Oil Options Skew Strikes Again

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

One month after the drone attacks on Saudi oil infrastructure, WTI and oil product prices have returned to their pre-attack levels.  Implied volatility on at-the-money WTI, gasoline and Ultra Low Sulfur Diesel (ULSD) options has also similarly retreated.  Options skew, however, while well off its highs, remains very different now than before the attacks on the world’s top oil exporter.

Usually, the WTI and oil products skew is negative, meaning out-of-the-money (OTM) puts are more expensive than OTM calls.  After the attacks, that skewness flipped: OTM calls became more expensive than OTM puts.  Since then, they have gone back in the other direction but remain much less negatively skewed than is typically the case (Figures 1,2 and 3). What’s more is that as of mid-October, their skewness remains in the upper 20% of their historical trends (Figures 4, 5 and 6) and at levels that have, in the past, been associated with an above-average likelihood of further price declines over the next three months.

Figure 1: WTI Options Have Rarely Skewed Positive.

Figure 2: One Month After the Attacks, Gasoline Options Were Still Less Negatively Skewed Than Normal.

Figure 3: ULSD Options also Remain Less Negatively Skewed Than Normal.

Figure 4: As of October 12, WTI Options Were Still in the 98th Percentile of Positive Skewness.

Figure 5: As of October 12, Gasoline Options Were in the 79th Percentile of Positive Skewness.

Figure 6: As of October 12, ULSD Options Were in the 98th Percentile of Positive Skewness.

Over the past decade, more positive (or in other words, less negative) than average skews for WTI and oil products have often presaged below average returns on long futures positions over the next three months.  The data in figures 7, 8 and 9 show the relationship between the two-year rolling percentile rank of the “risk reversal” skewness and subsequent three-month returns in the reinvested futures positions rolled 10 days prior to expiry.  Generally, a more positive skew indicates a higher likelihood (but by no means certainty) of a lower return (fall in prices), whereas exceptionally negative skews often signal that energy markets are oversold.

Whether WTI and product prices decline this time, as the past relationship between options skews and subsequent movements in prices suggests is more likely than not, depends, of course, on how both fundamental and geopolitical factors play out.  If inventories fall sharply, a possibility given that as much as half of Saudi oil output was offline for two or three weeks, that could boost oil prices.  Likewise, any strengthening of global demand or a supply shock of any sort could send prices much higher.   Indeed, the options markets is more concerned than usual that such upside could happen.  That said, options skewness has proven to be somewhat of a contrary indicator of near-term price direction over the past decade.  It’s often been that when oil traders were most worried about future price declines, prices, in fact, rebounded and when they were most concerned about upside risk, prices have the greatest propensity to fall. This inverse relationship is noticeable in WTI and much stronger for New York Harbor Gasoline (RBOB) and ULSD.

Finally, it’s worth pointing out, that in the month since the Saudi attacks sent options skews to their highest since 2011, oil and its product prices have indeed lost all their gains. The oil options skew strikes again.

Figure 7: WTI Often Gets its Best Returns After Skewness has Been the Most Negative.

Figure 8: The Top 20% of Skewness has Often Led to Negative Three-Month Returns on RBOB.

Figure 9: ULSD Options Skew has Generally Been a Contrary Indicator Over the Past Decade.

Bottom Line

  • One month after the Saudi oil infrastructure attacks, prices and ATM volatility are back to normal.
  • Options skews, however, are much less negatively skewed than normal.
  • Options skews have been decent contrary indicators of future price direction over the past decade.
  • Geopolitics and fundamental factors could push WTI and product prices higher even if options skews suggest otherwise.

 

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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