leased got cut back week after week after week, and everybody believed that all those drilling rigs shutting down would lead to less supply and higher prices.

And for a while, that’s what happened: Prices began to tick up.

The Twist

However, oil explorers borrow a lot of money to drill. They need to pump oil and sell it to pay off their loans. So, while the rig count fell on account of the cost of drilling, producing wells kept on producing.

Why would anyone turn off a producing well? They wouldn’t. It’s producing revenue, revenue they need to pay down their loans, for working capital, and something called profit.

Yes, the supply of rigs went down, but dismantling those rigs that weren’t producing oil but costing companies hundreds of millions to employ had nothing to do with dismantling producing rigs.

In other words, the same amount of oil is still being produced. Supply hasn’t changed.

When the price of oil moved up from its lows, and investors and traders thought it was headed right back up, they clamored for the stocks of companies whose value had plummeted.

They believed those stocks were massively undervalued if oil was headed right back up.

Lots of companies, to meet the demand for shares investors were begging for, conducted “follow on” offerings. (A company that has stock outstanding can offer fresh stock to investors in a follow-on offering.) And because investors wanted to grab cheap stock – and because companies wanted to issue more stock and use the proceeds to pay down their higher-cost loan borrowings – it looked like a win-win for everybody.

I didn’t see it that way.

Investors who bought follow-on offerings, which totaled about $15.87 billion worth in the oil patch so far in 2015, watched oil prices decline again and are now sitting on fresh stock they bought near the recent highs.

If you own some oil-related shares that you bought near the recent highs in the price of oil and you’re losing on those shares as they fall along with the price of oil, you’re going to sell at some point. It’s a matter of supply and demand. You have too much supply of shares that are less in demand.

So, share prices are declining again.

The Trade

Like I said, I keep my oil trading simple.

If you think there’s more supply than demand and that pressure on oil prices will take oil back down to its recent lows, maybe you want to make a simple trade, too.

You can use the United States Oil Fund LP ETF (NYSE ARCA: USO) as a proxy for “oil.”

It’s trading at $17.05. I think it will drop to $15 if WTI drops back to the mid-$40s range. A simple trade would be to buy the October $15 puts (USO151016P00015000) for about 50 cents per contract (that’s actually 50 cents times 100 shares per contract, or $50 per contract).

If USO drops to $15 or lower by the time your put options expire, you’ll make some good money. On the other hand, if oil doesn’t drop and you don’t sell your puts before expiration, you will lose whatever money you invested.

That’s a simple trade to me, based on a simple supply observation.

What do you think?

P.S. I hope you’re all liking and following me on Facebook and Twitter. Once you’re there, we’ll work together to uncover Wall Street’s latest debaucheries – and then we’ll bank some sky-high profits.

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5 Responses to Oil Is Down Again – Here’s How to Play It

  1. fred says:

    Rigs did not stop producing oil but did slow the amount pumped out to minimal amounts. Therefore they can open the spigot very fast when they want and increase production overnight thus keeping the supply of oil at demand levels for a long time.

  2. mike cieply says:

    Thank you for your summary and analysis of the condition of oil sector. I believe your projections of oil dipping down to mid 40 range is very plausible do to the present state of global economic malaise.(as you point out).

    Keeping a market summary report “simple” is a breath of fresh air, no complaints here. I like the October puts for USO. Lets make some money.

    mike from Indiana

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