(Bloomberg) — As computer screens flash red for energy markets from Houston to Singapore, oil traders are urgently asking themselves one question: is a historic crash about to repeat itself?
The meltdown caused by the Chinese coronavirus outbreak is increasingly reminiscent of a plunge that happened just over a year ago. In October 2018, a sell-off across commodity markets left Wall Street banks racing to cover insurance policies, such as options contracts, that they had written to oil producers, sparking a new wave of selling that ultimately caused prices to tumble by more than 40% over two months to $49.93 a barrel.
Brent crude, the global oil benchmark, has fallen by as much as 25% to a one-year low of $53.85 a barrel. The danger zone for a similar financial sell-off starts around $50 a barrel for Brent, according to Greg Newman, head of Onyx Capital Group, an oil market-maker based in London.
“If this is to happen then, yes, the option sellers will scramble to sell futures to cover their positions,” he said.
Though oil prices so far haven’t been driven by Wall Street selling, but rather by the collapse in Chinese oil demand, traders are alert to the potential for a vicious selling cycle. It’s what’s known on Wall Street as “negative gamma” event — the Greek letter labeling a gauge of how sensitive options contracts are to price moves in the underlying asset.
When an oil producer, such as a U.S. shale company or the Mexican government, wants to lock in, or hedge, the price of the commodity, it buys insurance from a Wall Street bank. The insurance, in the form of an option contract, gives the holder the right to sell crude at a predetermined price and time. In simplistic terms, the banks manage their own exposure to the options they have written by selling futures. The closer the price of oil falls…
Source: FuelFix
