Speculators’ tail wags oil market dog as paper trading dominates

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?

Oil market rally under threat as Doha meeting fails to agree

Naimi Apr16

Yesterday’s failure of the Doha oil producers meeting will hopefully reintroduce a note of sanity into oil markets.  After all, Saudi leaders have made it clear, time and time again, that they were no longer interested in operating a cartel where they take the pain of cutting production, and everyone else gains the benefit of higher prices.

Veteran Oil Minister Ali al-Naimi was quite explicit about this a year ago, saying that:

Saudi Arabia cut output in the 1980s to support prices. I was responsible for production at Aramco at that time, and I saw how prices fell.  So we lost on output and on prices at the same time.  We learned from that mistake.”

And there was a very clear statement from the deputy Crown Prince last Thursday, which made it abundantly clear there would be no deal at yesterday’s meeting:

“If all major producers don’t freeze production, we will not freeze production”

As Iran was never scheduled to attend the meeting, surely it was obvious that no deal was possible?

The Saudis have also been very clear about why they have adopted this new policy.  They recognise that oil, like coal, will end up being left in the ground.  So it makes no sense for them, as the world’s lowest-cost producer, to provide a price umbrella that enables higher-cost producers to monetise their oil at Saudi’s expense.

Naimi has been saying this for years, to anyone who would listen, telling reporters in 2012 in Qatar that Saudi policy was based on the fact that:

“Demand will peak way ahead of supply”

The same message was repeated earlier this month by Saudi’s deputy Crown Prince, who told Bloomberg that the country was now planning for the post-oil world and highlighted:

“His obsession with moving the Saudi economy away from oilAramco’s new strategy will transform it from an oil and gas company to an energy/industrial company”.

Despite these clear statements, oil prices have rallied 50% since January.  But lets be clear.  This move was never based on the improbable idea that a production freeze by Russia and some OPEC members (excluding Iran and probably Iraq), would somehow change today’s 2mbd surplus of oil into a more balanced market.

In reality, the real story has been buying of oil market futures by financial speculators.

They realised during January that the US Federal Reserve was unlikely to follow through with its proposed 4 further interest rate rises in 2016.  So they decided to rewind the clock, and buy up commodities such as oil and copper – repeating the “store of value” trades that were so profitable during the post-2009 US$ devaluation period:

  • At its peak in 2013, $80bn had been speculatively invested in this trade
  • Pension and hedge funds knew that a key purpose of the Fed’s easy money policies was to devalue the dollar
  • And so it seemed obvious that commodities such as oil and copper would do well as potential “stores of value”
  • China’s stimulus policy, which peaked in 2013 at $28tn/year, also artificially boosted commodity demand

And as I noted 2 weeks ago, by the end of March, the funds had built a record long position of 579m bbls in Brent/WTI – equivalent to almost 6 days of global demand

But as the futures market data showed then, the smart traders were already banking their profits and moving on to new opportunities.  The Doha story had done its job, as far as they were concerned.  And they knew that in a weak market, profits come from “buying on the rumour, selling on the news”.


My weekly round-up of Benchmark prices since the Great Unwinding began is below, with ICIS pricing comments:
Brent crude oil, down 58%
Naphtha Europe, down 57%. “Asian price gains were capped by a rising supply of arbitrage material for May at a time of receding Chinese demand for May delivery”
Benzene Europe, down 54%. “Europe remains the highest-priced region for benzene….US Gulf material is now being fixed for export to Europe for May onwards as Asian styrene numbers weaken.”
PTA China, down 40%. “Prices were assessed as mixed week on week, as choppy upstream energy prices caused prices to be volatile.”
HDPE US export, down 31%. “China market outlook is bearish due to reduced buying interest.”
¥:$, down 6%
S&P 500 stock market index, up 6%

Hedge funds exit oil price rally as Saudi plans post-oil economy

WTI Apr16Within 20 years, we will be an economy or state that doesn’t depend mainly on oil“.

