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

Hedgers Look to Verticals for Cheap Long-Term Protection

Energy markets joined equity and bond markets last week in some of the most volatile trading seen in years. There is no end in sight as financial institutions across the western world refuse to lend to each other; investor panic has also intensified as investors pull money out of commodity and equity indexes. Realization has begun to dawn that the $700B US bailout will not halt the slowing of global manufacturing and production, resulting in sharp drops in commodity prices across the board. Front month WTI crude oil ended last week below $95 as bearish pressure continues to be exerted on the market.

Despite the volatile trading and increased margin requirements, very cheap protection is available for those with both upside or downside exposure in the form of verticals (call spreads and put spreads). Protection between $85 and $65 for the next 6 calendar months can be purchased for only about $3,800 of total risk per month. That's $97,200 of total downside protection for the entirety of Q4 2008 and Q1 2009. The premium paid for the put spread can easily be cut in half by selling the $100/110 call spread in the same tenor. The hedge would then provide a total of $108,600 of downside protection for only $1900 per month of premium. The hedger would also have $10,000 of upside risk per month between $100 and $110.

Singapore, 21:30

Consumer hedgers coming back

US demand figures from Wednesday took centre-stage in trading yesterday as energy markets sold off across the board. Product demand is showing a 7.1% decrease in September from the same period a year ago. Traders are watching the outcome of the US House of Representatives vote on the bail-out package. Unfortunately, while a "no" vote may result in a financial meltdown, a "yes" vote may cause nothing more than increased volatility across all markets.

Option volatility returned in front-month crude oil yesterday, although consumer hedgers have stepped back into the market to buy cheap upside protection in the form of call spreads. The WTI Q4 $100/115 call spread strip can now be owned for an average price of only $2.20 per month. That's $2.20 of total exposure in a market that is moving more than $5 per day in any given direction. The $2,200 of risk buys the consumer hedger $12,800 of protection per month, or $38,400 of total Q4 protection.

Singapore 10/2/2008 0759

Volatility subsides awaiting next data point

Crude options volatility subsided after spiking into the high 60s%, which indicates a fear factor equivalent to stock volatility index 40+%, only equal to major market events such as 9/11 or serious crashes. Crude players globally are scratching their heads to come up with a strategy short term to hedge cargoes and inventory. The Q4 110 Asian crude call could be had for $3/bbl, which seems to be a reasonable premium given what has been happening. The zero cost hedge for that period would be the 89/110 (Collar).

The inventory stats posted today showed unusually bearish numbers in RBOB. We feel they underestimate RB inventory and likely will bounce.

With the potential for $10 moves in crude oil, options are still the best tool. Selling volatility as part of an overall strategy (part of a 3 way) may not be bad as volatility is likely to subside.

The US Senate is set to vote this evening (730 pm EST) on the new package. The US House of Representatives will vote on the proposal Friday. Meanwhile, credit markets remain in limbo.

NY - 1/10 502pm EST

Market Volatility Continues to Surge

Volatility increased across all markets yesterday as the US House of Representatives rejected the proposed $700 billion bail-out package. Gold traded well over the $900 mark as traders sought a safe haven from the increasingly negative outlook from all other major markets. The CFTC released data showing the number of net longs in November WTI crude increased throughout September as the market rallied back towards the $110 level. With yesterday's selloff, expect the pressure to increase on these longs to all head for the door at the same time, possibly forcing the market down further.

Cheap option strategies are the most sensible choice for this turbulent market. Hedgers looking to protect against further downside moves in the next 6 months can find inexpensive protection in the Q408 - Q109 $90/80 put spread for only about $3.20. With the market gyrating more than $5 per day in either direction, a hedge with max exposure of only $3,200 per month begins to look very shrewd.

Singapore Fuel Oil hedgers looking to protect their downside can combine the above strategy with the sale of 180 Fuel Oil Swaps in the WTI/Fuel Oil crack, currently trading around $12.00.

Singapore, 09:18

Producer Hedges for a Volatile Market

Crude oil consolidated above $105 in late-day trading Friday as commodity markets remain buoyed by fear of a failure to pass the US Treasury's bail-out plan. As several weeks of extremely volatile trading looks set to continue, option premiums remain at increased levels. Recently, both consumer and producer hedgers have looked to the option markets as a way of protecting their fuel inventories or future purchases as the swaps markets have become too dangerous to navigate. Spreads can be purchased on the cheap to provide both upside and downside protection with very little or no premium at risk.

An example of such a producer hedge strategy can be found using Asian options in WTI crude oil. The Q4 $100/85 put spread strip can be owned for only about $3.10. That represents $3,100 of total premium at risk per month with $11,900 per month of downside protection. Again, if the market reverses and moves higher, the max loss on the hedge is only $3,100 per month. The protection can be made costless by selling the Q4 $118 call. This zero premium strategy provides about $12 of room on the upside before the short call becomes active.

Singapore, 23:17

Late rally but more questions than answers

Washington Mutual being the latest financial to call it quits, we now move into the weekend with more questions than answers. While there has not been much of a range today, volatility remains firm. Asian markets will have a jump on markets on Sunday evening and will be able to trade on data coming out over the weekend.

The downside risk here is that crude sells of with financial markets. The outcome of Morgan Stanley still remains to be seen. Credit default swaps were trading higher as of Friday evening for MS debt.

Hedgers protecting inventory may want to consider the WTI 90-105 put spread here for $3.90 per bbl. If the market drives back down to $90, this trade will prove to be very beneficial. Please contact HCEnergy Asia for up to date strategies Monday AM Asia time. Likely there will be some short term strategies that will pay off quickly. HCEnergy will provide liquidity to customers as of 0900am Singapore time.

NYC, 16h00 Fri.