Start buying oil.
That’s not only this morning’s recommendation by Dennis Gartman but, as this afternoon, also Citi’s commodities team (led by OPEC’s impressario Ed Morse) which moments ago issued a report according to which crude oil markets will not only bottom, but more importantly, “investors should position now for a potential V-shaped rebound in crude oil prices, as price risk seems asymmetrically skewed to the upside.“
Do two wrongs make a right? But we digress…
Citi explains the recent collapse (which it did not in any way anticipate as it was bullish all the way into a bear market), by noting that WTI flat price has sold off another ~5% this week, as bearish sentiment continued to prevail among oil market participants. However, it counters, “both weekly and monthly storage data are pointing to a tighter market by end-2017, and Citi expects global oil stocks to draw ~200-m bbls to year-end. While it is possible for prices to dip even lower near-term, we do not view this as sustainable, and once market sentiment turns, prices could rally sharply.”
Some additional observations from uber-bullish Citi on the crude vol surface:
The flattening of the vol skew has gathered pace. The discount of the 3rd contract’s 25-delta call implied vol to the ATM vol narrowed to ~0.9 vol pts or just ~3%, the smallest in over a year, while the call skew on longer-dated contracts shrank significantly as well (Figure 1).
Meanwhile, WTI short-dated implied vol remains cheap, despite having bounced off the lows. The negative relationship between implied vol and oil prices has restored after breaking down briefly last week, marked by the 1-month implied vol (OIV) repricing ~4 vol pts higher during the sell-off in flat price to ~32 pts, in line with the current realized vol. While the implied breakeven is back up to $0.86 from just below $0.80, it still looks cheap historically, even compared to the $0.75-1.05 range established in the low vol environment so far this year (Figure 2).
We do not expect a quick reversal of such dynamics, as muted producer activity as well as stronger consumer hedging demand at this price level should continue to suppress downside vols and support upside vols. Should market sentiment improve, a build-up in investor length, which is near the lowest since last November (Figure 3), could keep calls better bid, too.
Assuming Citi is right this time, and in case readers want to trade alongside (or maybe’s that opposite from) the bank, here are the three trade recommendations from Morse’s team:
- Trade Idea 1: Buy Dec17 WTI 46/53 call spreads; sell Dec17 WTI 40 puts for zero cost. Pricing as of 9:35am EST, Jun 22nd, 2017. Transaction costs are included. Reference prices: NYMEX WTI Dec17 futures at $43.75/bbl. Expiry: Nov 15th, 2017. Net delta: 0.56. Max payout: $7 (16% of reference prices).
- Risks: The trade is subject to losses if WTI trades below the $40 put strike by maturity, which remains an unlikely scenario in our view. As aforementioned, we cannot rule out the possibility of another leg lower in oil prices in the near-term, but it should be short-lived, in our view.
- Trade Idea 2: Buy 1x Dec17 WTI 44 call; sell 2x Dec17 WTI 52 calls for $1.67. Pricing as of 9:48am EST, Jun 22nd, 2017. Transaction costs are included. Reference prices: NYMEX WTI Dec17 futures at $43.69/bbl. Expiry: Nov 15th, 2017. Net Delta: 0.12. Max payout: $8 (18% of reference prices and x4.8 of costs).
- Risks: The payout of this trade will turn negative should WTI trade above $60/bbl (or ~37% higher than the reference price) by maturity
- Trade Idea 3: Buy Sep17 WTI 44 calls for $1.63. Pricing as of 9:55am EST, Jun 22nd, 2017. Transaction costs are included. Reference prices: NYMEX WTI Sep17 futures at $43.09/bbl. Expiry: Aug 17th, 2017. Delta: 0.45.
- Risks: The trade will lose the premium if oil prices remain under pressure in the near-term and WTI trades below the $44 strike by maturity. We like the risk-reward of this trade which takes advantage of the relatively cheap implied vol on shortdated contracts.