After oil’s wild ride from $100 per barrel in 2014 to $26 earlier this year, the oil futures curve is almost perfectly flat, with prices hugging $50 per barrel as far as the eye can see.
This, however, doesn’t mean that the oil market will be lackluster. While the futures curve suggests that market participants see $50 as being close to oil’s long-term equilibrium price, the options market doesn’t appear to believe that oil will actually spend much time being in equilibrium. Implied volatility on options are off their highs from February but about one-third above their five-year average (Figure 2).
The combination of the futures and options prices suggests that oil prices might range-trade for a very long time in an exceptionally wide channel. If the price of WTI is $52 one year out, and implied volatility is 40%, and one assumes log-normality, this suggests that one year from now, there is a 68% probability that prices will be between $34 and $76, and a 95% likelihood that they will be between $23 and $116 per barrel. If this is a trading range, it’s one that is wide enough to drive a truck through.
In the oil markets there is plenty of precedent for wide-trading ranges. The 2014-2016 oil price collapse is hardly the first such collapse in history. The previous oil-prices collapse, which reached its crescendo in late 1985 and early 1986, offers interesting lessons. Following that collapse, from $32 per barrel to $12, the market traded in a range for the next 14 years (Figure 3). From January 1986 to December 1999, oil prices averaged $19 per barrel, but the range was $10 to $41 per barrel. The $41 per barrel occurred after Saddam Hussein invaded Kuwait in the summer of 1990. With the exception of the Persian Gulf War, oil prices never exceeded $28 per barrel.
Futures and options markets are currently pricing an analogous scenario, with the range shifting upwards. Instead of averaging $19 per barrel as they did during the late 1980s and 1990s, oil prices suggest an average just above $50 per barrel between now and 2024. If this comes to pass, one might expect a similarly wide range. It’s possible that the recent low of $26 per barrel could be the low end of the range. If so, the high-end of the range could still easily be $80 per barrel, and perhaps over $100.
What could cause oil prices to fluctuate in such a wide range? For starters, both supply and demand for oil are notoriously inelastic, so small perturbations in supply or demand can produce outsized moves in prices. There are numerous upside and downside risks to oil prices. Here are a few of them:
All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the authors and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.
Erik Norland is Executive Director and Senior Economist of CME Group. He is responsible for generating economic analysis on global financial markets by identifying emerging trends, evaluating economic factors and forecasting their impact on CME Group and the company’s business strategy, and upon those who trade in its various markets. He is also one of CME Group’s spokespeople on global economic, financial and geopolitical conditions.
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