Rebounding Air Travel & Rising China to Fire Up WTI CrudeBack in the 70s, oil prices spiked shockingly from $2.90 to $11.65 a barrel; gasoline soared 6-times from 20 cents to 120 cents a gallon in a matter of days. Fuel shortages forced factories to shut, airlines to cancel flights and stations crying "Sorry, No Gas Today". Fistfights ensued, including occasional gunfire. President Nixon called for America to end its dependence on foreign oil.
In those five lines of history lies the genesis of both West Texas Intermediate (WTI) Crude Oil and WTI Crude Oil derivatives.
This paper is set in two parts. Part 1 looks back at the remarkable 40-year history of CME Group’s WTI Crude Oil Derivative. Part 2 of the paper analyses the fundamental drivers fuelling WTI crude oil prices higher and an accompanying case study delivering 1.75x reward to risk.
PART 1: ENABLING RISK MANAGEMENT IN ENERGY PRICES FOR FORTY YEARS
Energy markets form the backbone of the global economy. Its prices can make or break nations. Unchecked volatility in energy prices can adversely impact every aspect of daily lives from food to work to shelter to travel.
WTI is high-quality crude oil extracted from the Texas Permian Basin. Crude oil is then refined into gasoline, distillate, and kerosene. WTI is known as light sweet crude oil. It is considered "sweet" as it contains low levels of sulphur. Given the low density, it makes WTI "light".
WTI Crude is a widely used global benchmark for oil prices. It is the underlying commodity for one of the most liquid futures contracts in the world – the CME Crude Oil Futures ("CL Futures"). CL Futures is a physically delivered contract with tight correlation to the physical oil market.
Over one million contracts of CL Futures change hands daily on NYMEX, representing $7+ billion in notional values. Each lot of the CL Futures contract represents one thousand barrels of oil. CL Futures provide deep liquidity and high-quality market structure for hedgers and investors to participate in and protect against oil price action.
NYMEX began trading CL Futures on March 30th, 1983. Among the pioneer commodities to list and trade on NYMEX was the WTI Crude.
In November 1986, NYMEX launched American options (LO) on CL Futures allowing participants greater sophistication and flexibility in hedging against oil price volatility.
In March 2008, the CME Group acquired NYMEX for $9.4 billion.
In April 2014, CME introduced weekly options on CL Futures (LO1-LO5) with more granular strike prices. In December 2021 CME launched Micro WTI Futures, which further enable affordable access to the oil market.
The CME also offers options on calendar spreads which are useful as tactical trading and hedging tools given the cyclicality in the oil market.
PART 2: TURNING UP THE HEAT ON WTI CRUDE OIL PRICES
Travel Rebound & China Re-opening.
Air travel is rebounding. Global air traffic was at 75% of its pre-pandemic levels in November 2022 as per IATA.
Pandemic restrictions in China held it back. With China having re-opened its borders, air traffic growth has taken off. The International Energy Administration (IEA) mentioned in its latest report that Chinese domestic air traffic had rebounded sharply in January and was well above pre-pandemic levels by February.
The IEA predicts that overall global oil demand growth will increase by two million barrels per day (bpd) in 2023. It is slower than the growth of 2.6 million bpd in 2022 but nevertheless taking demand to its highest level of 102 million bpd. The OPEC expects crude oil demand to increase by 2.3 million bpd in 2023, with Chinese demand growing by 710,000 bpd.
Both OPEC and IEA have lifted their forecasts for demand from China given the surprising reopening pace. Nevertheless, banking crisis, recession risk, and economic uncertainty continues to weigh in and might dampen demand.
US Strategic Reserves Running at 40 Year Lows
The US Department of Energy’s (DoE) Strategic Petroleum Reserve (SPR) is a reserve set up in 1975 following the oil embargo of the 1970s. These reserves are used to tackle tail events causing significant disruption to global oil supply.
Last few years, there have been one too many tail events leading to the depletion of SPR. The DoE released a record 266 million barrels of crude from SPR to contain scorching inflation unseen in 40+ years.
The US has signalled that it may take several years to refill the SPR and that it may never reach previous baseline of 600 million barrels given high prices.
Refilling the reserves can take a long time. In the 80s, it took DoE 15 months to fill 100 million barrels. In the 2000s it took even longer – almost 2.5 years – to fill 100 million barrels.
Regardless of time taken, the need to replenish is certain. The DoE has signalled that it will refill when prices trade between $67-$72 a barrel. Hence, this price range serves as a strong support and floor for WTI prices.
Rotation out of Risk Off Assets.
Collapse of SVB and Credit Suisse has lit up forgotten fears. Financial markets suffered a massive tailspin. Liquidity easing measures by central banks have helped assuage worries but contagion concerns remain. Heightened economic uncertainty and recessionary fears plunged crude prices to their lowest levels in more than a year, even below the SPR replenishment price range.
Risk sirens are blowing loud. Unsurprisingly, investors have sought shelter in haven assets such as gold and treasuries. If measures to contain the crisis proves adequate, investors will rotate back fuelling a breezy recovery in energy prices.
Supply disruptions serves as a solid tailwind.
Oil demand is critical, so is supply.
Last December, OPEC+ conveyed its intent to cut output by 2 million bpd in 2023. Although pre-existing production shortfalls have kept OPEC+ output below their targets, these cuts are expected to translate to 1 million bpd of real supply shortfall.
Adding fuel to fire, last week a legal dispute in the middle east has led to Iraqi oil exports via Turkey to be entirely halted, disrupting 400k bpd of supply.
Oil prices are sensitive to supply disruptions. Persistent disruptions will drive prices high.
MARKET PARTICIPANTS ARE STILL NET LONG AND BULLISH CRUDE OIL
The CFTC COT report dated March 21 indicates that investors in the Other Reportable category nearly doubled their net long position on CL Futures from before the start of the banking crisis.
However, the Managed Money category showed that these investors reduced net long positions by 65%. These investors have rotated into safe havens such as precious metals. Despite the reduction, these investors still remain net long on CL Futures. A shift in market sentiment could quickly have these investors piling into CL Futures.
The put/call ratio on CL options is 0.56. For every oil bear, there are about two oil bulls. In fact, this ratio has actually fallen since the banking crisis began suggesting that investors are even more bullish on oil.
TRADE SET UP
This case study argues that a long position in WTI Crude Oil Futures expiring in September 2023 will deliver a 2.1x reward to risk ratio given the positive price drivers. CLU2023 offers exposure to 1,000 barrels of WTI crude and has a maintenance margin of $5,000 per lot.
● Entry: 72.78
● Target: 79.53
● Stop: 68.92
● Profit at Target: $6,750
● Loss at Stop: $3,860
● Reward-to-Risk Ratio: 1.75x
To hedge or trade with granular precision and for affordable access, investors could opt for CME’s Micro WTI Crude Oil Futures which offers exposure to one hundred barrels with a maintenance margin of $500 per lot.
MARKET DATA
CME Real-time Market Data helps identify trading set-ups and express market views better. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs www.tradingview.com
DISCLAIMER
This case study is for educational purposes only and does not constitute investment recommendations or advice. Nor are they used to promote any specific products, or services.
Trading or investment ideas cited here are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management or trading under the market scenarios being discussed. Please read the FULL DISCLAIMER the link to which is provided in our profile description.
