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13 Feb 2015

The Volatility of Oil

Oil volatility has reached its highest level since the financial crisis, as dropping prices and changing supply levels surprise fuel consumers and traders alike.  Trading volumes have almost doubled since the start of February, as market participants attempt to profit from a nearly 60 percent crash in crude prices since June 2014.  With increased volatility matched by uncertainty in both demand and supply levels, the future of oil prices remains unclear. 

The CBOE Crude Oil Volatility Index climbed to 63.14 on February 5, the highest level in almost six years.  The oil price collapse fuelling this volatility is a result of both decreasing demand and rising production, with economic growth in China slowing, weakening demand in Japan and Europe, and increasing supply levels in the US and elsewhere. 

Current conditions are so up in the air that price forecasts for next year range from as low as US$20 a barrel to as high as US$75.  According to Judith Dwarkin, chief economist at ITG Investment Research, "There are many more laps to come on this roller coaster," with the price of petrol, diesel, and other fuels also in limbo.  While consumers might be smiling at the petrol pump with prices so low, oil traders are even happier as volatility levels go through the roof.

"Volatility for traders is always what you want, you don't want a market that has nothing to offer...  The volatility in the last two months has been outsized." said Doug King, the London-based chief investment officer of the Merchant Commodity Fund.  Brent crude, the global benchmark for purchases of oil worldwide, recorded over 5 million contracts last month alone on the London-based ICE Futures Europe exchange. 

This represents an increase of 29 percent over the year, with traders taking advantage of large movements in oil prices.  After declining for the seventh month in a row in January, Brent rebounded to make its biggest two-week gain for 17 years in the period ending February 6.  After the lowest oil volatility levels since the economic crisis during the last two years, 2015 looks much more eventful for oil traders.

"Prices have been moving by $10 a barrel over the last few years," said Hamza Khan, a senior commodity strategist at ING Bank NV, adding "In 2015, they could rise by $30, $40, even $50. If you're on the right side of that trade it presents huge opportunities."  However, even with prices at historic recent lows, no-one is certain which way oil prices will swing in the coming months. 

While the recent surge in oil contracts is based on news that US drillers are pulling back, that doesn't necessarily mean prices will rise.  The Energy Department reported last week of a record 1.18 billion barrels of oil in storage in the US, which is more than enough to account for any short term lack of supply.  The International Energy Agency expects prices to stabilise over the course of the year, in a range "higher than recent lows but substantially below the highs of the last three years."