Calm before the storm? Commodity volatility mired at low levels

By Eric Onstad

LONDON (Reuters) - Commodity traders curse it while industrial users of oil, metals and grains applaud it.

Several years of low volatility on commodity markets have hammered profits for speculators and constricted trading opportunities, while providing stability for firms that buy such goods.

But both camps may get more than they bargained for when the current period of extraordinarily narrow price movement ends, entering uncharted territory after a number of banks departed the sector.

While prices have fluctuated more in some sectors such as oil in recent weeks, it's risky to predict how soon volatility in commodities, which has halved in many markets over the past three years, will see a significant and lasting rebound.

The period of relative calm may press on since many commodities have plentiful supplies and global interest rates are still rock bottom.

But the sharp withdrawal of many banks from commodity trading, sucking liquidity from markets, could send volatility soaring if unexpected catalysts emerge.

"Banks have been liquidity providers and market makers, and given the diminishing number of banks genuinely active in commodity markets, a move in volatility could be much exaggerated," a commodity executive at a major bank said.

"When we do finally start moving, the impact in commodities could be much bigger than other financial markets. There isn't going to be the natural supply of liquidity," said the executive, who declined to be identified.

Credit Suisse (CSGN.VX) said last month it was winding down its commodities trading, joining the likes of Deutsche Bank (DBKGn.DE), JPMorgan (JPM.N) and Barclays (BARC.L), which are either exiting or significantly downsizing their activities in the sector.

BIG PLAYERS

While other financial markets have also seen declining volatility, the slide in commodities volatility has had a bigger impact. Stock markets have been on a bull run, but commodities have been hit with sliding prices and withdrawals by investors, squeezing profit opportunities for funds and traders.

The slide in volatility has extended throughout commodity markets from gold to grain to Brent crude oil, where at the money (ATM) 30-day implied volatility (LCOATMIV) has slid to 17.09 from 40.32 three years ago.

Gold is down by about 50 percent to 14.74 since 2011.

Implied volatility is how the market prices future volatility, while realised volatility is actual past volatility.

It's a big contrast to the situation several years ago when commodity prices lurched higher, prompting regulators to impose new rules on speculators, who were blamed for the volatility.

"Recent volatility in prices for basic commodities -- agriculture and energy -- are very real reminders of the need for common-sense rules in all the derivatives markets," Gary Gensler, then chairman of the U.S. Commodity Futures Trading Commission (CFTC), said in 2011.

The CFTC declined to comment on the current decline in volatility, as did Britain's Financial Conduct Authority and the European Securities and Markets Authority.

“The withdrawal of banks from commodities has had a big effect on volatility," said Itay Simkin, chief executive of commodity hedge fund Krom River. "Historically those (bank) guys used to be big players in volatility."

Guy Wolf, global head of market analytics at broker Marex Spectron, said banks' withdrawal had not only cut liquidity but resulted in the winding up of trading books, which included structured products, embedded with a short vega profile.

Vega measures the sensitivity of an option price to changes in implied volatility.

"The market could probably have absorbed one major exit. But having multiple exits at the same time with no natural new hands was a problem," Wolf said in a report.

While volatility is no longer falling sharply and in some cases rising slightly, many fund managers and speculators are cautious after being burnt in recent years.

Failing to make money through other strategies in lacklustre commodity markets, some positioned themselves for a rebound in volatility from levels that seemed extremely low, but lost money when volatility sank further, industry sources said.

"Implied vol and realised vol for most metals are relatively similar, which seems to suggest we're approaching a fair value, albeit that fair value is at historical lows," the bank executive said.

"You've had many people over the past two to three years saying we're at the low so now's the time to buy, but that's been proven wrong and they bled profits."

CUSHIONED FROM SHOCKS

Wolf said it was likely the volatility bear market had ended, but that did not mean a bull market had begun.

"How quickly volatility goes back up is a function of many things, rate hikes being one," he said.

Some analysts and traders believe the flood of cheap money during the global financial crisis has been a key factor in depressing volatility, while others point to healthy supplies cushioning commodity markets from reacting to shocks.

In the oil market, since 2011 every new geopolitical worry has resulted in a lower peak, said Ole Hansen, senior commodity strategist at Saxo Bank.

“We are seeing increased supplies coming from non-OPEC sources, which is making the market less responsive to any geopolitical events."

David Bicchetti, associate economic officer at the United Nations Conference on Trade and Development (UNCTAD), warned that the current low volatility may be deceptive.

He and UNCTAD colleagues have previously called for increased transparency and stronger regulation to pop price bubbles and prevent crashes.

"I do not think that low volatility means that the problems are solved. It is maybe like the calm before the storm as it happened in 2007-2008, where most people did not foresee any crisis looming," he told Reuters.

(Additional reporting by Claire Milhench; Editing by Dale Hudson)