LONDON, May 11 (Reuters) - Oil traders are snapping up options to protect against another steep price drop in case OPEC and its partners fail to deliver enough of a supply cut to satisfy investors of their commitment to tackle a three-year-old surplus of unused crude.
The Organization of the Petroleum Exporting Countries meets on May 25 and will discuss extending its agreement forged with a number of its rivals, including Russia, late last year to cut output by 1.8 million barrels per day in the first half of 2017.
That the supply agreement will be extended is being billed as a dead cert, not least by the de facto leader of OPEC, Saudi Arabia, whose energy minister said the group would do "whatever it takes" to reduce global inventories.
But the price of crude oil is lingering around $50 a barrel, close to its lowest levels this year.
Volatility, one way of measuring the price of an option, remains fairly muted by historical standards, but has picked up the most for bearish sell options expiring on May 26, one day after OPEC's meeting.
This suggests investors are willing to pay up more for protection against a sudden, sharp drop in the price.
"Before, OPEC was given the benefit of the doubt. Now, the market says 'show me the data'," said Ole Hansen, senior manager at Saxo Bank, referring to figures on global inventories. "It is a testing time, no doubt."
"There are still many (bullish players) in the market that are potentially starting to look for a handbrake and that has increased demand for downside protection ... the market is uncertain about whether it will be $40 next or $55."
A put option, which gives the holder the right, but not the obligation, to sell oil at a set "strike", or price, by a certain date, is one way of securing that protection.
Volatility on three-week put options with strikes well below the current price has risen to 37 percent from around 32 percent a week ago. When OPEC announced its decision to cut supply this year, volatility rose to nearly 70 percent on similar options.
Options on July Brent futures, which expire on the day of the meeting itself, show most open interest is clustered in put options at $50 a barrel, followed by call options - which give the right to buy at an agreed price - at $52 a barrel.
Further ahead, open interest in the last week has spiked in December $40 and $45 puts, which suggests investors believe the underlying Brent futures could well be trading below those levels by the end of the year.
"I'd argue you could see $8-10 off the price (in case of disappointment)," one options trader said. "You will see more put buying here and even with an extension, you still might see a sell-off."
The price of oil fell by 5 percent last week, under pressure from investors concerned over OPEC's ability to cut supply enough to counter rising U.S. output.
But the options market can often paint more than one picture. While interest in bearish sell options has picked up, traders have also snapped up cheap buy, or call, options.
With the sell-off last week, the premium of out-of-the-money puts over that for out-of-the-money calls, or "skew", expiring around the time of the meeting shrank to its smallest in a month, around 110 basis points.
Back in April, the premium for options expiring on, or close to, May 25, was closer to 400 basis points.
BNP Paribas head of commodity strategy Harry Tchilinguirian said this development showed sentiment in the market was not quite as "unilaterally bearish" as some might believe.
"When the price was collapsing, skew would (normally) have been bid on the puts and it wasn’t, it went the opposite way," Tchilinguirian said.
"Does that mean the market is now viewing $40 before $50? Perhaps not." (Reporting by Amanda Cooper; Editing by Dale Hudson)