THFJ interviewed John Farley, portfolio manager at Emil van Essen llc, and Peter Keavey, executive director and head of North American Energy Products at CME Group to find out why volumes in energy spread options are rising so fast – and why a growing proportion of the volume is traded electronically.

John Farley has spent years as a proprietary trader and market maker in energy options, and he joined Emil van Essen in 2012 to help manage programmes. The largest has $120 million in a model-driven spread-trading strategy, focused mainly on trading commodity spreads. A cross-asset volatility programme also trades spread volatility, providing liquidity and making markets in OTC options on energy and other markets. Says Farley, “each programme benefits the others through modelling and sharing of information.”

Oil options liquidity at multi-year highs
Average daily volumes (ADV) in energy options are up 25.6% year-on-year for July, as shown in the CME Group Monthly Options Review.[1] CME Group has been seeing multi-year highs in volume and open interest for crude oil CSO (Calendar Spread Options), where ADV has reached 17,652. Open interest is also at multi-year highs of around 730,000 contracts for crude oil CSO options (and stands at over 8.5 million for all types of energy options on CME Group exchanges).

To some extent, the steep increases in crude oil CSO option volumes may reflect similar advances in trading on the underlying oil futures: the CME Monthly Energy Review shows Light Sweet Crude Oil (ticker symbol: CL) futures volumes up 12.8% year-on-year in July 2015.

Spread options have seen robust growth and Farley argues: “Spread markets have grown as it doesn’t usemuch notional to trade them.” The flexibility of the CME Group offering is also helpful – the 7A contract settles into cash, which is useful for those who do not want to deal with futures. But the benchmark product is simply the plain vanilla options, settling into the future each month with average volume of 150,000. Farley points out “this contract is significant as it focuses on two very discrete areas – the volatility of the front month spread between the first two months.” This often overlooked variable can have a huge impact on returns, for participants who are long or short – and those pursuing other strategies that entail combinations of long and short positions.

Everyone trading energy futures is exposed to calendar spreads
To some extent, the steep increases in crude oil CSO option volumes may reflect similar advances in trading on the underlying oil futures: the CME Monthly Energy Review shows Light Sweet Crude Oil (ticker symbol:CL) futures volumes are up 38.39% year-on-year in May 2015. The addressable market for the CSO contracts is enormous, as Farley explains that, “anyone using futures has exposure to spread risk as they have to roll contracts, and they may wish to use CSOs to mitigate the risk or to enhance returns.” Examples of those using futures contracts abound and include both physical and financial traders. On the physical side, “oil producers, pipeline companies, oil refiners and storage operators are all using futures,” observes Keavey. On the financial side, “commodity trading advisers (CTAs), managed futures funds and other asset managers are also using oil futures,” adds Keavey.

Calendar spread volatility
Although the front month spread should normally mirror costs of storage, it can become both more volatile, and less liquid, as spreads become “prompt” or approach maturity. “Players want to curtail that risk,” stresses Farley. Return forecasts for longer-term investors factor in particular levels of spreads, and if these turn out to be different, the return forecasts get thrown out of kilter by spreads that can overshoot well beyond, or drop far below, costs of storage. Naturally spreads can go both ways. ”You might get an unexpected windfall that you need to monetize, or you could be on the wrong side of the spread,” says Farley. Taking a multi-year perspective, there have been periods when investors in futures generated positive returns, despite bear markets in commodity spot prices – because the positive “roll yield” spread arising from backwardation of the curve, outweighed the downtrend on spot prices.

Within the last month, the WTI forward curve has steepened to nearly $8 from $2.50 (as shown in Fig.2). Depending on the shape of the crude term structure, rolling futures to maintain a long position can be costly. If the market is in contango, traders have to pay a premium each month to roll their long position forward. Calendar Spread Options can help lower rolling costs and hedge term risk.

But in the shorter-term, spreads to some degree track inventory levels at Cushing, Oklahoma. “As inventories climb, costs of storage rise and spikes in these costs can be disruptive,” warns Farley. Yet he has noticed over time that the spread tends to mean revert back to the cost of carry. In June 2015 spreads were in fact close to the cost of storing oil, which typically ranges between 20 and 60 cents per month.

