Is Oil Volatility Changing Trading?

 

Oil prices have been on the downswing for more than a year now.  As U.S. crude futures fell to a fresh six-year low last week, rising global supply and subsiding demand from China provide little indication of an end to the trend.  Volatility is still below historic highs, but it remains a significant factor.  On August 12, the Chicago Board Options Exchange Crude Oil Volatility Index closed at the highest level since April.

The story of oil bear markets is one most often told by supply side economics. The U.S. is on pace to produce the most oil since 1972, according to the Energy Information Administration, and drillers have made little indication of curbing production despite price dips and squeezed profit margins.  In fact, U.S. stockpiles remain at the highest levels during the peak driving season in approximately 80 years.  CME Group Senior Economist Erik Norland highlighted this in his recent report.

While Americans are driving about 5% more miles than they did last year, oil inventories have not been declining as much as they usually do at this time of year.  Not only are inventories near record highs, their year-on-year pace of increase is at a record-breaking 25 percent.

 

Crude Oil Inventories August 2015

 

Global output levels are also growing as the leading world oil exporter Saudi Arabia ramps up production. The Iran nuclear agreement could lead to the addition of Iranian crude inventories to the existing supply glut sometime in 2016.

While supply is certainly increasing, demand hasn’t followed suit. Demand for oil in China, the world’s second largest petroleum consumer, has fallen as economic growth declines. Currency fluctuations only further complicate the situation. Devaluation of the Yuan could further hurt the country’s demand.  A weaker Yuan compounded with a strong U.S Dollar will make commodities imported from America, such as oil, more expensive for Chinese consumers.

The conflation of these factors makes for crude oil markets that are unpredictable as producers and consumers await an unknown equilibrium price.  But what does heightened volatility mean for trading?

For starters, volumes have risen. WTI futures volume on NYMEX was up 83 percent for the week ended August 14 compared to a year ago.  But it’s not just an increase in trading.

Participation and activity in derivatives markets have shifted.  New participants are entering this space, particularly investors turning towards derivatives contracts to manage the uncertainty in oil prices.  Open positions from managed money were up 16 percent since the end of June, according to the CFTC’s Commitment of Traders report for August 4.

There has also been a stronger than normal move towards options. WTI options rose 50 percent in July compared to July 2014. 71 percent of those were traded electronically, a new record.  The move towards electronic options has been happening for some time, and can be summed up by a previous post by Jeff White:

 More trades that might previously have been executed on the trading floor or through a voice broker are now moving to the screen. One of the reasons for this is the increased activity in Request for Quotes (RFQ), the mechanism that allows market participants to execute spread trades on Globex, CME Group’s electronic trading platform. 

The move towards options overall, however, might be best explained by the current fundamentals and volatility levels. Most volatility is occurring at the front end of the curve as participants look to EIA storage levels each week.  That is encouraging spread options trading, especially as the forward curve steepens.  Calendar spread options are one example of how participants are utilizing derivatives to express their view on the forward curve, hedge their positions, and mitigate rolling costs.

 

WTI Contango Spread 880x440

 

With the curve steepening, the market is showing its increasing belief that prices will bounce back in the next year. The Crude Oil futures and options markets are the most liquid and actively traded commodities contracts in the world. They are mature markets. So as storage levels rise and demand diminishes, activity in these markets will continue to tell the story of where prices are headed.

Peter Keavey is Executive Director of Energy Products at CME Group.

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