Volatility continues to dominate oil markets, as the above chart confirms. Some weeks have seen prices move by over 18%. These are extraordinary moves in a market which is very well supplied, with near-record inventory levels. Some recent daily moves are equally extraordinary, with prices jumping $2.50/bbl on Tuesday.
The volatility highlights the power of the futures market to temporarily overwhelm anyone trading on the basis of physical supply/demand. As I noted last month, futures trading in just the WTI contract has averaged around 10x physical volume. So prices can take wild swings, without anything happening in the “real world” – especially when the automated high frequency traders get involved with their media-led algorithms.
Tuesday’s move, for example, was caused by speculators buying 300 million barrels of oil via call options (betting that the price would be higher in H1 2017) – over 3x daily physical volume. This was why the price soared.
The speculators particularly love “stories”, as these are impossible to prove or disprove. So the story this year about an OPEC/Russia production agreement has been perfect for their purposes. It is the “gift that goes on giving” as one major player told me. But at some point, probably quite soon, the story will run out of road – you can’t keep bouncing prices around forever on speculation, if nothing ever happens.
It therefore seems worth looking at the 3 key questions that will need to be answered by the end of this month, if the promised production agreement is to mean anything tangible. As always, this week’s Monthly Oil Report from the International Energy Agency provides valuable input:
Will there be an OPEC cut? It is very easy to talk about stabilising output at today’s level, given it is currently at record production. The IEA’s view on OPEC output is clear:
“OPEC crude output rose by 230 kb/d to a record 33.83 mb/d in October after production recovered in Nigeria and Libya and flows from Iraq hit an all-time high. Output from the group’s 14 members has climbed for five months running, led by Iraq and Saudi Arabia. In October, OPEC supply stood nearly 1.3 mb/d above a year ago.
“It has only been two months since OPEC last met in Algiers and announced it would examine how to set up a production ceiling of between 32.5 mb/d and 33.0 mb/d. OPEC also said it would seek to bring leading non-OPEC producers into the process. We can’t predict the outcome of the 30 November meeting, but we can see the scale of the task ahead. In this report we estimate that OPEC members pumped 33.8 mb/d in October, well in excess of the high end of the proposed output range. This means that OPEC must agree to significant cuts in Vienna to turn its Algiers commitment into reality.”
Would non-OPEC countries make a cut? Again, the IEA is clear:
“Unfortunately for those seeking higher prices, an analysis of the other components provides little comfort. The world’s biggest crude oil producer Russia will see its output increase by 230 kb/d in 2016, and sustained production at current record levels would result in growth of nearly 200 kb/d next year. With production also expected to grow in Brazil, Canada and Kazakhstan, total non-OPEC output will rise by 0.5 mb/d next year, compared to a fall of 0.9 mb/d in 2016. This means that 2017 could be another year of relentless global supply growth similar to that seen in 2016.”
What would happen if production was cut, and prices then rose to, say $60/bbl? The head of the IEA gave their view in a Reuters interview on Wednesday:
“U.S. shale oil producers will increase their output if oil prices hit $60 a barrel, meaning OPEC will have to walk a fine line if it curtails production to prop up prices. OPEC members are due to meet in Vienna at the end of the month to push through the first output limiting deal since 2008. If this decision pushes the prices up (to) around $60/bbl, we may well see a significant increase from shale oil from the U.S. This level would be enough for many U.S. shale companies to restart stalled production.”
It is therefore clear that OPEC has an uphill battle ahead of it. Of course, it is great fun, and highly profitable, to simply “wave away these facts” if you are a trader trying to profit from the “story”. But this is a zero-sum game: in other words, the trader’s profit is someone else’s loss. They are simply making money for themselves, and leaving the rest of the market to pick up the bill.
Of course, it is possible to believe that that OPEC and Russia will be forced by the downside risk to make real, and major cuts. It is also possible to believe that “this time will be different”, and that most OPEC members won’t immediately cheat on the new quota, if an agreement is reached.
