Options Present Safer Hedging Opportunity than Swaps or Futures

Crude oil led the way lower yesterday during a broad-based sell-off across both commodities and equities. Hedge funds have become increasingly bearish on oil products, helping to push unleaded gasoline and heating oil futures to lows not seen in over a year. While the futures market continues to search for that level which restrains demand growth but does not destroy it, the macroeconomic disaster befalling much of the western world continues to pull financial flows away from the energy complex.

Implied volatility pushed to fresh one-year highs yesterday in front-month WTI crude. Again, vertical spreads remain the best answer to the current market turmoil; simply buying or selling swaps exposes the hedger/trader to swings of more than $5 per day. A simple consumer vertical such as the Q4 $95/105 call spread strip provides $10 per month of upside protection with a max loss potential of only $1,700. Buying a swap at this point to protect against an upside move can quickly result in unlimited losses and daunting intraday volatility.

Simply using Fuel Oil options does not appropriately address the risk issue. It's important to understand that the Fuel Oil options market is extremely illiquid as there are very few market-makers. These traders are forced to take into account both counter-party credit risk as well as basis risk (often backing out of the trade with more liquid crude oil options). Hedgers would often prefer to use the product which most closely matches their physical exposure, hence bunker traders may hedge with Fuel Oil options. Even though the hedger doesn't believe he/she is taking basis risk into account, the market-maker they are trading with often is, as well as a lack of liquidity and counterparty credit risk. Trading on an exchange-cleared market allows a hedger to take advantage of liquid markets and manage the basis risk on their own, instead of giving it up on a wide bid/offer spread to a bank.

Singapore Fuel Oil hedgers looking to protect their upside can combine the above strategy with the purchase of 180 Fuel Oil Swaps in the WTI/Fuel Oil crack, currently trading around $16.00.

Singapore, 08:51