A mass of options betting that oil will reach $100 could accelerate its ascent, demonstrating the latest spike reflects money management issues rather than supply/demand fundamentals. The price could also plummet just as rapidly if the $100 mark is reached, again because of the impact of options-related trading, analysts said.
"At this point the market is no longer trading on the physical supply/demand factors it's trading on the financial supply/demand factors," said Adam Robinson, energy research analyst at Lehman Brothers.
Oil producers and consumers use options to protect against price volatility and investors such as hedge funds also use them in their trading strategies. A call-option gives an investor the right to buy an underlying futures contract at a set price by a certain date, while a put-option gives the right to sell.
There were nearly 50,000 December "call" options with a "strike" price of $100 open on the New York Mercantile Exchange as of October 30, according to NYMEX data. The sellers of these "call" options have to hedge by buying the underlying futures market, thus creating another layer of demand that has pushed prices higher.
This hedging has already helped drive the price above $90. "The next large concentration is at $100 a barrel so it is possible that a move towards $100 a barrel may be accelerated by this...effect if we get closer to it," said Jeffrey Currie, head of commodities research at Goldman Sachs.
The market has got more volatile as it has climbed higher, with a difference of nearly $5, for example, between the high and low on US December crude futures on Wednesday. "The trading parameters are outside of normal," said Olivier Jakob of oil consultancy Petromatrix. "It's a pretty dangerous market right now, an unsafe investment environment." Liquidity could suffer as a result of oil's roller-coaster behaviour.
"You've got a whole bunch of players who are sitting on the sidelines because they are not sure what is going to happen," Robinson said. "Even on a small piece of news that is fundamentally not that important you could see disorderly rallies or disorderly drops," he said, adding that this was what had happened this week, for example, after an unexpected fall in crude stocks in the US weekly inventory data.
The fall in crude stocks helped boost US crude to new record peaks above $96 a barrel. The record prices also reflect concerns over tightening supplies ahead of winter, the weak dollar and tensions in the Middle East. Analysts predict the market could fall sharply once the US December crude futures contract expires next month.
This is because hedge funds are expected to close out positions because they do not want to take delivery of physical oil and then market makers will be able to unwind their hedges. Goldman Sachs says the option effect is a short-term phenomenon.
"It should be emphasised that these kind of effects in the option market can exacerbate the oil price moves but not motivate high/low prices for a long time," Currie said. "Ultimately fundamentals will decide whether we are going to stay in the upper $90 a barrel area or above or below."