Oil Prices and the Y2K Problem

For those who were around during the Y2K saga, the setup was this: computer code written decades earlier could not process the transition from 1999 to 2000, and the fear was that systems worldwide would fail the moment the calendar turned. Stocks tied to fixing the problem soared through the late 1990s as consulting fees poured in. Then they hit a wall. The market, being a forward-looking mechanism, began pricing in the inevitable: once January 1, 2000 passed, the work would be done, the recurring revenue would fall off a cliff, and the earnings story would collapse. The stocks sold off well before that actually happened. The finite deadline was the whole trade.

Oil is setting up the same way.

Oil is in deep backwardation right now. Front-month WTI is sitting near $102 a barrel. Brent is near $110. But if you look out to December, the futures curve has already priced oil back down to the high $70s. By the early 2030s, the curve is in the high $50s.

The market is telling you something: this is a shock, and the shock has an expiration date.

The Strait of Hormuz closure following the U.S.-Iran conflict has taken roughly 8-9 million barrels per day off the market, the largest monthly supply disruption on record according to the EIA. That is why spot prices are where they are. But the long end of the curve has barely moved, because traders believe the disruption is temporary. The infrastructure of global oil supply is intact. U.S. production is at record highs. OPEC has spare capacity. Once the geopolitical pressure releases, the fundamentals reassert.

So when does it release?

The standard answer is: whenever Iran and the U.S. reach some kind of agreement, and nobody can know when that is. That is true. But there is a second clock running that the futures curve may not be fully pricing. Midterm elections.

High gas prices are one of the most direct and punishing transmission mechanisms between macro conditions and voter behavior. More visceral than equity prices, more immediate than inflation data. A sitting president prosecuting a war while $5 gas grinds on American households heading into midterms faces a very specific kind of political math. The incentive to find an off-ramp becomes structural rather than purely diplomatic.

This is the Y2K scenario. Y2K worked as a trade because the deadline was exogenous and certain. The midterm thesis gives you the same thing: a politically-imposed deadline that creates its own resolution forcing function, independent of what Tehran decides to do. The conflict does not need to resolve on Iran’s timeline. It needs to resolve on the American political calendar.

I have been selling out-of-the-money calls on USO expiring one week out, collecting theta decay while waiting for current spot prices to eventually converge with what the longer-dated futures are already telling us.

The bet is simple. Oil prices will eventually edge down toward where the longer-dated futures are already priced. The elevated uncertainty in the market right now has pushed option premiums to attractive levels, which creates a favorable risk/reward profile for selling calls. And because these options expire every week, time decay works in my favor even when I am wrong on direction in the short run.

I have been wrong on timing for part of this trade. I started selling the $150 calls a few weeks ago, got pushed higher and rolled to $155 and $160 as the rebound strengthened after the drop, then to the $165 to give me some breathing room, and currently I sit at the $170s with a sizeable position. Each time USO pushed higher, I rolled up to a higher strike to stay out of the way, accepting a smaller net premium in the process to keep the position alive. A financial game of keep away, so to speak. The position has since become very profitable.

My trading model, Pendulum, is based on the premise that the stock market behaves like an infinite game of blackjack, where the odds of a winning or losing hand change constantly, and these odds can be inferred from market behavior and exploited to create alpha for investors.

At the moment, the inputs I use for Pendulum have started to give early signals that the deck may be starting to get colder. In card-counting terms, a cold deck means the probabilities are beginning to shift away from further upside, the way a card counter recognizes when the remaining cards in the shoe are less favorable for the house. There will still likely be violent moves in oil over the coming weeks and months. But I think the risk/reward is skewing in favor of these out-of-the-money call options eroding to generate some profits.

Kids, don’t try this at home.

This content is for informational purposes only and does not constitute investment advice. Past performance is not indicative of future results. Performance figures shown reflect a proprietary account and are not representative of client results. Parabolic Asset Management LLC is a Registered Investment Advisor.