Clearly every business that uses significant quantities of oil needs to prepare a Scenario analysis of the possible outcomes from the OPEC meeting. And this analysis needs to be realistic about the probabilities of success. Does OPEC have a 90% chance of reaching and enforcing an agreement? Is it a 50% chance. Or is the whole story merely wishful thinking, with just a 10% probability of happening? You have to make your own judgement.
Equally important, of course, is that you then spend time thinking about what would happen to your business and investments in each of these Scenarios: if (a) prices rise to $60/bbl (b) stabilise around today’s levels, or (c) collapse below $30/bbl? It is essential that you spend time debating these possible outcomes today, and planning how you would respond to them.
The key issue is that today’s oil market not being run for the benefit of people who actually use or produce oil. The speculators couldn’t care less who does well, or who goes bankrupt, as a result of their activity. They simply want to make the maximum amount of money for themselves, as quickly as possible.
Essentially, therefore, it is best to see today’s market as a very high stakes poker game. And as any good poker player knows, “If you don’t know who is the fool at the table, then its probably you“.
It 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.
Central banks have acted as the proverbial tooth fairy towards financial markets in recent years. But they have not just left a small amount of money under the pillow when a child lost its first tooth. Instead they have printed trillions of dollars via Quantitative Easing (QE), to persuade investors to buy shares and commodities, and drive prices ever-higher.
Their justification for this strange behaviour was a belief that this would create a wealth effect, and so somehow restore the economy to its BabyBoomer-led peaks. But now the Great Unwinding of these stimulus policies is underway, starting in China. And so prices on major world stock markets are falling as they return to more normal methods of valuation.
Of course, now they are falling, those who made fortunes in the market from QE are starting to complain. One obvious target are the high frequency traders, whose computer-led trading based on algorithms now accounts for more than 50% of daily trading in many markets. But investors never complained when these same strategies were taking prices ever-higher. It is only now, when bonuses are under threat, that reality is starting to dawn, as JP Morgan wrote last week:
“These technical factors can push the market away from fundamentals. The obvious risk is if these technical flows outsize fundamental buyers.”
Such trading strategies should never have been allowed in the first place, as these “legal highwaymen”add nothing to the process of price discovery – which is the fundamental purpose of any market. These complaints are just noise, however, hiding the real issue – which is shown in the chart above from Nobel Prizewinner Prof Robert Shiller.
It highlights how this central bank support means share prices are now valued at levels well above historical levels, according to his tried and tested Cyclically Adjusted 10 year Price/Earnings ratio (CAPE):
- They are valued at levels previously only seen in recent times in 2000 and 2003-7
- This, of course, parallels previous central support during the dotcom and subprime bubbles
- In turn, this support led to the surge in margin debt used to finance share buying, as discussed last week
- Now, of course, the Great Unwinding of all all this debt is underway
The key question is how to know what real fundamental value should be for shares. Luckily, a simple formula provides the answer to this question. Shiller, like Warren Buffett and many others including myself, is a follower of Ben Graham’s work. Known as the ‘Father of Security Analysis’, Graham developed a simple formula to explain the relvance of the Price/Earnings ratio:
- He showed that a P/E ratio of 8.5 meant markets were expecting zero earnings growth over the next 10 years
- Each 2 point change, up or down, meant they expected earnings to rise or fall by 1% a year for the next 10 years
Thus today’s CAPE ratio of 24.5 means investors are expecting S&P 500 earnings to rise by 8%/year till 2025. Yet earnings are already at near-record levels, so this is clearly impossible. (For a fuller analysis by the Harvard Business Review of Graham’s pioneering work, and its confirmation during the 1987 stock market crash, please click here.)
Analysis can only tell you where you are in the cycle. It cannot tell when a reassessment will take place. But certainly China’s New Normal policies seem to have broken the myth that markets can only go higher. Markets are now looking very fragile indeed, especially as investors worry that the Janet Yellen tooth fairy may have other things on her mind, as I noted last week:
“More QE is needed if stock markets are to move higher. But this could be a very risky move in a US Presidential election year. Populist candidates such as Trump and Sanders might well ask what had happened to the $4tn the Fed has already spent on QE since 2009.”
