On first glance, oil prices appear to have stabilized since the attack on the Saudi oil facilities at Abqaiq in mid-September, which led to a major surge in prices. But the crude oil options market is telling a different story: the energy industry remains extremely nervous.
Activity in options based on WTI crude oil futures -- the world's most actively traded energy market -- shows that traders are anxious to protect themselves against increased volatility and against the potential of further sharp price rises.
This underlying tension in the oil market is revealed primarily in two areas: the risk-reversal of the 30-day WTI option and the call skew of the 30-day WTI option.
Waiting for a Call
Looking at the risk-reversal, also called a protective collar, is a standard way of testing whether the WTI options market is bullish or bearish.
The risk-reversal in this case is the difference in implied volatility between a call and a put in WTI options, both of which have a 20% (20-delta) chance of finishing in the money.
A "call" in WTI options gives the buyer the right, but not the obligation, to buy an oil futures contract at a specified price within a specified time. The opposite position is a "put" that gives the buyer the right, but not the obligation, to sell at a specified price within a specified time.
Over the past five years, the 20-delta put has averaged 4% higher volatility than the equivalent call, implying that participants were more worried about protecting themselves against the volatility resulting from a fall in futures prices than they were about an increase.
This difference reached as high as 6% on September 13 -- the day before the Saudi attacks -- as participants focused on the potential of a global economic slowdown, which would reduce oil demand.
The news from Abqaiq immediately reversed this bearish pattern and on September 16 -- the first trading day after the attacks -- the call jumped to 6% higher than the put.
The trend towards calls persists. By September 20 the call was nearly 9% higher than the put, which was the highest difference between the two in more than eight years. In early October the call remained slightly elevated relative to the puts, even though the Saudi authorities have reassured the market that they have restored full operations.
The risk-reversal tells us that, although prices have fallen since the post-attack highs, the oil markets are more concerned about another sharp move higher in futures prices, largely because of potential supply disruptions, than they are about further falls in prices relating to the weakening economic picture.
Reasons to Smile
The other key metric used to assess how the market views upside risk relative to downside risk is the volatility skew, which is also known as the volatility smile.
The volatility skew represents the difference in implied volatility between out-of-the-money options (OTM) and at-the-money options (ATM). When OTM puts or calls have higher implied volatility than ATM options, market participants are anticipating that a move in the underlying futures price will result in higher volatility.
Prior to the Saudi attacks, the skew in WTI options typically implied higher volatility if the underlying oil futures traded lower. Conversely, the slope of the call skew implied lower volatility if futures were to move higher, up until a point about $10 higher when volatility would start to recover.
The news from Abqaiq immediately reversed this trend. On September 16, the skews flipped, making calls positive and puts negative relative to the ATM volatility.
By early October, the skew in WTI options evened out showing a more symmetrical "smile" that means that volatility would likely go up in a move either direction. But the call skew remains highly elevated compared to the typical shape of the curve. The options market is implying higher than usual volatility to the upside if another market-moving event occurs.
Leave Options Open
The oil market remains finely balanced. On one side, there are bears that are concerned that a potential economic slowdown and the impact of trade disputes will reduce oil demand and weigh on prices. The bulls instead point to ongoing supply challenges around the world and the potential of another significant incident in the Middle East.
While the bears are in the driving seat in WTI futures at present, the WTI options market suggests that for the moment concerns about a bullish scenario dominate. The risk-reversal and the volatility skew both reveal a market that is more concerned about upwards price movements and resulting volatility than about moves to the downside. Behind the image of relatively stable WTI futures prices, significant hedging of upside risk is taking place through WTI options.
This article was written by Owain Johnson and Jeff White
(This article is sponsored and produced by CME Group, which is solely responsible for its content.)