As oil volatility settles in, experts point to range-bound market

4 min read
mike kentz

The sharp reduction in crude oil volatility levels and a flattening of the oil futures curve owing to recent gains in Brent crude and WTI oil prices point to a range-bound market over the near-term, analysts note.

One-month implied volatility on WTI crude has declined from 91.69% in mid-February to 48.40% on Wednesday, according to Thomson Reuters data. Brent volatility, meanwhile, has declined from 79.12% on February 22 to 44.12%. They were both the highest levels of volatility for either market since mid-2011.

The decline in volatility is a reaction to a 26.5% recovery in oil prices since mid-February that was kickstarted by a Russia-OPEC agreement to freeze production on February 18 and has been supported by falling US shale production, easier-than-expected US monetary policy, and a strong seasonal pick-up in driving demand, analysts at Bank of America Merrill Lynch wrote in a note to clients.

Additionally, the oil futures curve has flattened over the same time period. Front-month futures prices have risen sharply with spot, but longer-term futures contracts have budged only slightly or stayed largely the same.

The price of May 2016 delivery rose from US$33.85/bbl on February 15 to US$40.12/bbl on Wednesday – while prices for May 2018 delivery only rose from US$44.84/bbl to US$47.59/bbl.

All three factors – supply/demand fundamentals, volatility, and the futures term structure – are pointing to a range-bound market over the near-term, according to the analysts.

Though US shale production has begun to decline and capital expenditures continue to be cut across the spectrum, the market is still in oversupply – meaning any move to the upside will be capped by hedging demand from producers looking to protect against another sharp decline in prices.

The flattened term structure is evidence of this. When prices rise as they have over the last month, producers rush to buy futures contracts that serve to lock in revenues for the future. The contracts protect against a price decline by locking in a specific price for sale.

That buying demand holds the back-end of the curve – or later maturities for delivery – down, thus holding oil below a ceiling until supply/demand fundamentals have rebalanced and producers no longer feel the desperate need to hedge.

“Producers remain exceptionally underhedged on a forward basis, so any move over US$50/bbl would likely encourage a lot of hedging activity and thus cap forward prices in a US$50 to US$55/bbl band,” the analysts note.

Downside support

However, declining supply from US shale producers has begun to take hold, meaning producers may not have to fear a catastrophic drop below the recent lows.

Energy Information Administration data analysed by Societe Generale shows that production in the lower 48 states declined sharply by 159 killobarrels/day in December – bringing total production to 7.1m barrels/day, down from a peak of 7.3m b/d in March 2015.

Additionally, US crude production is expected to average 8.67m b/d in 2016, a drop of 760,000b/d year-over-year. And the number of rigs directed towards oil production is down by two-thirds since a peak in late 2014, Michael Wittner, oil analyst at SocGen, wrote in a research note.

The long-awaited declines in production are providing support to the theory that oil has established its lows and will remain above the US$26.21/bbl bottom that was hit in mid-February.

“If Lower 48 output declines even come close to consistently matching that pace in the coming quarters, the global rebalancing will be well and truly under way,” Wittner wrote.

Both the current supply rebalancing and the demand for hedges on the upside are expected to keep oil prices range-bound and subsequently push volatility lower. Implied and realised volatility have come back in line in recent days after trading at a -20% spread in early March.

A negative spread means realised or historical volatility is much higher than the market is implying for the future. The fact that volatility is back in line implies the market has found an equilibrium at least for the moment, according to SG analysts.

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