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The "Message from Markets"

Posted by on 26 September 2017
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Ahead of Global Derivatives USA, Ehud Ronn delves into crude-oil contracts to show us how we can discern what markets are telling us about the world, if only we looked close enough. Ehud will be presenting at #GDerivsUSA on equity and commodity markets and dispersion and correlation trading

Abstract

Financial markets serve numerous roles, amongst them of course the uncoerced exchange of securities. However, in addition to that role, they inadvertently serve a very useful function of conveying to market observers information about the future, the challenge being our ability to elicit and interpret that information.

This paper addresses that latter function regarding the markets for WTI (West Texas Intermediate) crude-oil futures and option contracts traded on the New York Mercantile Exchange (NYMEX). In particular, we focus on the informational content of two aspects of these markets — the level of spot prices and the implied volatility of these crude-oil contracts.

Crude-Oil Contracts: The "Message from Markets"

1 Overview

One of the most oft-cited, and frequently hotly debated, questions in financial markets pertains to the question of what it is markets are “telling us”: What is it about the level of prices, and their volatility, that conveys the message of the current state of the oil markets.

To address the "Message from Markets," this paper considers two important indicators:

1. The Level of Crude-Oil Spot prices (aka crude-oil "prompt-month" prices)

2. Volatility - not the historical, but rather the "priced," or so-called "implied," volatility - of Crude-Oil Futures Prices

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2 The Level of Crude-Oil Spot Prices

The “spot price of crude” is defined to be the price of the “prompt-month” futures contract, that is, the futures contract closest to maturity. As the nearby contract matures and ceases trading, on or about the third week of the calendar month, the next maturity futures contract takes over the role of the prompt-month contract. When we splice together the prices of these prompt-month contracts, we obtain Figure 1 which depicts end-of-quarter crude-oil spot prices over the 30-year period (9/30/86 thru 12/31/16). Over the first part of this period, thru 2002, prices remained remarkably stable in the $20 ± $5/bbl range — the exception being the price spike to circa-$40 surrounding “Persian Gulf I” in the Aug. 1990 – Feb. 1991 period.

Fig 1: Derivatives Figure 1

Beginning in 2002, prices began a dramatic increase, driven primarily by the voracious demand of the developing economies such as China and India. This particular run reached its apogee as prices rose to the $140-level at the beginning of July 2008. Then, with the onset of the worldwide recession, prices collapsed to the mid-$30 range. Subsequent to the 2009 end of the “Great Recession,” prices recovered to the $100 mark before the precipitous decline in 2014 to sub-$30 levels before then appreciating again to their current $50’s.

As important, if not more so, than the demand side, oil prices are dramatically impacted by supply-side concerns, geopolitical and meteorological in nature. The geopolitical concerns are found in several regions of global unrest. As is well-known, geopolitical uncertainty in at least three distinct areas of the Middle East evokes supply concerns: The eastern Mediterranean, Iraq and Iran. Outside the Middle East, supply concerns arise due to domestic unrest in the oil-producing areas of Nigeria. Finally, current relations between the United States and one of its Latin American providers, Venezuela, are occasionally sources of concern.

With the growing importance of on-shore oil production using hydraulic fracturing (“fracking”) in the continental U. S., the importance of meteorological phenomena such as hurricanes in the Gulf of Mexico (and, for that matter, El Niño in the Pacific Ocean) may have diminished in its ability to impact crude-oil prices.

3 Crude-Oil Futures Options' Implied Volatilities 

One of the most interesting message-from-markets indicator is that of a metric inferred from option prices — the implied volatility that can be extracted from option prices using the famed Black-Scholes (1973) and Black (1976) option pricing models. After defining implied volatility, to lend perspective to the analysis we will first consider implied vol in the equity market, then make the transition to the crude-oil futures market.

To read the full article, including notations and references, please click here. 

Join 150+ academics, financiers, regulators, quants and technologists, as they discuss dealing with negative interest rates, volatility and more at Global Derivatives USA, 1-3 November.

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