Over in Europe, ECB President Mario Draghi confirmed on Thursday he is happy to provide his share of the cash. But how easy would it be for the US Federal Reserve to reverse its current course? They have said their next move will be to increase interest rates – and nothing in Friday’s jobs report gave Ms Yellen any excuse for further delay.
It could be quite a volatile autumn if the tooth fairy fails to appear.
WEEKLY MARKET ROUND-UP
My weekly round-up of Benchmark prices since the Great Unwinding began is below, with ICIS pricing comments:
Brent crude oil, down 52%
Naphtha Europe, down 52%. “Europe’s naphtha traders are keenly watching macroeconomic data coming out of China but are expected to keep sending volumes east because of excess regional supply.”
Benzene Europe, down 60%. “With price drops reminiscent of late 2008, there is still some uncertainty among industry players concerning market direction for the rest of the year”
PTA China, down 46%. “Winter clothing demand had set in later this year because of the slower economic performance in China, such as stock market volatilities and lower economic growth”
HDPE US export, down 35%. “Domestic export prices slipped a little on the general market trend toward lower prices.”
¥:$, down 16%
S&P 500 stock market index, down 2%
Whisper it quietly to your friends in the futures markets, who are convinced oil prices will soon surge higher. We don’t want to upset them as they work at their spreadsheets, and send their electronic trades down specially constructed lines at near the speed of light.
But global oil demand growth has already more than halved at just 0.6%/year. And as the latest International Energy Agency monthly report notes (their emphasis):
“OECD industry oil stocks built by a steep 38.0 mb in April, to stand 147 mb above average levels, as refined-product stocks moved to their widest surplus in over four years.”
That really is quite a lot of surplus oil. And the US is doing particularly well at building surplus inventory, as the chart shows. Its levels remain at record highs, with the latest weekly figure 13% higher than a year ago.
Last week also saw the publication of BP’s annual Energy Statistics review. It showed that US oil and gas production remains on a steep upward curve:
- Oil production has been rising at an annual rate of 9%/year since 2009 (green line)
- Oil consumption has actually been falling slightly over the same period
- Vehicle miles travelled per driver is back at 1995 levels, whilst autos have also become more fuel-efficient
- Meanwhile gas production has been rising 4.5% over the same period (blue line)
- And it, of course, is still much cheaper than oil on an energy equivalent basis
- So the trend of fuel conversion from oil to gas remains very attractive, with lower prices and abundant supply
There is also the great irony that the flow of funds betting on higher oil prices is actually allowing more oil to be produced, not less. As the Wall Street Journal has reported:
“Wall Street’s generous supply of funds to U.S. oil drillers helped create the American energy boom. Now that same access to easy money is keeping them going, despite oil prices that are languishing around $60 a barrel.
“The flow of money into oil has allowed U.S. companies to avoid liquidity problems and kept American crude production from falling sharply. Even though more than half of the rigs that were drilling new wells in September have been banished to storage yards, in mid-May nearly 9.6 million barrels of oil a day were pumped across the country, the highest level since 1970, according to the most recent federal data.”
The oil cartel OPEC have similarly been taking advantage of their generosity, producing 1mb/d above its quota in May, and 1.8mb/d about its forecast for demand.
The problem is that a whole generation of oil traders have never known a period when prices were set by markets, not central banks. They therefore assume these vast surpluses can therefore somehow be wished away. But instead, their money is leading to a bigger bust for oil prices down the road, not the boom that they expect.
The amount of cash being poured down holes in the ground to produce more oil is vast – $16.7bn of secondary equity offerings took place in Q1, the highest since the boom began in Q3 2010. And at the same time, the drilling companies are becoming much more efficient in their operations.
