Consumers Buying Cheap Upside Protection

Energy markets along with equities plumbed new lows yesterday as the financial turmoil continued. Front-month November WTI is now trading below the $85 level, marking a drop of more than $62 since only mid July of this year. In a swift reaction, Opec has dropped its prevarications and announced an emergency meeting on November 18th in Vienna where many traders feel the cartel will announce further cuts to production. The initail 500,000 barrels per day cut of only several months ago has yet to be fully realized by Saudi Arabia, the defacto group leader and only member capable of quickly increasing or decreasing production. Oil demand in the US was reported as down 8.6% last week against the same week in 2007 by the US Department of Energy.

Implied volatility in WTI Crude Oil softened somewhat yesterday, decreasing substantially the premiums demanded for upside call options. Consumers looking to protect against a return to higher prices in the first half of 2009 can buy cheap protection in the form of the 1H09 (First Half 2009) $110 call for only about $4.75. By buying this Average Price Option, the consumer has unlimited upside protection above $110 with a maximum risk of only $4,750 per month. This upside strategy can be made costless by selling the $73.50 put in the same tenor. In this instance, the hedger would only need to post margin and would have Zero premium at risk at or about $73.50.

Singapore Fuel Oil hedgers looking to protect their upside can combine the above strategy with the purchase of the 180 Fuel Oil Swaps in the WTI/Fuel Oil crack, currently trading around $15.50.

Singapore, 08:00

Petroleum resistant to market selloff

Crude markets were largely unchanged all day until the stock market (Dow) fell dramatically near the close. Volatility in stocks is now higher than crude oil at 65%. Lower heating oil prices have created an excellent opportunity for diesel and jet hedgers to protect their consumption for the balance of the year and 2009. Natural gas remains resilient to the downdraft across markets.

Opec Statements, US Inventory Data result in Opaque Outlook

Crude oil briefly traded into positive territory yesterday shortly after coordinated world-wide interest rate cuts were announced. However, the slashing of borrowing rates was not enough to sustain the market as further demand destruction data as well as bearish US inventory numbers caused traders to push the market lower once again. Petrol demand continues to weaken in the western world while US crude stocks showed a remarkable build last week of 8.1m barrels on the back of increasing imports as well as weak refinery demand. Traders are also keeping an eye on Opec, which appears to be flirting with the idea of an emergency meeting in November to drop output for the second time in only 3 months. Several members of the cartel, including Iran, have pointed to data indicating the world is oversupplied by as much as 400,000 barrels per day.

Bearish and potentially bullish news continue to keep implied volatility levels inflated in crude oil options trading. The VIX (volatility index) also is trading at inflated levels- traders watch the vol levels of both markets in tandem, as they often support each other. Regardless, the high premium levels are expected to continue, thus resulting in traders moving to profit from downside moves by buying cheap put spreads such as the November 2008 through March 2009 $85/70 put spread strip. With a maximum loss potential of only $5,300 per month, this trade provides a total of $48,500 of downside protection through the first quarter of 2009.

Singapore, 08:30

Crude and gasoline builds

Statistics revealed gasoline demand destruction and significant crude inventory builds. However, crude did not decline as much as expected. Consumer hedgers for diesel and jet fuel are starting to buy upside insurance now for 2009, which has given support to heating oil markets. Gasoline demand has forced the RB cracks to the negative territory, creating opportunities to buy cracks for 2009 at very depressed levels.

With volatility remaining at very high levels, using spreads (collars) or 3-way structures is very attractive. A November through December 95-105 call spread (Asian) is zero cost selling a 77 put. This hedge would be good for those that are holding low or no inventory against short sales for Nov and Dec.

Implied Volatility Softens; Vertical Strategies Remain Paramount

WTI crude oil bounced back up towards the $90 level yesterday on thin trading as the dollar pared gains and equities softened further. The continued shutdown of almost half the production of crude and natural gas in the Gulf of Mexico may be back in the focus of trader's attention. Interestingly enough, preceeding Hurricanes Gustav and Ike the Gulf region was able to produce 1.3m barrels per day; prior to Hurricane Katrina in 2005 the production level was 1.6m. This begs the question of can the region even return to the depleted levels of the post-2005 hurricane season? On a similar note, Pemex (Mexico's state-run oil producer) announced evacuations from several offshore Gulf platforms as tropical storm Marco bears down. This latest bullish data needs to be absorbed along with continued demand destruction figures. US oil consumption remains close to 10-year lows and products demand continues to decline at a rate of approximately 6% per month based on the previous year.

Despite a softening in implied volatility yesterday, option premiums remain inflated. The best (and cheapest) protection in current market conditions continues to be found in verticals and combination strategies. After yesterday's bounce, producer hedges should be considered this morning. Using Average Price Options, the Q408 through Q109 $85/75 put spread provides $10 of downside protection per month for only about $3.50 of total premium at risk. The put spread can be made cheaper by selling the $110/125 call spread in the same tenor at $1.00. Using this combination strategy, the hedger has $45,000 of total downside protection for the next 6 months while paying only $15,000 in total premium. The hedger also has upside risk from $110-125.

Singapore 08:50

Crude volatility remains high, heat/diesel hedgers active

Monday's late day floor trading action bid up crude volatility over 70%. This level subsided today to the mid 60s% for November American options which expire next week. The markets remain torn between fundamental directional hedges and the pure play asset sell-off experienced across global markets. Though led by the financial sector, the lack of liquidity in equity and bond markets have created a down draft seeking the next bid. We have not seen a sell-off in crude as one might expect. Major players may be sitting on the sidelines if not forced to liquidate. Although demand destruction in refined products (especially gasoline) is now well documented, the low inventory positions and refinery turnaround schedule should compensate. Negative RB cracks form November and December have reached $-2.15 per bbl. Heating oil remains firm with winter cracks above $21/bbl. Consumer hedgers have been active buying the heating oil upside calls.

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