Low volatility supports prices

Volatility is the embodiment of market confidence and/or uncertainty. Spikes in volatility can be the result of changes in a number of underlying factors such as supply and demand, market sentiment and investor behaviour, macroeconomic developments, or the interconnection of financial markets. A well-balanced fundamental backdrop usually provides a predictable trading environment whilst unexpected events can lead to nervousness and consequently volatility would swell.

What is intriguing to observe is the reverse relationship between oil prices and volatility. The lower the price the higher the volatility and vice versa. It is also conspicuous on the chart above that the spikes in volatility usually last for a relatively short period of time. In the last 16 years it has happened during the 2007-2009 financial crisis and on the onset of the Covid outbreak when sharp price falls were coupled with volatility jumping well over 100%. It is noteworthy that the period of 2011-2014 saw a relative calm when a WTI price range of $80-$110 was coupled with a volatility that hardly exceeded 40%.

The inverse relationship between price and volatility is the function of uncertainty. A “black swan event” usually leads to a re-evaluation of demand estimates and during this brief period risk assets, including oil, are deserted. In a “panic mode” length is shed. Again, the Great Recession and the health crisis are graphic examples of this phenomenon.

Curiously, but possibly understandably, the beginning of the Ukraine and Russia conflict saw both prices and volatility rise considerably as one of the world’s largest producers has been involved in the conflict – a rare occurrence when supply came under scrutiny. However, it is clearly perceptible that the rise in oil prices since March (the U.S. benchmark has gained 25% in the last five months) coincided with a drop from 50% to around 20% in volatility on a weekly basis; the gap between the two has widened meaningfully. Historical evidence suggests that the sustainability of the move higher could be impacted by re-emerging uncertainty, which could lead to a tangible rise in price volatility.

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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 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.

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