Crude mid-range, trading weak on ST fundamentals. Implied volatility at extended levels, setup for OPEC Nov 30th, large flow going through the market
Macro investors are still processing the post-US election shock. Doing so by reassessing inflation expectations (perceived to have been unrealistically too low) and now boosted by the pre-election campaign of mega infrastructure, tax cuts (ie. increase demand) and protectionism. There are big moves going on in all major asset classes (and trading opportunities) across the board. Rates moved significantly (eg. US 30Y ~3.0%), spilling over across EM/commodities/FX etc. Various cross-asset correlations have broken down, some major ones gapping by several standard deviations.
In this context, and given the fanfare surrounding the Trump reflation theme, it appears odd that oil, for the most part, is really one of the few major assets driven by its own fundamentals, somewhat independent of the macro “noise”. The Trump election is expected to mean a positive for US (tight oil) production (lower tax, easing of environmental regulation etc). Like all recent presidents, he “wants” the US to be energy independent from the Arab gulf/OPEC. As a “counter” to this expected increase in US supply, there is the idea that the Iran deal would be (partially?) reversed with re-imposed sanctions.
Still oil is mostly driven by its own specific factors right now and the market is expecting big things to happen soon. As we are coming closer to 30th Nov OPEC meeting, the market’s setup is nothing short of huge. In the options market, participants are paying up for front volatility in a big way. Brent Jan and Feb is trading ~48% and we have to go back to March/April to find vols at these levels (and flat price was trading ~$10 lower then). This is clearly driven by flow as the implied versus realised volatility spread is now ~10 point wide (yes even despite the flat price move yesterday). The breakeven at current volatility level requires a daily move of close to $1.45 (YTD average at $1.17, see chart2 below). Some are putting their money on it aggressively, yesterday afternoon, a large buying clip of live options bought 20k of Feb Brent 51 calls and size in multiple call strikes and call spreads in WTI. Therefore, as most recent option flows show, there is definitely sizeable fresh length being established now. In spreads, as well, it is not just the front dated but deferred spreads which are bid recently (see chart3 below).
Newswires of OPEC related deal has been hitting the tape hard in recent days without managing to really prop up prices. So, the recent 2- day bounce seems more a function of positioning rather than specifics in recent avalanche headlines. Indeed, coming into the election, managed money data shows that it was the biggest net sell week since the data was compiled (WTI + Brent combined). It also shows open interest net length at or close to the year lows. This positioning “caught off sides” seems the most plausible reason for yesterday’s 5.00% pop. That was impressive given the +3.65 API builds yesterday and trading wise reinforced by the previous day’s price action where crude managed a solid roundtrip closing flat(ish) on the day.
There is also the way the market makers are positioned now which probably explains in part (or perhaps in dominant part) the flat price swings of late. There is a large (recurrent) national hedge deal that was executed a few months ago (as well as other producer structures) and as time went by, the market is right on the strike(s) and the risk has gone from volatility to gamma.
Dealers have been scrambling to cover via the broker market their short gamma/volatility positions feeding into crude vol.
For sure, OPEC’s tone is assertive and the fact that some of OPEC’s heavyweights with Russian energy officials are meeting in Doha (17th and 18th) is surely causing some short covering. As a side note, there are numerous scheduled events where bullish headlines may emerge (23rd/24th Nov technical OPEC meeting, 25th Nov OPEC High Level Committee meeting with the final decision on the 30th). Also, given the thanksgiving weekend, it seems, anecdotally recently at least, that flat price grinds higher on positive headlines in recent holiday periods.
Taking a big picture view though, I continue to believe that OPEC is getting inspiration from the central banks’ template: They basically managed YTD, to bring OPEC basket price up by $10 while increasing production by over 1 mbpd, and that in the context of unexpectedly resilient US production and 500+ mil in US stocks. The October data by Reuters show that OPEC exports (25.51 mbpd) is the highest ever.
My view is that the price reaction post-Nov 30, will not justify the current high vol environment and the outcome will not be as binary as the price expects (+ thanksgiving holiday). Most probably the range will hold. If it does not, a great opportunity to place fresh producer hedges.
In more traditional fundamentals, just when the market was grasping that Nigeria production issues did not impact exports all that much after all, it now looks like this is changed. The “rebels” are said to have taken down quite a bit now (300 kpbd of Bonny light + 200 kbpd on Forcados), add to that some 100 kbpd down on Escravos and it adds up. Until now, this recovery in Nigerian and Libyan oil is the cause of the current glut in the Atlantic basin. In the background, there is the data of continued strong production from the FSU. Hence, exclude an OPEC deal and the picture is not bullish, at least definitely not short term. Perhaps, through all the “Trump” related noise, the October data out of China is the most important. China is definitely pulling less oil for its equivalent of SPRs, as I had noted back in early Q3. This can prove to be a problem for all this crude if it lasts.
For oil producer companies, the strategy, for now and until OPEC day, has got to be to “hold the line”. The $42 – $53 range appears unbreakable now for a number of months (perceptions reinforced as attempts to break higher 3 – 5 times failed). The right structure to take advantage of this continues to be a three-way structure, as it permits to (1) take advantage of the high price of wings, (2) gives a better entry point by monetising the high put volatility (skew) via the put spread and (3) takes advantage of the high volatility environment by selling the OTM calls.
CHART1: BRENT 3M Implied versus Realised vol
CHART2: BRENT front theta/gamma
CHART3: BRENT front & dec17/dec18 spread
CHART4: BRENT price range
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