Goldman Expects Oil Rally; Sees Prices Popping Soon
Sentiment is at negative extremes, the bank’s derivative strategists say, a contrarian buy signal.
By STEVEN M. SEARS
Updated Jan. 19, 2016 12:24 p.m. ET
Ever since oil started its multi-year free fall, investors have been predicting a turnaround. But the knife kept on falling, below $60, $40, and most recently $30. One year ago, Barron’s wrote that oil could fall to $20.
Now Goldman Sachs, arguably the world’s most influential bank, is telling clients to bet that oil rallies higher by March.
The recommendation may seem incredible as oil prices orbit around $28 to $30 and fears of deflationary pressures sweep global markets. Yet, Goldman is advising clients to buy March $58 calls on the Energy Select Sector SPDR ETF (ticker: XLE ).
The exchange-traded fund was recently around $54, and the March calls were recently around $1.98. The price of the options has moved higher since Goldman’s call, but still have significant upside. If XLE is at $62 by expiration, the calls are worth $4. If XLE doesn’t rise above $58 by expiration, the trade is a failure.
This contrarian trade, which anticipates a pop higher rather than the start of a long, sustained advance, attempts to monetize extremely pessimistic investor sentiment, and derivative pricing levels. Both indicate that investors think oil prices will fall to even lower prices.
The implied volatility of three-month options on West Texas Intermediate oil is around five-year highs. XLE implied volatility is around a three-year high.
“While fundamentals of supply and demand will ultimately drive the price of oil, we see the potential for shifts in positioning to be a tailwind for the energy
equity sector in the near-term,” John Marshall and Katherine Fogertey, Goldman Sachs derivatives strategists, recently told clients in a trading advisory.
Trying to pick oil price bottoms and positioning for snapback rallies – rather than betting on declines as now characterizes oil trading patterns – has been a fashionable and frustrating trade since at least 2014 when oil traded over $100.
Hordes of investors have mostly lost loads of money trying to anticipate oil’s various twists and turns. The losses occurred in spite of logical trading narratives. Now, oil prices are around levels last seen in 2003, and they seem poised to head lower for a new reason.
The United States and others recently lifted sanctions against Iran. Some market watchers – though not Goldman Sachs – fear Iran will increase oil production, perhaps by as much as 500,000 barrels a day, adding more supply to the global glut and forcing prices even lower.
Though oil prices are ultimately determined by a blend of supply and demand, Goldman is encouraged by investor sentiment. Investors have not been so pessimistic – toward oil and financial markets – since the 2007 and 2008 credit crisis. Extreme sentiment is often tradable even when other facts may point to cloudy conclusions.
The market mob almost always tends to be too fearful or too bullish at tops and bottoms. When fear reaches extreme levels, as it now appears toward oil, it often indicates that investors are done selling. In the absence of continued selling pressures, prices can rise. This is an axiomatic truth of markets that often creates opportunities to use trading strategies similar to Goldman’s upside call recommendation.
Many investors find contrarian options trades to be irresistible. If the trades fail, all that is lost is the price of the option. Should the trade prove successful, the profits are often immense.
This risk-little/win-big trade structure could guarantees that betting on an oil rebound will prove popular. It is human nature to want to believe in better days, or to think that this time will render a different conclusion.
All that is really certain is this insight from Samuel Beckett, the Irish writer, which applies to people and markets: “Ever tried. Ever failed. No matter. Try again.”