International Oil Market Risk Anticipations and the Cushing Bottleneck: Option-implied Evidence

Abstract

This paper studies crude oil market integration and spillovers between Brent and WTI oil indexes over the 2006-2019 period. In addition to prices, we estimate time series of model-free option-implied moments to capture forward-looking market views and anticipations of different risk categories. We describe the WTI-Brent equilibrium relationship in prices and in risk expectations measured by implied volatility, skewness, and kurtosis. Using a fractional cointegration model, we find long memory in the price cointegrating vector and in implied moments, implying that persistence of shocks is an important feature of crude oil markets. The evidence supports a differential in implied volatility but not in prices, and suggests equilibrium fragmentation during the Cushing bottleneck period. Analysis of implied moments reveals that Brent and WTI risk anticipations generally share a common equilibrium. Unlike volatility, asymmetric and tail risks are more locally driven, especially during market disruptions such as the Cushing bottleneck, so there is potential for diversifying extreme risks using both indexes.

The Skewness Risk in the Energy Market

“…Van Hoang et al (2019) and Chuliá et al (2019) present the existence of a spillover effect in the energy market in the US and Europe, respectively. Gagnon and Power (2020) find skewness and tail risks are locally driven in Brent and WTI oil indexes and suggest that these two indices can be used for hedging extreme risks during market disruptions. Dutta et al (2020) study how equity investors in clean energy markets can reduces their downside risk.…”

“…Skewness risk is often used to measure the possibility of a market crash. Oil price fluctuations also often result from a demand shift in the sources of energy that effectively influence the performance of energy stocks (Hamilton 1983; Van Hoang et al 2019;Gagnon and Power 2020). Studying the skewness or crash risk in predicting future returns has been extensively explored at the individual and market level in the existing literature.…”