It has been quite a while since Excell with Options looked at the oil market, having last discussed it at the end of January. Suffice it to say, a lot has happened since then. At the time, we looked at the various puts and takes, the drivers of potential supply disruptions, and the sources of demand changes. Additionally, we looked at the aggregate supply and demand as measured by the EIA.
Stating “If we put all of this together, we can see that there are potential impacts on both the supply and demand of oil. As with any commodity, the price will be impacted by the supply and demand of the product over every time horizon. Using U.S. Department of Energy data that measures world consumption and world supply, I created a custom index in Bloomberg to measures this supply & demand imbalance in percentage terms. We can see that whenever we get more than 2% out of balance (areas I have circled) there is an impact on price. The 2014-2016 bear market for oil was a period when the supply of oil was outstripping demand. Independent oil producers, using the new fracking technology, oversupplied the product. Fast forward to the end of 2020 and all of 2021. Demand levels have returned to pre-Covid levels, yet supply has not kept pace. Perhaps this is due to disruptions in US pipelines, challenges in Middle East shipping lanes, or unrest in countries like Kazakhstan.”
I have updated the custom index which uses that same data. Figure 1 shows the supply and demand balance, according to EIA data, has come back down to zero over the last six months. There have clearly been other drivers of supply disruptions, but there has also presumably been demand destruction from the persistently higher prices and now the fears of a slowing global economy. Perhaps it is this condition of moving back toward balance in supply and demand which has led to the move off the highs in the generic front month crude.
Figure 1: Oil supply and demand versus generic front month crude
While the world may be in balance, the Administration is not resting. President Biden recently returned from a trip to the Middle East to discuss many issues. One issue that was discussed was Energy Security, particularly in the meeting between the U.S. delegation and that of Saudi Arabia. Per the White House, the steps discussed amounted to increased production that will help stabilize markets, as the press release indicates.
Figure 2: White House press release on U.S./Saudi Arabia meetings in July
The spare capacity of OPEC, or the ability to produce more oil at the margin, has long been a topic of discussion. As with most market drivers, there are bulls and bears. Those that believe there is meaningful flexibility for OPEC to bring capacity online to reduce the volatility in market prices and those market players that are more pessimistic in the actual amount of capacity OPEC, especially Saudi Arabia, can produce. According to Reuters, the amount of spare capacity could drop to less than one million barrels per day by the end of the year. With little wiggle room in capacity, the potential for increased volatility in price remains a risk.
Figure 3: OPEC spare capacity
What will this mean for the market going forward? Where will the extra supply come from in the event a global slowdown does not bring down demand from current level? In a separate Reuters story, we might have some clues as to where the ‘spare capacity’ can come from. Saudi Arabia has more than doubled the amount of oil it imported from Russia for its own domestic power uses. This, in turn, potentially frees up oil for the Kingdom to export to other countries that need it. The new OPEC+ quota includes Russian production, but this has been constrained by sanctions. Is this a path to be able to access more of this production?
Figure 4: Saudi Arabia imports of Russian oil
With the next OPEC meeting on August 3, the spare capacity and therefore the global supply of oil is the major issue on traders’ minds. The IEA looks at the issue from an OPEC+ standpoint and see the UAE and Saudi Arabia as the two potential sources of new supply, assuming that there are no changes to the sanctions on Russia, and assuming Russian oil will not continue to be used as domestic replacement that allows for even more capacity than in the chart below. Suffice to say, there is a good deal of uncertainty as the market heads into the next OPEC meeting.
Figure 5: OPEC+ spare capacity per IEA
Another issue to consider is the market positioning. In the days heading into the meeting and announcement between the U.S. and Saudi Arabia on July 14, the market was soft in anticipation of announcements of new supply. Even with those announcements, the price of oil (as measured by the front month) has bounced almost $10 from the lows hit right after the announcement. This could be an issue of too many traders leaning in the same direction ahead of the event, or the event itself being largely priced into the market at current levels.
Figure 6: Generic front month intraday price chart for the July 11-18 period
These factors work together to create a situation where the August 3 OPEC meeting may become a larger than expected catalyst for the market for the rest of the year. On the one hand, there is the potential for even more supply to be announced by OPEC if it is willing to buy Russian oil for domestic use and sell more of its own oil to foreign markets. While this is a wildcard, the recent actions by Saudi Arabia open the door to the possibility. How will other countries and governments respond to this news? Will it be negative because it is circumventing announced sanctions or positive because it is helping alleviate domestic energy inflation that is plaguing many countries? In addition, how will traders position for the event and price the outcomes? Could we see a replay of the July 14 news where the price moves counterintuitively because the expectation of that news was priced in? There are several moving parts to work through and thankfully CME Group has the tools to help us do so.
