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COLUMN-Lower oil prices are exaggerating the appearance of volatility: Kemp
January 26, 2016 / 1:08 PM / 2 years ago

COLUMN-Lower oil prices are exaggerating the appearance of volatility: Kemp

(John Kemp is a Reuters market analyst. The views expressed are his own)

* Chart 1: tmsnrt.rs/1RKEuw0

* Chart 2: tmsnrt.rs/1RKEFY2

* Chart 3: tmsnrt.rs/1RKEmMN

* Chart 4: tmsnrt.rs/1RKErQD

* Chart 5: tmsnrt.rs/1RKEGes

* Chart 6: tmsnrt.rs/1RKELyQ

By John Kemp

LONDON, Jan 26 (Reuters) - Headline 1: "On Thursday and Friday last week, the price of Brent crude surged more than 15 percent higher in one of the largest two-day moves on record."

Headline 2: "On Thursday and Friday last week, the price of Brent crude rose by $4.30 per barrel, which was a large but not uncommon two-day increase that occurs a few times most years."

The first version describes an extremely rare event that needs special explanation while the second describes something much more like the everyday rise and fall in prices.

Headline writers obviously prefer the first formulation because it is more exciting, but both headlines describe exactly the same movement in oil prices that occurred on Jan. 21 and Jan. 22.

Writers and analysts measure and describe oil price movements in both relative (percentage) terms and absolute (dollars per barrel) terms.

In theory, it should not matter how the price moves are measured. In practice, the choice of measurement has a big impact on perceptions of volatility and how market movements get reported.

Volatility appears to be more constant in dollar than percentage terms.

As the absolute price of oil has fallen, volatility measured in dollars has remained roughly constant but percentage volatility has risen sharply (tmsnrt.rs/1RKEuw0 and tmsnrt.rs/1RKEFY2).

At the moment, oil market volatility measured in percent terms appears unusually high, but in dollar terms it appears far more normal, especially for the post-2005 era (tmsnrt.rs/1RKEmMN and tmsnrt.rs/1RKErQD).

In percentage terms, Brent rose 4.91 percent on Thursday and then another 10.0 percent on Friday. The price changes were equivalent to 2.22 standard deviations and 4.53 standard deviations respectively.

In percentage terms, Friday's price move was extremely unusual, and has only occurred on 10 other occasions since 1990 (tmsnrt.rs/1RKEGes).

However, in dollars, the increases were just $1.37 and $2.93, equivalent to 1.22 standard deviations and 2.61 standard deviations respectively.

In dollar terms, Friday's price move was somewhat unusual, but even larger movements have occurred on more than 90 occasions since 1990 (tmsnrt.rs/1RKELyQ).

The price of Brent options is often expressed as implied volatility in percentage terms, which has made them look increasingly expensive, but the cost has risen much less if it converted back into dollars.

After nearly four years between 2011 and mid-2014 when oil prices above $100 came to seem "normal", the challenge is to maintain a sense of perspective about daily moves when the baseline is repriced far lower. (Editing by David Evans)

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