Here’s How To Play An Increasingly Volatile Oil Market

If you needed a reminder that oil prices can be volatile and are hyper-sensitive to every single data point and/or headline that crosses the wires, you got all the proof you needed last week. And then you got some more evidence on Tuesday when, as we wrote earlier, oil whipsawed as API data clashed with Saudi headline hockey.

Needless to say, all the drama has had observable knock-on effects for anything commodity-related as HY credit, metals & mining, copper, and energy stocks all sold off in sympathy…

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…junk spreads widened…

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…and HY’s correlation with crude and copper spiked…

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All of this has at least one analyst wary about the outlook going forward. Below, find the latest from Barclays Maneesh Deshpande, who says you might want to consider XLE straddles to capitalize on two-sided risks in the space.

Via Barclays

We expect the stock prices of energy companies (XLE) to exhibit higher volatility than what is implied by current option prices due to two-sided risks in the sector and uncertainty in oil prices. We, therefore, recommend buying XLE straddles and selling SPX straddles as a low-cost way to take advantage of these risks.

Oil price fundamentals have weakened recently. Oil prices sold off sharply last week as higher than expected production from US shale and other non-OPEC countries led to the expectation that demand growth might not be robust enough to warrant inventory draws in 2017/18. Moreover, Barclays’ commodity analysts believe that it is highly unlikely that the December OPEC agreement will stay in place (as it is predicated on non-OPEC participation, especially Russia), due to high supply growth expected from these countries. The current speculator positioning in WTI futures is at an all-time high and the current weakness in fundamentals could trigger a significant deleveraging and further decline in oil prices.

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However, XLE has underperformed both equity and oil prices over the past few months and this trend could revert. Energy companies’ valuations have trended lower in recent months even as both equities and oil prices have continued to rally. Although, valuations have room to go down further, the recent sell-off in oil prices could trigger a reversion in this trend. Moreover, Barclays’ commodity analysts are of the view that if OPEC’s production rebounds, the spare capacity cushion is likely to be far less, making oil prices prone to sharp rallies if a supply disruption event were to occur.

Given the two-sided risks above and uncertainty about oil prices and the demand/supply outlook we recommend buying XLE straddles and selling SPX straddles against it. Despite SPX volatility trading at absolute lows, the implied continues to trade expensive to realized volatility and hence we recommend selling SPX straddles to cushion some of the time decay from long XLE straddles.

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