Oil derivatives indicate traders view Middle East shocks as short-lived

Oil futures and options are signaling that the Middle East conflict could be short-lived as traders rush to?structures which profit from a decline in prices following the initial spike.

The options and futures market?often provides the earliest indication of whether traders view a supply shock?as fleeting or structural. This creates opportunities to profit from sharp swings in price.

Israel and the United States' attack on Iran has caused shockwaves in energy markets. War-risk insurance costs have risen, freight rates are at record highs and disruptions along the Strait of Hormuz have snarled oil flows and left hundreds of vessels stranded. On Friday, oil prices were at record highs.

LSEG data show that traders are interpreting the price shock to be temporary. The 30-day Brent implied volatility at the money rose 17.5 percentage points in the week ending Tuesday. 60- and 90 day tenors only increased 5.9 and 2.8 points.

Brian E. Kinsella said at the Global Markets Forum that "we're watching real-time the difference between a logistic crisis and a structural crisis."

He added, "The market bets it's logistical. I think this is the right read."

Brent futures curve sends a similar message. The spread between front-month Brent and six-month Brent contracts widened by about $10. This is the largest backwardation since the Russia-Ukraine War in 2022. It indicates a tight supply near-term while also suggesting short-term disruption.

CME data shows that the put-to call ratio for West Texas Intermediate options has roughly halved from Friday to 0.35 by Monday, which indicates heavy bullish buying of calls. On Tuesday, demand for downside protection returned and the ratio rebounded to 0.56.

A call option grants the holder?the right, but not obligation, to purchase a crude futures contract for a fixed price.

To gauge the market's sentiment, this ratio compares bullish call options with bearish put options. Bullish call options benefit from price increases, while bearish put options profit from price declines.

Rebecca Babin is a senior energy trader with CIBC Private Wealth US. She said, "Dealers have already sold a significant amount of these calls that are out-of-the money and this has created a negative gamma in crude." This is in contrast to the typical situation where dealers sell into rallies and are long on gamma. Gamma is a measure of how an option's sensitivity to futures prices (delta), will change when the market moves.

Babin noted that a large portion of the 2027 Brent Strip still trades under $70 per barrel. This is a sign that markets have not yet priced a structural change in long-term supplies.

She added that producers have used the rally to hedge their forward production, creating natural pressure on volatility longer-dated.

Darrell E. Fletcher is the managing director of commodities for Bannockburn Capital Markets. He said that traders still view the disruptions as temporary.

BRENT OPEN INTERESTS SURGE

Brent options open interest dropped in late February, before rising in early March. This suggests traders unwound their positions before rebuilding hedges.

The front-month open interest dropped from approximately 388,000 contracts in February to about?73,000 on Feb. 27 before soaring to over 700,000 contracts by March 2, as new positions were created.

The open interest data is a clear indication that there was not a structural price change, but a sudden unwinding of the position. Kinsella stated that the front end of a trade is clearly closed, while the backend is what to pay attention to.

CME data shows that futures positions follow a similar pattern. More than 40% of the open interest is concentrated in expirations from April to July, and the position becomes thinner as you move further out along curve.

(source: Reuters)