Prepare for Volatility

I saw a comment from someone yesterday that if this week’s inventory report shows a sharp drop in crude inventories, oil will probably spike up above $100. I do think that because of the storms in the North Sea and the flooding in Mexico we will see a decent inventory draw this week. But I don’t think the price will spike to $100 on the news, because this week is complicated by a number of factors.

The first is that the inventory report will be delayed by a day this week, due to the government holiday on Monday. The second is that the front-month WTI contract expires the day after the inventory report is released. There are a lot of people holding contracts that must be sold by Friday. What I expect then is that any bad news that pushes prices higher will be met by speculators selling into the rise.

Another factor that may cause tremendous volatility is that December options contracts expire on Tuesday. If crude doesn’t trade at or above $100, those options expire worthless. This means that there is a tremendous incentive for a lot of people to talk up the price today and tomorrow. I would expect a load of analysts over the next couple of days to appear on TV and “explain” why things are much worse than they seem.

Today’s Houston Chronicle has a story on the expected roller-coaster this week:

Wild week ahead for price of oil

Here is a quick summary, pulled from excerpts in the story:

It’s a situation one analyst likened to a high-stakes poker game. A showdown between traders who believe the price will rise and those who believe it will fall could bring both results — a brief taste of $100, followed by a rapid sell-off.

Lehman Brothers’ Morse said in the report that the Dec. 7 futures contract for West Texas Intermediate crude — the U.S. benchmark — will expire Friday, and 360,000 contracts remained outstanding. Most of those contracts are held by financial players in the oil market and must be sold by the expiration date, Morse said.

“Presumably, market participants know that the exits are going to be crowded over the next few days if they do not sell their positions soon,” he said.

Adding fuel is the West Texas Intermediate options market on the Nymex, where 42,000 Dec. 7 call options for $100 are set to expire Tuesday.

An option to buy at $100 a barrel will only be profitable if oil costs more than that sometime before the option expires. So those 42,000 call options will “expire worthless” on Tuesday if oil doesn’t reach $100 a barrel by then.

“Perhaps, before Tuesday, holders of these calls will attempt to push oil to $100 in a last effort to force these options into the money,” he said.

So there are 360,000 contracts, most of which must be sold between now and Friday. And there are 42,000 options that will only benefit if oil makes it to $100. The expectation is that the traders holding those 42,000 options will talk the price up. But they are going to face the headwind of those holders of those 360,000 contracts trying to liquidate by Friday. I just can’t see oil reaching $100 in the face of that.

Eric Wittenauer, an analyst with A.G. Edwards & Sons, said 42,000 call options at $100 indicated that the holders expect they will be able to exercise them at that price.

“I think it’s a logical argument that someone’s going to have a lot of money on the line and potentially want to drive the price up to $100 and above,” he said. “If you break through $100 and tack on some more, you make that much more profit on your positions.”

Morse said speculators could back off and take profits before a barrel hits $100, but the price most likely will make “a serious run at $100” by Tuesday and perhaps reach $105 before selling pressure ensues.

It is certainly a credible argument that the holders of those options will try to talk up the price. But I don’t think it is at all credible that they can actually talk up the price to that level. It will take a major geopolitical event or natural disaster to affect prices that strongly. If we don’t see any major news by Tuesday’s close, and oil trades over $100, I will be stunned. As I write this, WTI is trading at $94.94. It’s not going to make it to $100 by tomorrow just on the basis of traders trying to talk it up.

I do agree that we could see a sharp sell-off by Friday:

Then, with the contracts that must be sold by Friday, the rush to sell “may be stronger than anything the oil market has seen in several years,” Morse said.

He said prices could fall to the low $80 range by early December.

I don’t think oil is going to fall to $80 in 3 weeks, but I have said again and again that I don’t think the current price is sustainable in the short term. I think we will pull back shortly, and make another run at $100 in 2008. However, if OPEC doesn’t say the right things following their meeting this week, they will toss more fuel on the fire and make it more unlikely that prices will have a huge correction.

Full Disclosure: I don’t hold any commodities positions. Although I am beginning to think that I should. 🙂

14 thoughts on “Prepare for Volatility”

  1. This morning’s discovery: Anyone interested in the human reaction to gasoline prices should read (at least) the first excerpt here

    It talks about gasoline directly for much of that section.

    Page nine talks about price unfairness, as perceived by capuchin monkeys. It seems to me that when I’ve wanted to talk (in comment sections) about price fairness having deep rooted or biological origins, I’ve been the odd man out.

    I think defenders of a particular price or practice have a tendency to say people who argue from “unfairness” are just wrong or just irrational.

    Sorry, that’s like an engineer blaming his materials. If you operate in a social environment, you can’t do it by ignoring the social rules (the nature of the material).

  2. Odograph – our shareholders also have a perception of a “fair” return on their investment. Historically, the energy industry has been pretty low.

    Robert – my problem with options speculators is that they are trying to make a few pennies at the expense of several dollars for every consumer that is fills up his tank this week. My attitude on $100 crude options is that they ARE worthless. A $100 option implies that somewhere in the world there is crude supply that is being kept off the market at $100. This might be true at $60, where some stripper well might get 20 barrels of water for every barrel of crude. But $100? Madness.

    My solution to the problem is to force options traders into the physical market. For the right to trade options we have a lottery where a portion of the options traded must take physical possession of the underlying option. Now if you have a chance of getting stuck with a contract to buy $100 oil, you’ll think twice about it. The way it stands now traders have very little at risk, yet they drive up the price for everyone.

