What’s In Store For Oil Now That Half of Saudi Arabia’s Production is Offline?

Macroeconomics, Oil, Options

This week was supposed to be all about the Fed meeting. The September FOMC meeting is the first since July, and quite a bit is riding on what the Fed decides to do with interest rates. It’s one of the most critical FOMC meetings we’ve seen in years.

However, the Fed’s thunder was stolen by an unexpected asset, oil. The drone strike on Saudi oil facilities this weekend has grabbed headlines as the price of crude oil spiked as soon as the futures markets opened (after the attack).

First, some background: A group, possibly backed by Iran, attacked an oil production facility in Saudi Arabia using drones. The ensuing fires shut down half of Saudi’s oil production output or roughly 5% of global oil production. The result was about a 15% one-day jump in crude oil prices.

However, Saudi Arabia recently announced that full production would resume by the end of the month. Oil futures are already down about 7% as of this writing. Currently, crude oil is trading at about $58 per barrel.

So, is this disruption going to result in any lingering effects on the market? Is there more concern in store for oil? Or, will the investment crowd quickly forget about this situation and move on to interest rates and the Fed decision?

While traders will undoubtedly be laser-focused on what the Fed says and does, there still may be plenty of action ahead in the oil markets. There’s certainly been a substantial amount of activity in United States Oil Fund (USO).

USO is the most popular ETF for directly trading oil prices. It is based on oil futures rather than oil companies. On the day of the Saudi production restart announcement, USO traded almost 100 million shares (90-day average 30 million) and nearly 400,000 options (90-day average 115,000).

Looking at the options action shows mixed results. Indeed, the production shutdown was bullish for oil, while the production restart is bearish. But what’s next for USO?

Well, there’s at least one very large trader who is bullish on USO (and oil prices in general). This trader bought a massive amount of covered calls on USO which expire in October.

More specifically, the trader/fund bought 1 million shares of USO for $12.30 while simultaneously selling 10,000 October 18th 15 calls for 7 cents. Why sell a call for 7 cents? Well, that does work out to about a half percent yield for a month, or 6% annualized.

Considering that USO doesn’t pay a dividend, why not make some extra cash while holding the shares? Another possible reason is that USO charges a 0.45% expense ratio (a normal amount for this type of product) and that half percent yield basically covers the cost for buying all those shares.

Meanwhile, the trade doesn’t cap out USO stock appreciation until $15. That amounts to over 20% upside potential in the stock at max gain ($15 or above). As such, this is clearly a bullish trade. The buyer is leaving plenty of upside potential open while just receiving enough yield to amount to a small dividend (or to cover the expenses).

If you’re bullish on oil and want to do a similar trade in USO, you could also increase the trade’s yield by selling a call closer to the stock price. For example, the October 18th 14 call trades for 14 cents, or double the price of the 15 call. That works out to a full percent yield over a month and still allows for over $1.50 worth of upside in the stock.

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