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

*Source: Austerlitz Capital, Bloomberg*

**Volatility primer**

**Volatility measure against time**

**Term Structure Definition: the relationship between market expectations of a given pricing measure and their term to maturity.**

As the market prices its expectation of future volatility, it takes into account three aspects: recent realized volatility, event risk and long-run dynamics. Volatility is a mean-reverting, non-observable process which tends to jump on occasion when the underlying experiences sudden re-pricing.

On the short end, implied volatilities tend to be more sensitive to the market's perception of event risk, as well as current realized (historical) volatility levels. Indeed, realized volatility tends to cluster (i.e. persist) for periods of time so traders factor that into its pricing estimates.

The middle and long end of the term structure tend to price the mean reverting properties of volatility and hence are less sensitive to immediate price gyrations. Rather they express longer term opinions on the future variance of underlying prices. Unless there is a fundamental regime change, they tend to be fairly stable. The slope of the term structure is driven, as it is in the interest rate markets, by market participants' expectation of forward volatility (for example, what is the one month volatility going to be in one month, etc.). The higher the expectation in a given time period, the steeper the curve between the associated points on the curve.

**Volatility measure against price levels**

**Volatility Smile Definition: It is possible to compute a unique implied volatility from a given market price for an option. When implied volatility is plotted against strike price, the result is what is called a volatility smile.**

In equities, the market for volatility (i.e. insurance) is mostly one-sided. Holders of large stock portfolios are naturally long and look to buy downside protection. They also often sell upside insurance as a way to generate extra yield. The tail risk is mostly to the downside and is reflected in the skew implied by option prices: volatility is expected to rise when prices fall and vice versa.

This is where the oil options market differs from equity options. In the oil options market, producers need to hedge downside risks to their production output, while consumers need to protect themselves against supply disruptions, with speculators and market makers providing liquidity. Hence option prices reflect a relationship to prices that is "smiley", with tilts (i.e. skew) to the downside or the upside depending on prevailing market sentiment towards price direction. The skew can favor downside (negative demand shock or supply glut) or upside (positive demand shock or supply disruption) risk at different times. Simply put, participants expect volatility to increase with significant price moves to either the downside or the upside. The deeper the smile, the more the market expects volatility itself to be volatile.

**Figure - S&P500 vs WTI Crude Oil Front Month Futures Implied Volatility Smile**

*Source: Austerlitz Capital*

**Likely drivers for dampened volatility**

**Market structure in the short dated volatility market**

As news of an imminent fiscal deal in US reached screens in late December, many participants sold short dated volatility into the February G3s (January last trade) and March H3s (February last trade) expiries, leaving market makers disproportionately long gamma (convexity). With excess inventory on their books, traders need to trade the underlying (i.e. "delta-hedge") around their outstanding strikes in order to capture volatility and replicate the cost (theta or decay) of their position. It is easy to see how the aggregate effects of this situation reinforce themselves. Realized volatility falls as event risk disappears, implied volatilities drop as traders sell their positions and someone is left "holding the bag" with decaying positions in an environment of subdued volatility. In sum, a long volatility holder's nightmare. In order to capture whatever price moves are left to pay for the time value of their portfolio, traders "trade the gamma", selling any upward move and buying the dips around their strikes, dampening realized volatility further.

The figure below illustrates the current situation: as the WTI crude oil futures March H3 expiry nears, price moves are highly influenced by option hedgers whereby the price tends to "slip" through short strikes and "stick" to long strikes, causing the price action to follow a step function versus time.

**Figure - WTI Crude Oil Front Month Futures (CLH3) Tick data Feb 6-Feb14, 2013**

*Source: Austerlitz Capital, Bloomberg*

**Supply side fundamentals**

U.S. crude output grew by a staggering 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.

**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.

**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*

**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).

**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.

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

*Source: Bloomberg*

**The added bonus**

Not only are the absolute levels of implied volatility at all time lows (overall a 10 point downwards shift from December to February), but the market conditions grant the buyer another opportunity. When buying volatility there is always a trade-off between its capture and the carry incurred. Shorter dated options tend to have greater sensitivity to underlying moves (spot convexity) and higher upside volatility of volatility (volatility convexity), but are more expensive to carry should volatility take time to materialize - convexity has a price, there is no free lunch. In this environment, the very flat term structure offers an interesting opportunity to gain upside volatility exposure without incurring the high cost of short term carry or the implied negative roll by shifting the position one month out.

