An Extraordinary Trade For Extraordinary Times

There can be no doubt that we are living in strange times. Looking like a bandit when we leave our house has passed from behavior that is considered reprehensible to something that is required, and stores that just a few months ago wouldn’t let people in if their faces were covered now won’t let them in if they are not. Nor is it just in the area of face-coverings that things have gotten weird. Financial markets are all over the place, with virtually nothing seeming to make any sense.

In energy, we saw an expiring crude future drop to below negative $30 a barrel. I don’t think anyone saw that coming, but in many ways, the bounce that we are seeing now that has resulted in the June contract trading above $20 is even more remarkable. It is in response to a feeling initially, later backed up by hard data, that the supply cuts that basic supply and demand theory told us were coming as the price collapsed are kicking in.

The long-term issue with oil, particularly in the U.S., has been supply so I’m sure that anything that pushes prices up is welcome for some oil traders, if a little late for some others and a double-edged sword for most producers. However, there is still a great big elephant in the room that everyone is ignoring. Demand for crude has been destroyed around the world as gasoline demand has dried up, and that hasn’t really changed.

There is a lot of talk amongst politicians about “re-opening” states, but what does that really mean? Texas, for example, is supposedly reopening today but how many restaurants are going to open and bring back staff costs at 25% occupancy? Or, for that matter, how many restaurant workers are going to go back to work for massively reduced tips?

Of course, any hint of a return to normality is welcome in the long-term, but front-end crude futures aren’t about the long-term, by definition. So, does June WTI tripling from its lows just over a week ago really make sense to you? It doesn’t to me…

Even with supply reducing, if demand doesn’t pick up significantly, we will still have a problem in a few weeks. The issue for WTI as the May contract expired was that storage facilities at the Cushing hub were full. There may be less supply coming in right now, but without a significant increase in demand and with tankers full of crude sitting offshore all over North America, there has to still be a reasonable chance that that becomes a problem again in a couple of weeks.

Still, what this bounce does do is to give hope for the future. If crude can hit $20 and longer-dated contracts can remain in a state of contango with an obvious issue looming, the long-term outlook can’t be too bad. That may be why, even as the carnage in oil futures unfolded, energy stock still found support.

To me, that suggests a trade.

As I said initially, these are crazy times, and not suited to massive exposure in any area. In these circumstances, a hedged trade of some sort makes sense and there is an opportunity for one here.

The idea is to short oil by selling a small amount of June CL, while simultaneously going long energy stocks by buying the sector ETF, XLE. Normally, that would be a nonsensical trade, but now is anything but normal.

There is a good chance that, as we approach the expiration of CLM20, the June WTI contract, short-dated crude will be forced lower again. As happened last time, though, that will be seen as a temporary phenomenon that doesn’t have a huge impact on the long-term prospects of energy companies, so stocks could hold up relatively well.

As with any hedged trade, the upside here, should it work out as anticipated, would be less than, say, just shorting oil. The other side of that coin, though, is that the downside is significantly less, assuming that things don’t get even crazier and oil jumps while energy stocks fall.

I really can’t imagine a scenario where that happens, so, for now, shorting crude and buying XLE looks like a trade that is just weird enough for these weird times.