Volatility surface for the UK gas market

26 May, 2011

There is a well established Over-The-Counter (OTC) market for UK NBP gas monthly put and call options. From traded prices in this market it is possible to generate implied volatilities; although the information has really only been available to market participants (typically through broker-provided at-the-money options quotes). However the listing of NBP monthly options on ICE earlier this year means that a transparent implied volatility surface for the UK gas market is now available for the first time.

Plotting implied volatility against strike and maturity simultaneously shows both the term structure of volatility and any volatility smile or skew that might be present (for a range of strikes across a single maturity). A recent volatility surface is shown in Chart 1.

Chart 1: UK gas implied volatility surface

Implied versus historical volatility

Implied volatility provides a market expectation of future volatility, whereas calculating volatility from historic price movements only yields information about how prices have moved in the (recent) past. This has the advantage that the impact of future changes in supply and demand fundamentals will be included in implied volatility, which can be particularly important in tight supply and demand conditions. For example, immediately after the recent Japanese earthquake it would be reasonable to expect implied volatility to increase to reflect the uncertainty around the impact on Japan’s demand for LNG (as a replacement for the stricken nuclear stations). This effect would not have been observable in volatility calculated from historic prices in the days preceding the earthquake.

Volatility surface shape

So what can be read into the shape of the volatility surface above? Probably not alot given the limited liquidity to date in the ICE NBP options that underpin the calculation of the implied volatilities. That said, the shape does provide a couple of features that are worthy of comment.

First, the classic commodity market term structure of volatility is observable with decreasing volatility for longer dated maturities. Second, it is possible to see that for shorter dated maturities the implied volatility monotonically increases with strike for out-of-the money calls. One explanation for this is as follows: it is easier to think of market conditions creating extreme price increases in natural gas prices (or commodity prices in general) than creating extreme price falls. Therefore, buyers of natural gas are more likely to want to protect themselves against these adverse price increases by buying out-of-the-money calls, thereby increasing the price and associated implied volatility, for these contracts. This is the opposite of what you would expect to observe in equity markets where investors generally look to protect themselves from extreme share price falls by buying out-of-the-money puts.

Volatility surface applications

In addition to providing a valuable new source of data for valuing vanilla options across a range of strikes for traders, middle office and risk managers, the volatility surface provides a credible alternative source of volatility assumptions for valuing structured transactions and assets (such as gas storage, gas swing and gas fired generation contracts). It will be interesting to observe how the liquidity of the underlying listed options contracts develops. This will be a critical factor in determining the extent to which market participants come to rely on the implied volatility data as a valuation and risk management input.