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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


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