The Organization of Petroleum Exporting Countries is widely expected to leave oil prices unchanged at Friday’s meeting. But what if OPEC surprises everyone, and investors all around the world find themselves on the wrong side of the incredibly crowded oil trade?
With oil prices up some 40% since March, this is a key question permeating the market.
To position for a potentially explosive move on Friday, Goldman Sachs is telling clients to buy Select Sector SPDR-Energy (ticker: XLE ) straddles in anticipation oil prices make a sharp move up or down on OPEC news.
The short-term trade proves profitable if XLE moves more than $1.42, up or down, on OPEC news. Should the fund hit $82, for example, the call is worth $4.50. If XLE moves less than the cost of the straddle, however, the money spent on the trade is lost.
“The options market shows a dangerous level of complacency in oil and energy equities ahead of the OPEC meeting,” John Marshall and Katherine Fogertey, Goldman Sachs derivatives strategists, are advising clients.
Indeed, major exchange-traded funds that track oil are trading without fear or greed premiums in the options market.
One-month implied volatility levels for XLE and U.S. Oil Fund ( USO ) have steadily declined in recent months. This is unusual because major market events — and oil is one of Wall Street’s top trades — tend to be framed by sharply elevated options prices and volatility.
USO one-month implied volatility has declined 17 points to 33% since March. The Select Sector SPDR-Energy one-month implied volatility is down seven points at 17%.
Investors who have strong convictions about oil can simply choose to trade the call or put. In fact, previous trades to sell puts on the U.S. Oil Fund have produced good results. The USO put trade reflects a view that oil prices have effectively set a bottom around $60 a barrel, and may advance.
Indeed, directional oil bets are emerging as a key trade in some major exchange-traded funds.
With the Market Vectors Oil Services ETF ( OIH ) around $37, an investor bought 10,000 June $39 calls for 25 cents.
With the SPDR S&P Oil & Gas Exploration & Production ETF ( XOP ) around $50, an investor bought 5,800 June $52 calls for 50 cents.
To be sure, the Street’s major banks are largely split on what happens to oil prices. Friday’s OPEC meeting is discussed as a “market-clearing event,” which means investors may swing into action on the news.
Hedge funds, which are largely short oil, may try to bang prices lower. Mutual funds, and other asset allocators, are expected by some to buy oil and to warehouse stocks for three to five years. This split response reflects a disagreement between Goldman and JPMorgan.
Even though oil has advanced since March, Goldman is bearish on oil’s price trajectory. The bank is warning investors that oil prices are poised for a “double-dip decline.” Goldman is concerned about too much supply and not enough demand.
Indeed, a big question hovering over the oil market is what happens if Iran is allowed to return to pre-sanction production levels. Since 2012, Iran’s daily production has been limited to a million barrels.
JPMorgan, however, is bullish on oil, largely due to stock valuations. The bank recently told investors to Overweight oil stocks, up from Neutral, because energy sector valuations were attractive in a richly valued market.
To be sure, the debate on oil’s price trajectory is likely to remain one of the hottest topics on Wall Street. The recommended XLE trades puts investors squarely into the center of the debate.