It has been some time since we’ve seen a 10% overnight range in oil futures, as we did on Monday, but the situation in Libya — which has the largest oil reserves in Africa, and the ninth largest worldwide — can only be described as absolute chaos.
The severity of rioting in Arabic nations seems to be increasing in speed and intensity, and the domino effect isn’t played out yet. The U.S.-benchmark WTI crude oil is trading a hair away from $100, and I believe this will likely cause dislocations in other financial markets this week.
Here are some ideas about how to approach the situation from a trading perspective.
Oil Stocks Are Not How You Aggressively Play Oil
The biggest mistake that many investors make is to try to play underlying commodity moves with commodity producers — they are not one and the same thing. In the situation with oil, there is plenty of oil on the market right now in the United States, but a potential closure of the Suez Canal and further escalation of the situation in Libya will likely cause supply disruptions. There are reports that the Libyan army has fired on protesters on several occasions, making the situation very different from how Egypt played out.
In addition, the overall stock market is overdue for a correction, which is likely to keep oil stocks under pressure. Even if oil keeps rallying past the open on Tuesday, the commodity is likely to outperform stocks. The way to play this is via oil futures or the U.S. Oil Fund ETF (NYSE: USO).
There will likely be highly volatile trading with an upside bias where only short-term aggressive trades will work — this is not a buy-and-hold market in oil right now. The USO ETF has liquid options, which are appropriate for short-term trading. You can buy March at-the-money USO call options or consider put credit spreads that limit your upside, but also limit your risk. With that said, this trade idea should be aggressively managed, probably on an hour-by-hour basis.
For a longer-term idea, Italy-based ENI (NYSE: E) has huge exposure to the country and was down quite a bit in Milan on Monday. If the situation is resolved soon, this will be a dip to buy as Libya has huge oil reserves and ENI has a big foothold. A new, more progressive government is certain to address years of neglect in the oil sector, where Libya has large potential. A more protracted war opens the possibility of a much larger decline in the stock, as operations in the country will have to stop. In both cases, it will be probably a dip to buy, but in the second scenario the dip is likely to be deeper.
Spikes in Oil Act as Economic Brakes
There is no doubt that the U.S. economy was picking up speed before this whole mess erupted. The economic statistics have been coming in on the strong side and there had been much hope for a strong February employment report — data suggesting that long-term interest rates would head higher.
But a huge oil spike — if it comes — should be a short-term negative for the economy. This may create a short-term trading opportunity in bonds, which have been under significant pressure since November. It is difficult to advocate Treasury bonds as a long-term investment given my outlook for entrenched deficits for quite a few more years, but short-term call options on the iShares Barclays 20+Year Treasury Bond Fund (NYSE: TLT) might make sense here. Just like any USO calls or put credit spreads you may consider, you may have to manage such bullish trades on an hourly basis.
As for short-oriented ideas, I can see how all of the above will add increased pressure on selected European financials and PIIGS sovereign debt, which were already ripe for a sell-off, even without the Libyan mess.