(John Kemp is a Reuters market analyst. The views expressed are his own)
By John Kemp
LONDON, Oct 4 (Reuters) - 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.
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 basis.
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 oil consumption.
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 quarter.
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 recession.
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)