Commodity Online The slow progress by the European Central Bank in stabilising European debt crisis has led to serious risk of jeopardizing the economic recovery by limiting consumer and corporate credit availability. Crude oil and refined products have not seen the same increase in implied volatilities as those seen in US and European equities may be due to anticipatory nature of equities to oil, according to an analysis by Bank of America-Merrill Lynch.
The phenomenon reflects the fact that oil prices are now more and more geared towards emerging market growth, particularly in Asia.
As is typically the case when volatility spikes, implied volatilities have increased more in the front end of the curve than in the back. The WTI ATM implied volatility term structure that was unusually flat has now reverted to a more typical downward sloping shape. However, the move in the slope of the term structure has not been as sharp as the moves seen with similar events in the past. In fact, the move observed in the volatility surface of other asset classes like equities has been substantially more pronounced, particularly as it relates to tail risk, BofAML analysis said.
The search for downside protection in WTI crude oil has also sparked a retracement in skews. The WTI options market has reversed to levels seen at the start of the year when uncertainty regarding the cyclical recovery was much higher. BofAML is cautiously optimistic that the breadth of the upturn outside Southern Europe will prevent a double-dip scenario. Should the global economy experience another meltdown, however, skew in oil seems a more attractively priced hedge than in equities, FX, or credit.
This week, despite more signs of resilience in the global economy such as positive revisions to Asian global growth forecasts and some strong data coming out of the US, WTI crude oil prices gravitated at around $70 to $75/bbl and the Euro continued to head down towards four-year lows.
Given the ongoing European sovereign debt crisis, the riskier macro environment is continuing to weigh on oil prices with expectations of lower European consumption, investment, and a more muted demand recovery overall. With a weaker Euro and slower-than-expected European growth, BofAML recently lowered its average WTI and Brent crude oil price forecasts for 2H10 to $78/bbl.
The fiscal vulnerabilities of peripheral Europe are spreading quickly to other asset classes and increasing systemic risk. Credit spreads for Western Europe sovereigns are up 58 bps from last month while credit spreads for European companies are up 47 bps.
Furthermore, the S&P 500 and the Euro are down about 10% from the highest levels seen last month. Meanwhile, relative to their April lows, the VIX index is up 14 vol points while 3M ATM implied volatilities the EURUSD are up 5 vol points. Commodities have also seen implied volatilities surge, with the MLCXV3M index up by 6 vol points from its lows in April.