Specious Argument

This is yet another installment on the latest oil price movements.

The Doha pow-wow turned into a non-event as Saudi Arabia at the last moment pulled the plug on any potential deal, stating that in order for there to be a deal, Iran must be included.

The Doha failure surprised me because I thought there was no downside and only upside. All represented countries were at or near maximum capacity, so landing on a deal would not have made any significant difference to their production levels. Yet, if a deal had been struck, that action might have added more confidence to an oil rebound.

Even more surprising to me was the oil price reaction after the Doha failure. Oil has been remarkably strong during the past two weeks. John Kemp at Reuters suggests in his article “Oil rally is not just about hedge funds” that oil prices are becoming dangerously overheated. We will discover soon whether recent prices are warranted.

At this point, I am skeptical of oil rising much further or falling back close to prior lows in the near term.

As a follow-up to my February post regarding oil prices, I am still not optimistic about a quick recovery.

As we have seen, there was no March meeting for OPEC and some non-OPEC countries to agree to a production freeze. Now, the latest plan is for those countries to meet in the Qatari capital of Doha on April 17. Assuming that the meeting does proceed and that they do agree to a production freeze, I am unsure of the benefits. That agreement would just freezes oil production at or near maximum levels. In other words, the world would remain awash in surplus oil.

Compounding the problem, according Janet Yellen’s speech yesterday (New York Times—a subscription might be required), global economic growth remains sluggish.

While I remain skeptical of a quick recovery, I am hopeful that oil prices won’t fall much further.

In December of 2015 I indicated that I was no longer confident that oil would not remain in the US$30s for more than two months. Well, now that we are at the end of February 2016, we see that oil has remained in the US$30s and even briefly sunk lower.

The question now is, where will oil prices go from here? Unfortunately, I am not optimistic about a quick recovery. I have been following as closely as possible various news articles related to oil. Some members of OPEC plan to convene a meeting by mid-March in hopes of achieving a production freeze. Because I doubt that Iran will agree to a freeze as it ramps up its production back to pre-sanction levels, I am doubtful that OPEC and others will agree to a production freeze. Even if they were to agree, with or without Iran, I am not sure that it would have much effect. The world is still awash in oil. And as we have seen in recent weeks, prognosticators seem to be lowering their price forecasts. Moreover, there is still considerable uncertainty about the strength of the global economy and its desire for more oil.

I want to wait for a few more months to see how world oil production reacts to these very low prices. Do these low prices finally cause oil production to fall more precipitously than was previously expected or does oil production remain resilient?

I honestly do not think anyone has a very good crystal ball at this point. So we wait for more information.

The Wall Street Journal featured a helpful article “Happy New Year…Now What?,” (subscription required) that stated:

Collectively, Wall Street forecasts are similarly inconsistent. Since 2000, the S&P 500 has returned a 4% average annual gain, excluding dividends. By comparison, Wall Street strategists have predicted 10% yearly returns, according to Birinyi. And, on average, the consensus always has predicted annual gains, missing all five down years in that stretch.

So what’s my take? My take is that Wall Street strategist forecasts are essentially useless.

Going into 2015, I wrote that SPX options had a skew to the downside, implying that there was more downside risk. Using a similar process, let’s look at SPX options for 2016.

On Thursday, December 31, 2015, the SPX closed at 2043.94. Looking at the SPX December 2016 Options (those that expire on December 16, 2016) and using thinkorswim’s platform for options, I note the following:

• About an 80 percent probability that SPX closes above 1725;
• About an 80 percent probability that SPX closes below 2275; and thus
• About a 60 percent probability that SPX closes between 1725 and 2275 at expiration.

I arrive at these values by finding the SPX value at expiration where the put delta is roughly -0.2 and the call delta is roughly 0.2. I am using option deltas as a rough proxy for the probabilities.

The lower level is about 84 percent of the current SPX value and higher level is about 111 percent. Again, we see a skew to the downside because that implies about an 18 percent downside risk compared to about a nine percent upside risk. There is an approximately equal risk that SPX closes below 1725 as there is that it closes above 2275.

Even if the risks were perfectly balanced, there should be a skew to the downside because of dividends. Dividends make puts more expensive. So let’s adjust the put value to incorporate the dividends. SPY dividends have been about 2.4 percent. 2043.94 times 2.4 percent yields 49.05. Thus, to arrive at the amount of skew while incorporating dividends, we get a higher level of 86.8 percent (equals (1725 plus 49) divided by 2044). Thus, the downside risk of about 15 percent is nearly twice as great as the upside risk of about 11 percent.

When learning of various forecasts, remember to keep an open mind. As the opening quotation shows, Wall Street forecasters are traditionally an optimistic bunch. While option pricing models are certainly not crystal balls, they do provide a quick snapshot as to how market participants view the current market. With the passage of time, of course, that view will change. In short, I am not wildly optimistic in my outlook for 2016.