The oil-options market shows traders are almost equally divided on where crude is headed, a sign the 30 percent gain in prices since unrest erupted in the Middle East is ending.
Speculation that Japan’s earthquake and aftershocks will cut oil consumption raised the cost of put options, which protect investors from a decline in crude, to within 0.53 percentage point of call options, which provide a hedge against rising prices, on April 6, according to data compiled by Bloomberg based on crude for May delivery. That compares with as much as 2.92 percentage points on March 10, the day before the disaster.
“While geopolitical risk in the Middle East will continue to push the market to seek protection against a move up in prices, the potential for a soft patch in industrial activity in the aftermath of the earthquake in Japan can lead to buying protection against a correction,” said Harry Tchilinguirian, head of commodity-markets strategy at BNP Paribas SA in London.
The quake may knock as much as 1.4 percentage point off economic growth in Japan, the world’s third-largest crude consumer, according to the Organization for Economic Cooperation and Development. That’s countering speculation that the fighting in Libya, North Africa’s biggest producer, will keep a squeeze on supplies even after about 1.3 percent of global production was lost to markets because of the conflict.
Crude capped its biggest two-day decline in almost 11 months on Tuesday on the New York Mercantile Exchange after Goldman Sachs Group Inc forecast a “substantial pullback” in prices and the International Energy Agency said it sees a slowdown in demand. Barclays meanwhile said it’s premature to detect any signs of “demand destruction.”
Before the quake, as the Middle East turmoil threatened to spill into Saudi Arabia, the cost of out-of-the-money May crude calls was 4.3 percentage points more than that of comparable puts, according to data from the Nymex. Saudi Arabia is the world’s biggest oil exporter.
Traders use the options market to purchase the right to buy and sell assets and commodities at pre-arranged prices to protect against market fluctuations. When the cost of puts and calls is even, prices present a U-shaped pattern, or “smile.” The value at which an option can be exercised is known as its strike price. A call option is considered to be out of the money if the futures price is less than its strike. A put is out of the money when the reverse is the case.
West Intermediate crude for May delivery rose to a 30-month high of $112.79 a barrel on the Nymex on April 8, bringing the advance this year to 23 percent. It settled at $106.25 a barrel yesterday. Brent, the benchmark grade for more than half of the world’s oil, closed at $120.92 a barrel on the ICE Futures Europe exchange in London yesterday, after trading at $127.02 April 11.
“Although potential contagion risk in the Middle East and North Africa remains elevated and has pushed prices above $125 a barrel, at these price levels, the risks are becoming more symmetric, which shifts the risk-reward of being long oil,” Goldman Sachs analysts Jeffrey Currie in London and New York- based David Greely said in an April 11 report.
The cost of options is linked with their implied volatility, which gauges the probability of swings in the price of the underlying security, in this case the value of crude oil futures. Implied volatility determines the likelihood that the right to buy or sell can be profitably exercised.
The “structure of options volatility has shifted at the front of the curve towards a smile and away from a steep positive call skew,” Tchilinguirian said.
Out-of-the money call options for May had an implied volatility of 28.79 percent, compared with 28.25 percent for equivalent options to sell, April 6 data from the Nymex show. The implied volatility of those calls was 39.58 percent the day before the earthquake. That compared with 36.67 percent for out- of-the-money puts.
Japan lost as much as 29 percent of its oil-refining capacity as a result of the quake and tsunami that killed about 27,000 people and sparked a radiation alert at the Fukushima Dai-Ichi nuclear plant. The disaster may result in a larger hit to the economy than previously predicted, Economic and Fiscal Policy Minister Kaoru Yosano said yesterday.
The call skew has waned as investors have become accustomed to the loss of exports from Libya, said Keith Leung, an options trader with Hudson Capital Energy in Zug, Switzerland.
“In order for the call skew to be supported you need outsized gains” in the price, he said. “Every time there is something going on in Libya, you’re not seeing that huge rally in crude anymore. We’ve just been grinding, maybe a dollar or so up or down. Because of that there’s no way to support that volatility and the skew on the upside.”
Libyan rebels this week turned down an African Union cease- fire plan that would have left Muammar Qaddafi in power. The country, holder of the largest crude reserves in Africa, has been effectively split since the conflict began mid-February. The nation pumped 390,000 barrels a day in March, compared with 1.6 million barrels in January, Bloomberg data show.
Investors who have purchased oil futures in anticipation of rising prices may be able to use the current decline in call- option volatility to their advantage by selling call spreads, according to Leung. That involves selling a call option with a strike just above the current futures price and buying another that allows the right to buy at a higher level.
The holder of this spread would benefit as the volatility, and with it the price of the sold near-the-money option, continues to fall, Leung said. Because options further out-of- the-money are subject to greater volatility, the option purchased would protect the holder in the event of any new supply disruption, he said.
“It’s a good strategy if the market just kind of grinds higher,” Leung said. “You’re not shorting the overall crude market because obviously there’s still a bullish trend. If the market does explode higher you’ll see the call skew go out and that will benefit your spread.”