Implied Oil Volatility Soars, But Path Ahead Is Unclear

The 44% decline in crude oil prices in the fourth quarter of 2018 was dramatic, but pales in comparison to the 79% plunge between July and December 2008, or the 76% tumble from late 2014 to early 2016, writes the financial market company CME Group. “Remarkably, implied volatility on 30-day West Texas Intermediate (WTI) crude oil options spiked to levels in line with those seen during the 2014-2016 bear market, although they fell short
of the record highs in 2008,” the company comments.

It adds that longer-dated options came close to both the 2015-2016 and 2008-2009 highs. Moreover, even though oil prices have rebounded substantially from their recent lows, oil options continue to trade at levels of implied volatility similar to the most volatile periods of the 2014-2016 price collapse.

Whether WTI options maintain such high levels of implied volatility going forward depends greatly on realized volatility and the future direction of prices. For example, if oil prices begin to decline again, and if they break through their recent lows, oil options volatility may remain at or near record highs.

CME Group outlines that another scenario under which oil options could conceivably maintain or even move to even higher levels of implied volatility would be if there was a supply shock that sent prices soaring. Such shocks are difficult, if not impossible, to forecast and are also exceedingly rare. Supply reduction shocks occurred in a big way in 1973, 1979, 1990, arguably in 2003 in the aftermath of the U.S. invasion of Iraq, and on a smaller scale in 2011 with the implosion of the Gaddafi regime in Libya.

If anything, Middle East tensions have waned in recent months following the Khashoggi murder scandal and the U.S. granting exemptions to eight countries on the Iran sanctions, including China and India. This appears to have helped contribute to the abrupt collapse in oil prices and the spike in volatility in the 2018 fourth quarter. “That said, there is always the potential for more instability as the U.S. prepares to wind down its involvement in Syria and Afghanistan, and as other flashpoints in the Middle East remain unresolved,” notes CME.

The company recounts that investment in the U.S. energy sector contracted in 2015 and 2016 as oil prices crashed. It began to rebound in mid-2016 as oil prices moved back above $40/bbl and then went into overdrive as prices soared to the $60/bbl to $80/bbl range by the summer of 2018. With prices back down to around $50/bbl and some hydraulically fractured wells in the U.S. not producing as much as had been hoped, U.S. production might crest, at least temporarily, at some point over the next six months. If so, this would mitigate a major source of downward pressure on oil prices.

Further, although imperfect as an indica- tor, rig counts are still worth watching, CME Group emphasizes. If the number of operating rigs begins to fall, it may signal a peak in U.S. oil production is coming in about three to five months. In recent months, the number of operating rigs has been stagnant, which might indicate U.S. output is nearing a local peak. However, the limitation with the rig-count indicator is that it fails to account for varying productivity between rig deployments.

(SOURCE: The Weekly Propane Newsletter, February 4, 2019)