Oil traders hunger for lost years of volatility; “As long as oil remains rangebound, it’s like free money to write puts and calls, so a lot of people are coming into the market to do it. The problem is that if oil does move, you lose a money”

October 23, 2013 10:35 am

Oil traders hunger for lost years of volatility

By Gregory Meyer in New York and Ajay Makan in London

Clive Capital has thrown in the towel. Deep into its third year of losses, what was onceone of the world’s largest commodity hedge funds shut down late last month. The closure is symptomatic of a broader trend – or more accurately, the lack of one. Hedge funds once feasted on wild action in oil. Now, volatility has fallen to historic lows. Plodding prices have forced traders to experiment with new ways to make money.Many hedge funds do not care how high prices are. They only want oil to move. Using complex options trades such as “straddles”, which gain value when markets go up or down, they “buy” volatility. A straddle involves buying both a bullish call option and a bearish put option at the same strike price – say, $110 a barrel.

Clive, in a letter to investors, bemoaned “limited” opportunities to use its “directional, long volatility approach to generate the strong returns of the past”.

Just how limited have those opportunities been? Brent crude has gained less than 1 per cent in the past 12 months, hovering on both sides of $110 a barrel in nine of them. Wednesday was a case in point, with oil ranging from $108.79 to $110.06 by London afternoon.

Volatility implied by options on spot Brent has slumped consistently below 20 per cent for the first time since the mid-1990s, suggesting expectations of daily price movements of roughly 1 per cent. Before the 2008 financial crisis daily moves averaged around 2 per cent, says Francisco Blanch, head of commodities research at Bank of America Merrill Lynch.

Analysts cite several causes for the lull. The Federal Reserve has held down US interest rates, soothing fears another financial crisis would again hit demand for oil.

Oil producers have also increased output, blunting worries about shortages. Saudi Arabia pumped a record 10.19m barrels per day in August, while shale drillers have lifted US production to a 22-year high of 7.5m b/d.

This gives outages, such as in Libya, less power to shock. “Even with the spate of supply disruptions we’ve had, you haven’t seen a big pick-up in volatility,” says Soozhana Choi, head of energy research for Deutsche Bank.

Banks, the main dealers of complex options to oil traders, have become more cautiousamid balance sheet pressures and regulatory constraints. Commodity value-at-risk, a measure of how much money a bank might be expected to lose in a single day, fell an average of 28 per cent between 2008 and 2012 at six top banks.

“Banks are not taking a lot of risk. Hedge funds are not taking a lot of risk. And volatility has generally come down a lot,” says Mr Blanch.

Volatility in oil linked to delivery in the far future used to be less than volatility in contracts for immediate delivery, encouraging funds to wager that futures linked to the “back” of oil’s term structure would grow more jumpy as they approached expiration. No longer: volatility implied by options on crude for December 2015 delivery was 17 per cent this week, the same as spot Brent volatility.

“If you’d said five years ago, ‘Would there ever be a time you didn’t have a huge long “vol” position’, I would have laughed. Right now we’re running negligible ‘vol’ positions,” says the chief of a US-based commodity hedge fund.

If headline oil prices will not budge, more arcane corners of the market are still in flux. “Time spreads”, or the relationships between futures for immediate and later delivery, have swung in the West Texas Intermediate crude market. The once-stable price difference between Brent and WTI has widened and contracted like an accordion.

We need to find funds which can make huge returns in order to justify our fees, so we like physical traders with a deep knowledge of their market

– Gabriel Garcin, ERAAM

But manoeuvring these twists requires familiarity with storage tanks, pipelines and refinery operations that is more the forte of physical houses such as BP’s trading arm or Vitol than hedge funds.

“We are hungry for volatility,” says Gabriel Garcin at ERAAM, a Paris-based hedge fund of funds. “We need to find funds which can make huge returns in order to justify our fees, so we like physical traders with a deep knowledge of their market.”

One alternative is to sell options to people betting on higher oil volatility. Bankers say that market participants such as pension funds and fund managers are edging in on this business, making the price of such contracts unfeasibly cheap and hard for banks to compete in a business they have traditionally dominated.

“As long as oil remains rangebound, it’s like free money to write puts and calls, so a lot of people are coming into the market to do it,” a banker says. “The problem is that if oil does move, you lose a lot of money.”