By John Richardson
HEDGE funds and other speculators had amassed a record amount of futures contracts of 885m barrels by 31 January, according to the Financial Times. These contracts were equivalent to almost nine days of actual, physical demand. And the overwhelming majority of these contracts were “long” – i.e. they were of course based on the assumption that prices in the future would be higher.
The Historical Context
Whilst this is a speculative record, there is nothing new in the overall trend. Speculators have been playing an ever-growing role in the market ever since the early 2000s following liberalisation of rules on speculation, as we wrote in Chapter 3 of our 2011 book, Boom, Gloom & The New Normal.
In summary, we argued that the traditional way of looking at the crude market – measuring real supply and demand by talking to the people who produce and consume oil, and crunching the data on physical supply and demand – had become less and less important.
What had grown in importance, and we contended that this process would continue, was measuring the number and nature of speculative contracts in crude markets at any one time.
The other major point we made in 2011 was that speculators were not bothered about whether a story that was capable of moving markets was actually true. All that mattered was that it moved markets. They would thus pour their support behind “analysis” – and I use that word in inverted commas because it wasn’t really proper analysis – that supported whichever way they had chosen to gamble.
A recent good example of this was the entirely false notion that China and the rest of the emerging world was rapidly becoming middle class by Western standards. This dominated the overall macroeconomic and commodities markets narrative up until September 2014.
What this analysis overlooked was that China’s “economic miracle” since 2008 had been founded on an unsustainable rise in debts, and that China’s average income levels were many miles behind those in the West. This even applies to China’s relatively rich urbanites. For example, government figures show that average per capita urban incomes were just $5,061 in 2016. This would be well below the poverty line in any Western country.
Further, all the evidence well before September 2014 showed the Chinese government knew that its debt-driven growth model was unsustainable. It was also clear that the government had long recognised that its entire economic growth model needed to be dismantled and rebuilt, with major negative short –and medium-term consequences for GDP growth.
The world suddenly woke up this fact from September 2014. The collapse in oil prices – as the physical reality of the market temporarily took hold of pricing again – was also down to another two facts. Firstly, there was the understanding that the rise in US shale oil and the realisation that its production costs would continue to fall. And secondly, markets realised that OPEC, led by Saudi Arabia wouldn’t cut production but would instead pursue a market share strategy.
Before we move on today’s highly questionable story that’s driven oil prices to where they are today, it needs to be stressed that technology has moved ahead since we wrote our chapter in 2011. At that point, computer trading was already playing a major role in markets as algorithms replaced people. Now, though, systems and processes are a great deal more sophisticated – as are the volumes of money involved, as the FT article I linked to at the beginning of this post confirms.
Hundreds of millions of dollars can be moved in and out of oil and other commodity markets in a fraction of a second, based on nothing more than the number of re-Tweets of a story on Twitter. These algorithms are not designed to assess whether a story is true or not because they are built for speed and momentum trading.
As September 2014 reminded us, though, the physical reality of oil prices can very quickly cause the speculators to change direction, leading to major volatility in markets.
The future of oil prices could thus hinge on whether the OPEC cutbacks amount to a real tightening of the market. As fellow blogger Paul Hodges points out in this post, US shale oil production has risen, with the potential for a major further increase. On the details of the OPEC cuts, he adds that the burden has been overwhelmingly shouldered by Saudi Arabia. What will therefore happen if Saudi Arabia changes course?
Energy consultant and former White House national security advisor Robert McNally also says in this second FT article:
Some believe recent pledges by OPEC and Russia to restrain production mark the return of supply management. Hardly. Since these producers began talking about restraint last February, they added around 1.4m barrels per day to the glut.
Their recent pledges to trim production from historically high levels resemble ad hoc, collective supply restraint agreements that sprang up occasionally since oil’s earliest days by producers spooked by price busts.
But, as I said earlier, speculators are not bothered about whether a story is true. All that matters for them is that it supports their existing positions and moves markets further in the long or short directions that they have chosen. They are therefore supporting the narrative that the OPEC cuts will be deep and long lasting enough to drive crude prices higher.
Equally – as the first FT article I linked to above also says – they back the view that the Trump White House’s infrastructure spending and tax cut policies will be good for the global economy, and so crude demand. But what about the Trump administration’s trade policies? They risk a global recession in 2017.
What Petrochemicals Companies Need To Do
Petrochemicals companies must not be swayed by all the speculative noise in today’s market. They should instead look at the real data on crude supply and demand, and put this data into the context of all of the risks ahead.
This will lead companies to these three scenarios for 2017:
- Prices average around $30/bbl as the global economy enters recession because of a US-China trade – and as producers, unable to support prices through output cuts, chase markets share.
- Oil averages around $60/bbl on a stable global economy and fairly effective supply cuts.
- Prices instead average around $90/bbl on geopolitical crises. The global economy is in already recession, which is deepened by expensive crude.