Potential For Volatility Returning to Oil Markets

Potential For Volatility Returning to Oil Markets

Potential For Volatility Returning to Oil Markets
Potential For Volatility Returning to Oil Markets Getty Images

Over the past several weeks oil has bounced in well-defined ranges through the $40’s with step changes up and down brought about by updates in fundamental data. That range may have changed last week as WTI crude broke out of recent ranges to ascend higher and re-approach the psychologically important $50 level. As debates in trading circles rage as to the future price direction for oil, we feel observing the signals of rising volatility might be more important than a point of view on the actual price direction for a short-term binary options trader.

Oil markets have been boxed in by a supply glut, and it is our point of view that the near constant talk of inventories is almost solely driving the market at this point. Any indicator or data important to inventory, such as the API inventory report, the EIA weekly inventory report, or the weekly Baker Hughes rig count, is being over traded and brings higher levels of event risk with wider moves in price action than the underlying data should warrant. The longer the oversupply persists, the more pronounced the effect should be.

A daily price chart below shows oil price movement with an average true range indicator showing the distance price movements are covering and the bottom panel indicating the relative volatility index. The range has been increasing for several weeks, and the relative volatility is building and persisting at elevated levels.

Potential For Volatility Returning to Oil Markets

 

Actual data indicates we are nowhere close to making material progress towards supply and demand balance, and we remain starkly above the five-year range for crude oil supply. Based on the dramatic increases in overall production levels, much of it attributed to innovation in drilling technology and increases in per rig productivity in the US, we expect to remain at the high end of the range through 2018 at least, which should be generally bearish for prices over a longer time horizon.

Potential For Volatility Returning to Oil Markets

However, at some point supply, and by consequence price, should find a new direction.

Historically, the change in the spread on WTI futures prices and the change in inventory levels have closely mirrored each other with price dictating supply levels. If we look over the last ten years, we see correlated movement, with decreases in inventory levels lagging decreases in the WTI futures spread by a quarter or two.

Potential For Volatility Returning to Oil Markets

However, we can see this pattern broke down in 2015. Inventory levels continued to increase year over year into 2016, even after a sharp decrease in the WTI futures spread. Normally supply would fall in tandem with a drop in the futures spread and only lag by about a quarter. In this most recent cycle it lagged by over a year, a delay 4x longer than the market normally anticipates.

For a short-term binary options trader, this means increasing volatility due to the market being so far removed from historical precedent while possessing a pent up need to rebalance basic principles, and we expect a material increase in volatility in the current period as a result. We believe in such an environment, where long term connections between supply, demand, and price have seemingly broken, that actual price direction has been harder to discern and matters far less than the distance price is covering, regardless of direction. The current $50 perch is an important benchmark where there are deeply held opinions in the market as to where price goes from here. This disagreement, which is far more pronounced at $50 than $40, will manifest itself in short term volatility marked by asymmetric swings back and forth in price. This could allow for a binary options trader to build a strategy to trade on the in period volatility in contrast to trading in support of one price direction or the other.

The below chart demonstrates the volatility brought about by changes in inventory at such elevated levels. The impact on price has introduced a volatility with heteroskedasticity, meaning there is currently a non-linear relationship between changes in inventory and volatility in price. With each step up in inventory, the variability of potential moves in price has widened. This produces the effect of overall direction being harder to anticipate as elevated inventory levels have produced a wider range of potential impacts on price. This is seen in the chart below by the widening scatter representing changes in price as we move out to higher inventory levels.

Potential For Volatility Returning to Oil Markets

Short term traders feel this heteroskedasticity when there are sharp moves based on weekly inventory reports, for instance. There is no underlying economic reason for a one time weekly net draw of a few million barrels, which might represent 1% or less of total supply, to fuel a sharp move and direction in price, especially with no consideration of demand fundamentals or other data. However, the market is seeing that possibility now because traders are left to speculate as they have a lack of historical precedent or context for guidance.

In summary, the market is over reacting and over correcting because the typical relationship between supply and price has been distorted leaving little to no information to guide future decisions. When a <1% change in underlying supply results in a pronounced move in price, you have a heteroskedactic environment and the best path for a trader might be to play the week to week volatility as opposed to trying to determine direction.

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