Posted March 15, 2018
The U.S. Energy Information Administration (EIA) recently noted that for the first time in since 2008, S&P 500 Index’s implied volatility briefly surpassed that of crude oil in February. In this context, “volatility” is a measure of the rate and magnitude of variations in prices. EIA’s observation could be important if it suggests stock prices are about to fall, like they did during the 2008-2009 financial crisis.
The EIA’s volatility comparisons also are interesting as indicators of market sentiment. Financial markets have grappled recently with uncertainty over price inflation, interest rates and trade policies. At the same time, EIA’s comparison also indicates it’s not business as usual for oil markets, which structurally changed as U.S. crude oil production more than doubled between 2007 (5.1 million barrels per day) and 2018 (10.3 million barrels per day).
API’s Monthly Statistical Report (MSR) for February provides the latest details, but the step change in U.S. oil production has provided a greater cushion for global petroleum inventories and therefore prices. In Q1 2018, for example, oil price volatility was roughly 30 percent less than its typical levels since 2007. U.S. consumers and manufacturers who depend on abundant and affordable energy have been the winners, and keeping this going requires mainly that we focus on energy policies that continue to foster the U.S. energy renaissance.
Where the stock market is concerned, corporate profits ultimately are the main driver of equity values, and recent U.S. tax reform has bolstered corporate competitiveness and profitability, despite the myriad financial and economic uncertainties that always come into play. There’s good reason to be optimistic, if sound economic and trade policies continue.
Let’s look at the EIA’s analysis in greater detail. EIA has compared implied volatility indexes for the S&P 500 equities (VIX) and crude oil (OVX). “Implied volatility” means the volatility that the market expects to see, calculated based on the prices of constantly changing portfolios of put and call options – the right to sell or buy a commodity at a specified price and time – on the S&P 500 Index and West Texas Intermediate (WTI) crude oil.
EIA’s key observations:
- For four consecutive days in early February, stock market implied volatility surpassed crude oil price volatility for the first time since 2008. The VIX, the market’s expected range of near-term price changes on S&P 500 index options, closed higher than the OVX, the index on crude oil options The VIX has only closed higher than the OVX four other times since the inception of the OVX in 2007; all previous instances were in 2008.
- Under typical trading conditions, a single commodity – in this case, the price of WTI light, sweet crude oil, the underlying commodity for OVX – would be expected to have higher implied volatility compared with an index whose underlying value consists of a basket of 500 large capitalization stocks representing a variety of U.S. companies.
In plain English, this means that oil prices generally have greater volatility than stock prices, so it’s interesting to see the opposite occurred in early February. We can make some additional observations made on the EIA’s chart:
- The stock market’s implied volatility fell since 2008 and in 2017 averaged only 40 percent of its historical average level since 2007; this was unusually low market volatility and coincided with a strong economy that was helped by low oil and natural gas prices. As the market has digested economic and financial data coming off a cyclical high for the U.S. as well as the possibility of rising price inflation and interest rates, stock market volatility so far in 2018 has rebounded toward average levels since 2007.
- By contrast, crude oil price volatility rose as prices fell during the 2008-2009 financial crisis and again beginning in late 2014, when growing U.S. tight oil production spurred OPEC to pursue market share rather than cut output. After OPEC, together with Russia, reduced production again beginning in Q3 2016, the market’s supply/demand fundamentals rebalanced, and price volatility fell. However, oil price volatility in Q1 2018 has remained about 30 percent less than its average since 2007. This is a significant tempering of oil price variation as prices remained at levels that were less than half of their 2008 peak, so consumers (rather than traders) are the ones who are able to say, “Volatility is your friend.”
The root cause for the oil market changes appears to be the cushion that U.S. tight oil production has provided as inventories of crude oil and refined products trended toward the upper end of their historical ranges, as the following chart from API’s MSR for February 2018 demonstrates, showing U.S. crude oil and refined product inventories:
It’s notable that total U.S. inventories of crude oil and refined product inventories rose in February, as they have for four of the past five years with the energy renaissance. But prior to that U.S. stock building in February was rare and occurred only five times in 58 years, between 1956 and 2013.
The spike in oil price volatility was a great thing as global oil markets absorbed the rapid increase in U.S. oil production and prices fell. And the U.S. energy renaissance has helped keep oil price and oil price volatility relatively low compared with history. These changes have been remarkable by any measure and provide the U.S. with opportunities the scale of which have not been seen for generations. Let’s stay focused squarely on the enabling technologies and policies that will keep the energy renaissance going.
ABOUT THE AUTHOR
Dr. R. Dean Foreman is API’s chief economist, specializing in energy and global business. With a Ph.D. in economics from the University of Florida, he came to API from Saudi Aramco Strategy & Market Analysis in Dhahran, where he managed short-term market monitoring and the long-term oil demand outlook. Foreman has more than 20 years of industry experience in corporate strategic planning, forecasting, finance / risk management and regulatory policy at ExxonMobil, Talisman Energy and Sasol North America.