Crude's Rally is Cracking -- Here's How to Profit

The price of oil has jumped more than 50% since hitting a 12-year low in February, on hopes of production freezes that could reduce the global supply glut.

But there is good reason to believe the market is getting ahead of itself. Little has changed in the oil supply picture to merit this price rebound. In fact, several signs suggest there could actually be even more supply over the next few months. 

Another plunge in oil prices would not just drag down companies in the space, but likely the entire market, which is why I want to have some protection in place. 

Oil Rally Not Driven by Fundamentals

The problem with the recent run in oil prices is that it hasn't been driven by fundamentals; it's been driven by speculation and trading. We have seen massive short covering in oil futures. Data from the Commodity Futures Trading Commission (CFTC) shows investors increased net-long positions by 17% in the week ending March 15 to the highest level since June.  

But once weak fundamentals come back into focus, the market may not be so positive.

For starters, the Saudi-Russian agreement to freeze production at current levels may not be much of a concession. Saudi Arabia produced 10.2 million barrels per day (bpd) in January, just under its June 2015 record of 10.5 million bpd. Meanwhile, Russia produced nearly 10.9 million bpd -- a record for the post-Soviet era.

It's not increased production from these two heavyweights that investors should fear, though. The Iranian Oil Minister has called the planned production cap "ridiculous," and the country plans on adding up to 1 million bpd of output and exports this year.

In addition to the potential for a wave of Iranian oil to hit the already over-supplied market, U.S. production may not fall as some are predicting. While the U.S. rig count has fallen to its lowest point in the 67 years of Baker Hughes tracking, the rebound in oil prices looks to be bringing production back online. 

Last week the U.S. oil rig count increased from 386 to 387 -- the first gain in three months. And demonstrating the speed at which shale assets can be brought back into production, the Eagle Ford Shale region added three drilling rigs last week as well. 

Investors have been betting that falling rig counts would translate to quickly declining U.S. production, causing prices to rebound as they have in the past. But the industry is much more flexible than it used to be.

Between the 1970s and 2000, the time it took producers to drill a well was cut in half to just 39 days. And according to EOG Resources (NYSE: EOG), it currently takes as few as 8.9 days to drill shale assets in the Eagle Ford region. This means producers can quickly increase production as prices rise above the break-even point. 

For the cherry on top, IHS Energy estimates shale producers have built an inventory of up to 1,400 drilled but uncompleted wells in the Eagle Ford region alone. These wells can be converted to production without incurring drilling costs and may be profitable with oil as low as $30 per barrel. This is just another overhang in U.S. oil that could bring a wave of production back to market.

Earn a Potential 21.5% Profit as Oil's Rally Fades

Already, oil prices are falling this week on higher-than-expected crude supplies, but I expect the rally to show more substantial cracks in coming months based on the factors outlined above. When that happens, it will be the explorers and producers that get hit the hardest, so I plan on adding some portfolio protection in the form of a put option on SPDR S&P Oil & Gas Exploration & Production ETF (NYSE: XOP).

The fund holds shares of 61 U.S. oil and gas companies and has a median market capitalization of $3.2 billion. From its January lows to last week's high, XOP shot up nearly 44%. But it has already started to pull back this week, and I expect the downward trend will resume in full force soon.  

With XOP trading for $29.41, we can buy a XOP Jun 31 Put for a limit price of $3.40 per share. That is a put option with a $31 strike price that expires on June 17. Each contract controls 100 shares, costing you $340 per contract.

The trade breaks even at $27.60 per share ($31 strike price minus $3.40 options premium), which is 6.2% below the current price.

A 50% retracement of the recent rally in XOP gives us a downside target of $26.87, which would represent a decline of 8.6%. But if XOP falls to this level before the June expiration, the option would be worth at least $4.13 ($31 strike price minus $26.87 stock price) for a 21.5% gain in just 86 days.

Even more impressive, this works out to an annualized return of 91%, which really highlights the power of put options. 

If you're interested in making money on falling stocks using put options, you should consider following my colleague Jared Levy. In the past year, the average put option trade he recommended was open for just 26 days and returned an annualized gain of 918.1%. He shares the secret to his success for free here.

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