Despite Europe's Debt Crisis, Oil Prices Will Bounce Back

| About: iPath S&P (OIL)

The volatility in the oil market has notched up this week, courtesy of another bout with debt jitters in Europe. Oil and gasoline futures are moving down -- and taking most of the energy sector along with them.

In a situation like the current European debt mess -- where maximum uncertainty is channeled into a very focused concern -- oil futures will generally overcompensate, exaggerating the downside. Of course, that is of little consolation to the traders who in the past few days have seen about $3.00 cut from the near-month futures (July).

We are just into the next month of options (this one-month cycle ends June 18), and the prevailing trend in calls remains up. That is, the preponderance of plays on the call side (buying options) are in a range betting on a price of between $27 and $31 for the iPath S&P GSCI Crude Oil Total Return Index ETN (NYSEARCA:OIL).

(For some context, that ETN closed Tuesday at $25.91, an increase of 56 cents, or 2.21% per share. OIL is the most direct way for average investors to participate in crude oil futures, with options on the ETN the least risky way of insuring against high volatility.)

It is not anything intrinsic in oil supply and demand that is prompting this volatility. This one is all about what the renewed concerns over Greek and Italian debt are doing to perceptions of European oil demand and the exchange rate between U.S. dollars and European euros. In fact, the dollar is improving against the euro -- another sign that the debt problem is pressuring forex.

With Nymex West Texas Intermediate (WTI) crude prices down further than Brent crude prices, one might wonder how a European debt problem could be having a greater impact in New York than it is in London. The spread between WTI and Brent has been a lingering concern for almost a year. At current prices, that spread has intensified from an average of about 13% of the WTI price over the past 10 trading sessions to almost 16%.

This tells us two things: First, that the primary impact of European debt has been working into Brent pricing right along, augmenting the downward volatility that was already being experienced in the market during the last week; and second, that the pressure ends when the debt crisis abates. This is not oil-market-induced pressure; it is exogenous to the market.

Stay the Course

We can, of course, point out that the weight of debt can depress the demand expectation and, as a result, push the price down. Yet in the current circumstances, the default prospect is quite low. Neither Brussels, Athens, or Rome will allow that. Whatever pressure we experience will be short-term.

And this is what the OIL options are telling us. Despite the protracted concern and distraught remarks from the tube's talking heads, the debt situation will resolve. If it does not, the entire euro zone is in peril. And despite the angst that possibility prompts, the likelihood of that is remote.

It's simply not going to happen. So stay the course.

Disclosure: None

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