Another way of getting around the potentially high price of options, especially for those seeking long-term protection, is to use a “swaption,” says Kase. A swaption is an early-exercise option, giving the buyer the right to enter into an underlying swap within a particular time period prior to the commencement of the swap. It’s cheaper than a plain-vanilla option because it expires prior to the commencement of the swap.
Say a company buys a swaption now at $100, for example, and the market is at $120 on the exercise date six months from now. The company would exercise the swap and be $20 in the money. In essence, it would be buying crude oil (at least on paper) from the counterparty for $100, and the counterparty would be paying back the company $120. (If the market is below $100 at the exercise date, the company would not exercise the swap and would forfeit the premium.) In the remaining 12 months, the swap would protect the company against a further rise in prices. Oil would subsequently have to fall by more than $20 for the company to lose money on the swap, not counting the premium paid for the initial swaption.
How High Can Oil Go?
Where will oil prices go from here? “[One hundred dollars] will be difficult to overcome without new outside input,” says Dean Rogers, manager of market analysis at Kase & Co. In a recent report, “How High Can Crude Oil Go?” Rogers says a correction of crude-oil prices below $94 would open the way for $88 and possibly an extension toward $78. On the upside, $120 would be a key resistance threshold, he says.
The U.S. Energy Information Administration, which doesn’t take into account market speculation, projects the price of West Texas Intermediate Crude oil will average $102 per barrel in 2011, and rise to an average of $105 per barrel in 2012. That forecast assumes real gross domestic product growth in the United States of 3.3% in 2011 and 3.7% in 2012.
Most experts concur with Kase and Lee that the current price results from hype and speculation. Oil is at a “false price,” contends Kase. “I don’t think oil should be cheap, but I don’t think it should be $100, either.”
“The markets always react very strongly to a disruption [like Libya] and then they drift back down,” says Lee. “With oil, the disruption is never going to be, ‘We discovered a 100 billion-barrel oil field in an environmentally nonsensitive place that we can bring to market immediately.’” Instead, says Lee, “Someone’s going to say, ‘We no longer have a supply problem in oil,’ and the market is going to tank.”