How Crude Oil Prices Are Driven by the "Uncertainty Factor"

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Despite a world of geopolitical tension, crude oil prices have remained steady.

West Texas Intermediate (WTI) has been holding in the mid $90s, while Brent continues to trade in the low $100 range.

This trading dynamic tells us two things…

First, traders obviously do not think the crises in Ukraine, Iraq, or Gaza will have a major impact on the global market (at least not yet). As a result, they are discounting the impact of the tensions on overall availability.

Second, other hotspots – especially the ongoing hostilities in Libya – are having an immediate knock-on effect when it comes to crude supply.

In this case, traders are factoring in a couple of related dimensions – the lower worldwide demand that is expected this time of year, and the rise in other sources of oil – especially unconventional (tight and shale) production in North America.

This is causing traders to discount the impact on overall deliverability as well.

As a result, the daily news does not seem to be adversely impacting the price of oil.

But that doesn't mean we're out of the woods yet – not by a long shot…

What Really Drives Crude Oil Prices

Crude Oil Prices

The key here is to recognize that crude oil prices are still determined by the balance between readily available supply and existing demand. That means that even relatively small swings in either supply or demand can have an outsized effect.

It's the expectations of future changes in this balance that ultimately drives how traders view the market.

After all, these guys are attempting to deal with what the price of oil will look like months in advance. That's the very nature of futures contracts. Traders need to deal with the "uncertainty factor" in determining their contract pricing.

This factor is usually accounted for in the calculation of volatility or, to be more correct, the implied volatility. In essence, traders must compensate for how the price is likely to change one way or the other over the life of the futures contract.

To offset their risk, they take out options at a different strike price from the futures contract, which requires that a certain amount of oil be purchased at a set price and on a set date. Conversely, an option is just that, the right (but not the obligation) to do the same.

To exercise an option, the trader simply pays a premium based on a percentage of the underlying value. If it turns out the option is unnecessary, it's merely allowed to expire and the premium is the only amount lost.

In short, options are the insurance policies traders take out to hedge a futures contract. In fact, it operates in the same way your own insurance policies do: A premium is paid to protect you against major unforeseen losses.

The key to determining the cost of that premium is in calculating how much volatility to expect during the life of the contract.

That's where the element of implied volatility comes in big time.

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About the Author

Dr. Kent Moors is an internationally recognized expert in oil and natural gas policy, risk assessment, and emerging market economic development. He serves as an advisor to many U.S. governors and foreign governments. Kent details his latest global travels in his free Oil & Energy Investor e-letter. He makes specific investment recommendations in his newsletter, the Energy Advantage. For more active investors, he issues shorter-term trades in his Energy Inner Circle

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