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Crude oil prices are down due to global recovery concerns and a strong dollar. However, the price outlook for thrid quarter of 2010 is near to $90/bbl according to an analysis by Bank of America-Merrill Lynch. Crude oil prices have moved in a narrow range since October 2009; after a strong rally in first half of the year, crude oil has traded in $70/bbl to $85/bbl in the past four months.

Notwithstanding the sharp moves this week, the relatively narrow price range has continued to bring down realized volatility in global oil markets. While realized volatility is now back at levels last seen in 2007, WTI implied volatility has not declined as much. Implied vs. realized volatility spreads in WTI contracts remain quite rich in historical terms. In part, this is because the oil market is still surrounded by macro concerns regarding the cyclical recovery, BofAML analysis said.

Other than macro shocks affecting all asset classes, volatility in oil markets is mainly a function of inventories, particularly those around Cushing, Okhlahoma. With stocks on a gradual move towards normal levels, the risk of a sudden price collapse should continue to decline going forward, as growing spare storage capacity can better accommodate negative demand shocks, BofAML analysis said.

What to make then of this week’s sharp drop in oil prices? Since the price drop has come with tighter timespreads and higher near-dated volatility, BofAML sees it as an inflection point for the oil market. The relationship between WTI timespreads and implied volatility is on the mid range of their historical levels, suggesting an inflection point ahead for the oil market.



BofAML said that its historical analysis of the relationship between inventories, volatility and timespreads points to a flatter term structure of prices and a steeper implied volatility term structure. In recent days, crude oil prices farther out in the curve have been falling faster than near-dated prices. Meanwhile, the term structure of volatility has firmed up. With prices poised to pick up cyclically over the coming weeks, this is a cocktail for backwardation in the oil markets.

From a fundamental perspective, crude oil inventories are no longer high enough for limited storage capacity to be a concern to the market, and a continued cyclical demand recovery can be expected in the months ahead. inventories are currently in a robust, albeit gradual, trend towards more normal levels. Given the spare storage capacity to accommodate negative demand shocks, BofAML reports said the risk of a sudden price collapse has diminished significantly.

Downside risks to crude oil prices have diminished with various economic data points suggesting that the worst is over for oil demand. As a result of the better outlook for demand, the marked put skew present in WTI contracts in the past 12 months has come in considerably. While the macro environment still presents a downside risk to our view, BofAML predicts WTI prices supported above the $70/bbl levels and trading towards an average of $92/bbl in 2H2010. Hence, the gradual cyclical recovery coupled with comfortable inventory levels should keep prices range bound for some time and realized volatility relatively low. Therefore, investors can profit from the current rich implied to realized spreads through variance swaps on the back end of the WTI curve.

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