“But when the tanks are close to overflowing and operators are forced to use floating storage, then costs can increase to 80 cents – or maybe more as tail events become more frequent,” explains Farley. Keaveyelaborates how CSO options can smooth out these peaks and troughs. “CSO contracts allow for hedging and transfer of economic risk when conditions are out of balance or equilibrium. The CSOs provide a very transparent way to value the risk and trade out of it.”

Incidentally, CME Group also offers LOOP Crude Oil Storage futures (LPS) on storage capacity at the LOOP Clovelly Hub in South Louisiana. These storage options can also be used as part of hedging strategies.

Benefits of spread trading
CME Group has seen a 65% increase in number of clients trading CSOs, as they appeal to a broader group. A growing proportion of energy options are spreads for many reasons. Farley finds that spreads “allow any participant to structure a trade in line with their risk aversion and give them a cost profile, with a specific amount of money to spend so they can tailor the trade.” Another reason for wider penetration of spread trades is education, which comes partly from CME Group but also from multiple other sources. “Research is available to everyone now, so even small oil firms have the know-how to structure trades however they want,” explains Farley.

CME Group’s Keavey notes that spread option users include oil producers, “who use spreads to protect a range of outcomes. Spread options allow them to decide which risks they want to take on or shed.” For instance in June 2015 CME Group Senior Economist Erik Norland released a paper entitled Oil Set to Fall After Summer Driving Season.[2] This flagged up the risk that ballooning inventories of oil could pose a threat to the price, and indeed in mid-July, oil fell well below its highs of the year.

Spreads can express views more cheaply
As well as being a versatile toolbox, Farley suggests that spread options can be cheaper ways to express views, with “lower risk and lower tail risk than outright positions.” In some cases spreads may even permit the same payout with lower cost. Capital efficiency can be enhanced due to significant margin offsets for WTI versus Brent, or for crude oil versus heating oil or gasoline, for instance. Different types of spreads can be used for specific purposes: Farley enumerates how “horizontal, time or calendar spreads can be a way to play short-term versus long-term volatility.” Time spreads are a natural consequence of needing to roll a position, but he points out “a two-legged time spread can also be used to take a longer-term view.”

Vertical spreads
In contrast, vertical spreads are usually directional, with traditional one-by-one (1×1) ratio call spreads or put spreads a cheaper way to express directional views, while ratio verticals – involving different numbers of contracts at differing price levels within the spread – can be used when participants see a floor or ceiling at certain levels – or perhaps face cost or revenue barriers at particular points.

The oil price collapse of 2014 has thrown into sharp relief the wide spectrum of cost curves in the US shale oil industry – and this is another area where options can come into play. If breakeven costs do range from $30 to $80 then Farley counsels “participants can tailor hedges to their own cost curves,” and divergent views on where oil prices are heading also explains why there is more volatility in the forward curve.

Volatility spreads
Butterfly structures, often abbreviated to “flies,” can be used to express views on volatility increasing, decreasing or staying constant. Payoffs can be very attractive at 2:1, 3:1 or even 4:1 depending on how the trade is structured, Farley has seen in his years of trading.

Crack spreads
So called “crack spreads” between crude oil and its derivatives such as heating oil, gasoline or jet fuel, can be also traded via CME Group options. “These are not as liquid as the CSO options but crack volatility can be high and we often end up with second or third derivatives of crack spreads,” says Farley. Certain contracts within this space are becoming more widely used: the RBOB gasoline contract recently hit record volumes and seems set to continue widening its user base as US export or refined products increase, Keavey predicts. Moreover the CME Group’s Open Markets online magazine and thought leadership blog recently set out the case for ending the US export ban on crude oil, with CME Group Chief Executive Terry Duffy arguing that the ban distorts markets.

Geographic spreads
The third or fourth most widely traded spread option is the geographic spread between Brent Crude and West Texas Intermediate. “This has a direct correlation with forward curves in Brent and WTI and there are economic reasons why people need to trade it,” Keavey says. CME Group observes how the Brent-WTI spread has recently settled down into a trading range of about US$5, having been very volatile previously. Freight rates can sometimes be a relevant component of geographic spreads – and CME Group does also now offer freight futures.

Weekly and mid-curve
Maturities on CME Group energy options range from single day to 10 years out with one month CSOs listed out to five years. In CSOs most of the volume is in shorter tenors because “this is where the supply and demand dynamics play out,” says Keavey. In particular intra-month maturities such as weekly versus monthly can also be very popular. The weekly option that settles every Friday is in fact an outright option, not a spread option.

