Best of the Week
Most Popular
1. US Housing Market Real Estate Crash The Next Shoe To Drop – Part II - Chris_Vermeulen
2.The Coronavirus Greatest Economic Depression in History? - Nadeem_Walayat
3.US Real Estate Housing Market Crash Is The Next Shoe To Drop - Chris_Vermeulen
4.Coronavirus Stock Market Trend Implications and AI Mega-trend Stocks Buying Levels - Nadeem_Walayat
5. Are Coronavirus Death Statistics Exaggerated? Worse than Seasonal Flu or Not?- Nadeem_Walayat
6.Coronavirus Stock Market Trend Implications, Global Recession and AI Stocks Buying Levels - Nadeem_Walayat
7.US Fourth Turning Accelerating Towards Debt Climax - James_Quinn
8.Dow Stock Market Trend Analysis and Forecast - Nadeem_Walayat
9.Britain's FAKE Coronavirus Death Statistics Exposed - Nadeem_Walayat
10.Commodity Markets Crash Catastrophe Charts - Rambus_Chartology
Last 7 days
Stock Market Election Year Cycles – What to Expect? - 4th Jun 20
Why Solar Stocks Are Rallying Against All Odds - 4th Jun 20
East Asia Will Be a Post-Pandemic Success - 4th Jun 20
Comparing Bitcoin to Other Market Sectors – Risk vs. Value - 4th Jun 20
Covid, Debt and Precious Metals - 3rd Jun 20
Gold-Silver Ratio And Correlation - 3rd Jun 20
The Corona Riots Begin, US Covid-19 Catastrophe Trend Analysis - 3rd Jun 20 -
Stock Market Short-term Top? - 3rd Jun 20
Deflation: Why the "Japanification" of the U.S. Looms Large - 3rd Jun 20
US Stock Market Sets Up Technical Patterns – Pay Attention - 3rd Jun 20
UK Corona Catastrophe Trend Analysis - 2nd Jun 20
US Real Estate Stats Show Big Wave Of Refinancing Is Coming - 2nd Jun 20
Let’s Make Sure This Crisis Doesn’t Go to Waste - 2nd Jun 20
Silver and Gold: Balancing More Than 100 Years Of Debt Abuse - 2nd Jun 20
The importance of effective website design in a business marketing strategy - 2nd Jun 20
AI Mega-trend Tech Stocks Buying Levels Q2 2020 - 1st Jun 20
M2 Velocity Collapses – Could A Bottom In Capital Velocity Be Setting Up? - 1st Jun 20
The Inflation–Deflation Conundrum - 1st Jun 20
AMD 3900XT, 3800XT, 3600XT Refresh Means Zen 3 4000 AMD CPU's Delayed for 5nm Until 2021? - 1st Jun 20
Why Multi-Asset Brokers Like TRADE.com are the Future of Trading - 1st Jun 20
Will Fed‘s Cap On Interest Rates Trigger Gold’s Rally? - 30th May
Is Stock Market Setting Up for a Blow-Off Top? - 29th May 20
Strong Signs In The Mobile Gaming Market - 29th May 20
Last Clap for NHS and Carers, Sheffield UK - 29th May 20
The AI Mega-trend Stocks Investing - When to Sell? - 28th May 20
Trump vs. Biden: What’s at Stake for Precious Metals Investors? - 28th May 20
Stocks: What to Make of the Day-Trading Frenzy - 28th May 20
Why You’ll Never Get Another Stimulus Check - 28th May 20
Implications for Gold – 2007-9 Great Recession vs. 2020 Coronavirus Crisis - 28th May 20
Ray Dalio Suggests USA Is Entering A Period Of Economic Decline And New World Order - 28th May 20
Europe’s Coronavirus Pandemic Dilemma - 28th May 20
I Can't Pay My Payday Loans What Will Happen - 28th May 20
Predictive Modeling Suggests US Stock Markets 12% Over Valued - 27th May 20
Why Stocks Bear Market Rallies Are So Tricky - 27th May 20
Precious Metals Hit Resistance - 27th May 20
Crude Oil Cuts Get Another Saudi Boost as Oil Demand Begins to Show Signs of Life - 27th May 20
Where the Markets are heading after COVID-19? - 27th May 20

Market Oracle FREE Newsletter

Coronavirus-stocks-bear-market-2020-analysis

How the “Uncertainty Factor” Drives Crude Oil Prices

Commodities / Crude Oil Aug 22, 2014 - 03:58 PM GMT

By: Money_Morning

Commodities

Dr. Kent Moors writes: Despite a world of geopolitical tension, oil prices have remained steady.

West Texas Intermediate (WTI) has been holding in the mid $90′s, while Brent continues to trade in the low $100 range.

This trading dynamic tells us two things…


First, traders obviously do not think the crises in Ukraine, Iraq, or Gaza will have a major impact on the global market (at least not yet). As a result, they are discounting the impact of the tensions on overall availability.

