Oil: Implied Volatility Soars but Path Ahead is Unclear

  • 16 Jan 2019
  • By Erik Norland
  • Topics: Energy

The 44% decline in crude oil prices in Q4 2018 was dramatic but pales in comparison to the 79% plunge between July and December 2008 or the 76% tumble from late 2014 to early 2016.  Remarkably, implied volatility on 30-day West Texas Intermediate (WTI) crude oil options spiked to levels in line with those seen during the 2014-16 bear market, although they fell short of the record highs in 2008 (Figure 1).  Longer-dated options came close to both the 2015-16 and 2008-09 highs. Moreover, even though oil prices have rebounded substantially from their recent lows, oil options continue to trade at levels of implied volatility similar to the most volatile periods of the 2014-16 price collapse.

Figure 1: Implied Volatility Spikes to 2014-16 Levels. Longer-Dated Options Peaked Near 2008 Highs.

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.

Figure 2: Rig Counts Often Lead Production Changes by About Four Months on Average.

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.

Figure 3: Oil Inventories are Up Slightly YoY but have Been Relatively Stable Compared to Recent Years.

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.

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

Figure 4: Movements in Vegetable Oil Prices have Often Presaged Movements in Crude Prices.

Figure 5: Soybean Oil Implied Volatility Signals a Narrow Range for Veg Oil and Maybe Crude Prices.

Bottom Line:

  • 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.


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 author(s) 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.

About the Author

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.

View more reports from Erik Norland, Executive Director and Senior Economist of CME Group.

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