The Fuse

Options Market Is Not Buying OPEC’s Game

by Matt Piotrowski | June 13, 2017

  • Options traders turn bearish after OPEC meeting and upticks in the rig count
  • Only a 13 percent chance that $55 will be reached for September Brent
  • Activity along the WTI curve suggests some shale producers hedging below $50
  • OPEC losing ability to use verbal intervention to support prices
  • Movement to the downside will increase the number of puts, driving prices down further

OPEC has poured all of its energy into convincing traders and analysts that it is rebalancing the market for the benefit of producers and consumers—seeking a price equilibrium that prevents low prices that will derail upstream investment and culminate in a disastrous oil price spike. But according to the options market, traders aren’t buying it. Lately, they have shifted to aggregating around put options (bets on lower prices) in NYMEX and ICE crude, which is the opposite of what the market saw earlier this year when the bias was toward buying more call options (bets on higher prices) because of the belief that the cartel’s production cuts added more upside risk. The swift move into the put camp and the abandoning of call options reflect the underlying expectation that supply tightness won’t emerge this year.

Options give a buyer the right, but not the obligation, to buy or sell a specified number of shares at a predetermined price within a set time period. The options market, which can be a predictor of future price moves, reveals a conviction that prices will stay in the current range or move lower. Although some players hold onto bullish sentiment, traders are skewed toward a downside or rangebound bias in the near term—OPEC has lost credibility, the large inventory overhang persists, shale’s resurgence and a rising rig count continue, and the spat over Qatar didn’t affect the market. None of these factors should change anytime soon.

The buying of put options contrasts with the first five months of the year, when open interest in option calls were six times the amount of puts, as traders bought into OPEC’s strategy and wishful thinking.

In the WTI August options implied probability distribution, which is derived from volumes of August options, there has been a growing shift toward bearish bets (see below). Most open interest for August is in $45 puts and $50 calls, which makes sense, given the overwhelming bearish news. It also suggests that traders are betting on prices to stay congested within a tight range. That contrasts with the first five months of the year, when open interest in option calls were six times the amount of puts, as traders bought into OPEC’s strategy and wishful thinking.

options

In Brent, $55 call options for August and December have the highest open interest, reflecting the bullish sentiment shown earlier this year (both contracts traded up to $57 as recently as April). There are also a significant amount of calls for $60 for December (see below). The large bets accumulated for these contracts indicate the collective opinion of traders throughout this year. But here’s the rub. The probability of hitting these strike prices is low, with only a 13 percent chance that $55 will be reached for the August and September contracts. Moreover, the fact that the number of call options peak at $55 point toward that price level being the ceiling for the Brent market.

brentoptions

$80 oil by December?

Last week, there was an anomaly in the Brent market—a huge amount of call options were purchased at $80 for December, which of course raised eyebrows but also a lot of shrugs. Why $80 oil by the end of the year? The buying, according to market sources, was mostly an inexpensive bet on a geopolitical black swan event rather than a real conviction that prices will rally to that level in the next six months.

On the opposite end of the spectrum, the $40, $45, & $50 levels dominate the open interest for put options Brent, with very little action for a strike price of $30, indicating that many do not see prices collapsing below the $40 level, despite today’s bearish sentiment.

Reality bites for OPEC; shale producers hedge

This backdrop, of course, doesn’t guarantee prices will mostly sit still. The increased volatility as of late, thanks mainly to OPEC’s words and actions, has kept volumes and open interest on the ICE and NYMEX very high, attracting more technical traders, high-frequency players, and a number of other non-commercial actors, some of whom remain convinced oil prices will rally in the second half.

The increased volatility as of late, thanks mainly to OPEC’s words and actions, has kept volumes and open interest very high, attracting more technical traders, high-frequency players, and a number of other non-commercial actors, some of whom remain convinced oil prices will rally in 2H.

Activity along the curve, particularly in the contracts for December 2017 and 2018 contracts, has remained very strong recently, an indication of continued commercial hedging. This is a worrisome sign for OPEC and market bulls. Some U.S. shale producers are locking in contracts 6-12 months out below $50, signaling that costs are continuing to come down (the forward curve through mid-2021 is in fact below $50). The current OPEC strategy could be a disaster for its members, but it’s easy to appreciate the many ironies. In an effort to reduce stocks, it has given a major lifeline to its main competitor.

Reality has no doubt continued to bite for OPEC this year. Oil prices are off 14 percent year-to-date despite OPEC’s commitment to cutting output for the rest of the year and some forecasts calling for a deficit and stock draws to emerge during the second half of 2017. Since early 2016, OPEC has been able to support prices through verbal intervention and its agreement late last year to cut production, but the market is down roughly $10 from where it traded right after the deal was struck in late November. Over the weekend, Saudi Energy Minister Khalid Al-Falih said that inventories are declining and the pace will accelerate in the coming months, while his Russian counterpart confirmed his country’s commitment to helping balancing the market. The market got a bump from the comments, but only a slight one, reflecting that OPEC and its non-OPEC brethren are running out of ammunition. All OPEC supply news is already factored into the price, and increases in Libyan and Nigerian production are further limiting impact of the cut. “If in Q4 we need to do something different, we will seriously consider it,” said al-Falih, but such attempts at verbal support will fall on deaf ears unless it’s back by imminent action. In fact, such a comment is bearish in that it shows that the cartel’s action may not be large enough to get prices where it wants them to be.

The current OPEC strategy could be a disaster for its members, but it’s easy to appreciate the many ironies. In an effort to reduce stocks, it has given a major lifeline to its main competitor.

With shale output overperforming once again, other non-OPEC supply also coming online, demand growing within expectations, hedge funds becoming exhausted with OPEC’s rhetoric, Nigeria and Libya recovering, another leg down or a rangebound market shouldn’t be a surprise. And a number of options traders are betting on that right now.

 

 

 

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