The first step is to try to determine what the market expectations for the OPEC meeting are. The OPEC+ Watch Tool, from CME Group, does exactly this. As the CME Group website states: “There are different methods for extracting probabilities from options prices. A number of these involve estimating a probability density function (PDF) by inverting an options pricing formula such as Black-Scholes and using option market prices to solve for the pricing density function.” More specifically for this meeting, “Once the CME Group OPEC Watch Tool starts tracking, an implied distribution will be derived in real time from the generated August 3 expiration:
- The probability area ≥ +1 SD price will be the ‘No Change or Small Output Decrease’ %
- The probability area ≤ -1 SD price will be the ‘Further Output Increase’ %
- The probability area > -1 SD and < +1 SD will be the ‘Maintain Output Increase’ %
Putting this into practice, the imputed expectations (as of July 20, 2022) for the August 3 OPEC meeting are:
Figure 7: Market expectations for August 3 OPEC meeting (as of 7/20/22)
There is a two-thirds probability that OPEC maintains the output increase already announced. Said another way, the OPEC+ Watch Tool based on the options market is saying there is a two-thirds chance that this meeting is a non-event. If that is the case, then there may be no trade to consider other than selling implied volatility. But at these levels of implied volatility relative to both recent history and relative to realized volatility, it may not be that attractive.
However, we can also consider the possibility of the market being surprised. If the market were surprised, and there is a one-third chance of that, in which direction might it be more so. There is a much smaller 6% probability priced in of a further output increase and a much higher probability of 27% that there is no change or even a small decrease. If one considers this range of probabilities, one can surmise that the market would be less surprised with the more bullish news of no change or small increase than it might be with a larger than expected increase, given the options only assign a 6% chance of that. The options market assigns a four times higher chance of a small or no increase than a larger than expected increase. In layman’s terms, the market would be more surprised by a bearish announcement.
The next step we want to consider is the options market pricing. For this, there are several tools I look to. First, looking at the CME Group Volatility Index (CVOL) tool to see not only where the at-the-money volatility is priced but also where the various measures of skew and kurtosis are priced. Figure 8 shows the current CVOL level of 55.61 is roughly in the middle of the year range. Both UPVAR and DNVAR have moved lower, which I interpret to mean that the lower demand for out-of-money options suggests that traders do not anticipate the need for the insurance of these options and may instead be looking to use these relatively higher volatilities as a source of income generation. The relative pricing of UPVAR to DNVAR gives us a measure of SKEW that itself is a bit lower but reflects also the higher demand for upside options than downside options.
Figure 8: Energy products CVOL
We can also look at the time series of both CVOL and skew and see how it overlays versus the futures price by clicking directly on the WTI chart (left of WTI in CVOL). Both skew and CVOL have moved higher from the end of 2021 through the March-April 2022 time frame suggesting a positive relationship. Both have moved lower since then, even as the underlying traded in more of a sideway pattern and even before the move lower in crude from June through July. As of late, we can see a subtle uptick in CVOL, perhaps because of the events that have most recently occurred and are going to occur at the OPEC meeting.
Figure 9: Time Series of WTI CVOL
Next, I look at the short-term technicals. Plotting the crude’s active contract daily chart, two things stand out to me. The first is in the middle panel where the MACD line is turning higher. It has not yet crossed over, so it isn’t a clearly bullish sign, but it is hinting toward a more bullish formation. The second is the lagging span on the Ichimoku chart. While the price itself moved below the cloud, the level where the majority of buying and selling has occurred in open positions, the lagging span, which smooths this out by using trailing data, has held the cloud level. This can also be an early sign of bullishness in prices.
Figure 10: CLA daily Ichimoku, MACD and RSI charts
I like to corroborate this by seeing if I get the same signals in the weekly charts. If I do get the same signals, I feel more confident that if both daily and weekly technical signals point here, a directional move may be occurring. If I do not it of course leads to uncertainty. If we look at the weekly chart the trend is potentially stalling out as the weekly MACD has turned lower. In addition, on the new highs the market set in June, there was not a confirmation on the RSI, which did get elevated but did not go to new highs on its own. This chart gives more of a signal of a consolidation of gains. As I said, if the weekly does not confirm the daily, it leads to uncertainty for me from a directional standpoint. However, I also know that some traders only look to one or the other – are only shorter term swing traders or are only longer term trend-followers. Thus, the two different constituencies may be thinking differently in the direction of crude. This sounds to me like the possibility of higher than expected volatility as one group potentially will change its mind after the catalyst of the OPEC meeting occurs.
