Crude Oil Volatility At Record Low Levels

Feb.21.13 | About: The United (USO)

WTI Crude oil volatility (NYSEARCA:USO) has fallen to lows not seen since over a decade. 21-day realized volatility, an annualized measure of actual underlying price moves for the front-month delivery contract price, reached an all-time low of 10.1%, in February 2013, levels not seen since the late 80s.

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Figure - WTI Crude Oil Front Month Futures 21-day Realized Volatility

Source: Austerlitz Capital, Bloomberg

Fundamentals

U.S. crude output grew by a whopping 766,000 barrels per day in 2012, the biggest jump since 1859. Through the first 10 months of the year, the U.S. met 84 percent of its own energy needs and is now the world's largest fuel exporter. This is seen as a stabilizer of prices by offering some additional protection against upside swings. At the same time it offers more visibility and predictability against other sources of production. However as much as US benchmarks (e.g. WTI) may seem to have decoupled from international ones (e.g. Brent), as evidenced by the persistent widening of the Brent-WTI spread, US prices are going to stay supported by simple arbitrage considerations into the Gulf Coast and should track international benchmarks closely in the event of exogenous shocks.

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Figure - Crude Oil Production

Source: Austerlitz Capital, Bloomberg

At work in the meantime is a continued and steady buildup of crude inventories in the US.

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Figure - Crude Oil Inventory Buildup In the US

Source: Austerlitz Capital, Bloomberg

This makes crude prices potentially vulnerable to the downside on any revision to growth expectations or uncertainty regarding the macroeconomic backdrop. Potential candidates are a worsening of Europe's austerity driven recession and the disorderly passing of fiscal measures in the US.

Oil implied volatility may be an interesting buy

Attractive technicals

Volatility technicals are flashing the "BUY" signal unequivocally. One month implied volatility is at a significant low not attained in over a decade, and is currently the lowest since the 2008 crisis. The realized range that can be captured by option traders has shrunk to a post crisis low as well. Historically, the premium of implied to realized volatility in WTI options has tended to stay very stable. Any pick up in realized volatility would immediately trigger a re-pricing of the front month and subsequently shift the term structure up.

Figure - Post Crisis WTI Crude Oil Front Month Futures Implied vs Realized (captured) Volatility

Source: Austerlitz Capital, Bloomberg

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Figure - Post Crisis WTI Crude Oil Front Month Futures Volatility Technicals

Source: Austerlitz Capital, Bloomberg

Furthermore, implied measures of downside risk (skew) and expected moves in the volatility itself (smile) are at extreme values with z-scores above 3, whilst the term structure exhibits an uncanny flatness (see figures below). All these signals point to a market that is stretched and is bound to revert to averages. The extreme downside skewness implies that market participants are pricing in a greater probability of either a negative demand shock or a flood of excess supply - or combination thereof. In other words, they anticipate prices could fall due to an unforeseen slowing in demand, or excess production and inventory buildup (i.e. glut).

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Figure - WTI Crude Oil Front Month Futures Volatility Skew and Smile

Source: Austerlitz Capital, Bloomberg

The seasonality argument

As illustrated in the figure below, oil volatility seasonality tends to favor the first and the last quarter of the year. In the period following the 2008 crisis, January through March have exhibited strong contribution to annual price variance.

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Figure - WTI Crude Oil Front Month Futures Variance Contribution (Seasonality)

Source: Bloomberg

Note: exposure to WTI Crude Oil Futures Volatility can be achieved through buying options (e.g.: as a straddle) on the ETF USO

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long WTI Volatility through WTI Crude Oil Futures Options