Experience RS

Turbulence Ahead, Hang on to Your Magic Carpet

Imagine navigating the volatile world of oil prices on a magic carpet in search of that heavenly state called market equilibrium, where supply equals demand. The voyage isn’t easy. You careen from bearish pitfalls to bullish peaks, punctuated by unnerving periods of silence and uncertainty. Navigating these treacherous conditions can be overwhelming; your mark-to-market is at stake.


Luckily, you are not alone – for accompanying you on the journey is a prophet, a seer – an all-knowing genie that has granted you one wish.


Genie warns of the challenges ahead on your magic carpet ride, pointing out current global economic risks decidedly skewed to the downside and elevated geopolitical risks reminiscent of the Arab Spring. He makes special mention of the oil-producing beast now unleashed in the heart of Texas.


At first, you are skeptical of the genie’s prophetic powers, convinced current pockets of turbulence (Figure 1) will pass. But then he reminds you how your magic carpet dipped, wrinkled and stretched during previous oil market shocks (Figures 2, 3 and 4). Increasingly convinced of the genie’s prescience, you make your one wish, “If a rougher ride is really in the cards, I wish for some instrument or option derived by mathematical sorcery, to help make my journey smoother.”


The magic carpet in this analogy is the Brent volatility surface, which indicates current market bias on price risk. At present, the forward curve for Brent is backwardated and hovering at ~$65/bbl for the next 24 months. The volatility surface has become increasingly wrinkled as of late, suggesting the market is beginning to price in heightened uncertainty. Nonetheless, current volatility – as captured in the volatility surface – appears low compared to what could ensue, should the bevy of near-term fundamental risks pointed out by the genie be realized.


This suggests an opportunity for taking defensive action still exists – which has implications for corporate hedging programs, the use of options to mitigate existing positions and the pointing of risks when trading a forward view. And while some folks would argue against hedging because predicting the price of oil is very difficult, we would counter: it is because predicting the price of oil is difficult, that one should hedge.

Need To Know: A Brent volatility surface is loosely defined as a three-dimensional representation of those options most in demand at a given time. The higher the volatility, the more expensive option prices become. The vertical axis indicates the popularity of the option – e.g., the market’s assessment of price volatility at a given term; the horizontal axis shows the term of the option; and the depth is the delta of the option. Delta is the ratio of the change in the price of the option to the corresponding change in the price of Brent. If an option has a delta of 25, an investor can expect a $0.25 move in that option’s premium given a $1 move up or down in Brent. The following volatility surfaces are for ICE Brent calendar swaps.

 

FIGURE 1 | Recent Brent Volatility Surface

''

Source | Bloomberg

Need to Know: The CBOE Crude Oil ETF Volatility Index measures the market's expectation of 30-day volatility of crude oil prices to United States Oil Fund (NYSEARCA: USO) options spanning a wide range of strike prices. USO is an exchange-traded fund that attempts to track the price of West Texas Intermediate light sweet crude oil.

 

FIGURE 2 | Oil Volatility Index

''

Source | RSEG, Bloomberg

 

FIGURE 3 | Brent Volatility Surface, November 30, 2016 – Day of OPEC Announcement to Cut Supply

''

Source | Bloomberg

 

FIGURE 4 | Brent Volatility Surface, October 24, 2008 – OPEC Cuts Production to Support Prices During the Great Recession

''

Source | Bloomberg

 


RS Energy Group Disclosure Statement:

© Copyright 2019 RS Energy Group Canada, Inc. (RSEG). All rights reserved.

All trademarks, service marks and logos used in this document are proprietary to RSEG. This document should not be copied, distributed or reproduced, in whole or in part. The material presented is provided for information purposes only and is not to be used or considered as a recommendation to buy, hold or sell any securities or other financial instruments. Information contained herein has been compiled by RSEG and prepared from various public and industry sources that we believe to be reliable, but no representation or warranty, expressed or implied is made by RSEG, its affiliates or any other person as to the accuracy or completeness of the information. Such information is provided with the expectation that it will be viewed as part of a mosaic of analysis and should not be relied upon on a stand-alone basis. Any opinions expressed herein reflect the judgment of RSEG as of the date of this document and are subject to change at any time as new or additional data and information is received and analyzed. RSEG undertakes no duty to update this information, or to provide supplemental information to anyone viewing this material.  To the full extent provided by law, neither RSEG nor any of its affiliates, nor any other person accepts any liability whatsoever for any direct or consequential loss arising from any use of the information contained herein. The recipient assumes all risks and liability with regard to any use or application of the data included herein.

Caution Regarding Forward-Looking Statements:

This public communication may contain forward-looking statements within the meaning of the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended. These statements are based on our current expectations about future events or future financial performance. In this context, forward-looking statements often contain words such as "expect," "anticipate," "intend," "plan," "believe," "seek," "see," "will," "would," or "target” or other words that convey uncertainty of future events or outcomes.

These statements involve known and unknown risks and uncertainties that may cause the events we discuss not to occur or to differ significantly from what we expect. When evaluating the information included in this communication, you are cautioned not to place undue reliance on these forward-looking statements, which reflect our judgment only as of the date hereof. We undertake no obligation to publicly revise or update these forward-looking statements to reflect events and circumstances that arise after the date hereof.

Note to UK Persons:

RSEG is not an authorised person as defined in the UK’s Financial Services and Markets Act 2000 (“FSMA”) and the content of this report has not been approved by such an authorised person.  You will accordingly not be able to rely upon most of the rules made under FSMA for the protection of clients of financial services businesses, and you will not have the benefit of the UK’s Financial Services Compensation Scheme. This document is only directed at (a) persons who have professional experience in matters relating to investments (being 'investment professionals' within the meaning of Article 19(5) of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2005 (the "FPO")), and (b) High net worth companies, trusts etc of a type described in Article 49(2) of the FPO (all such persons being "relevant persons").  RSEG’s services are available only to relevant persons and will be engaged in only with relevant persons. This report must not be acted or relied upon by persons who are not relevant persons.  Persons of a type described in Article 49(2) of the FPO comprise (a) any body corporate which has, or which is a member of the same group as an undertaking which has, a called up share capital or net assets of not less than ( i ) in the case of a body corporate which has more than 20 members or is a subsidiary undertaking of an undertaking which has more than 20 members, £500,000 and (ii) in any other case, £5 million, (b) any unincorporated association or partnership which has net assets of not less than £5 million, (c) the trustee of a high value trust within the meaning of Article 49(6) of the FPO and (d) any person ('A') whilst acting in the capacity of director, officer or employee of a person ('B') falling within any of (a), (b) or (c) above where A's responsibilities, when acting in that capacity, involve him in B's engaging in investment activity.