By Avi Salzman

Investors often buy energy stocks because of their high dividends, which can pay off over the course of several years. But lately, the hottest trade in energy is a much more short-term and risky one: Making options bets that oil prices will soar over $100 per barrel.

The hit-or-miss trade can either pay off with huge gains, or it will be a total loss if prices don't get to $100.

Oil still has a long way to go to get there. Brent crude, the international benchmark, was down 0.6% to $78.89 per barrel on Friday. West Texas Intermediate crude, the U.S. benchmark, was down 0.8% to $75.28.

Traders have placed an unusual number of bullish call options since the conflict between Israel and Iran has heated up in the past two weeks. Oil prices are up more than 10% since Israel caused pagers carried by members of Iranian-backed Hezbollah to blow up two weeks ago, escalating the war. Since then, Israel killed Hezbollah leader Hassan Nasrallah. Iran, in retaliation, shot about 200 missiles at Israel.

The world now awaits Israel's response. Oil last hit $100 in 2022, propelled by the shock of Russia's invasion of Ukraine and the resulting sanctions.

The abrupt turn of events in the Middle East could play out in various ways, risk analysts say. "It would not be surprising for a large-scale response from Israel against Iran," said Ian Byrne, an analyst at Beacon Global Strategies, in an interview.

One sign of just how precarious the situation has become is that some large oil tankers appear to be avoiding Iran's large export hub in the Persian Gulf, Byrne said.

That chance of further escalation has pulled traders into the options market.

"On average, close to 250 million barrels of bullish calls have changed hands in each over the last 10 days, setting a record," wrote Natasha Kaneva, the head of global commodity strategy at JP Morgan. "These volumes have led to significant additions to call options open interest at $100 for both WTI and Brent."

A bullish call is an option to buy an asset at a set strike price in the future. The buyer pays a fee, or premium, for that right. If the asset price rises above the strike price, the call buyer can exercise the option. If the asset price doesn't rise that high, the call buyer loses the premium. The all-or-nothing nature of the trade makes a bullish call similar to a lottery ticket.

While professional traders often trade options on high-volume oil futures markets, retail traders tend to trade them on the most popular exchange-traded fund that holds oil futures -- the United States Oil Fund $(USO)$, according to Rebecca Babin, senior energy trader at CIBC Private Wealth US.

The volume of bullish call options on the USO has quadrupled in October from September levels, according to data provided to Barron's by Cboe Global Markets. As of Monday, traders were holding 3.6 times as many bullish call options as bearish puts, the most all year, the data show. One month ago, the ratio of calls to puts was 1.9.

Babin said that some of the options activity comes from professional traders protecting themselves on the upside in the event that oil prices spike. Many traders had placed bearish bets before the conflict escalated because analysts expect the oil market to be oversupplied next year.

Most analysts don't expect Israel to directly attack Iran's major energy infrastructure in the near term, and that could mean that oil prices trend downward.

"Sustaining bullish price momentum in oil has proven to be a high maintenance task: without additional catalysts, the 'war' and 'stimulus' premiums have shown easy susceptibility to fading," Kaneva wrote.

But if the war escalates significantly, all bets are off.

"We could come in tomorrow, and we could have a million barrels of production offline," Babin said. "So it's much less conceptual and more real."

Write to Avi Salzman at avi.salzman@barrons.com

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October 11, 2024 14:10 ET (18:10 GMT)

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