03/19/2021 QUICK NOTE ON YESTERDAY’S OIL SELLOFF

by | Mar 19, 2021

Prices in WTI and Brent sold off sharply yesterday. There are a few reasons for this.

PHYSICAL OIL DEMAND CONCERNS

First, there were concerns that new EU shutdowns, particularly in France and Italy that may cause softening in the physical market. In addition, refinery buying has slowed in Asia, the EU, and the US due to the seasonal increase in maintenance during the shoulder demand in spring.

NEGATIVE GAMMA EFFECTS

The volatility spike in rates that is causing bond liquidation by risk parity mechanically requires the unwinding of recent added speculative length in oil futures held for inflation hedging. As prices fell through option strikes of large open interest, this created an amplifying effect as counterparties scrambled to hedge their exposure. This is known as a negative gamma-induced sell-off.

Put option sellers have negative gamma, meaning their delta-exposure increases as the underlying asset goes lower and they’ll need to sell more underlying as the market sells off. 

FINAL COMMENT

The market already is bouncing strongly overnight, that said, today will be a crucial day. CTA’s do not fully deleverage in reaction to a one-day volatility event, but if the vol spike continues for 2-3 days, then they will have no choice but to sell. I do not expect this to turn into a major sell-off, despite everyone screaming oil is going to zero again. We have had three large sell-offs 9%-13% over the past year, including this one (since the April 2020 debacle), and the market has rebounded sharply. Fundamentals remain strong and the physical market continues to tighten. In addition, crude prices have gotten a little ahead of themselves, the pullback has been overdue, presenting new buying opportunities.

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