In those days – even 20 years ago, as the chart shows – the role of the speculators on the futures markets was very small. They were often wealthy individuals who liked gambling against the professionals. And since the professionals tended to “group-think”, a contrarian view could sometimes provide big profits at the industry’s expense.
Today, however, the world has turned around 180 degrees. Free money from the central banks has destroyed markets’ role of price discovery. Instead, speculation rules and the fundamentals of supply/demand no longer seem to matter on a day-to-day basis:
So far this year, trading in just the WTI futures contract has averaged nearly 10x physical volume
And these aren’t individuals betting their own money as a hobby
The main volume is from hedge funds with deep pockets – who aim to earn their bonus at the end of the year
The difference in approach can be seen with reference to the above chart from the International Energy Agency. It shows the truly dramatic increase in OECD inventories over the past 2 years – at a time when the IEA calculate that OPEC oil production has been steadily climbing to reach “an all-time high” of 33.6mbd.
High inventories and record OPEC production levels would not have been a recipe for price rises in the past, especially when the IEA add that:
“The lower price environment has also forced companies big and small to cut costs and do more with less. As a result, non-OPEC supply is expected to return to growth next year.”
But this is not the world in which we are living today. The hedge funds have free cash from the central banks, and it is getting close to bonus time at year-end. So they need a “story” that will create enough volatility for them to make a profit. And as the 3rd chart shows (of speculative purchases on the futures market), they have found one in the idea that OPEC and Russia will agree a deal to bring the oil market back into balance:
In just 2 weeks, they have bought 100 million barrels of oil (a contract is 1000 bbls) – more than daily production
They have also been busy buying gasoline, even though we are now well beyond the end of the US driving season
The result has been that oil prices have jumped by $6/bbl – despite OECD inventories and OPEC production being at record highs
The issue is that the hedge funds are operating in a parallel universe where financial flows, not product flows, rule.
They don’t care whether the oil market is long or short, or whether there is really any chance of OPEC agreeing substantial output cuts. Nor do they have any interest in speculating whether OPEC and Russia might agree a deal. That is not their business, and not how they make money.
They are paid simply to take free cash from the US Federal Reserve, and to invest it where they can make the most money, as quickly as possible. In terms of the oil market, they are therefore part of the “post-fact economy”, where the details of supply and demand, and inventories, simply don’t matter. If they can make $6/bbl in 2 weeks on borrowed money, why should they care?
Whether the rest of us should care is another issue.
The answer depends on whether one worries about what might happen when the hedge funds decide the party is over, and move on to a new hunting ground:
In the past, policymakers would certainly have cared. As former Fed Chairman, William McChesney Martin, used to argue, the Fed’s job was “to take away the punch bowl just as the party gets going”
But they too, now live in the “post-fact economy”, and believe “the world is different this time” because they are able to print electronic money
Oil markets are therefore living in the world of the South Sea Bubble, the Dutch Tulip Mania and the Mississippi Company, where speculation is allowed to rule. These rallies are fun whilst they last for those riding the wave, but you don’t want to be on the wrong side when the party ends.