London, 31 July 2011: Reuters

Oil markets have hit an unusual lull after weathering a series of storms that marked the first six months of the year and wrong-footed even some of the most fabled traders in the market. In recent sessions, oil prices have barely moved despite mounting concerns about European debt restructurings and the threat of default in the United States.

Since July 8, benchmark Brent prices have moved on average just 0.5 percent per day and oscillated in a tight range only a little over $5. The lack of volatility contrasts with the wild gyrations and multiple-standard deviation moves in May and June

Moves have been unusually small on both a close-to-close basis and in terms of intra-day trading ranges. Most of the widely used volatility measurements (trailing 20-day and 30-day averages) are hovering close to their long-term averages because they still include some relatively large daily moves in late June and early July.

But as those moves drop out, measured volatility is plunging and is on course to hit some of its lowest levels in the last two decades. On a 10-day trailing basis, which captures the most recent market environment, close-to-close volatility has fallen to 12 percent a year. It lies in roughly the 3rd and 4th percentiles of the 2006-2011 and 1990-2001 distributions respectively. Volatility has only been lower 2-3 percent of the time in the last 6 and 21 years.

UNCERTAIN AND EXHAUSTED

The absence of more variability may surprise some observers given the number and scale of risk factors facing supply and demand over the coming year. Sources of uncertainty include the timing of resumed Libyan exports; a shrinking margin of spare capacity; overheating in emerging markets; the risk of a slowdown in the advanced economies; and uncertainty about policy linked to the U.S. debt ceiling, European restructuring, and the Fed's flirtation with more large-scale asset purchases.

But markets are notoriously bad at pricing significant uncertainty. Prices often over-react to relatively minor developments and under-react to major emerging risks, as participants struggle to comprehend them, reach a consensus on what they mean and price them appropriately.

Like a rabbit trapped in the headlights of an oncoming car, markets often ignore major risk factors and hope they resolve themselves. For much of late 2009 and the first eight months of 2010, the market traded in a $65-85 range with very low volatility as investors and hedgers struggled to make sense of competing upside and downside risks. Something similar may be happening again.

Few investors or forecasters are expecting large price movements in the near term. Despite the continued bullish rhetoric, most published forecasts by the main commodity banks see little or no move in Brent prices over the next 12 months. Few are willing to bet on a decline in prices but the potential for upside moves is mostly seen as capped.

"The oil market remains extremely range-bound," according to a note from Barclays Capital. "The oil market has shown dynamics that should not be frightening to anyone, as prices have been well and truly stuck. That is not because nothing has been happening; it is rather that too many things have been happening".

More colourfully, the bank observes there is "no reason to do much else than to drift gently sideways like an oligarch's yacht in the Aegean. The year of living dangerously has, for the moment, become the year of having a large and extended lunch and then a long siesta under the boardwalk before the next brief period of volatility commences."

BEATEN UP AND CAUTIOUS

The bank might also have noted many market participants are still nursing wounds from wild moves in spot prices as well as timespreads and the Brent-WTI spread, which caught out many during Q2, and counsels caution in the short-term. It is easier to take risks with the P&L when participants are already showing healthy profits for the year.

Unanticipated price and spread swings seem to have inflicted significant pain on banks (Goldman Sachs, Morgan Stanley), trading companies (BP, Phibro), and many hedge funds according to performance reports.

Of course there were winners (reportedly JP Morgan, Deutsche), and investors seem to be tip-toeing back into the market. Money managers have boosted net positions in WTI-linked futures and options in each of the last three weeks. But the return has been cautious. There has been none of the widespread QE2- and Libya-induced bullishness that characterised the market in late 2010 and the first four months of 2011..

The question is whether this is a temporary summer pause or will become a more extended lull. Some of the shor-tterm risks which are weighing on sentiment should resolve themselves. Not even the U.S. Congress can spin out the debt ceiling standoff forever without risks either crystallising or lifting.

But more medium-term sources of uncertainty, such as whether oil prices have already reached the limit compatible with continued global growth, or need to rise further to dampen demand, may not be resolved so easily and quickly.

Volatility is itself notoriously variable. As mathematician Benoit Mandelbrot observed, volatility tends to "bunch", with periods of high volatility ("wild markets") alternating with quiet ones ("mild markets"). The current low level of volatility cannot last forever.

But after the tumultuous rally unleashed by Fed Chairman Ben Bernanke's decision to pursue QE2, then reinforced by the Arab Spring, the market may return to a same desultory trading pattern for a while -- something likely to disconcert banks and funds that depend on volatility and trends to make money (at least when they get it right).

Ends --

By John Kemp, Reuters market analyst – for Commodities Now.

The views expressed here are his own.