Algorithms drive oil prices up 6%, yet fundamentals remain weak

Oil markets

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WTI Oct15It only took 2 days for a shocking example to confirm my concern on Monday about the volatility being created by central bank stimulus:

  • As the Wall Street Journal (WSJ) chart shows, a major oil price move took place early in Wednesday’s trading
  • US WTI oil had been trading below $44/bbl, when suddenly prices jumped from $43.92/bbl  to $45.63/bbl
  • This nearly 4% move was almost certainly an algorithm trade from the high-frequency traders (HFT)
  • It caused chaos in the markets as hedge funds then rushed to close short positions, pushing prices up over 6%

Nothing actually happened in the physical market to cause prices to rocket in this way.  A careful search of news media yesterday provides no reason for a panic move such as this.  The latest data on supply/demand fundamentals had in fact been negative:

  • The EIA had reported another rise in US oil stockpiles last week
  • Natural gas prices had tumbled to a 3-year low as stockpiles rose and demand weakened
  • Bloomberg has noted that oil’s other major competitor, coal, is facing “its worst market downturn in decades
  • The end of contango trading (where future prices are above today’s) means inventory is being reduced
  • US and EU distillate stocks are near tank-tops, and EU refinery margins have fallen to break-even levels

Michael Lewis highlighted the problem with HFT activity in his book Flash Boys last year.  They now dominate energy market trading, because they can access vast amounts of virtually free money as a result of the stimulus programmes.  But they perform no useful function for the market:

  • They do not put money at risk to build assets that produce or consume oil and oil products
  • They do not act as a market-maker, always buying and selling to maintain liquidity
  • Nor do they use specialist knowledge to arbitrage the market towards supply/demand balance

What they do instead, is to make guaranteed profits every day of the week, every month, and every year because of their ability to trade millions of contracts in milliseconds.  The CEO of Virtu confirmed in April that they trade 5 million times a day, and have suffered only “one trading day of losses in 6 years” – which was caused by “human error”, presumably someone wrongly programming the computer.

Trading is a zero-sum game.  If the HFTs are making money every day, then everyone else using the markets are losing money as a result.  Even more important is that Wednesday’s oil price action confirms that oil markets are not fulfilling their primary role of price discovery.  Instead, they have become the plaything of those whose only function is to make risk-free profits.

Inevitably, however, something will happen to cause the HFT’s trading to blow up in their faces.  As discussed on Monday,  the number of flash crashes is increasing all the time.  And equally worrying is that the size of the crashes is also increasing.  This will not end well.

 

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