Robust supply and dwindling demand already have conspired to erode crude oil prices.
And guess what? They could continue to move lower.
America’s oil supply continues to expand at a rapid rate. According to the Energy Information Administration, total U.S. crude oil production averaged 8.7 million barrels per day in September, the largest monthly volume since July 1986. Total crude oil production is expected to average 9.5 million barrels per day in 2015, up 2.1 million barrels per day over the past two years.
Demand is starting to dwindle, too. In its latest estimate, the Department of Energy reported that gasoline demand averaged 8.7 million barrels per day, lower by 1.3% from the same period last year. Heating oil and diesel demand averaged 3.8 million barrels per day over the last four weeks, down by 0.6% from the same period last year.
With supply increasing and demand declining, you can bet that in addition to speculators betting that prices will continue to decline, oil producers are also actively hedging future oil production.
One way oil producers are hedging their production is by purchasing oil puts, which give the owner the right to sell or short oil at a specific price on or before a certain date.
And one way to see the most likely trajectory of crude oil prices is to evaluate the open interest of crude oil put options.
Since there is a seller for every buyer (including when it comes to options), investors who are short strike prices with large open interest could be setting themselves up for large losses, as prices tend to move in the direction that will cause the most financial pain.
To see where crude oil prices are likely to go, we’ll want to evaluate option open interest as well as the price chart of the United States Oil Fund (USO).
Click to Enlarge The January 2015 USO options contracts have substantial open interest, with largest positions at the $28 strike put. As of the writing of this article, the open interest in the $28 strike put was 29,446, the second-largest open interest for all of the January 2015 USO put options.
The large open interest in the $28 strike put will likely act as a magnet, drawing prices to that level as it will generate issues for option sellers.
Recall that if the price of USO falls below $28 per share, investors who are short the January 2015 $28 put might be forced into buying the USO at $28 as the market continues to fall.
Click to Enlarge A weekly chart of the USO shows horizontal trendline support near the June 1012 lows at $29.31. A break of this level would quickly lead to a test of the $28 level, as traders test the resolve of investors who are short $28 puts.
Negative momentum also is accelerating, with the MACD (moving average convergence divergence) index generating a weekly sell signal. This occurs as the spread (the 12-day moving average minus the 26-day moving average) crosses below the 9-day moving average of the spread.
Investors who are looking to take advantage of USO prices moving lower can simply short sell the USO. Normally I would also suggest purchasing put options on the USO, but the implied volatility on USO options are at 52-week highs near 35%, making option premiums very expensive.
As of this writing, David Becker did not hold a position in any of the aforementioned securities.
