CRUDE OIL OPTIONS MARKET FOUND TO BE EFFICIENT

The U.S. crude oil options market operates efficiently and does not overreact, say Harvard University researchers Gordon Phillips and Robert Weiner.

The authors, with the JFK School of Government, studied the crude oil options market under a Department of Energy grant.

The current market was created in November 1986 when the New York Mercantile Exchange introduced an options contract for delivery of West Texas intermediate crude futures. It has grown greatly since then.

Phillips and Weiner said, "One of our most important results is the finding that volatility is positively associated on days on which news is released into the oil market but negatively associated with trading volume, suggesting that trading depth is increased by the increase in volume.

"This finding is just the opposite of the often-heard claim that options and futures trading tends to destabilize the oil market.

"Our finding that the market has worked well leads us to the conclusion that using futures and options can be an effective, as well as inexpensive, short term forecasting tool for the Department of Energy as either a supplement or a substitute for forecasts developed by computer models."

Phillips and Weiner said a study of the options market is of interest for Strategic Petroleum Reserve policy planning for two reasons.

The first is forecasting. An options contract gives the holder the right-but not the obligation-to either purchase or sell oil at a fixed price in the future. In contrast, the holder of a futures contract has the obligation to make or take delivery.

The right to sell oil is called a "put" option. The right to purchase oil is a "call" option. Options prices depend on the volatility of spot prices, and thus market consensus estimates of future spot price volatility can be "backed out" of current options prices.

For example, when spot oil is selling at $25/bbl in a calm market, the right to purchase a barrel at $30 is worth little. In a turbulent market, in contrast, the right to purchase at $30/bbl could be worth quite a bit because the chance that the price will rise from $25 to $30/bbl over the life of the option contract (typically a few months) is substantial.

In combination with futures markets, options markets can reveal to policy makers market participants' best guesses about the direction and uncertainty of spot prices. The use of options and futures prices is best suited to providing forecasts during a 1-6 month time horizon, Phillips and Weiner said.

"This is the very horizon when computer models of the oil market tend to be least effective because expectations tend to dominate supply and demand fundamentals in determining oil price movements over short periods.

"The short term also is the time horizon of greatest interest to policy makers concerned with crisis planning and certain SPR decisions (such as a drawdown during a crisis), for obvious reasons."

The authors said the options market also could serve as an automatic trigger for the sale of SPR oil in a disruption because it could act quickly enough to exert downward pressure on prices.

"The basic idea behind these proposals is straightforward: In a crisis, selling options on SPR oil at high exercise prices could be an attractive market alternative to the present system of spot sales and proposed alternatives of forward sales because if the crisis diminishes the options will not be exercised, and the reserve will not be drawn down."

They said if DOE decides in the future to sell call options on SPR oil, it should receive fair compensation for the options it sells.

However, they noted their study covered a period of relative calm, and the performance of oil markets, including options, during a period of extreme stress remains unanswered.