By HCB Investment Management The crude oil market has experienced a significant amount of volatility over the past six months. After closing at $107.26 per barrel on June 20th, one key oil futures contract dropped more 30%, falling to $74.58 as of November 19. So what should we expect going forward?
Coming out of an early summer market driven by uncertainty over Russia and into a fall market dominated by oversupply concerns, it is clear that the only certainty is that market conditions are uncertain. However, since the earnings strength of the exploration and production sector is so heavily tied to crude prices, it is important to have a handle on the probability of where prices might go. Although we may not be able to accurately forecast the direction of future prices, the crude oil options market gives us a very rich source of information about the probability and potential magnitude of future price moves. To the uninitiated, options trading can be pretty confusing, with lots of arcane jargon and terminology. In isolation, a single options trade might only reveal a bet between two traders about the likelihood of prices exceeding some threshold.
In aggregate, however, the options market reveals a probability distribution of future price settlements. Here is a simple example. The December 2015 crude oil futures contract most recently settled around $75, and the premium for a $100 call option was almost $1. Embedded in that premium is the market's assessment of the likelihood of the December 2015 crude oil futures contract exceeding $100, and the magnitude by which it might exceed $100. Let's assume that the premium had been $2 instead. That would imply a greater likelihood of the December 2015 contract exceeding $100, and by an even greater magnitude.