How Certain are Trading Desks of Their Own Price Forecasts?
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Guest Blog by: Mike Morgan, P.Eng., Manager of Engineering, GLJ Petroleum Consultants
We’ve had a roller coaster ride on oil and gas prices, but what kind of price changes can we expect over the next few quarters? One way of estimating this is to look at the cost of buying options from a trading desk.
To explain this, think of buying insurance: you sign a contract, pay the insurance company a premium and then you have the chance of claiming a payout if disaster strikes. The insurance company won’t force you to make a claim (they’d probably be happy if you didn’t) but it would be in your best interest to do so if you had an accident. Now consider how things would change if you suddenly become more likely to make a claim, maybe your teenager started driving or you just bought another five cars. Pretty clearly your premiums would go up. You could flip this around and start by looking at your premiums: if they went up you would know that the insurance company thinks you’re more likely to make a claim.
Just like you can buy insurance to cover the cost of a car accident, you can buy contracts that lock in set oil or gas prices (the “strike prices”). You can buy these contracts directly on openly traded markets or directly from investment banks.
These contracts are called “options”, as you’re not forced to use them (though right now you probably would take advantage of an option that had a January strike price of $85/bbl). By comparing the cost of buying the options to the current hydrocarbon price and the strike price of the option, you could estimate how likely the trading desk thinks you are to exercise the options. What you’re doing, in effect, is calculating how likely the trading desk thinks that the price will actually hit pre-set upper or lower bounds. In trading terms you’re calculating the “implied volatility”. Once we have this we can estimate the chance of hitting any other set of upper or lower price bounds.
We won’t go into the detail of the underlying math to calculate the “implied volatility” in this blog post. For now, the most important thing to keep in mind is that if a trading desk is more certain of the price, it will price its options so that there is less implied volatility. This would result in a smaller difference between the upper and lower price confidence bounds. If a trading desk is less certain of the price, then the opposite will be true. Selling commodities options is a very competitive business so there’s generally not too much difference between the options prices that each trading desk offers.
One of the ways we at GLJ check our pricing forecasts is to take a look at these confidence bounds. We take options prices, calculate the implied volatility, then estimate an upper and lower price confidence bound. This gives a good feel for how concerned or excited we should be of major price changes. This is a straightforward activity using VISAGE: one of its most powerful features is its ability to merge data from multiple datasets without requiring end users to be programmers or developers or understand anything about query languages.
To see this in action we prepared VISAGE plots of historical prices, the current forward strip and an estimate of both an upper and a lower confidence bound. For the confidence bounds we choose a set of options prices from a local trading desk at random and calculated the implied volatility using a European Option pricing model. We can see that (as of January 15, 2015) there’s only about a 60% chance that the price of WTI oil will be between 40 and 80 $/bbl and that Henry Hub gas will be between 2 and 4 $/MMbtu. That’s not much confidence for a pretty big range in prices. It’s also surprisingly close to the range of prices that WTI traded at during the last major drop in prices.
…by Mike Morgan, P.Eng., Manager of Engineering, GLJ Petroleum Consultants
Thanks Mike! I look forward to the next blog from GLJ next week about how current price changes impact valuations of oil and gas assets.
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