Oil Volatility Provides Dose of Reality

| About: iPath S&P (OIL)

The volatility in the oil market has notched up today, 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 have seen about $3.50 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), the most direct way for average investors to participate in crude oil futures, with options on OIL the least risky way of insuring against high volatility. It's currently trading at around $25.20. That means the market is pricing crude oil higher, despite the downturn in the first day of trading on the new month's option.

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 dollars and 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 about $3.50 a barrel, and Brent down only 50 cents, 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 in mid-morning trade (it is approaching noon on the East Coast as I am writing this), that spread has intensified from an average of about 13% of WTI price over the past 10 trading sessions to almost 16%.

This tells us two things:

  1. First, the primary impact of European debt has been working into Brent pricing right along, augmenting the downward volatility being experienced in the market anyway of the last week.
  2. Second, the pressure ends when the debt crisis abates. This is not oil-market-induced pressure. It is exogenous to the market.

We can, of course, point out that the weight of debt can depress the demand expectation and, thereby, 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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