- Elevated geopolitical risks from potential escalation of the Russo Ukrainian war.
- Potential short squeeze in Oil, as shorts reach highest level since early 2022.
- 3M ATM IV is currently at a 2YPc1 and at a 5YPc5 vs the SX5E- attractive to add gamma on energy stocks
Brent prices have dropped c.10%, following a spike on the back of Iran’s retaliation against Israel, as the market downplays the risk of escalation in the Middle East. However, we now see a fresh escalation risk coming out of the Russo-Ukrainian war. Several NATO countries have openly stated that they will allow the use of supplied weapons in attacks against Russia, something that Russia has cited as a reason to make direct hits on NATO members, which could potentially send oil prices soaring similar to the onset of the war when Brent prices reached USD120 per barrel.
In addition, at the upcoming OPEC+ meeting on June 2, the block is expected to extend the current 2mn barrels-per-day output cuts into the second half of the year and although this is widely anticipated, an official confirmation could still lead to a surge in oil prices. Further risks to the upside also arise from Saudi Arabia’s likely announcement of a secondary share offering of Aramco, potentially raising over USD10bn, with the block likely to want to keep oil prices elevated during the sale by potential altering the duration or volume of cuts.
Looking at market positioning, speculative bearish bets against have reached multi-year highs, and at levels Saudi Arabia has chosen to repel in the past, such as last year (when the kingdom announced supply cuts to counter Brent shorts that were heading towards 100,000 contracts). Also, a notable pair trade since the market rebound in 4Q23 has been shorting Energy stocks to fund Tech stock longs, with broader downside risks exacerbated from having to reverse the pair. Signs of convergence between QQQ and SXEP are starting to appear, potentially adding further upside risk to energy stocks.
In terms of volatility, 3M ATM IV is currently at a 2YPc1 and at a 5YPc5 vs the SX5E making it attractive to add gamma on energy stocks. Valuation also still remains attractive in the sector relative to the broader European market while also characterised by superior cashflows. Putting all of the above together we recommend buying the SXEP Dec24 410 calls at a cost of 1.5%.