Volatility

Volatility of crude oil and natural gas is quite a bit higher than that for many financial instruments. Volatility is generally referenced as either historic or implied. Historic price volatility is a measure of how the price of the futures contract has actually been changing over a given period. Implied volatility is "implied" by the option price on a given futures contract²⁵ and is the market's perception of how that underlying futures contract will trade in the future. There may be major divergences between historic and implied volatility at different times depending on market conditions, though over the long run they tend to be similar.

Exhibit 7 is a chart of 1995 implied volatility for the US Treasury Bond options, natural gas and crude options on the December futures contracts. As can be seen, natural gas is the most volatile of the three, and crude is still quite a bit more volatile than the Treasury Bonds. Though 8¹∕₂ months is not an adequate timeframe for making sweeping generalizations, it is an accurate depiction of the type of relationships that would be observed over a longer period.

Data on historic volatility for mid-June 1991 through mid-March 1994 reveals that historic natural gas volatility ranged between 10% and 83%; historic crude oil volatility ranged between 15% and 38% and historic volatility for Treasury Bonds ranged from about 6% to 13% during that 3-year period.²⁶ Since volatility is a measure of risk (or uncertainty) we can conclude that, all else equal, a portfolio of natural gas options would be riskier than a portfolio of crude oil options, which would be riskier than a portfolio of Treasury Bond options.

The term structure of volatility — how volatility in more distant months relates to that in closer months — tends to be downward sloping for both natural gas and crude (as is true of most commodities). The term structure of implied volatility for crude oil as it looked on November 28, 1995 is illustrated in Exhibit 8.

Exhibit 8

Crude Oil - Volatility Term Structure

Nov. 28, 1995

20%

14%

Jan Mar May Jul Sep Nov Contract Month

14

The information flow affecting the physical situation is much greater than the flow that acts to create the long-term price equilibrium (the price of oil is generally believed to be mean-reverting), resulting in this decreasing volatility pattern. This pattern also supports observations that movements of short-term prices are large and erratic, while the prices of longer maturities tend to remain relatively stable.²⁷