Morgan Stanley: Oil Prices Will Crash Again Soon

Image of an oil refineryMorgan Stanley’s chief oil analyst Adam Longson just issued some bearish commentary on oil prices, which he says have been buoyed lately by short covering, but are destined to fall again soon.

That temporary bump should fade in a couple of days, as options expiration approaches this week:

The Option Squeeze Lifts Oil Prices
Sentiment regarding oil continues to swing with price momentum, and in the short run, rapid shifts in positioning can move prices. A large option position and delta hedging left the market vulnerable to a rally. Thus, bullish comments from OPEC and the IEA caught the market uniquely offside to reverse bearish positioning (see detail and calcs inside). Yet, once option expiry passes on Aug 17th, this issue should fade.

Moreover, this move higher also brought in bullish buying from those who believe the worst is past, and the call skew is now shifted bullish for Sep. The problem is that fundamentals tend to be a stronger driver medium term, and the picture appears skewed negative over the coming months.

So it looks like investors who thought oil was putting in a bottom over the past week might be badly positioned for another leg down.

Positioning is moving short term prices, but fundamental setup remains bearish.
Sentiment regarding oil continues to swing with price momentum – from bullish in May/June to bearish in July/Aug and back to bullish of late. In the short run, rapid shifts in positioning can move prices. Even this past week, the market sold off sharply on bearish DOEs before reversing late in the week on OPEC and IEA comments. We expect this back-and-forth volatility to continue. However, fundamentals tend to be a stronger driver medium term, and the picture appears negative over the coming months.

Large option position and delta hedging left the market vulnerable to a rally. The market had built up sizeable WTI put positions for Sep at $40 and $45, which had recently come into or near the money. As these options gain or fall in value, traders/dealers need to buy and sell a corresponding number of contracts to hedge their exposure (the delta value). These delta values tend to rise quickly as contracts approach the money.

Therefore, bullish comments from OPEC and the IEA caught the market uniquely offside to reverse bearish positioning. Rising prices lifted the weighted avg Sep WTI put delta across over 380,000 contracts from (0.30) to (0.17) in just 2 days. As these puts fell in value and delta values climbed, traders/dealers were forced to buy back contracts quickly to cover their exposure. To put this in context, we estimate traders needed to buy 48,000 Sep WTI contracts from 8/10-8/12 vs. only 215,000 reported open interest in WTI Sep futures (although Sep option interest is far larger), simply to cover this hedging interest before we consider other short covering.

Morgan Stanley currently has a $35 floor price on oil, which could be tested again in the coming weeks due to the aforementioned short covering, record production and reserves, and weakening demand. The firm concludes that fundamentals in the oil market remain very weak, hence the continued bearish view in the face of a 16% bounce off multiyear lows.

The United States Oil Fund LP ETF (NYSE:USO) rose $0.19 (+1.81%) to $10.69 per share in Monday morning trading. The largest exchange traded fund tied to the price of WTI oil has fallen 3.09% year to date.

USO-2016-08-15

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