August 11th, 2014: Markets See Little Upside Risk in Crude Oil

To put it bluntly, crude oil got slammed pretty hard in the past few weeks. September futures on NYMEX for crude approached a seasonal high of $110 in June. Nothing unusual there. Historically speaking, oil trades higher in the summer months for various reasons (e.g. peak travel, costlier gas blends, etc.). In late July, futures fell below $100 and are currently trading near $98.

Crude: Sept. Expiration

Notice the heavy sell on volume starting late July.

"Data from the Commodities Futures Trading Commission released Friday showed that hedge funds and money managers decreased their bullish bets in New York-traded oil futures in the week ending August 5. Net longs totaled 236,381 contracts as of last week, down 14.5% from net longs of 276,741 in the preceding week." (Source)

The price per barrel isn't necessarily the important nor relevant part. It's the fact that markets see little near-term risk for a price jump in crude oil. If you keep up with the world news at all, you'll remember that ISIS is currently in the midst of a military offensive and is controlling a sizable portion of Iraq and parts of Syria. Russian and Ukraine have also seen escalation in their own militarized conflict. What do these two things have in common? Both of these areas hold key strategic and logistical importance in energy production, particularly oil and gas.

Despite this, the markets don't seem to be pricing in the risk of these events on oil prices. Let's look at the volatility chart for the S&P Crude Oil Index (OIL):

S&P Crude Oil Index ETN (OIL). Red: IV30, White: HV30

Taking a look at the 30-day forward looking implied volatility, the markets expect less volatility in oil prices now than most times in the past two years. This in spite the fact that the past two years saw little militarized escalation of the magnitude we are currently experiencing. Taking a look at the skew chart confirms this:

Not only do markets see little upside risk, their expectations largely reflect a continued price drop in crude oil. One final chart I'd like to show you is the CBOE Crude Oil Volatility Index (OVX). This instrument tracks crude oil volatility, much like the VIX tracks S&P volatility.

As you can see, the OVX is not a very popular instrument with very little volume in the past year or so. However, the implied volatility of the index jumped from 0 to 40 sometime in May indicating a bullish ante on the volatility of crude prices. Since then, the volatility has dropped minutely, but I think that someone at the Chicago Board is expecting some instability with oil in the coming months.