COLUMN-Strange calm robs oil options of their value: John Kemp

Thu Jan 26, 2012 6:53am EST

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(John Kemp is a Reuters market analyst. The views expressed are his own)

By John Kemp

LONDON Jan 26 (Reuters) - EU sanctions on Iran's oil exports. Signs of building economic momentum in the United States. Renewed recession in Europe. China's slowdown. Forecasts from the Fed that it expects to leave interest rates at ultra-low levels until the end of 2014.

Ordinarily any one of these factors would be enough to cause a sharp move in oil prices. Prominent analysts have warned that price risks on both the upside and the downside will be unusually large in 2012. The mantra was "buy volatility".

But it has been a lousy trade so far this year. Front-month Brent crude futures have barely moved since the beginning of the month, slashing the value of options. Realised volatility has fallen to 24 percent on a 30-day trailing basis (annualised), putting it in the 33rd percentile of the distribution of daily price changes since 1989.

What's more, trailing measures are still being inflated by price jumps late last month and when markets re-opened on Jan. 3. Over the last 10 trading days, realised volatility has plunged to an exceptionally low 12.6 percent, putting it in just the 3rd percentile for all periods since 1989.

Low levels of realised volatility have begun to filter through into implied volatility and option values. Implied volatilities for out of the money puts and calls (ranging from 25 to 40 percent) remain mildly elevated compared with the current low level of realised price moves but appear in line with long-term average levels of volatility (averaging 35 percent since 1989).

Volatility is itself notoriously volatile. The market alternates unpredictably between periods of much higher than normal daily price movements (a "wild" state) and periods when daily moves are much smaller (a "mild" state). No one expects the calm to last forever. Nevertheless, the lack of price moves when oil-related news flow has been heavy is remarkable.

One explanation is that large upside and downside price risks (Iran, the global economy) are cancelling one another out in investors' minds. Another is that market participants are struggling to price in a number of low-probability, high-impact events (such as the closure of the Strait of Hormuz or a widespread European debt default), which could in theory rock the market severely but by definition are not very likely to happen.

Forecasting volatility has proved to be just as tricky as forecasting the outright direction of prices.

WAITING FOR A NEW STORY

Long-term narratives have also changed. Until recently, most analysts and investors were confident the only long-term direction for oil and other commodity prices was up as supply struggled to match demand from emerging economies. The dominant narrative was that commodities were in the early stages of a decades-long super-cycle.

But signs of an aggressive supply-side response in oil, gas and grains markets have tempered expectations and are forcing a reassessment of where commodities are in the super-cycle. The cycle may be more mature than previously expected.

Few analysts or institutional advisers are now prepared to recommend unambiguous directional exposure to rising prices. Price increases are no longer outstripping the long-term carrying cost of positions.

The result is that the oil market has been left without a dominant narrative for the moment. Malthusian stories about burgeoning demand in Asia and the rest of the developing world, and peaking supplies, geopolitical risk, or money supply growth and inflation have lost their resonance with investors.

So far nothing has come along to replace them, leaving the market drifting listlessly, still looking for the next big idea. (editing by Jane Baird)

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