SHARE How Options-Hedging Turbocharged Oil Volatility Trade amplified a price drop to 15-month lows and now could help fuel a rebound Oil has traded this year within a relatively narrow price range. Storage tanks at a California refinery.PHOTO: BING GUAN/REUTERS By David Uberti , Bob Henderson and Joe WallaceMarch 26, 2023 5:30 am ET The economic fears gripping Wall Street have sparked outsize swings in oil prices, exacerbated by trading that investors and analysts say has little to do with the fundamental value of crude. One culprit is an arcane area of trading known on Wall Street as delta hedging, aimed at reducing the risks tied to directional price moves. Earlier this month, oil’s steepest weekly slide in almost three years accelerated as futures approached levels where many producers owned derivatives designed to lock in prices. As declines mounted, banks and trading firms on the other side of those trades had to unload crude to mitigate potential losses, investors said, dragging benchmark prices to 15-month lows. Now, many expect similar dynamics could add momentum to any rebound if the economic outlook improves—leading to more expensive oil that could increase the cost of gasoline and diesel later this year. It is the latest example of how volatility in financial markets can spill into the real world, shaking an oil industry stretching from the shale basins of Texas to refineries in China. The recent retreat “in many ways had not a lot to do with oil,” said Ben Luckock, co-head of oil trading at Trafigura Group, at an industry confab hosted by the Financial Times last week. “We got caught up in the macro world again, which happens all the time. It’s OK,” he added. “But it distorts what happens in the future.” In the coming week, investors will continue parsing the health of banks, along with new readings on home prices, consumer confidence and the Federal Reserve’s preferred inflation gauge. A U.S. slowdown would eventually have big implications for crude and other commodities, as well as stocks. Delta hedging revolves around a type of derivative known as put options, which are contracts granting their owner the right to sell oil or other investments at a specified price. For oil-and-gas producers such as EQT Corp. and Hess Corp., put options can function like a form of insurance, ensuring they can sell their output at a profit months in advance, even if prices fall. Banks and trading firms get paid premiums to sell puts. But the value of the options can rise—saddling them with paper losses—as crude approaches the “strike” price of the contracts. Traders can protect themselves either by buying puts of their own, or by delta hedging, which in this case entails unloading crude futures. These types of trades can shake up all kinds of markets. When stocks endured bursts of volatility between long periods of calm in the years before the pandemic, some investors said hedging with derivatives was to blame. During the meme-stock craze, frenetic options trading in shares of companies such as GameStop Corp. and Tesla Inc. led to delta hedging that often amplified price swings in both directions. “It’s not just volatility to the downside,” said Giovanni Staunovo, a commodity analyst at Swiss bank UBS Group. Oil has traded this year within a relatively narrow price range as investors weigh resurgent demand in China against growing recession fears in the U.S. and Europe. Worries about the banking sector fueled a fresh round of selling Friday, sending benchmark West Texas Intermediate crude futures down 1% to $69.26 a barrel. At Hess, which pumps oil from projects including offshore rigs near the coast of Guyana, the hedging strategy includes put options that cover about 65% of the company’s projected crude output in 2023, a spokeswoman said. The New York-based company this year has bought contracts covering 80,000 barrels a day of U.S. crude output at $70 a barrel, as well as 50,000 barrels a day of Brent, the global price gauge, at $75. “Just like you have insurance in your home, you hope you never have to use it,” said Hess Chief Financial Officer John Rielly, speaking at an investor conference this month. Crude prices recently began falling when stocks and bond yields dropped and algorithmic, trend-following trading programs began to sell oil futures, said Pierre Andurand, chief investment officer of Andurand Capital Management. His firm and other funds then sold some of the oil futures they owned to cut potential losses, he added. Options dealers were hedging puts on roughly 80 million barrels of crude oil with strike prices near $70 a barrel when oil dropped toward that level on March 15, according to Standard Chartered. As the possibility grew that financial institutions would need to pay out on those contracts, investors said those trading desks sold futures at an increasingly rapid clip. “The more you do that, the lower the price goes and the more it pushes other people to do the same thing,” said Ilia Bouchouev, managing partner at Pentathlon Investments. “It’s a chain reaction.” The moves accelerated a selloff that pulled the domestic crude benchmark to $66.74 a barrel by the close on March 17, a 13% week-on-week drop that was the sharpest such decline since the pandemic dragged U.S. crude below $0 in April 2020. SHARE YOUR THOUGHTS What is your outlook on energy markets? Join the conversation below. Eventually, lower prices encouraged some bullish traders as well as oil consumers—such as airlines—to step in and buy. That propelled prices higher before Friday’s selloff eroded some of the gains. “A lot of consumers were sitting on dry powder waiting for this move,” said Brian Murphy, a derivatives broker at Tullett Prebon. Mr. Andurand, whose $1.3 billion hedge fund lost money in the recent rout, said his firm plans to rebuild its bullish position as energy markets stabilize. He is among the traders who think China’s appetite for oil will push prices up later this year, even as some analysts suggest that demand outside Asia is sluggish and global supplies are plentiful. Chinese refiners have recently snapped up supertanker shipments of oil in a sign that China’s long-awaited recovery from pandemic lockdowns is finally beginning to take hold. Citing mobility data in China and the restart of international flights in and out of the country, Mr. Andurand believes oil prices could reach as high as $140 a barrel later this year. “Demand will really surprise…in a significant way,” he said. Write to David Uberti at david.uberti@wsj.com, Bob Henderson at bob.henderson@wsj.com and Joe Wallace at joe.wallace@wsj.com