In the Eagle Ford field, for example, Statoil has cut its drilling rigs from 3 to 2, but still lifted production by a third. As it notes, “necessity teaches the naked woman to knit”, and in this case the necessity is clear:
“We can’t control the commodity prices, but we can control the efficiency of our wells. The industry has taken this as a wake-up call to get more efficient or get out.”
Investors who continue to ignore these developments will get a wake-up call of their own one day, as the oil price resumes its decline to historical price levels around $30/bbl.
An astonishing coup appears to have begun 10 days ago, in the last 45 minutes of trading in US oil markets. Yet we still don’t know who master-minded it, or their full objectives. .
What happened to oil prices? Prices jumped 8% in the last 45 minutes of trading on Friday 30 January, taking Brent to $53/bbl and US WTI to $50/bbl. And by Tuesday they had surged still higher, taking Brent to $59/bbl and WTI to $54/bbl. This meant prices had risen 20% in just 2 days.
This would be astonishing at any time, in any major financial market. But it is almost incredible in today’s oil market.
Prices have surged even as the US has been reporting record levels of oil inventory, as the chart shows. Last week, they were the highest-ever seen since records began in 1982. And US oil production of 9.2mbd is also at the highest level since records began in 1983.
Clearly the people who master-minded the coup knew what they were doing.
How did it all happen? Traders were winding down at month-end, and leaving their offices early on the Friday afternoon ahead of the SuperBowl weekend. A record 114 million Americans were planning to watch the American football final. And large numbers were planning viewing parties for friends, family and colleagues.
Suddenly, a flood of “buy orders” appeared in the last 45 minutes of trading. With trading volumes low, the buyers concentrated their firepower and achieved spectacular results. This was clever enough and, of course, entirely legal.
But even cleverer was the way that suddenly “a story” was created to explain why prices needed to go higher. Most people, after all, would think that an all-time record level in inventory meant the market was very weak – particularly as the peak was taking place in January, normally a major month for consumption.
Instead, a story appeared from nowhere that focused on the decline underway in the number of active drilling rigs in the USA. This was spun to suggest it was, as the Wall Street Journal reported, “a sign that crude production may be starting to ebb“.
Who benefits from the surge? The clear winners are the people who developed the concept for the coup and implemented it so effectively. They obviously had deep pockets to fund their market raid, and also extensive knowledge of how to drive it higher in a matter of moments. As Reuters reported on Friday:
“People have only started paying attention to the oil rig count in the past week despite the fact they have been falling for weeks,” said Gene McGillian, analyst at Tradition Energy in Stamford, Connecticut. “I think the people really benefiting from these market gyrations are the high frequency traders (HFT) as volumes are really up.”
Creating “a story” around the rig count was critical, as it meant the HFT traders (who usually provide 50% or more of trading volume), had the necessary news feed for their algorithms to operate. Their volume on a quiet Friday afternoon would overwhelm any trading done on the basis of supply/demand and inventory levels.
Of course, the other people who benefit are oil producers in the US and elsewhere. Most of them will have active trading organisations either in-house, or on contract, in order to manage their sales.
What happens next? We will find out this week. If it was a group of traders, then they will likely step back, having made such a large gain in such a short space of time. They would be foolish to stay in the market, and risk attention turning back to the dire state of the supply/demand balances.
But if it was one or more of the producers at work, then we will likely see further efforts to build on the momentum created. They will need to widen ”the story” to suggest that the energy ”glut” reported by the International Energy Agency is now about to magically disappear.
Hopefully one of the major news media will follow-up and tell us what is really happening.
WEEKLY MARKET ROUND-UP
My weekly round-up of Benchmark prices since the Great Unwinding began is below, with ICIS pricing comments:
Benzene Europe, down 59%. “Some tentative upward momentum was seen from derivative markets, but there was still no cause for bullishness due to healthy availability in the region”
Brent crude oil, down 46%
PTA China, down 43%. ”Polyester demand weakened significantly in the latter half of the week”
Naphtha Europe, down 43%. “A prolonged strike at US refineries could drive up demand for crude and oil products in Europe although there is mixed reaction to the industrial action in the markets so far”
¥:$, down 16%
HDPE US export, down 26%. “Prices remained mostly stable during the week”
S&P 500 stock market index, up 5%
In olden days, highwaymen would hang around stagecoach inns, waiting to see when wealthy people were travelling. Then they would hide out along their likely route, getting wet and cold, in order to take their cash.
