Can Oil drop $30 a barrel and go to $20 a barrel?
I have recently read an article from CITI Group on Bloomberg, noting that the Oil futures will
drop down from the current price of approx., $50, down to $20 a barrel which “may
soon be on the way”. This got me thinking, how did someone come up with this
figure? Is it even possible and what are the probabilities of this event happening?
I put
together some information;
Based on
the current share price I have read that there is about a 3% chance that the
oil futures will touch at $20 some point in the next 60 days.
I now then
went over to the USO the oil ETF. This ETF is currently trading at $18.94. If I
compare the futures and the ETF pull backs in 2008 I can see that the oil
Futures market fell about 70% and the USO ETF fell about 81%. Pretty close to
the same pull back. The article notes that the Oil futures is expected to touch
$20 range meaning it needs an approx. pull back of 60%. This is similar to the
2008 pull back.
Without
getting to technical as the ETF is not an exact replication due to “Drag”, but
for this example let’s look what will happen. In this case the article pretty much
expects that the USO ETF will trade down to about $8 give or take. Once again, there
is no data on the exact formulas used and the best I could do is look at the
last major pullback. So it’s not that accurate but you get the idea.
So what is
the probability of USO ETF trading below say $8 in the next 60 days? Well I looked
at a couple of things. One is the option volatility and this noted to me that there
is a 99% chance the market will not touch $8 in the next 60 days. I then look
at the history of the ETF and over the last 8 years the ETF has moved that
amount 14 times within a 60-day time frame.
Based on Historical
data if the ETF fell to $8 this is 57% pull back from current prices, based on
the last 8 years of data and over 2000 occurrences the ETF has only moved that
amount 14 times.
We will
also need to note that the current Oil futures and Oil ETF market is already in
a large pull back of about 55%, so we are expecting a further fall of another 60%
from current prices. This would take the entire pull back in the vicinity of
about 80%. Similar to 2008/2009 move and also the move in 1980/1986, but these
moves were over a 9month time frame and a 6 years’ time frame. We are roughly 8
months into this move, so the timing is in line with the 2008 move, but we are
years away from the 1980/1086 move. There is some cyclical action but that is
beyond this blog.
The Take
Away;
If you
believe that oil futures are going to fall rapidly over the next short period
of time, you should probably buy Puts like crazy. The probability of it falling
in line with the Articles expectation is about 3%. This means you have a 97%
probability that your expectation for the trade is going to be wrong. But that
is not 100% and this is the market and there is always chance big moves can
happen, as can be shown and noted above, it has happened before in history. Based
on the information maybe the plays is going long, if there is this sort of move
down to the $20 levels, or just wait a bit longer to avoid catching the falling
knife.
