High-frequency trading distorts oil markets

Oil markets

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Brent 23Mar12.pngA blog reader has kindly forwarded an important UNCTAD paper (UN Conference on Trade and Development), analysing the growth and impact of high-frequency trading (HFT) on oil and financial markets.

It provides important “new evidence regarding the financialisation of commodity markets”. These are now driven by computers which trade in micro-seconds, creating correlation trading which means no single market now knows what it is pricing.

The chart illustrates these trading strategies in action last Friday:

• Reuters reported a 300kbpd drop in Iran’s oil exports due to sanctions
• Computer trading then led oil futures volume to jump (green column)
• The price surged $3/bbl (2%) in 3 minutes (red highlight)

The computers are programmed to trade on news reports. Thus it is no surprise the market spiked. Yet this was confirmation, not real news. Anyone following the Iran issue would have known weeks ago that its exports would be lower due to sanctions.

HFT would not be a problem if it was supporting the price discovery function. This, after all, is the prime purpose of financial markets. But it actually has the opposite impact. Even on Friday, it meant that prices ended $1/bbl higher than at the start of the day. Thus UNCTAD conclude:

“As commodity markets become more financialised, they are more prone to external destabilising effects. In addition, their tendency to deviate from their fundamentals (of supply/demand) exposes them to sudden and sharp corrections”.

A month ago, the blog suggested companies should be very cautious about chasing oil prices higher. It also noted that the market was worryingly similar to that seen in July 2008, and added:

“The only prudent course, as the outcome is essentially unknowable, is to hedge both possible outcomes:
• Most companies will by now have put hedges in place against higher prices, as part of their contingency plans. If oil now heads higher out of the triangle, then they have covered this risk.
• If prices fail to break higher, then their next step might instead be to use today’s higher prices as a platform for opening new hedges to guard against the downside risk

A month later, given that prices seem indeed to have stalled at the $125/bbl level, it sees no reason to change any part of its analysis.

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