Oil: Implied Volatility Soars but Path Ahead is Unclear

Whether WTI options maintain such high levels of implied volatility going forward depends greatly on realized volatility and the future direction of prices.  For example, if oil prices begin to decline again and if they break through their recent lows, oil options volatility may remain at or near record highs.

Another scenario under which oil options could conceivably maintain or move to even higher levels of implied volatility would be if there was a supply shock that sent prices soaring.  Such shocks are difficult, if not impossible, to forecast and are also exceedingly rare.  Supply reduction shocks occurred in a big way in 1973, 1979, 1990, arguably in 2003 in the aftermath of the U.S. invasion of Iraq, and on a smaller scale in 2011 with the implosion of the Gaddafi regime in Libya.  If anything, Middle East tensions have waned in recent months following the Khashoggi scandal and the U.S. granting exemptions to eight countries on the Iran sanctions, including China and India. This appears to have helped contribute to the abrupt collapse in oil prices and spike in volatility in Q4 2018. That said, there is always the potential for more instability as the U.S. prepares to wind down its involvement in Syria and Afghanistan, and as other flashpoints in the Middle East remain unresolved.  

Perhaps the most likely scenario for oil prices would be for them to trade sideways in a range from $40-$60 per barrel.  Range-trading would most likely be bearish for WTI options, which might, under this scenario, return to levels seen during past periods of sideways trading where implied volatility averaged roughly half of its current levels. While acknowledging a wide range of possible outcomes, there are several reasons to support the range-trading scenario:

1. U.S. production may stop growing in the next several months.
2. Oil might be supported near $40 per barrel, which is probably close to the marginal cost of production of U.S. swing producers.
3. After years of wild swings, inventories may be stabilizing.
4. Vegetable oil prices, which correctly presaged the recent crash in oil prices, as well as many past moves in oil, are not sending particularly bullish or bearish signals at the moment.

U.S. production: Investment in the U.S. energy sector contracted in 2015 and 2016 as oil prices crashed.  It began to rebound in mid-2016 as oil prices moved back above $40 per barrel and then went into overdrive as prices soared to the $60-$80 range by the summer of 2018.  With prices back down to around $50 per barrel and some fracking wells not producing as much as had been hoped for, U.S. production might crest, at least temporarily, at some point over the next six months.  If so, this would mitigate a major source of downward pressure on oil prices.

Although imperfect as an indicator, rig counts are still worth watching.  If the number of operating rigs begins to fall, that may signal a peak in U.S. oil production is coming in about three to five months.  In recent months, the number of operating rigs has been stagnant, which might indicate that U.S. production is nearing a local peak (Figure 2). The limitation with the rig-count indicator is that it fails to account for varying productivity between rig deployments.

Inventories: After soaring in 2014 and 2015, and then drawing down substantially in 2017 and 2018, inventory levels appear to be stabilizing where they are just a few percent above where they were at this time last year (Figure 3).  This also argues for the notion that oil prices might range-trade going forward to the likely detriment of implied volatility levels.

Finally, vegetable oil prices, which have been an excellent indicator of future movements in crude oil prices for the past decade and a half, are pointing nowhere.  Vegetable oil prices presaged the early stages of crude’s rally in 2016 and 2017 but began falling in late 2017, appearing to anticipate the recent collapse in crude prices just as they did in 2008 and 2014 (Figure 4).  In recent weeks, vegetable oil prices have been stable yet directionless.  Perhaps that’s crude oil’s near-term future as well.

• Crude Oil’s Next Move? Clues from Soybean Oil

Implied volatility on soybean oil is trading near record lows (Figure 5).

• Crude oil options implied volatility spiked to 2015/2016 levels amid Q4 2018 selloff.
• WTI implied volatility could maintain or exceed current levels if strong price movements continue.
• Range-trading, however, would likely be bearish for crude oil options.
• Easing of Middle East tensions, stabilizing U.S. production and inventories, and directionless vegetable oil prices point to a significant likelihood of range-trading in crude oil prices.
• As such, implied volatility on crude oil options might be unsustainably high.