Figure 11: Weekly Ichimoku, MACD and RSI chart of CL
In thinking of where I would look to place my options trade, I want to consider the term structure of implied volatility, which we can do via QuikStrike. Looking at the shape of the curve, it has very much a SIN curve wave shape to it, with elevated implied volatility in the September futures that cover the OPEC meeting, relatively lower implied volatilities in October and November, and then higher volatility for the end of the year and beginning of next year. However, in absolute terms, we are looking at a difference of about 0.5 vols (52.15 in September vs. 51.55 in October). This is probably not enough of a difference to get me to consider calendar type of ideas.
Figure 12: CL|LO term structure of implied volatility
Crude option put spread example
Putting together all this information, an example starts to coalesce for me.
- We have a known catalyst of the August 3 OPEC meeting, where we will get information on potential supply additions.
- The market is not expecting much new information at this event, with the OPEC Watch Tool telling us there is a two-thirds probability to maintain the output increase. More notably, the options market (as we can see in the OPEC+ Watch tool) is implying higher odds of a disappointment in the form of little or no increase at all, which could potentially be bullish. However, it seems to be expected, at least by some, and based on the price action we have witnessed after July 14, the expectations of the news matter as much or more than the news itself.
- Looking to the technical charts, the possibility that short-term and medium-term traders have a different opinion of the direction of crude.
- Implied volatility as measured by CVOL is well off its highs for the year.
- Skew is also well off its highs for the years and favors the upside. Finally, the September options contract has elevated volatility relative to the October and November contracts but the difference in absolute terms is not that large.
In my framework, I look at fundamentals, behavioral and catalyst reasons to decide on a trade. Fundamentally, according to EIA, the current market is roughly in balance. There is an expectation of increased supply as announced by the White House post its meeting with Saudi Arabia. The market is largely pricing this in. The potential wild card is a larger than expected supply announced by OPEC which could be driven by the ability to buy Russian oil for domestic reasons, freeing up more capacity which is expected to be tight for this year. The behavioral reason is there is a potential mismatch between investment communities. A move in either direction will confirm either the daily chart or the weekly chart, which right now are at odds with each other. This means, there is some group of investors that will be offsides with any news that is not expected. The biggest surprise, according to the OPEC watch tool, would be the larger than expected supply announcement which I indicated is a potential wildcard. This could be bearish for oil, therefore. Finally, is there a catalyst to get people to change their minds? Yes, the August 3 meeting. With September options priced at roughly the same levels as the rest of the curve, this is where I want to look to buy options.
I have put together a bearish trade that buys some volatility for the event. Because of the catalyst and where volatility is relative to its history this year, I am comfortable with a small, long gamma, and vega trade. Since the outlier is higher supply, and that may catch some off guard, I like the bearish direction. I have chosen to do a put spread instead of outright puts to reduce my cost. For those traders with more ability to spend some premium, they may choose to simply buy the puts ahead of the event. The top strike on my spread is the 95.50 strike and I have sold the 91.50 put to finance this, taking in small premium in implied volatility. My total cost for the spread is $1.41 with a total potential gain of (95.50-91.50-1.41) of 2.59. This gives me about a 1.8 to 1 reward to risk ratio. I generally prefer a 2 to 1 or higher reward to risk, but that isn’t always available. Like I said, you may choose to simply buy the put outright. To risk the same premium of $1.41, you would have to buy about an 85.50 strike, thus this spread kicks into the money $10 earlier. I like the put spread because the payout can start earlier for the same amount of premium spent.
For some accounts, this same trade could be constructed using Micro Crude options as well. Micro Crude options and futures have several appealing benefits. First, they are cost-effective since the Micro products are 1/10 the size of the standard contract. This means that the tick value is $1 vs. the $10 for the standard contract. The value of one point in the future is then $100 versus $1,000 for the standard contract. Because of this smaller size, they provide a similar exposure without the margin requirement of a standard contract. This means that Micro products provide access to more accounts that may not be able to trade the standard contract given portfolio size. Thus, these accounts get the benefit of portfolio diversification and flexibility in tailoring their exposure and managing their risk. Using Micro options, I would choose the same strikes and have the same $1.41 premium, it is just that the multiplier is lower to get to total premium outlay.
Figure 13: Expected return of the put spread
We looked at a lot of moving parts. However, given that OPEC only meets twice a year so this could be a major event for all markets, it was worth doing as thorough of an analysis as possible. Using our analysis to come up with an example that has explored what can go right and what can go wrong from many angles. It may not be for everyone, but it hopefully shows what we can do with options and how we should think about options.
Micro WTI Crude Oil futures and options
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