COLUMN - Oil volatility settles near long-run average: John Kemp

An attendant works at a petrol station in Hyderabad in this June 2008 file photo.

-- John Kemp is a Reuters columnist. The views expressed are his own --

By John Kemp

LONDON (Reuters) - If the oil market has appeared quiet since the start of the year that is because prices have been relatively well-behaved, with few surprises. After a roller-coaster in the wake of the financial crisis, volatility has settled down close to long-term average levels.

Nearby prices have recently been a little less volatile than usual. Prices further forward have been a little bit more variable. But with volatility hovering close to typical levels throughout the curve option-related trading strategies are not particularly attractive at the moment.

The following charts show volatility for both spot prices and one-year forward since the late 1980s. Click here and here

Volatility has varied widely. For the spot month it has typically ranged from 20 percent to 40 percent (Chart 1). But there have been two major peaks associated with the start of Operation Desert Storm (1991) and the banking crisis (2008-2009), as well as several smaller ones linked to the price collapse (1998) and attack on the World Trade Centre (2001).

Volatility does not follow a Normal distribution. There are many more days with very large price changes than would occur if volatility was Normal (Charts 2 and 3). In technical terms the distribution is positively skewed and displays kurtosis ("fat tails").

But even allowing for the occasional peaks, volatility has not remained constant over time. Volatility was generally higher in the late 1980s and then fell during the first half of the 1990s (notwithstanding the price spike in early 1991).

In the last 15 years, the distribution has been more compressed. There have been fewer days with very small price changes (the market has become more "active") but that has been matched by fewer days with very large ones (the market has become more "continuous"), at least until the financial crisis struck (Charts 4-6).

SPOT VOL REMAINS MODERATE

Contrary to much of the commentary, prices were not unusually volatile in the run up to the super-peak in July 2008 -- at least not until the very end of the bull-run. Between June 2007 and June 2008, volatility was within the usual 20-40 percent range. While the cumulative increase was huge (from around $70 to $140 per barrel), and daily price changes were sometimes large in dollar terms, measured in percentage terms daily changes were not especially big.

Only when the bull market began to break down in the middle of July 2008 did the market become unstable, with volatility rising above 40 percent. Even then, volatility peaked at just 45 percent, still relatively low by historical standards.

It was the financial crisis, evaporation of liquidity in the autumn, and freefall in global manufacturing that unleashed the massive spike later in the year as prices tumbled. Ironically the market was more volatile on the way down and in the early stages of recovery than it had ever been during the bull-run.

Now the market has settled down, the current level of volatility (around 30 percent) is pretty typical, only a shade below "average." In fact 30 percent is the peak of the frequency distribution; volatility tends to cluster around this level.

Owing to the distribution's positive skew, with a few instances of very high volatility, the current level is slightly below the average if by that we mean the mean or the median. The current level lies in the 42nd percentile of the distribution; the 50th percentile (median) would be only marginally higher, at 32 percent. The arithmetic mean is 35 percent. But by any measure current volatility is very close to what would be expected under typical conditions.

RISING FORWARD VOLATILITY

In contrast to spot-month volatility, which has remained unchanged for 15 years, volatility further along the curve has trended upwards, particularly since 2004. Forward prices have been noticeably more volatile in the five-years beginning in 2006 than in previous periods. Median volatility has been 25.3 percent in 2006-2010, up from 22.6 percent in 2001-2005, 20.0 percent in 1996-2000 and 13.0 percent in 1991-1995 (Chart 11).

At the same time, forward prices and volatility have become increasingly integrated with the prices and volatility in the spot market. John Parsons of the Sloan School of Management attributes increased volatility at the back end to the dramatic growth in futures and options trading since 2004, especially at longer maturities, led by financial investors rather than physical market participants. He notes that hedge funds and swap dealers account for all the growth in open interest and liquidity at dates beyond one year.

The lengthening maturity profile, combined with increasing integration of spot and forward prices, and increased involvement of financial players has made the market increasing forward-looking. Expected future fundamentals rather than the current supply-demand-inventory balance now dominate price setting at all maturities.

FORWARD VOL EXPENSIVE

From a trading perspective, it is hard to work up much enthusiasm for buying nearby options at present, unless the volatility implied in prices is substantially below the observed level; the prospect of making money is more or less evenly matched by the prospect of losing it.

Looking further along the curve, options seem even less attractive. Realised volatility one-year forward (around 27 percent) is quite high (around the 80th percentile) making forward options expensive. Even if we allow for the fact forward prices have become relatively more volatile since 2004 (Chart 12), current forward volatility is still a bit higher than normal (58th percentile), though not by much.

Downside puts are especially expensive at the moment, suggesting buying interest from oil producers, anxious to protect against a fall in prices, is not matched by strong selling interest from investors. The volatility skew implies the market is a good deal less confident about prices over 2010-11 than some bullish commentaries imply.

The searing dislocations over the last two years (in oil as well as other assets), combined with a high degree of uncertainty about the outlook (whether supply constraints or weak demand will dominate over 2010-11), have kept potential volatility sellers on the sidelines, and left traded volatility at an abnormally high level.

As a result, there might be an opportunity to buy nearby volatility and sell it forward at current levels. But only for the brave, and those with pockets deep enough to play the averages.