Today the arrival of electronic trading has changed all this. High-Frequency Traders (HFT) now have computer programmes to act as their lookouts, and ultra-fast connections that mean they are sure to out-run their prey.
Even better is the fact that none of their trading activities are illegal. and there is no risk of being hung. In fact, many naïve regulators have even argued that HFT helps investors by providing liquidity. But this is not the liquidity of the old market-makers, who had to continue buying if the market crashed.
If you want to know more about how they do it, then you must read Michael Lewis’ new book, Flash Boys. He shows that their business model is very simple in concept:
- They place small buy and sell orders for every single stock traded on the exchange, at market prices
- When a large buyer or seller arrives at the exchange, this bait is traded, confirming the prey has arrived
- Immediately, the HFTs then rush to other exchanges to cover the full order ahead of the actual seller/buyer
- When the real order arrives, they then lock in a guaranteed profit
And yes, it does seem to be guaranteed. Unlike any other trader or investor, the HFT doesn’t take any risk to earn his money. As Lewis documents:
- The CEO of HFT firm Tradebor said in 2008 ”his firm had gone four years without a single day of trading losses“.
- Whilst last year, Virtu Financial boasted that it had suffered just one day of trading losses in five and half years. It added the loss was caused by “human error” – presumably someone wrongly programmed the computer
Unsurprisingly, the HFTs have come to dominate the markets in which they trade, as Lewis notes: “From 2006 – 8, HFTs share of total US stock market trading doubled from 26% to 52% – and it has never fallen below 50% since“.
And their profits are huge, running into billions of dollars:
- Thus the HFTs were happy to pay $40k/month to NASDAQ and the New York Stock Exchange (NYSE) for use of a computer line that cut 2 microseconds off their trading time. No ordinary investor would care about saving 2 microseconds in dealing time
- Equally revealing is that the new NYSE data centre is nearly 10 times larger than the old building on Wall Street – which housed all the floor-traders. The reason is that NYSE can charge the HFTs for “co-locating” their computers next to the exchange, saving them valuable milliseconds of trading time
Then there is Lewis’ story of Spread Networks. In 2010 it laid 827 miles of fibre optic lines on the straightest possible route between Chicago and New York. This ended up reducing round-trip trading time to just 13 milliseconds (the theoretical minimum is 7 milliseconds). By comparison, your eye takes 300 – 400 milliseconds to blink.
Spread was then able to charge each HFT user an amazing $10.6m on a 5-year contract. With added costs of signal amplifiers etc, they expected the line to generate $2.8bn revenue over 5 years, with Spread deliberately limiting the number of users to just 200 to add further competitive advantage for users.
The HFTs risk-free profits are obtained legally. But someone has to pay the bill for them. That someone is clearly the ordinary investor, or the employee investing her money in a pension fund.
The blog has written many times over the years about high frequency trading, and the damage it is causing to the integrity of financial markets. But it was still amazed, and surprised, by some of the revelations in Lewis’ book. Superbly written, and never dull, you will find it hard to put down once you start reading.
The blog lives in hope that its global impact may finally force regulators to act to restore true liquidity to the markets.
Benchmark product price movements since January 2014 are below, with ICIS pricing comments:
PTA China, down 11%. “Several Chinese producers were considering to export PTA cargoes in the near term, and were studying the feasibility,”
US$: yen, down 2%
Brent crude oil, flat
Naphtha Europe, up 2%. “Demand from Asia continues to draw upon volumes, although at lower levels than previously seen”
S&P 500 stock market index, up 2%
HDPE US export, up 6%. “Prices are too high to work in most global markets”
Benzene, Europe, up 7%. “Domestic prices remain structurally high compared to key downstream markets”