FxWirePro: US EIA’s inventory check stimulates WTI’s vibrant OTC actions but likely to mute, Uphold call spreads on mounting risk reversals vouch

We obtain supportive bullish sentiment in this week’s crude oil inventories, U.S. EIAs registers crude inventories a larger than expected draw (-7.6 mln barrels versus forecasts -3.2 mln and previous -6.3 mln barrels) and investors cheered data pointing to an increase in demand for oil from China as imports increased 13.8% to 8.55m bpd during the first six months of the year, compared to the same period a year ago.

Compared to realized volatilities, long-dated WTI and Brent options seem expensive. With flat prices surging by 10% in the final week of June, WTI 12-month 25-delta risk reversals (put minus call) soared from 4.70% to 6.80%, driven by opportunistic producer hedging and subpar liquidity in the options market (right chart below).

While we expect risk-reversals to ease back until flat prices recover again meaningfully above $47/bbl, long dated put skewness and the high levels of implied volatility discussed above suggest hedging is still unattractive for CAL18.

The oil analyst has recently revised the demand and supply balances for 2017 and 2018, noting that “it will take beyond 2018 for stocks to rebalance”.

The oil glut is therefore expected to continue and should mute long-dated realized volatility until tangible stock draws are seen.

Options Trade Strategy:

Stay long the October 2017 WTI and Brent call spreads (strikes of $45.13-52.5 for WTI and $48-53/bbl for Brent).

The base case assumption is that the stock draws that have proved so elusive in H1’17 will accelerate in the coming months.

However, given the still limited progress towards this objective, we retain an options strategy that limits downside exposure to the initial premium of 90¢/bbl.

Marked to market on 7 July at $1.21/bbl, for an unrealized gain of 31¢/bbl. Trade target is $3.00/bbl.