**Figure - WTI Crude Oil Implied Volatility Term Structure**

*Source: Austerlitz Capital, Bloomberg*

*Note: exposure to WTI Crude Oil Futures Volatility can also be achieved through options on the ETF USO (TICKER: [[USO]])*

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

*Source: Austerlitz Capital, Bloomberg*

**Volatility primer**

**Volatility measure against time**

**Term Structure Definition: the relationship between market expectations of a given pricing measure and their term to maturity.**

As the market prices its expectation of future volatility, it takes into account three aspects: recent realized volatility, event risk and long-run dynamics. Volatility is a mean-reverting, non-observable process which tends to jump on occasion when the underlying experiences sudden re-pricing.

On the short end, implied volatilities tend to be more sensitive to the market's perception of event risk, as well as current realized (historical) volatility levels. Indeed, realized volatility tends to cluster (i.e. persist) for periods of time so traders factor that into its pricing estimates.

The middle and long end of the term structure tend to price the mean reverting properties of volatility and hence are less sensitive to immediate price gyrations. Rather they express longer term opinions on the future variance of underlying prices. Unless there is a fundamental regime change, they tend to be fairly stable. The slope of the term structure is driven, as it is in the interest rate markets, by market participants' expectation of forward volatility (for example, what is the one month volatility going to be in one month, etc.). The higher the expectation in a given time period, the steeper the curve between the associated points on the curve.

**Volatility measure against price levels**

**Volatility Smile Definition: It is possible to compute a unique implied volatility from a given market price for an option. When implied volatility is plotted against strike price, the result is what is called a volatility smile.**

In equities, the market for volatility (i.e. insurance) is mostly one-sided. Holders of large stock portfolios are naturally long and look to buy downside protection. They also often sell upside insurance as a way to generate extra yield. The tail risk is mostly to the downside and is reflected in the skew implied by option prices: volatility is expected to rise when prices fall and vice versa.

This is where the oil options market differs from equity options. In the oil options market, producers need to hedge downside risks to their production output, while consumers need to protect themselves against supply disruptions, with speculators and market makers providing liquidity. Hence option prices reflect a relationship to prices that is "smiley", with tilts (i.e. skew) to the downside or the upside depending on prevailing market sentiment towards price direction. The skew can favor downside (negative demand shock or supply glut) or upside (positive demand shock or supply disruption) risk at different times. Simply put, participants expect volatility to increase with significant price moves to either the downside or the upside. The deeper the smile, the more the market expects volatility itself to be volatile.

**Figure - S&P500 vs WTI Crude Oil Front Month Futures Implied Volatility Smile**

*Source: Austerlitz Capital*

**Likely drivers for dampened volatility**

**Market structure in the short dated volatility market**

As news of an imminent fiscal deal in US reached screens in late December, many participants sold short dated volatility into the February G3s (January last trade) and March H3s (February last trade) expiries, leaving market makers disproportionately long gamma (convexity). With excess inventory on their books, traders need to trade the underlying (i.e. "delta-hedge") around their outstanding strikes in order to capture volatility and replicate the cost (theta or decay) of their position. It is easy to see how the aggregate effects of this situation reinforce themselves. Realized volatility falls as event risk disappears, implied volatilities drop as traders sell their positions and someone is left "holding the bag" with decaying positions in an environment of subdued volatility. In sum, a long volatility holder's nightmare. In order to capture whatever price moves are left to pay for the time value of their portfolio, traders "trade the gamma", selling any upward move and buying the dips around their strikes, dampening realized volatility further.

The figure below illustrates the current situation: as the WTI crude oil futures March H3 expiry nears, price moves are highly influenced by option hedgers whereby the price tends to "slip" through short strikes and "stick" to long strikes, causing the price action to follow a step function versus time.

**Figure - WTI Crude Oil Front Month Futures (CLH3) Tick data Feb 6-Feb14, 2013**

*Source: Austerlitz Capital, Bloomberg*

**Supply side fundamentals**

U.S. crude output grew by a staggering 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.

**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.

**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*

**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).

**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.

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

*Source: Bloomberg*

**The added bonus**

Not only are the absolute levels of implied volatility at all time lows (overall a 10 point downwards shift from December to February), but the market conditions grant the buyer another opportunity. When buying volatility there is always a trade-off between its capture and the carry incurred. Shorter dated options tend to have greater sensitivity to underlying moves (spot convexity) and higher upside volatility of volatility (volatility convexity), but are more expensive to carry should volatility take time to materialize - convexity has a price, there is no free lunch. In this environment, the very flat term structure offers an interesting opportunity to gain upside volatility exposure without incurring the high cost of short term carry or the implied negative roll by shifting the position one month out.

**Figure - WTI Crude Oil Implied Volatility Term Structure**

*Source: Austerlitz Capital, Bloomberg*