Oil Options Echo Citi-to-Merrill View of a Brief Bear Market

  • Decline into bear market to be short-lived, analysts say
  • December Brent, WTI put skew down 30% since early July

Oil analysts from Citigroup Inc. to Bank of America Merrill Lynch are confident that the new bear market in crude will be short-lived, while legendary oil trader Andy Hall sees a "violent reversal" ahead. The options market increasingly agrees with them.

Investors this week were paying the smallest premium in almost two months to protect against a drop in prices through the end of the year, even after oil entered a bear market.

The so-called put skew on December Brent and West Texas Intermediate options -- the premium traders will pay for insurance that prices will fall rather than rise -- has narrowed more than 30 percent since early July. The skew on second-month WTI contracts has fallen by almost half. That pullback in bearish sentiment fits in with the view that the worst of the oil rout is over and prices will recover as a global surplus continues to ease.

"This is telling us that they see little chance of us hitting $25 in the near term," said John Kilduff, partner at Again Capital LLC, a New York hedge fund focused on energy. "There’s only a little over a month for the price to fall more than $10. Also, options are protection against volatility and there hasn’t been a lot of volatility since the market has been moving in one direction: down."

Brent joined WTI in a bear market Tuesday, with both crudes down at least 20 percent from their June highs on signs that the global supply glut will take longer to trim. Canadian production has returned after wildfires, Libyan ports are reopening and U.S. producers have returned more drilling rigs to work. Money managers have responded by adding bets on falling prices at the fastest pace in at least a decade.

Strong Reversal

“The market is being driven by its own momentum and currently that is down," Hall wrote to investors in his Stamford, Connecticut, hedge fund, Astenbeck Capital Management LLC. “But extreme positioning coupled with improving fundamentals should ultimately – and at potentially any time – result in a strong reversal."

Demand growth is slowing, with U.S. gasoline consumption estimates reduced for a second month by the Energy Information Administration. American gross domestic product was also revised lower, signaling the world’s largest economy may not grow as fast as previously thought.

Changing Sentiment

The shift in options pricing may indicate a reversal in sentiment is in progress, according to BNP Paribas SA. It could also simply reflect that traders considered call options more of bargain than puts after their recent decline in cost, the bank said.

“The fact that the cost of downside protection -- buying out of the money puts -- relative to upside protection -- buying out of the money calls -- has lessened, may suggest that the market does not see the spot price too much lower from here,” said Harry Tchilinguirian, head of commodity markets strategy at BNP Paribas in London.

The price losses are being driven by a seasonal lull in fuel demand rather than any serious deterioration in market conditions, according to Bank of America Merrill Lynch. U.S. refineries typically perform maintenance in September and October as fuel demand eases with the end of the summer driving season. Over the past five years, their demand for oil has dropped an average of 1.2 million barrels a day from July to October. 

"It’s all extremely seasonal," said Francisco Blanch, head of commodity markets strategy at Bank of America Merrill Lynch, in a Bloomberg television interview. “We view this dip as a buying opportunity. We’re still looking for oil to be back in the $50-plus range heading into the year-end.” 

Prices might resume their upward trajectory in the fourth quarter as refinery maintenance winds down and heating-fuel demand picks up. Wall Street analysts tracked by Bloomberg predict WTI will average $49.85 a barrel in the fourth quarter while Brent will be $52.

“Supply is going down, demand is still going up,” Seth Kleinman, London-based European head of energy strategy at Citigroup, said by phone. “Those lines are going to cross.”

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