Crude Oil Set Up for Huge Volatility Spike

With the U.S. attack on a Syrian air strip early Friday and the subsequent price spike in crude oil futures, traders should start preparing for the return of volatility in the crude oil market after several months of sideways to lower movement.

Volatility doesn’t tell us which way the market will move, but it can be used to tell us when the market is likely to move. However, since the action by the U.S. against Syria may have drawn the wrath of its allies, Iran and Russia, two major oil producers, we’re going to be focusing on possible supply disruptions and this usually has a bullish influence on prices.

The CBOE Crude Oil ETF Volatility Index (OVX) measures the market’s expectation of 30-day volatility of crude oil prices. The United States Oil Fund is an exchange-traded security designed to track changes in crude oil prices. By holding near-term futures contracts and cash, the performance of the Fund is intended to reflect, as closely as possible, the spot price of West Texas Intermediate light, sweet crude oil, less USO expenses.

Volatility tends to widen and tighten at various times during the year. For example, on October 19, 2016, May WTI Crude Oil futures reached a top of $54.24 and sold-off until November 14, when it reached a bottom at $45.78. It was an $8.46, or 15.60 percent decline in 18 trading sessions.

On October 20, the OVX was trading at 32.48. By November 14, it was at 50.17. Eventually, it topped out at 55.09 on November 29, 2016, right around the time OPEC and non-OPEC members reached its agreement to begin curbing output.

Since the top at 55.09 on November 29, the OVX has trended lower, reaching a bottom at 24.67 on March 1. It then spiked to 33.45 on March 10. During this time period, crude prices dropped from $54.43 to $49.03 before reaching a bottom on March 22 at $47.01.

As of April 7, May WTI crude oil prices had reached a high at $52.94. As of the close on April 6, the OVX was at 26.79. This is slightly above the previous bottom at 24.67.

Unexpected news seems to be the main driver of volatility in the crude oil market. The anticipation of the OPEC production cut deal helped drive it higher. But once the deal was made, volatility went down.

The rapid sell-off from late February/March 1 also came as a surprise because traders had been led to believe that hedge and commodity fund traders had put on huge long positions, betting on a big rally. This created a false since of security so when the market fell apart, volatility spiked higher as long investors sought protection in the option market while liquidating unprofitable futures positions.

At this time, I expect to see a spike in crude oil volatility along with a rise in prices because we now have a new “unknown”. No one knows how Iran and Russia are going to respond to the U.S. air strikes. No one knows if the bombing was a one-time event or the start of escalating military action designed to overtake Syria’s President Assad. Consequently, no one knows how all of this will impact oil prices, but they do know, it anything, it will affect supply.

Because of all the uncertainty, investors should start to watch for the return of volatility in the crude oil market. The CBOE Crude Oil ETF Volatility Index supports my conclusion that volatility has reached a short-term low and is poised to move higher. The first target is 33.45. If this is taken out with conviction then volatility could expand into 55.09, a level not seen since late November 2016.