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Financial players have destroyed price discovery in oil markets

Oil markets
By Paul Hodges on 09-Dec-2014

Brent Dec14Oil prices should be set by the balance of supply and demand.  But as the chart shows, oil markets have instead become dominated by financial players, as pension and hedge funds decided to buy oil as a “store of value“.

Before 2000, financial market volume (red line) had been roughly equal to annual oil production (green line).  This worked well, providing physical players with sufficient liquidity to enable price hedging to take place.

But in 2000, after the dot-com crash, central banks stopped focusing on the need to defend the value of the currency – previously their main role.  Instead, they refocused on trying to maintain economic growth.  And they began to use their new weapon created in the dot-com revolution, the power to print ‘electronic money’.

The chart shows how this has played out.  Unfortunately for all of us, central banks couldn’t resist the temptation to play with their new toy.  They came to believe it had near-magical powers, and could control the economic cycle.

After the Crisis began in 2008, they even gave it a new name “Quantitative Easing” (QE).  And central banks around the world began to use it to print trillions of dollars.  Unsurprisingly, of course, this had side-effects.

One was that US pension and hedge funds realised very quickly that QE was also a way to devalue the US$.  They therefore rushed to invest in oil markets as a supposed ‘store of value‘.

What they didn’t realise was that this created a massive imbalance of financial versus physical market demand.  Producers couldn’t suddenly double their production at the touch of an electronic button.  Financial sector demand simply overwhelmed physical supply:

  • Hurricane Katrina in 2005 had already shown the potential for this type of speculation to occur
  • By the time US refineries were operating again after it, financial trading was 4x physical production
  • By 2011, with the support from QE,  financial players were trading the equivalent of 6x physical production

Thus financial market demand came to dominate physical demand, and prices leapt skywards (blue line).  The physical market’s key role, that of price discovery, was destroyed.

Many analysts failed to make the linkages, and instead claimed these high prices were justified by reduced supply or increasing demand.  But as we know today, there has never been any physical shortage of oil since the Crisis began.

Instead, what is now becoming obvious is that the collapse of the price discovery process led producers to over-invest and create an energy glut.

There are two key issues that will now determine future prices:

  • One is that gas has been increasing its market share at oil’s expense, as I will discuss tomorrow
  • The second, as I will discuss on Thursday, is Saudi Arabia’s need to ensure the 1945 US/Saudi ‘oil-for-defence agreement’ continues

We are in for a very bumpy ride, as oil prices return to being based on their own supply/demand fundamentals.