Escalation in the Middle East Countering Weak Economic Data

July and August delivered huge downside repricing on the oil market. Since mid-July, West Texas Intermediate price has slipped to the high 60s as weak economic data has been delivered. Core European economies remain sluggish and the labor market in the US has cooled significantly leading to recessionary bets alongside OPEC announcing supply hikes starting at the end of 2024.

WTI market bearishness that has accrued over the past few months due to weak economic data and announced supply hikes by OPEC led to bearish price action in July and August. Since the start of September, things have turned quite a bit. Federal Reserve cut faster than anticipated (50 basis point cut rather than 25 basis points cut). Furthermore, China delivered huge fiscal stimulus to negate the slowing of the economy and potential crash of the real estate market with Chinese oil stockpiling being in action once again after summer months. Chinese stockpiling at low WTI prices and occasional refills of American Strategic petroleum reserve in combination with the escalation of the war in the Middle East have easily propped WTI up to 75$ per barrel from 65$ per barrel just a month ago. Oil inventory reports have also been quite bullish, culminating with an Israeli ground operation in Lebanon and a rocket barrage by Iran targeting Israel. Currently, the market expects revenge on the Israeli army for targeting Iranian oil infrastructure which should result in higher oil prices. An additional reason for such a reversal of the bearish oil trend is the extreme bearish positioning of the speculators due to weak economic data leading to quick short covering. The escalation of the war in the Middle East was a catalyst for huge repricing on the oil market.

The market responded quickly over the course of four days with WTI price skyrocketing from 68.50$ to 75$. Such bullishness and buying calls may be also interpreted via skew which is shown on the chart below. 1 month 25 delta calls versus 1 month 25 delta puts have been significantly cheaper due to bearishness on the market, however, escalation of the conflict propped call prices to extreme levels. Pricing of options with a one-month tenor indicates that the market expects sizeable revenge of the Israeli army with a current difference of 25 delta puts and calls implied volatilities at more than 10 points. The only such extreme levels over the past three years have been seen when the war in Ukraine started. Buying calls was a great way to benefit from this move, however, that might not be the case anymore, at least the reward ratio is worsening as I type and skew moving further to calls. Another significant event over the next month is the elections in the US, however, I would argue that, regardless of the outcome, both Harris and Trump should be bearish for oil (Harris due to more renewable friendliness and Trump due to relaxation of regulation for oil companies). A covered call might be great for trading oil now as the premium for selling calls is huge and buying lower puts to protect downside risk is cheap in addition to backwardation of the curve rewarding long positions.

In conclusion, the oil market has experienced a dramatic shift from bearish to bullish due to a combination of factors, including aggressive monetary easing by the Federal Reserve, fiscal stimulus from China, and heightened geopolitical tensions in the Middle East. WTI prices surged from $68.50 to $75 per barrel, driven by strategic oil stockpiling and speculation of military retaliation targeting Iranian oil infrastructure. The extreme price action has also led to increased option volatility and skew toward calls. While recent moves were lucrative for call buyers, risk-reward dynamics are now deteriorating, suggesting that covered call strategies could be more favorable going forward.