Time for a market rethink on ethanol makers? Volatility, volume say maybe…

After a rough 52 weeks for ethanol producers, an upside earnings surprise by Pacific Ethanol (PEIX) this morning turned option traders’ attentions toward the outlook for upside in the broader sector. Pacific Ethanol options themselves are trading at more than 12 times the normal level as shares are up 47.5% to $4.72, and while implied volatility has come off by more than 25% since the release of the numbers, its continued high elevation (103%, which measures the likely share price fluctuation over the next 30 days compared to a historic record of 78% for the underlying shares over the past year) suggests that the market is roiling as its contemplates a new equilibrium price for the stock.

The fact that 4 times as many calls are moving as puts suggests this risk lies to the upside. June calls at the $5 and $7.50 strikes have traded freshly on volume of more than 1,000 lots each – the price of the $5 strike increasing 300% on back of the earnings surprise, and the 7.50 strike drawing volume even as the 15-cent price tag suggests just an 11% chance of a breach of the $7.50 line by June’s expiration.

Pacific Ethanol shares traded as high as the $15 level last July, but have come off sharply since then, registering a more than 67% drop in value over the past year and gapping well below the performance of the Russell 2000 Other Energies Index.

Enthusiasm over Pacific Ethanol’s earnings was infectious today, as the upside caught on in shares and options in sector peer VeraSun Energy (VSE). Like its West Coast counterpart, VeraSun’s earnings have gruelingly depreciated over the past year, down more than 57%. Today its shares gained 18.4% to $7.33 and, similar to the setup in Pacific Ethanol, the marked disparity between implied and historic volatility (80.5% implied volatility versus 69.3% historic) suggests the market is taking the opportunity for a larger rethink on the valuation of its shares. Options to buy and sell VeraSun shares are trading at 6.5 times the normal level, according to our market scanners, with action in June calls at the 7.50 and 10 strikes offset by what may be more directionally neutral volatility plays in the December contract at the 5/7.50 strikes. Heading into today, option traders had held 1.6 times as many puts as calls.

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Andrew Wilkinson

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