The mid-curve option allows users to take a shorter-term view on a longer-term contract – so they may take a view on where the June 2016 will be trading, in September 2015. Keavey explains how these mid-curve options have become very popular in other asset classes, because they “remove some of the time-value premium and can also allow users to lock in the economics on a forward-dated contract.”

Both the weekly and mid-curve options only launched last year but most of the contracts discussed above have been around for years. What is special now is that building liquidity makes them more accessible. The CME Group crude oil options suite also includes American-Style, European-Style, Average Price, Short-Term, and Futures Strip options. As more clients use the product range, liquidity and transparency are improving.  

Electronic screen-based trading
The cut and thrust of open outcry trading in the pit may still be how the media seeks to portray futures and options trading, but most open outcry trading pits for CME Group futures were closed in July 2015. Pit trading still has a significant share of options volumes in some product asset classes at CME Group, but here, too, the trend is inexorably towards electronic, screen-based trading of energy products, with CME Globex offering nearly 24-hour electronic trading.
 
Surge in screen-based trading
The proportion of CME Group’s benchmark crude oil options contracts (commodity code: LO) traded on screen has shot up to 70% from 20% in just three years and the reasons are clear. As the user base has grown, CME Group is reaching out to a client base that has not always used brokered markets. As most markets are transitioning to screen, barriers to entry – in the form of broker relationships – are falling off. But even those with access to brokers “will often choose screen-based trading for its superior transparency, liquidity and ease of use,” explains Farley, who points out the biggest reason for trading screen is very simple: “100% of a market sees the order on the screen whereas when using a broker you do not always know who is the market maker or who sees the order.”

Benefits of screen-based trading
Keavey goes on, that when trading CSOs on-screen, “people are sure everyone can see what is being traded as there is an open central-limit order book with full transparency.” CME Group has been monitoring the transition to electronic trading for years, and observes that “the earliest adopters of electronic trading were those trading short-term prompt month, but now electronic adoption is progressing rapidly across all tenors, contract sizes and complexities.” For instance, straddles, strangles and vertical spreads are now being traded electronically as well. For CME Group this is a natural and logical evolution of the market, “as traders get more comfortable with plain vanilla they progress to embrace more complex structures”, says Keavey, who has also noticed more players are making use of the RFQ (Request for Quote) function – and receiving rapid, multiple responses from it.

Keavey also argues that trading on-screen reduces operational risks – and lowers costs, as exchange fees are lower and users will avoid brokerage fees. Farley adds that “if the entire universe of participants see a trade, that generally tightens the bid-offer spread.” But Farley stresses that the same trade is cleared in the same way, regardless of whether it is routed through the pit, call-around OTC, or screen.

Exchanges are perhaps the ultimate network-effect or network-externality business, where the network becomes more valuable as it attracts more users. In energy options, it seems clear that liquidity is begetting liquidity, creating a virtuous circle for all involved.

John Farley joined Emil vas Essen, LLC in June 2012. He has over 16 years of derivative-trading experience across a wide range of commodity and equity markets with a specialization in options trading. From 2009 to May 2012, he established and managed the proprietary energy derivative division of Atlantic Trading USA. From 2006 through 2008, Farley managed a $30 million energy and $50 million equity hedge book at Della Camera Capital. From 1995 to 2006, he was a proprietary option market maker on the PHLX currency and equity floors, the CBOE equity option floor, and the New York Mercantile Exchange. He has a BA in Mathematics from Cornell University.

Peter Keavey serves as Executive Director and Head of North American Energy Products at CME Group. He is responsible for managing CME Group’s existing suite of energy products, including crude oil, refined products, natural gas, power, natural gas liquids, coal and renewables. In his current role, Keavey also works closely with customers to lead development and execution of new risk management tools for the energy industry. Keavey has 25 years of experience in the futures and options industry, including 15 years as a trader of physical and financial energy products across the natural gas and crude oil and refined product markets.

Footnotes

[1] http://www.cmegroup.com/education/files/monthly-options-review-2015-07.pdf
[2] http://www.cmegroup.com/education/featured-reports/oil-set-to-fall-after-summer-driving-season11.html