Crude oil markets experienced wild price swings this week. Prices ranged between $80 and $120 per barrel, with the current price of $100 as of this writing. Meanwhile, the oil volatility index has climbed steadily upwards. Oil volatility stood at 60% at the end of February. Oil volatility today is 120%.
$75 vs $100: The ‘hidden’ signal in December crude oil contracts – Global Market Pulse News | The Financial Express
These prices, and most headlines about crude oil, have focused on the front month contract. This is the contract for crude oil that delivers in one month. It tells us about the current state of the market. The current state is one of disruption, but not catastrophe. If oil crosses $200, that’s a different story.
The Divergence: Front-Month vs. Long-Term Contracts
If we dig further into the crude oil market, we find a new story. One that suggests the current conflict is not going to last very long. Or at least, the disruption to crude oil markets will be short lived.
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Instead of looking at the front month (April) contract, let’s look at the contract for delivery in December. The December contract has a current price of $75, much lower than the $100 April contract. This means that you can lock in the price of oil for delivery in December at $75. Prior to the start of the conflict, the front month contract was trading at $70. The current December contract is trading only marginally higher.
December Outlook: A Return to ‘Normalcy’?
The market is telling us that by the end of this year, crude oil markets will be back to normal. If we look at some other contracts, we see the same story. The contract for delivery in August is currently $84. This implies some disruption relative to before the conflict, but still not much. And so, the market is optimistic. Optimism might be warranted based on good information. Or it might be just hope.
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Either way, an important caveat here is that the market is pricing based on limited information. A typical crude oil analyst or trader may have a good idea of how the supply of oil evolves during normal periods. But in the current period, supply is dependent on actions of a handful of governments. None of us really know how or when this ends.
The Volatility Insurance: Why Hedging is Expensive
And so, there’s much more uncertainty in any forecast. The market may expect the conflict to end soon, but it is not very confident in its view. This uncertainty is evident in the oil volatility index, which has doubled. It means that if you want to buy insurance against oil prices changing, the current cost of doing so is very high.
Another possibility is that the conflict continues, but the crude oil market returns to normal. There may already be some signs of this. If enough individual countries make deals to keep their own oil flowing, then most of the oil will flow through. And the oil market stays well supplied. The Hormuz closure turns into a Hormuz toll. While nobody likes a toll, it is far better than not getting ships through.
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Disclaimer:
Note: The purpose of this article is to share interesting charts, data points and thought-provoking opinions. It is NOT a recommendation. If you wish to consider an investment, you are strongly encouraged to consult your advisor. This article is for strictly educative purposes only.
Asad Dossani is an assistant professor of finance at Colorado State University. His research covers derivatives, forecasting, monetary policy, currencies, and commodities. He has a PhD in Economics. He has previously worked as a research analyst at Equitymaster, and as a financial analyst at Deutsche Bank.
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