MarketsMuse Global Macro Trading dept. merges with our ETF dept. to provide the following excerpt profiling a compelling and conservative Crude Oil-centric strategy courtesy of global macro think tank Rareview Macro LLC. The following was posted to subscribers of “Sight Beyond Sight” on Wednesday, May 27. Irrespective of subsequent three day’s pricing and trade activity across crude oil marketplace, MarketsMuse editors have determined the strategy proposed by Rareview Macro’s Neil Azous remains ‘evergreen’ (for the time being).
Today we got long on WTI crude oil in the model portfolio. Take it for what it’s worth, but this is the first time we have traded Crude Oil during this entire corrective phase stemming back to last summer. As per the March 18th edition of Sight Beyond Sight, when we put a long crude oil strategy on our watch list for a reduction of the severe contango in the futures curve, we are finally comfortable with the risk profile, especially considering volatility has been reduced by more than half since then. Sadly we did not deploy a position on March 18th as it coincidentally was the day the “barrel” bottomed.
The reason we chose to utilize a risk reversal approach today to get long on crude oil is because of the pronounced put skew in the term structure. For example, the structure we entered captures seven volatility points of skew on the ask side.
We like the risk-reward in this position. For example, if the November 2015 crude oil future (symbol: CLX5) were to fall $6 in the next one to two months, the strategy stands to lose ~$1.4mm. Conversely, if it were to rise by $6 in the same time frame the expected profit is ~$3.2mm, which returns a profit ratio of 2.28:1.
Sidebar: A similar strategy can be employed in the US Oil Fund (symbol: USO) by buying the 10/16/15 $21.5 calls and selling the $16 puts, but the ETF position is vulnerable to the shape of the futures curve moving further into contango.
The main thesis is to side with the physical market’s position that demand is recovering at a faster rate and supply growth will stall.
The contango market structure is well into the process of reversing course. Put another way, as the price continues to recover the curve is flattening and at some point by the fall, is likely to enter backwardation. At that point the commodity world will have positive roll yield, a key missing ingredient to be long the product.
On that merit alone, and with the assumption that crude oil has bottomed, the high end of the new range has yet to be carved out. In determining what that new resistance level is, you have to take into consideration the price in which corporations would actually begin bringing many more rigs back online at a very quick pace. Now we are no expert in this arena, and don’t claim to be, but the number we hear most is $85 brings rigs back online. Given that we have no faith in whether that is true or not, we will err on the conservative side and argue that between the current price of $58 and the threshold price of $85, the middle ground is $70-$72, which is also the level where the last OPEC meeting took place. That is our price target.
From the FX side, moving forward the major determinant is Fed policy. In order to prevent a significant appreciation of the US dollar, the Federal Reserve will need to keep the US yield curve steep, and that will require an extremely gradual pace – potentially even variable – of interest rate increases. For example, at the maximum two interest rate hikes per year with a soft cap at 1% in the medium-term unless both domestic and global nominal growth accelerates. From there, the US dollar’s ascent will be much more gradual and the positive growth story could be a tailwind for crude oil.
There are a number of geopolitical wild cards that currently exist from the supply side of the equation between Libya, Iran, and Iraq. The collective risk of the three remains lower supply than what the market is already pricing in.
To read the entire trade strategy proposal and the details therein, please visit the Rareview Macro website (subscription is required; free trial subscriptions are available).