Second, other hotspots – especially the ongoing hostilities in Libya – are having an immediate knock on effect when it comes to crude supply.

In this case, traders are factoring in a couple of related dimensions – the lower worldwide demand that is expected this time of year, and the rise in other sources of oil – especially unconventional (tight and shale) production in North America.

This is causing traders to discount the impact on overall deliverability as well.

As a result, the daily news does not seem to be adversely impacting the price of oil.

But that doesn’t mean we’re out of the woods yet – not by a long shot

What Really Drives Oil Prices

The key here is to recognize that crude oil prices are still determined by the balance between readily available supply and existing demand.That means that even relatively small swings in either supply or demand can have an outsized effect.

It’s the expectationsof future changes in this balance that ultimately drives how traders view the market.

After all, these guys are attempting to deal with what the price of oil will look like months in advance. That’s the very nature of futures contracts. Traders need to deal with the “uncertainty factor” in determining their contract pricing.

This factor is usually accounted for in the calculation of volatility or, to be more correct, the implied volatility. In essence, traders must compensate for how the price is likely to change one way or the other over the life of the futures contract.

To offset their risk, they take out options at a different strike price from the futures contract, which requires that a certain amount of oil be purchased at a set price and on a set date. Conversely, an option is just that, the right (but not the obligation) to do the same.

To exercise an option, the trader simply pays a premium based on a percentage of the underlying value. If it turns out the option is unnecessary, it’s merely allowed to expire and the premium is the only amount lost.

In short, options are the insurance policies traders take out to hedge a futures contract. In fact, it operates in the same way your own insurance policies do: A premium is paid to protect you against major unforeseen losses.

The key to determining the cost of that premium is in calculating how much volatility to expect during the life of the contract.

That’s where the element of implied volatility comes in big time.

Now, my graduate students used to complain every time I made them calculate that “implied volatility thing.” But I forced them to learn it for a very important reason.

You see, most traders themselves don’t know how make this calculation; they simply hit an app button on an expensive calculator!

As a result, they don’t always understand what drives the most important single element in determining the insurance policy that is necessary to keep them from losing the farm.

Without understanding the calculation itself, they are blind to the real movement of volatility.

When Uncertainty Breaks the Model

Now, we certainly don’t have the time to talk in this format about what can happen next other than to say this: The formulas built into those apps are very limited in their operations. They require standard market assumptions and quite artificial arrangements.

Most of the time this doesn’t matter, since the likely movement one way or the other is not large enough to upset this arrangement. A trader may sacrifice some money now and then, but it is offset by the volume of contracts and options they run.

The problem is the “uncertainty factor” is discounted by a process that cannot possibly compensate if it were to hit in a big way.

This is the decisive point to remember when it comes to how a global crisis actually moves oil prices. As long as the uncertainty can be kept in a jar provided by an app, it’s not a serious problem.

Once the lid is off the jar, however, the normal pricing structure simply cannot compensate for it. Too much uncertainty means that prices no longer conform to the artificial strictures of the math determining the cost of trading insurance (i.e., options).

In that situation, traders are forced to overcompensate in setting prices, since that’s the only “real world” way to insure themselves against a catastrophic loss. They follow the direction of the pricing trend (up or down), aggravating the actual market move.

This happens because the way oil prices are determined is largely a result of statistical requirements – not genuine events.

And when events take over, there is no app for that.

As a result, we then end up with what I have called the “vega factor,” or the increasing inability to determine a genuine value for oil based on its market price.

Remember that the market price of oil in uncertain situations is driven by the traders, not what’s happening in the real world.

This doesn’t have to happen often for there to be a major impact on profits. We are not there yet, but several scenarios are emerging in which we could be pushed into a “vega factor” situation rather quickly.

When that happens, I have developed a strategy to make some quick money on these events, and will discuss it right here in OEI.

Consider it my own personal app.

Source : http://oilandenergyinvestor.com/2014/08/uncertainty-factor-drives-oil-prices/

Money Morning/The Money Map Report

©2014 Monument Street Publishing. All Rights Reserved. Protected by copyright laws of the United States and international treaties. Any reproduction, copying, or redistribution (electronic or otherwise, including on the world wide web), of content from this website, in whole or in part, is strictly prohibited without the express written permission of Monument Street Publishing. 105 West Monument Street, Baltimore MD 21201, Email: customerservice@moneymorning.com

Disclaimer: Nothing published by Money Morning should be considered personalized investment advice. Although our employees may answer your general customer service questions, they are not licensed under securities laws to address your particular investment situation. No communication by our employees to you should be deemed as personalized investent advice. We expressly forbid our writers from having a financial interest in any security recommended to our readers. All of our employees and agents must wait 24 hours after on-line publication, or after the mailing of printed-only publication prior to following an initial recommendation. Any investments recommended by Money Morning should be made only after consulting with your investment advisor and only after reviewing the prospectus or financial statements of the company.

Money Morning Archive

© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in

6 Critical Money Making Rules