Oil Storm Brewing?

Have several different oil positions and want to briefly explain reasoning behind them.

I own:
DXO – the 2X monthly oil ETF
USO AO- Jan 2010 $42 call on USO (USO)- time frame 7 months
OLL AI- Jan 2011 $35 call on USO (USO)- Time Frame 19 months

Why the options? Example:
You are of the mindset that oil is going to rise rapidly for a variety of reason the rest of this year and next. Because of that you want to own it. Buying, for exmaple 500 shares of the oil ETF USO (USO) would cost you over $15,000. With the options, you can control the same amount for a fraction.

Real life example…
I paid $550 for each OLL AI Jan. 2011 calls. So, to control the same 500 shares of USO in our example above, it would have cost me $2750, not $15,000. Since USO has risen closer to my $35 price target since the purchase, so has the value of the option. At its current price $660 each option has an unrealized return of 20%. With the option, it has real value at any price over $35 for the USO. The real gains will kick in once USO surpasses $35 a share.

At the $165 I paid for each of the USO AO options, the same $500 shares would have cost $825. Now, there is no free lunch. IF USO does not rise rapidly and hit $42 (23% higher) by Jan, 2010, my options are essentially useless/worthless. This type of far “out of the money” option is very high risk/high reward. These positions should be very small wagers as you can be right on the direction of the movement (oil prices rise) but wrong on the degree (15% rather than 20%) and still lose money. But, if you are right on both counts….ka ching..

Why own oil?

Supply: A picture is worth a thousand words..

Here is the supply/demand equation:

Here is an expmple of the steepness of the decline in Mexico for example from the Cantarell field:

Source of charts is this excellent post at The Oil Drum. Please read it

Geopolitical

A few recent events:

After President Obama said in a White House press briefing he wanted Iran to come to the table “by the end of the year” to hold talks on it nuclear program. He reiterated his “holding out a hand” to Iran to open talks with them.

Just days after:

President Mahmoud Ahmadinejad said Iran test-fired a new advanced missile Wednesday with a range of about 1,200 miles, far enough to strike Israel, southeastern Europe and U.S. bases in the Middle East.

General Commander of the Iranian Army Ataollah Salehi: It Will Take Us 11 Days “to Wipe Israel Out of Existence”

Now, whether either statement is 100% accurate is not really the point, nor is the “whose fault is it” argument. What is the point is that it is clear what Iran’s intention are and one would have to be a bit naive to think Israel will just sit pat and allow the storm to continue to gather.

Now, were this an Afghan leader saying this the effect on oil would be insignificant (or exponentially less). Because Iran is a huge oil exporter and it sits on the Persian Gulf, so it matters a great deal to oil.

In an odd move, 75 of 100 US Senators sent a letter to Obama reminding him of the “risks” Israel faces. Now, the letter is odd in that it almost implies the President is not fully aware of Israel’s situation or is discounting it. Coming so soon after the recent events, its curiosity cannot be ignored. Again, no matter your political leanings, both the left and the right must wonder at the letter coming from both party’s Senators to the President.

Right now crude oil sits at $60 given the current economic/political conditions globally. What are the risk to the price in either direction?

1- Global growth. An increase or decrease will lead to oil prices following in either direction. After a Q4 and Q1 globally worse than any in recent memory, improvement is probable. This does not mean we return to 2007-2008 levels soon, but with the oil supply destruction taking place, that is not necessary to cause prices to rise.

2- Geopolitics. Can anyone see a scenario in which the geopolitical risk to oil is lessened? What is far more likely is that it is increased. There are a number of nations in which the threat could come from as almost all are lead by, shall we say, erratic regimes?

3- Inflation. Eventually the trillions of dollars created out of thin air has to have its intended inflationary effect. Since oil is priced in those dollars, its price will rise accordingly. Can the Fed put the inflationary genie back in the bottle once it is out? Not easily, quickly or at all without destroying the growth it is intended to create…

My though is clearly heavy risk to the upside for oil. If oil can rise from under $40 to $60 on benign economic news then either good economic news, bad political news or renewed inflation (or all of the above, a very possible scenario) ought to cause it to spike……hard

Disclosure (“none” means no position):Long oil