Quick Study… Oil Shock Bond
In this issue, a quick Study examines an interesting option product currently used in the oil market. The oil market continues to be extremely volatile. Huge oversupply in late 1998/early 1999 culminated in 12-year lows being posted on WTI ($10.75 prompt). In March this year, OPEC agreed to cut production by some 2.1 million barrels/ day. Belief that this time OPEC could actually keep to the promises (promises that historically the majority of OPEC members have not kept) sparked a massive short-covering rally and the market is now trading back at levels seen in mid- 1998 ($16.50 WTI prompt). This kind of price action is typical in the oil market. As its name implies, the OIL SHOCK BOND takes advantage of such shocks and has been observed more or less continuously for the last 15 years.
Statistically, there is at least one such shock within a 3-year rolling period (see chart).
In the example above, the bondholder would gain as the future price moved above the upper strike to a maximum of 30% of notional. The maximum payout occurs if at ANY time during the life the Lipper Lo kin level is hit. This scenario is also true as future price go longer. Obviously, the maximum return is 30% in any one year i.e., Upper and Lower Lock in levels cannot both be hit in one year. The bondholder effectively has 3 chances of gaining a 30% return which, if successful each year, will result in a 90% gross return on notional.
The graph at left shows crude oil price action over the last 15 years:
As can be seen from the chart, there are at least 10 "shock" moves over 15 years, which indicates between 2 and 3 "shocks" in any 3- year period.
As the bondholder requires only one "shock" move to yield a near 5% net return, the potential to increase the net return to 35% or even 65% seems very good indeed.