This critical statement from Saudi Arabia’s deputy Crown Prince has been lost in the hype surrounding Q1′s hedge fund-inspired rally in oil, commodities and Emerging Markets.  There has seldom been a better example of markets failing to see the bigger picture by remaining focused on day-to-day detail.

But Q2 is likely to see attention return to the fundamentals of oil market supply and demand.  This week’s commodities market data showed the hedge funds were already starting to take their bets off the table.  This is hardly surprising, with prices having jumped 50% in a matter of weeks:

  • Iran is successfully re-entering the market, with its exports to India already up 4-fold since January to 500kbbl/day, and other Asian countries also keen to buy
  • US storage operators are resorting to ever-more desperate manoeuvres to stop their tanks from over-flowing

As I warned last month, the rally had nothing to do with a rebalancing of oil markets – either via major cuts in production, or a sudden increase in demand.  Instead, it was all about the funds betting, correctly, that further stimulus was on the way from the central banks.  As the Financial Times noted:

  • By the end of March, the funds had built a record long position of 579m bbls in Brent/WTI
  • This was equivalent to almost 6 days of global demand

But last week, they began to take their profits and close their positions. Chemical markets thus face major challenges:

  • Prices for the major petrochemicals are highly correlated to crude oil prices – most are more than 95% correlated
  • So sales managers are already busy raising their prices to try and maintain their margins
  • Purchasing managers are meanwhile building inventory to protect their own margins

And they are not alone.  The Q1 rally spread across the commodity sector, and led to major bond and share price rises for commodity exporters and Emerging Markets.  But none of the move was real.  It was simply the hedge funds spotting a short-term opportunity for profit, based on the realisation that another central bank panic was on the way.

So now, as one would expect, the smart funds are not hanging round to see what happens next.  Of course, US oil inventories will reduce as we head into the main driving season.  But fundamentals didn’t drive the rally, and the funds know all-too-well that sudden rallies can disappear as quickly as they appeared.

Attention is thus likely to turn to last week’s 5 hour Bloomberg interview with the deputy Crown Prince of Saudi Arabia. It confirmed, as I have argued for the past 18 months, that Saudi is focused on making plans for the post-oil world and highlighted, for example:

“His obsession with moving the Saudi economy away from oilAramco’s new strategy will transform it from an oil and gas company to an energy/industrial company”.

Companies and investors have to follow market trends, as they cannot afford to be on the wrong side of 50% rallies.  But they also have to recognise that the biggest rallies always occur in bear markets.  Oil’s next move may well be another 50% decline, and as I warned last month:

” If prices collapse again as the hedge funds take their profits, companies will face the risk of bankruptcy as we head into Q3.  They will be sitting on high prices in a falling market – just as happened in January. Only Q3 could be worse, being seasonally weak, and so it may take a long time to work off high-priced inventory”.

Market volatility jumps as Great Unwinding continues

GU 13Apr15

As I have feared, major volatility is developing in financial and chemical markets, as the Great Unwinding of policymaker stimulus continues.  The chart above shows the dramatic increase in the benchmark portfolio since the Unwinding began in mid-August:

  • There was very little volatility from January until August, with prices generally remaining within +/- 10%
  • Volatility then exploded, with prices for Brent oil (blue line), naphtha (black) and benzene (green) falling 50% within a matter of weeks
  • Prices for PTA (red) in China fell 40%, whilst US export prices for HDPE (orange) fell 20%
  • The value of the Japanese yen (brown) also fell nearly 20%
  • And even though the US S&P 500 Index (purple) appears stable, it moved >1% on nearly one-third of trading days in Q1 this year – twice the volatility seen in 2014

The issue, of course, is that markets are no longer anchored by previous certainties.

