Fear makes oil options increasingly expensive

LONDON: The price of oil options is soaring amid increasing uncertainty about the outlook for prices and indicating a mismatch between strong demand from hedge funds and caution among option sellers.
The implied volatility, and therefore cost, of at-the-money one-month Brent options contracts has surged to 53 percent, up from 46 percent at the end of last year and just 34 percent in mid-November.
The level of implied vol is now at the 95th percentile for all trading days over the last decade and only consistently exceeded this level during the financial crisis in late 2008 and early 2009.
The gap between implied vol (how much the market expects prices to jump around in future) and actual volatility (how much prices have moved in the recent past) has grown to almost its widest since the financial crisis.
At the same time, downside put options have become increasingly expensive relative to upside calls as the market fears prices are more likely to lurch lower in the short term than rally.
The big gap between implied and actual volatility, especially on the downside, suggests demand for option contracts that pay out in the event that oil prices slide further far outstrips supply.
Market participants seem increasingly convinced prices need to fall further to trigger a crisis, forcing shale firms to stop drilling and perhaps compelling OPEC members to rethink their decision not to cut production.
With signs growth in the US is slowing and China’s equity market sliding, that view no longer seems fanciful.
On the other hand, there are still an enormous number of hedge fund short positions in both Brent and WTI that will need to be covered eventually, which could act as a brake further price falls.
At the end of 2015, hedge funds and other money managers still held near-record short positions in Brent and WTI totalling almost 348 million barrels, according to reports from market regulators.
Combined Brent and WTI short positions had been reduced by less than 5 percent from the record 364 million barrels set three weeks earlier, which leaves most of the short positions still be covered.
— John Kemp is a Reuters market analyst. The views expressed are his own.