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Executive summary

With the current uncertainty in the energy markets, Rich examines two different ratio spread positions to express either a bullish or bearish opinion:

  • Crude Oil Christmas tree spread
  • Nat Gas Jade Lizard spread

It has been three months since we last looked at the energy space in Excell with Options. Suffice to say that a myriad of catalysts has hit the energy market from geopolitical risks in Europe, to environmental risks globally, to weakening economies and potentially falling demand in Asia. Energy prices are top-of-mind for all governments, and we are seeing U.S. and Europe taking action to combat the higher prices. When I have not looked at the market in some time, the first step for me is to typically look at the CME Group Volatility Index (CVOL). When looking at the CVOL, most volatilities are in the upper half of the range over the past three months.

Figure 1: Three month Energy CVOL

Furthermore, if we look on a year-to-date basis, we can see that we are at the upper end of the range for Nat Gas and for Energy overall. Implied volatilities remain firm in these markets as the level of uncertainty on a forward-looking basis has not diminished with many of the catalysts still solidly in play.

Figure 2: Year to Date Energy CVOL

With implied volatilities elevated, we need to be sharper than normal on our directional analysis because we will either pay more insurance premium if we choose to buy options or we will be looking to sell options, and short gamma can be difficult to trade in uncertain markets. To help me understand the lay of the investment landscape, I look to the Commitment of Traders (COT) Report to understand how various players are positioned in the market. In any trade there are two sets of fundamentals – the fundamentals of the underlying market and the fundamentals of the contract itself. Positioning can help us understand the latter because it may help us determine the reaction to news more so than determining what the news itself might be.

The first chart that catches my attention is the COT for crude oil. The chart shows that the length in the futures among the managed money community has been coming down steadily since the highs in the first quarter, but traders remain net-long though the positioning is dominated by spread activity. I am struck that the managed futures community is still net-long, even if less so, in a market that has been trading poorly for the last six months.

Figure 3: Commitment of Traders Report for WTI Crude Oil

My own thoughts on the fundamentals of the underlying market itself begins with an assessment of the supply and demand for crude oil products. I begin by looking at the U.S. Department of Energy EIA data. From this data, I can look at supply and demand and plot the difference in white below. I have drawn two horizontal lines showing whenever the supply and demand gets out of balance by 2% or more based on EIA data. The oil market is always closely in balance, and therefore, a difference of 2% of excess demand or supply can really begin to tilt prices. We can see on this 10-year chart that because of the U.S. fraction revolution in the 2014 to 2016 period, when there was less discipline on supply as independent companies were quickly bringing product to market, we tipped into an excess of supply of more than 2%. This had a negative impact on prices that lasted the entire period I have encircled while the excess supply lasted. Again, we see a supply and demand imbalance around Covid-19 with plummeting demand coupled with over supply. Once more, prices were under pressure until supply and demand got back within the 2% threshold. For all of 2021 and into early 2022, there was an excess of demand relative to supply and this led to rising prices throughout last year and into early this year, which were then only exacerbated by the geopolitical events in Europe.

Figure 4: Crude Oil EIA demand vs. supply relative to front month WTI Crude Oil

Adding to the difficulty of assessing supply and demand, the U.S. government announced back in March that it would be releasing supply from the Strategic Petroleum Reserve over the summer and into the fall. This will curb the higher energy prices that Americans were facing. The white line below shows that reserves have come down by 27% from 560mm barrels to 416mm barrels over the ensuing six months. This approximately 145 mm barrels over the 180-day period is equivalent to about 0.8% of demand, which runs about 100mm barrels per day. As of right now, the overall supply and demand imbalance sits at -1.85% and the U.S. SPR release is not quite half of that.  In addition, in the circle in red, we can see where last week OPEC+ announced that production would be cut by about 2mm barrels a day, which is about 2%. While there are some market participants that are skeptical, a full 2mm barrels per day can be achieved, we can assume that while we were on the cusp of breaching the 2% threshold, at the very least we might move back into the range.

Figure 5: Oil supply and demand vs. SPR releases vs. front month WTI Crude Oil

Adding to the uncertainty, the U.S. is not finished releasing from the SPR. In figure 6, it shows we are currently in release phase two, which will conclude at the end of October. Of the projected 190mm barrels, a total of 145mm barrels have been released so far. Thus, there may be pressure this month from the releases, which end in a couple of weeks with the conclusion of October. Is a big potential source of the supply and demand imbalance going away at the same time a force in the opposite direction, OPEC+ cuts, is coming online?

Figure 6: SPR oil release schedule

Adding to the picture, I look at the price of crude relative to the crack spreads. I look at both the 3-2-1 (3 barrels of oil into 2 gas and 1 diesel) and the 2-1-1 (2 crude, 1 gas, and 1 diesel) spreads and compare to the price of crude. There are a few drivers here that you can see on the time series. We can see the move based on the geopolitical uncertainty in February and March. Then we can see the summer seasonality in crack spreads through June. From June through September, we may be seeing the evidence of fears of slower economic growth hitting the crack spreads and crude prices. In the last month or so, we may be seeing the early signs of the winter seasonality in crack spreads, which may also impact crude prices.

Figure 7: WTI Crude vs. 3-2-1 and 2-1-1 crack spreads

We have a market that is still besieged by uncertainty but where there are a few catalysts unfolding, potentially slowing economic growth, ending SPR releases, and beginning OPEC+ cuts, but at the same time there may be some positive seasonality. With these catalysts in front of us, options expiring in December look to be an interesting place to position. Comparing those options to the rest of the curve when looking at the term structure of implied volatility, we can see that December compares relatively favorably as it is the low point on the curve.

