Speculators’ tail wags oil market dog as paper trading dominates

Oil markets

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WTI futures Jan17aTrading oil markets used to be hard work.

You had to talk to all the major players all the time (not just message them), and learn to judge whether they were telling the truth or inventing a version of it.  You had to watch for breaking economic and political news.  And you needed your own supply/demand balances.  Plus you had to guess how the fabled  “Belgian or New York dentist” – who traded oil futures to break the tedium of drilling teeth – might be feeling each day.

Today’s trading world is completely different:

   More than half of all trading is done by machines at ultra-high speed.  These are the “legal highwaymen” described in Michael Lewis’ great book Flash Boys. And they don’t care about the real world of oil markets or the economy, as these factors are irrelevant to their business models
   Then you have the hedge funds, and even some pension funds, with quarterly targets for profit.  They can’t afford to spend time developing a detailed analysis, and waiting for the market to catch up.  They have to play the momentum game of finding a story, and jumping on it as quickly as possible
   In addition, of course, there are still producers and consumers, who actually need to buy or sell oil.  They used to set the market prices in the past, but are just an also-ran today as their volume is so small relative to the others.  But in the “real world” outside of financial trading, they are the only people who matter

New data from the CME highlights the change.  It shows paper trading in just WTI futures averaging a record 11 million contracts each day in 2016 (each of 1000 barrels).  Actual physical production, by comparison, is around only 92 million barrels per day.  The speculative tail is indeed wagging the dog.

The chart above shows the current net position of the speculators, which is at a record 371k contracts.  It highlights just how much they love the OPEC production cut story – it is easy to understand, and is easy money for everyone, particularly the momentum traders, as the story seems never-ending.

OPEC Feb17The only problem – for players in the real world – is that the “story” isn’t true.  Today’s headlines may say that OPEC has 82% compliance, but this was only because of Saudi Arabia – which cut 564kb versus the promised 486kb, according to the Reuters data above.  Outside the GCC countries, not much happened.  Venezuela – which led lobbying for an output cut – delivered only 18% of its promise, and Russia only cut 117kb versus its promised 300kb.

“Who cares?”, you might say, if you are one of the highwaymen or a momentum trader.  Talk is cheap, and you can tell the media it is early days, and countries take time to adjust.  They love an easy story, just as you do, and believe their viewers want a quick trading tip – not a boring discussion about rising US inventories for oil (up another 6mb last week) and gasoline inventories (now actually above the upper limit of the normal seasonal range).

You certainly don’t want to dive into the detail of rising US shale production (already back at April’s level), and rising numbers of drilling rigs (back to November 2015 levels). And you certainly won’t discuss the 5300 drilled but uncompleted oil/gas wells, where producers only have to turn the tap to start earning revenue.

Well, not just yet, anyway.  Maybe in a week or two, it might be time to learn a new script.  After all, “what goes up, comes down”.  The dream scenario for the paper traders would be if today’s major rally was followed by a major collapse.  After all, the refinery maintenance season will soon be starting, causing physical demand to drop.

Of course, all this volatility has a price.  The market is a zero-sum game where overall, the consumer and the producer pay the cost of the speculator’s outsize profits.  And in the geo-political world, there is one major loser – Saudi Arabia.

The Saudis know that President Trump doesn’t support the ‘Oil for Defence‘ agreement made 70 years ago, which protected them in 1990/1991 when Iraq invaded Kuwait. So they have to stay close to the other OPEC members, and make the major share of the cuts.  But what will happen in Saudi, if and when prices fall back – say to the $30/bbl level seen a year ago?

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