Goldman’s Oil Thesis: Timing is Everything

Gyrating markets can sure interrupt beach season in the Hamptons. My attempts to unplug have been largely unsuccessful, and the collapse in oil and other commodities have the wheels spinning inside my Neanderthal-like brain cavity.

But grunting at my screen will only get me so far. They say that imitation is the sincerest form of flattery. And on Wall Street, very few people have original ideas. A Goldman Sachs research note from July 31st has been keeping me awake at night, and it appears I am several hours late in passing along my take.

Perhaps Goldman's timing was off by a few weeks...but it is worth examining their thesis in trying to explain moves in oil, which often defy "neat explanations".

Is the "negative gamma" trade in crude finally out of gas?

July 31st
Negative gamma issues pose near-term downside risk, but we maintain a year-end forecast of $149/bbl

Concern over demand weakness was likely a key driver behind a large financial liquidation that has underpinned the recent sell-off. The liquidation has brought prices close to levels where a large amount of put options are struck....

....increasing the risk of further selling pressure as financial traders who sold the puts need to sell further contracts to delta hedge their portfolio- a dynamic that we call the “negative gamma effect”.

However, while the pressure on prices may continue in the next few days, the fundamental picture has remained intact and we maintain our view that prices in the medium term will increase to reach our year-end target of $149/bbl
Goldman Sachs Research Note

Oil was trading at roughly $123 when the note was released..and Goldman and Morgan Stanley both issued buy recommendations at that time.

Clearly geo-political events and weather concerns have a role in today’s rise in oil, but the recent flirtations with the $110 level; associated option activity might also play a part.

Goldman’s timing was off by a painful two weeks or so, but the move down since the highs in early July caused problems that took a few weeks to work through.

Goldman drew parallels between the recent price action in oil to early 2007, when weather related issues set off a “negative gamma effect”. Goldman pointed out that a large amount of open interest was concentrated in the $120 and $110 strikes, and that breaching $120 might lead to a move down to the $110 level.

And the world has discovered in the past few weeks that hedge funds and financial players are far larger participants than previously assumed. The participants today are different than in early 2007, however:

The main difference is that this time around the majority of the put contracts are likely held by active financial players, such as hedge funds, as opposed to producers. Financial speculators are more likely to sell back the option as they get closer to being in the money, decreasing the need for the financial traders who sold the puts to sell oil futures to delta hedge their short put positions.

If should be emphasized that negative gamma effects and financial de-leveraging typically have a transient impact on prices that ultimately converge to levels explained by fundamentals.

On net, while the pressure on prices may continue in the next few days, especially if critical threshold levels are reached that could trigger a negative gamma effect, the fundamental picture has remained intact an we maintain our view that prices in the medium term will increase to reach our year-end target of $149/bbl. Goldman Note

The world has changed in the past month, but geo-political and weather concerns are likely to impact energy trading over the next few weeks, give the season and Russia.

Oil just bounced off the 200-day moving average as well, but if you choose to play poker with the big boys you had better stay on your toes.

And hopefully Hank Paulson stays out of the fray. His comments that oil prices “reflected supply and demand” coincided with the highs, and might have been inappropriate, in my view. Thanks, but no thanks, Hank.

Work your magic with Freddie and Fannie if you must Hank, but please stay out of the energy pits. Between hurricane season, production cuts and Putin we have enough to worry about.
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Oil was nearly as oversold as stocks were in mid-July

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