Oil Price Swings Amid a Record Rise Spawns Profit Opportunities
NEW YORK, June 11, 2008 (Dow Jones Newswires)
Oil prices are not just near record highs; they're also exceptionally unstable.
Volatility in the oil market has been whipped up in recent months with daily price moves of more than $3 a barrel a commonplace. On Friday, front-month crude on the New York Mercantile Exchange leaped an unprecedented $10.75 and zigzagged violently this week.
Light, sweet crude oil for July delivery on Wednesday settled $5.07, or 3.9%, higher at $136.38 a barrel on the Nymex.
The explosive up-and-down moves have turned long-term budgeting into a chronic headache for commercial sellers and buyers of crude oil. But they've also created opportunities for hedge funds gambling on volatility itself. For traders making straight bets on the direction prices take, it means more money won or lost in a day.
For years, the price of oil scarcely budged. Between 1991 and 2003, Nymex oil futures' annual trading range never exceeded $20.
That now resembles an era of mythical calm. Through Tuesday, prices have ranged more than $53 year to date.
Measuring volatility is complicated. Traders typically look at options on crude to infer market expectations about how far prices will move. Options on crude futures give holders the right to buy or sell futures at a fixed "strike" price later on.
Options markets now imply a $144 trading range in the next year - quadruple that of a year ago, according to data compiled by Lehman Brothers energy analyst Adam Robinson. After Friday's massive run-up, options implied 2-to-1 odds that crude futures could rise as high as $228 or as low as $84 in the coming year.
On Friday, options on shares of United States Oil (USO), an exchange-traded fund that tracks crude-oil futures, indicated the market expects up or down moves of 3% daily, said Sveinn Palsson, derivatives strategist at Credit Suisse in New York. A year ago they implied a 1.7% daily move.
Jumpy oil prices reflect supply's fragile overlap with demand. Whereas more oil used to be readily available when needed, now it's become more challenging to increase output.
"There's no way someone's going to magically add 5 million barrels a day of production capability," said John Hyland, chief investment officer at Victoria Bay Asset Management, which runs the U.S. Oil fund. "Because you don't have any cushion anymore, the natural outcome is to have a greater degree of volatility."
As hedge funds and other institutional investors slosh money in and out of commodities, stocks, bonds and other asset classes, they also aggravate price moves in oil. Heavily leveraged traders facing margin calls in some investments may need to buy or sell contracts in others to raise cash. Their actions can spill into markets once seemingly self-contained.
"Volatility is contagious," said Francisco Blanch, the head of commodity research at Merrill Lynch. "Every time volatility picks up in other asset classes, you will have some contagion."
Trading On Chaos
Traditionally, traders have exploited or hedged against volatility by purchasing baskets of options on oil futures. One strategy is a "straddle," in which traders hold both a call and put option with the same strike price and expiration date. On Monday, the straddle on $134 a barrel crude-oil futures for December delivery suggested 2-to-1 odds oil will rise or fall by $26 before the options' expiration in November, said Michael Korn, president of Skokie Energy, a brokerage in Princeton, N.J. Straddles are risky if prices don't move far. Another play on volatility is a "strangle," which consists of put and call options with the same expiration date but different strike prices.
Hedge funds are also adding variance swaps to their arsenal, Blanch said. Invented in the 1990s, buyers pay a fixed price for the swap contract and profits if the volatility actually evidenced in the market exceeds the volatility implied by the options market when the contract was issued.
Amid scrutiny from politicians, exchange operators contend more liquidity means less volatility, and taking speculators out of the marketplace would mean even wilder price action.
But the advent of electronic trading has enabled traders to move anonymously in and out of the market without funneling orders through the floor. On the Nymex, about 90% of crude futures trading volume is now executed on the screen.
"There's more anonymity," said Jim Ritterbusch, president of energy trading advisory firm Ritterbusch and Associates. "People can move on a seemingly inconsequential headline and unleash 500 thousand-lot orders in the market by the push of a couple of buttons."
Volatility also feeds on itself, Ritterbusch said. In the past, rallies would be quickly be checked as commercial crude producers sold into it.
Now, "their mindset has changed," he said. "They're thinking, 'Why sell it when it's up $2 when it's liable to be up $5 in two hours?'"
The Highs And The Lows
Volatility may also be convincing commercial producers to ignore obvious price signals and hold off new investments in supply. In a recent report, Lehman's Robinson said higher volatility leads oil companies to demand higher minimum rates of return on investments in new supply basins. Speculators pricing in this hesitation have pushed oil prices "radically higher," Robinson wrote.
Once volatility calms down, it may temper oil companies' return requirements and lead to new investments in supply.
"And while the timing is nearly impossible to forecast, when this occurs, it should lead to radically lower oil prices," Robinson wrote.
NEW YORK, June 11, 2008 (Dow Jones Newswires)