(John Kemp is a Reuters market analyst. The views expressed are
By John Kemp
LONDON Oct 4 Oil markets have swung from
irrational exuberance in the first half of the year to
increasingly irrational pessimism in recent weeks.
Participants risk exaggerating the risk of a deep and
prolonged recession hitting demand in both the advanced
economies and emerging markets.
Blind swings from hope to fear usually lead to temporary
mispricing, creating opportunities for those willing to take the
other side. Estimating the recession risk is perhaps the most
important trade in the oil markets right now.
If the market is exaggerating downside risks, some hedge
funds and option market makers will sense an opportunity to sell
overpriced put options to oil companies and investors willing to
pay too much to protect themselves against further declines.
DEFORMED VOLATILITY SURFACE
Implied volatility surfaces for both Brent and U.S. crude
(WTI) show the market charging a hefty premium for deep out of
the money put options (Charts 1-4).
Downside protection has become expensive even though prices
have already fallen more than $25 (20 percent) from their April
highs, using Brent futures for December 2011 delivery as a
The time to buy protection against a big drop in oil prices
was during spring and summer, when Brent was trading at
$115-125 and WTI was at $100-115 -- not when Brent
futures have slid to less than $100 and WTI is below $80.
Forward prices are now even lower. Brent for December 2013
delivery is trading around $90 per barrel, while WTI is $82.
But the more the market has fallen, the more investors have
come to fear an even deeper pull back, which is illogical. The
market is extrapolating recent movements rather than making a
calm assessment of what is likely to happen in future.
The current dread about recession and plunging oil prices is
the mirror image of the February-April panic about prices
spiking as market participants worried about supply disruptions
spreading from Libya across the whole of the Middle East
Back then, the option market exaggerated the risk of supply
disruptions -- confusing a possibility with something much
closer to a high probability. Now the market is in danger of
exaggerating the risk of a deep recession and a large drop in
RECESSION IS NOT YET CERTAIN
In spring and summer, there were plenty of reasons to think
oil prices were not sustainable at $110 let alone $120 per
barrel, and high energy prices would cause a global slowdown or
even a recession.
Some of those risks have begun to materialise, as soaring
energy and food prices, the eruption of a new crisis in the euro
zone, and faltering consumer and business confidence have caused
a sharp slowdown in growth since the start of the second
But while the threat of outright recession has risen, and
certainly become more apparent to investors, it is not yet a
certainty. Current indicators are mixed, and suggest the
economies of the United States, the United Kingdom and the euro
zone are struggling for traction rather than shrinking.
Just as it was a mistake to exaggerate geopolitical risk
earlier in the year, it would be an error to assume a deep and
sustained recession was inevitable rather than simply possible.
Oil prices are still high in real terms, but if they
stabilise around current levels, the threat of inflation would
start to recede, and households across much of North America,
Europe and Asia would receive a boost to spending power and
confidence, which might help avert a full-blown and prolonged
If the market has swung from irrational exuberance to
unwarranted panic, it may be over-charging for protection
against further price declines, at least relative to the
residual risks on the upside.
As researchers at several prominent investment banks have
noted, supply problems have not disappeared, which should help
put a floor under prices except in a really deep and sustained
recession, and leave some residual risk on the upside.
Option markets are notoriously illiquid, especially for
institutions wanting to trade in size.
But there will be at least some hedge funds and market
makers tempted to sell (expensive) downside puts and buy
(relatively cheap) upside calls in the hope a calmer assessment
of the 2012 outlook prevails.
(Editing by James Jukwey)