Figure 8: Crude oil options implied volatility term structure

Looking at the last six months of implied volatility history, it appears in line with where implied volatilities have been a few points above the trailing historical volatility, a rather ‘normal’ premium of implied to realized even if this year has been anything but normal.

Figure 9: Crude oil options ATM implied volatility history

Looking at the last six months of 25 delta risk reversal prices to see if the market has favored either upside or downside options, we can see on the far left that the upside was strongly favored but that fell meaningfully throughout Q2 before bottoming in late August and early September in terms of put preference. At this point, while puts are slightly favored, the risk reversal pricing shows little preference in either direction.

Figure 10: Crude Oil options 25 delta risk reversal time series

Similarly, the call skew or preference for low delta calls over more ATM calls is also relatively flat at only four vols. It has been flatter in the last month, but this level is in the middle of the pack of observations this year.

Figure 11: Crude oil options call skew

Pulling it together, there are potential reasons to lean long the crude market. The incremental supply that has been pressuring product has been coming from the SPR release, which will be ending this month. There is the potential for some economic weakness to hurt demand, but OPEC+ is also cutting production and we have some positive winter seasonality. The managed futures crowd is small long but this positioning is off the highs of the year. So on a move higher, there is reason to believe length could be added.  Implied volatilities are somewhat elevated in the middle of the range relative to the rest of the year. No strong preference is shown for calls vs. puts, which may further support that positioning is relatively neutral. Finally, the low delta calls look relatively fair vs. the meatier calls closer to the ATM.

Perhaps because I am thinking of December options, or perhaps because the trade really lines up well, the position that comes to mind is a Christmas tree spread. In this spread, I buy one nearer to the ATM call, sell three of the thirtyish delta calls and close my risk by buying two of the further out of the money low delta calls. There is a bullish lean to the position based on the strikes I have chosen. For this spread, I look at buying one-95 call, selling three-105 calls and buying two-110 calls to cover my risk. The trade is called a Christmas tree spread because you can see the breakeven diagram looks like a Christmas tree. I am spending premium on the position so if we move lower I will lose the money invested. If we have an extreme move higher above the 110 strike, I would also be above my upside breakeven and lose my premium, though my risk is limited. The way to profit on the position is on a move higher from the current 91 to the sweet spot of 105 at expiration. The Christmas tree spread benefits from the slow and steady move higher of spot and as we go higher you can see from the PnL at various dates we will begin to collect a lot more theta as we get closer to expiration. It is a low premium, relatively low risk, way to play a bullish idea on spot.

Figure 12: Expected return from a Crude Oil December Christmas tree spread

I would be remiss in speaking about energy without also looking at the Nat Gas market. As you recall from Images 1 and 2, Nat Gas implied volatility is at the highs of the year. One can see why options are quite expensive in this product with the news out of Europe on energy prices and commitments of U.S. supplies going to Europe.

However, if we look to the Commitment of Traders Report, we can see that managed money is getting shorter and shorter Nat Gas futures. In fact, on the last reading, the net-short position was the shortest of the year.

Figure 13: Commitment of Traders report for Nat Gas futures

Looking at the Ichimoku charts, we can begin to notice what the managed money may be seeing. The price chart has broken through support and looks ready to head back to the summer lows closer to $5. On the plus side, the MACD is beginning to show signs of turning up and the RSI is close to oversold, so it may not appear as if the bottom is going to fall out of the market. However, this is a weak technical set up.

Figure 14: Ichimoku Cloud chart for generic front month Nat Gas

Along the lines of expensive implied volatility, we can see from the Cross Correlation chart that the ratio of Nat Gas implied volatility to Oil implied volatility is 1.84x. It is highlighted in light green showing us this ratio is quite elevated relative to more normal levels. Suffice to say that Nat Gas implieds are high.

Figure 15: Cross correlation chart for energy products implied volatility ratio

Additionally, the ATM time series that implied volatility is at 100 and has been steadily moving higher over the course of the summer. An implied volatility of 100 means the future must move about 6.3% per day (100 / 15.8 – square root of trading days) in order for someone to long the options to breakeven. This is not impossible, but we see below the historical volatility is more like 70, which is about 4.5% per day. Thus, the hurdle rate to be long options is reasonably high in this product.

Figure 16: Nat Gas options ATM implied volatility history

The premium for low delta puts vs. meatier ATM puts has been compressing and there is actually a preference for the higher delta options.  This has disconnected from the future price.

Figure 17: Nat Gas options Put Skew

Pulling this together, I am inclined to be short implied volatility, given it is elevated against its own implied volatility history, elevated vs. its historical volatility and elevated vs. the implied volatility in other energy products. Technically, the futures price might look weak, but the positioning is as short as it has been. Therefore, the downside might be more limited because traders are anticipating the move lower. However, I am still happy to lean slightly short on a directional basis. When I combine these thoughts, I think of a Jade Lizard spread. Most think of this in relation to equity markets in which a trader is short a put and short a call spread but where the premium taken in is higher than the distance between strikes. I want to do the same thing, but on the downside, where I sell a December 7-6 put spread and sell an 8 call. Doing this, I would take in 118 ticks, so even on a move lower below the 6 put, I would still net 18 ticks.  On a move to the upside, I have taken in 118 ticks, so my breakeven is 9.18 vs. the future at 7.07, as a result I have about 30% on the upside before I need to worry about stopping myself.  It is primarily a short volatility spread that benefits from a lack of movement, which favors the downside ever-so-slightly.

Figure 18: Expected return for a Nat Gas Jade Lizard option strategy

A couple different ratio spread positions to express either bullish or bearish views on the underlying, but most importantly maximizes how the market is pricing risk at the time. As traders, we must always look for what the market is giving us because that way we construct ideas that give us the highest probabilities of success.

Good luck trading.

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