Complex Made Simple

How to protect your oil position

Commodity prices in general have reached record highs in the past few months. Recently the WTI-oil futures contract oil price hit an all time high around $146 per barrel. At the same time, rapidly developing countries, including India and China have increased their oil consumption.

Several analysts at major investment banks have raised their price forecasts.

Morgan Stanley, a big Wall Street energy player, said a few weeks ago that crude oil could reach $150 a barrel due falling inventories and tighter supplies outweighing world demand.

In addition, robust Asian demand will put pressure on oil prices.

Goldman Sachs, the most active investment bank in energy markets, put out an even a bolder statement: oil could shoot up to $200 within the next two years as part of a ‘super spike’.

‘Demand for oil is weak , but supplies are even weaker’, according to Jeffrey Currie of Goldman Sachs. The global head of commodities research cited supply disruptions in Nigeria and struggling output in Russia.

Oil price dollar link

In the current state of the US economy – and therefore the world economy – it will be interesting to see how oil prices will develop in the future.

As long as the dollar remains weak and demand remains strong, oil prices will keep rising.

Of course, oil prices might correct themselves, as has been occurring this week. Previously these retrenchments have appeared to be good buying opportunities.

The question is how high will oil prices rise? If Goldman Sachs is right, the current price is still far too cheap.

Investors holding long positions on WTI-oil contracts, and who would like to protect their position, might buy put options. These could be traded at the most liquid oil (derivatives) market in the world, the New York Mercantile Exchange (NYMEX).

Enacting the long put option

A (long) put option is a right to sell the underlying commodity (e.g. oil) at a fixed price within a certain period. For this right, a premium has to be paid to the seller of the put. The underlying value is 1 NYMEX light sweet crude oil futures contract (500 barrels).

For example, the current WTI-oil price (December contract) is traded at $137 and a December 137 Put is traded at $11.50. This gives the investor (who bought this put) the right to sell an oil futures contract until the expiration date in December at a price of $137.

Of course, the put premium paid has to be deducted: $137 – $11.50. In this case, no matter how far WTI might fall, the investor has fixed its (effective) selling price at $125.50. (This means an insurance of 8.4% in comparison to the current price.)

On the other hand (and this is very important), you maintain your upside potential! Because when the price of oil rises to, for instance $200, you just don’t use the put; you don’t exercise your right to sell at $137.00, because you can sell in the market for $200.00 Therefore you profit from your long future.

Of course investors are able to use various option strategies (like put spreads, call spreads etc), depending of the position and/or risk tolerance.

Our company Mercurious offers and delivers B-to-B training and consultancy, on option and future strategies such as these.