    Under my system energy companies and refiners won’t care because they are already in the physical market. But it will introduce some discipline into trading.

    I hope the longs eat it big time this week.

  3. Surely you could not have said that if you’d read the excerpt?

    I mean, which would shareholders rather … a piece of a company than understands the psychology of their market, or one that does not?

    To extend this a bit, and to return to the “social contracts” that oil folk find so troubling …. oil companies take out quite a bit of television time to tell people that they are finding “tomorrow’s energy.”

    Will they? What will the natural human reaction be, when tomorrow’s energy comes at $4 or $5 per gallon?

  4. A very brief article by Steven Pearlstein (11/11, Wash Post) says current prices can only be explained by speculation –not underlying S&D fundamentals: reserves at high level, recovery rates up, demand down in US this year, less than 1% worldwide. If true, shouldn’t we expect sharp price drop sometime soon, when fundamentals sink in.

    Title of article is: The Newest Bubble Oil. Be interested in r-squared view.

  5. You should charge for these reports, cuz others are makign money off of them. Oil down over $2 right now. What was that Lehman Brothers analyst on to think oil could get to $105 tomorrow? This looks like a fire sale this week with all those contracts needed to be sold.

  6. Odograph – I was merely pointing out that energy companies costs and their shareholder expectations have gone up too.

    The excerpt mentioned something about ExxonMobil’s CEO getting paid big bucks. I see no mention of Goldman-Sachs bonus pool, and their trading profits!

    On oil speculators. Essentially what they are saying is: “I’ll bet a few dollars that SOMEBODY else is going to pay $100 for crude oil.” That to me seems fundamentally unfair. Make em pay.

    WTI down $2.25! SELL SELL SELL!

  7. I think the interesting thing going forward might be: if oil companies see prices trending higher, should they tip that to the public (earning fairness points) or should they whistle along (earning actual dollars).

    They may have decided that they are not in the business of selling conservation and reduced consumption, and they’ll take the heat … and the profits, as people figure that out.

    From a stockholder perspective that may be good (maximize gain) even if it means taking some lumps in public opinion.

    (I can imagine the television ad they won’t run: “We’ll find tomorrow’s energy, but it’ll cost ya”)

  8. I think defenders of a particular price or practice have a tendency to say people who argue from “unfairness” are just wrong or just irrational.

    I completely understand the reaction, as I have the exact same reaction to many situations. I had that reaction yesterday when I was trying to buy airline tickets. So what I try to do is to explain to people why things are as they are.

    if oil companies see prices trending higher, should they tip that to the public

    I think what they need to do, and they have been doing this more lately, is to acknowledge that we are facing a serious supply/demand imbalance, and this will probably lead to much higher prices.

    Cheers, RR

  9. the price of any asset is on occasion held captive by speculation-recent realestate, e.g.
    in the long run appropriate adjustment to fair value will may take very long time and give some investors or speculators ulcers or worse.

    removing option speculation would be akin to halting blackjack in vegas.

    neither will happen ’cause the “HOUSE”[big money banker/broker, casinos] won’t allow it. THE HOOK IS SET!

  10. I like the post, but the talk about options is way off in my opinion. First of all, option contracts don’t represent ownership by themselves — i’m sure everyone already knows this, but when people talk about the number of options or futures contracts outstanding they are referring to open interest — if open interest on the 100 call strike is 42000, that means there are 21000 longs and 21000 shorts. So for every person looking to manipulate the market in order to push oil above 100, there are an equal amount of shorts looking to make sure those calls expire worthless.

    Secondly, buying futures to improve the chances your call will expire in the money is extremely risky — it is known as a “texas hedge” amongst option traders — long call holders are already implicitly long the future, so why double up?? Why not just sell the call right now while there is still some premium left rather than taking a huge risk trying to manipulate a futures contract that has over $27 billion in notional outstanding open interest? This is on top of the fact that in order to make the call profitable, you need to push the future not just to $100, but ABOVE $100 PLUS what you paid for the call in the first place.

    Finally, there is no way that all of the people long the 100 call are holding that position in a vacum — many call holders hedge their position by selling futures — by doing this, they are effectively “buying volatility” rather than making a directional bet. For those people, the last thing they would want is for oil to run to $100 — their call would still expire worthless and they would be stuck short futures in a rising market. This is the same for people who own the $100 straddle — if anything, they want oil to get as far away as possible from that strike come expiry.

    I don’t mean to criticize all this talk about the markets and where people think its going, so long as its just for fun — after all, everyone has an opinion about what team will win on Sunday. But I do think it is important to note that oil is a commodity market — it is not meant for investment — if you want to invest, invest in the companies that do something with oil rather than oil itself. And if you want to trade, know what you are talking about before putting up that margin………

  11. Heh, I said yesterday of big oil:

    “They may have decided that they are not in the business of selling conservation and reduced consumption, and they’ll take the heat … and the profits, as people figure that out.”

    today the wsj energy roundup says:

    “Never let it be said that Big Oil doesn’t have a stake in energy efficiency.”

  12. KingofKaty said:
    A $100 option implies that somewhere in the world there is crude supply that is being kept off the market at $100.

    I agree that the marginal price is almost unrelated to crude extraction. But from a US (WTI, NYMEx) PoV, outbidding another importer is essentially equivalent to adding supply: i.e., price is now set by demand curves only (inelastic in the short term, thus a high marginal price).

Comments are closed.