Global crude markets have been highly unstable over the past nine months as market participants wrestle with a deluge of information. That stack of information includes increasing North American production, lower global demand rates, a stronger dollar and a changing OPEC stance. As a result, volatility — historic and implied — is at the highest level in years. The inherent relationship between crude and petrochemical prices is invariably creating more volatility in petrochemical markets, and the higher level of uncertainty will certainly lead to more evaluation of project feasibility.
Brazilian chemical giant Braskem said in the first quarter that “new scenarios” are being incorporated into its Ascent cracker project that is under evaluation for the Northeastern part of the United States. Braskem said that a postponement of announced projects and the possibility of new delays or even cancellations, depending on the level of changing oil prices, are also positive factors to the industry margin.
In January, Qatar Petroleum and Shell announced that their Qatari project was cancelled as high capital costs in the current oil environment made the project unfeasible. It should be expected that future delays are plausible amid additional financial analysis in a more volatile market environment. However, a slowdown in project completions will lead supply tightness in some markets, assuming global petchem demand rises moderately. This scenario should benefit those who are expanding capacity in lower feedstock locations.
In the chart below, we can see the rapid increase in crude volatility over the past eight months. Annualized volatility in WTI is at a level not seen in the past four years. If the historical volatility in the chart below is used as a barometer of future volatility, it could be said that the expected return on WTI crude has a 67% chance of being in a range 65% above the current price or 65% below the current price. The last time this level of volatility was felt was in the summer of 2012, amid the threat of a Eurozone meltdown.
This increasing level of volatility is also being felt in the commodities that are essential to petrochemical production, and can be seen in the historical volatility of the Platts Global Petrochemical Index. Somewhat expected, the level of volatility has also increased in these markets as their prices are closely linked to crude benchmark prices.
By definition, historical volatility tells us what price variance has been — but what about the future volatility? That question can be answered by utilizing financial models to calculate the implied volatility of an asset.
Future expected volatility
In finance, an option gives a buyer or seller the right, but not the obligation, to buy or sell an underlying asset for a given price at or before a given time. Options are derivatives, meaning their value is derived from some underlying asset such as a stock, currency rate or physical commodity. Prices for options can be estimated through a model called the Black-Scholes-Merton model. This model is engrained with various statistical theories and one of the most important assumptions is that the returns on the underlying asset are normally distributed with a mean of zero. From the chart below, we can see that the theory holds true for WTI returns with the asset exhibiting normally distributed returns with a mean near zero
Further inspection of the Black-Scholes-Merton model leads us to the revelation that expected volatility of an asset, or implied volatility, can be calculated through the model. The exact derivation of implied volatility from the Black-Scholes-Merton model is unnecessary for this analysis. However, what is relevant is that the future volatility of an asset can be implied through the model. Luckily, the Chicago Board of Exchange has indices that measure implied volatility of many underlying indexes and assets.
In the final chart, we can see the CBOE’s OIV index, an index of 30-day implied volatility in WTI futures prices. The chart shows us that expected volatility in crude futures prices has also been on the rise. Since we already know that naphtha volatility and crude volatility is closely correlated, we can safely assume that the expected volatility in naphtha is also high. In addition, volatility in petrochemical products, which exhibit a high correlation to crude and naphtha, would also be expected to be volatile in the future.
Ultimately, the increasing level of volatility in oil markets equates to more risk and uncertainty in the petrochemical markets. Of course, uncertainty makes decision making more difficult and ultimately delays decisions to a time when there is more certainty. As a result, we may expect delays in capital expenditure projects in the petrochemical sector over the coming year where the need for additional future capacity is known but the certainty of profitability is not.
Finally, the market is telling us that future near-term volatility will remain high in the petrochemical sector as participants interpret the slew of information that pushes the direction of crude, and, ultimately, petrochemical markets as well.