Fra BNP Paribas:
Oil prices have pulled back from the highs reached between end May and late June. Is optimism over the oil market re-balancing wavering? Is a shift in sentiment emerging?
Market positioning shows that money managers are adding fresh new short futures positions. And while option skew at the front of the curve has yet to reflect heightened bearish concerns, open interest on put options with a $40/bbl strike is running high on the front September contract and beginning to rise for October.
Absent a collapse in demand or a positive supply shock, the current move down in oil is likely to continue to be an orderly one. The slow grind lower reduces the attractiveness of going long short term volatility, and by extension holding gamma in options.
Oil investors: are doubts creeping in? Technical analysts have no doubt noticed that ever since oil peaked in the first week of June, every subsequent rally has fallen short of that level. Is the oil market losing momentum?
The succession of supply outages that fuelled the oil price rise between February and May has partly unravelled. Canadian output is back albeit the situation in Nigeria and Libya remains tenuous due to domestic conditions. So why has the price declined recently? OPEC’s producers Saudi Arabia, Iran and Iraq continue to try maximising production, with Iran drawing on storage to help boosts exports and market share.
Oil product inventories are high relative to seasonal averages, notably for gasoline in the US. This is pressuring refining margins, raising the prospect of economic run cuts ahead of scheduled maintenance in the autumn that would lead to weaker demand crude demand. In addition, with the active oil rig count in the US creeping higher, dampening the much awaited y/y decline in US shale production, there is ample reason to be weary of a further correction in price.
Money managers’ net futures long exposure is beginning to erode (Chart 1), not because long positions are pared but short positions are being added.
Option skew vs. put option open interest Risk reversals at the front of the curve are good gauges of market sentiment as they reflect willingness to pay-up for upside/downside protection. Yet, the current skew on the front-month WTI options show a shallower put skew than during the end of June to early July period when the spot price was higher (Chart 2).
At first glance, this may suggest that concerns against protecting against downside risk are nuanced. In contrast, the open interest for put options with a $40/bbl strike (Chart 3) is running high on the frontmonth September contract and is beginning to rise on October. Arguably, the premium of OTM puts at the beginning of July may have been an opportunity to implement reversal trades and go long skew. But if the oil price continues to decline, the direction of the skew may easily head back the other way.
Not necessarily a good time to be long volatility. Changing sentiment and the possibility of lower prices raise the question of whether going long front-month volatility is attractive, notably when the implied measure is below the realised or historical measure on a 30 day basis (Chart 4). While the narrative above is negative for oil, the decline we have witnessed has been relatively orderly.
If the oil price grind lowers, going long short term volatility and/or owning option gamma, may not be attractive