They still believe central banks will never let stock markets fall – and New York Fed Chairman Bill Dudley duly rushed to support the S&P 500 last week after the weak jobs report.  But in the wider world outside stock markets, companies and investors are not so certain.  Oil markets provide a good example of the contrary views on offer:

  • Shell’s $70bn bid for BG is based on the belief oil prices will return to $90/bbl by 2017
  • The latest forecast from the US Energy Information Agency is for $59/bbl in 2015 and $70 in 2016
  • Goldman Sachs cut their forecast in January from $80/bbl to $42/bbl for 2015, and are now at $40/bbl
  • Citibank and myself both believe over-supply and weak demand will cause prices to fall below $30/bbl

BASF typify the uncertainly surrounding this key issue.  CEO Kurt Bock forecasts prices at $60/bbl – $70/bbl, but cautions that:

Oil and raw material prices are volatile, as are currencies; the emerging markets are growing more slowly; and the global economy is being damped by geopolitical conflict.”

Companies and investors clearly cannot avoid taking a view on the issue.  And the difference between the forecasts is vast in terms of future profitability.

One way to resolve this impasse might be to test strategies against the 3 Scenarios I proposed in my 2015-17 Outlook last November, Budgeting for the Cycle of Deflation.  This could help avoid the risk of an unpleasant surprise in the future.


My weekly round-up of Benchmark prices since the Great Unwinding began is below, with ICIS pricing comments:
Benzene Europe, down 46%. “Slight upward movement over the course of the week, with some cracker turnarounds and recent exports on benzene and pygas helping to balance out regional supply”
Brent crude oil, down 45%
Naphtha Europe, down 41%. “Activity remains low after the Easter holidays with demand for gasoline blending seen to be weak
PTA China, down 34%. “Overall polyester demand in Asia was described as largely flat, with majority of buyers sitting on ample inventories.”
HDPE US export, down 23%. “Prices held steady because of ongoing logistical problems in Houston.”
¥:$, down 17%
S&P 500 stock market index, up 8%

Oil market faces “historic shift” – International Energy Agency

WTI Jan15The above chart highlights one major reason behind my forecast last August that oil prices were about to collapse.  This was that US inventories were so high, storage was starting to run out:

  • Inventory had reached all-time record levels, and was at around 60 days of sales (blue area)
  • And so prices simply had to fall, to start rebalancing physical supply and demand (red line)

Today’s problem is that we now have to clear up the mess created by financial players’ search for their ‘store of value‘.

Oil companies can’t find new oil as fast as central banks can print electronic money, as I discussed last week.  Nor can they suddenly turn off the supply tap overnight, even though it is clear the world now has a major energy surplus.

This is becoming a very serious issue, as the International Energy Agency (IEA) keeps reminding us:

  • In December, it warned that OECD stocks could soon “bump up against storage capacity limits” if there was a mild winter and OPEC decided not to reduce its supply
  • As of today, we are clearly having a mild winter and OPEC has decided not to cut supply – for reasons described in my “pH Report” Research Note
  • Last Friday, the IEA updated its monthly forecast, and it is clearly worried about today’s rising inventory levels

The underlying issue is that the oil market, like China, is moving into the New Normal – or as the IEA describes it, seeing “a historic shift“.  They warn:

The next few years could nevertheless prove a period of reckoning for a market and an industry that, through the course of their 150-year history, have had to periodically reinvent themselves.” 

And remarkably, even the IMF is starting to accept the inevitable.  It has just cut its growth forecasts (again) for 2015 and 2016 – and there will be more cuts to come as the year progresses.

In turn, today’s energy glut creates a potentially major problem in March/April, when refineries shutdown for post-winter maintenance.  Where will the surplus be stored, and who will pay the bill?

We might still have some really cold weather between now and then.  This would make the problem manageable.  But if the weather remains generally mild, someone will have to pay for all the surplus oil to be stored at sea in tankers.

Will traders pay, as they did in Q2 2009, when they stored at least 70 million barrels?  Their incentive was a strong price contango in the futures market, where prices for Q3 were well above those for immediate delivery in March?  But 2015 is not the same as 2009, as demand growth is now falling.

So will producers have to pay?

This may sound a silly idea today.  But investors are currently paying the German central bank (via negative inerest rates) to look after their money for them.  This would also have seemed a silly idea, even 6 months ago,

After all, vast oil purchases by China and financial investors didn’t stop oil prices falling quite dramatically in Q4.  This is why it is quite possible that producers might have to pay someone to look after their surplus crude oil as well.