When investing into an asset class is deemed risky, naturally expectations for greater profit potential are on the ascent. Risk, nonetheless, is notoriously difficult to define and quantify. Probably the most reasonable approach to measure risk is volatility, which is the deviation from the mean price over a predefined period. The chart above illustrates the delicate yet visible inverse relationship between oil prices and volatility. A rising or stable market tends to be coupled with low volatility and vice versa. During the 2011-2013 period, the average monthly settlement price of WTI was just under $100/bbl in real terms, the highest of any three-year period since 1860, while volatility dropped to historic lows. The 2008 financial crisis, or the price war of 2020 between Russia and Saudi Arabia, which pushed the price of oil over the precipice, sent volatility spiking.

It is a fair and well-founded assumption that vicious price falls are either triggered by negative demand shocks (see the plunge from $140/bbl in 2008) or positive supply shocks (the short-lived geoeconomic animosity between the two critical oil-producing nations four years ago). The very definition of a price shock is an unexpected event or collective events. A negative price shock can trigger short sellers like producers to add hedges and re-adjust portfolios, while longs may also stampede towards the exit, creating a violent trading environment. The unforeseen souring of sentiment then becomes a self-fulfilling phenomenon as the cost of trading, margin calls, increases due to heightened volatility leading to illiquid trading conditions.

At the time of writing, May 3, the U.S. crude oil marker, WTI had dropped more than $5/bbl or 7% in the space of five days. There is understandably intense chatter whether the move could be maintained. Curiously, historical volatility failed to pick up, and perhaps more importantly, implied volatility, which reflects the market view on future price swings, remained relatively subdued. These insinuate no positive supply or negative demand shocks; consequently, while further and gradual weakness cannot be ruled out, panic selling is implausible, an unless volatility picks up the downside appears limited.