Gambling on oil: The price the market pays

OPEC Bulletin Commentary April 2015

When international crude oil prices fell by over $50/barrel between June 2014 and January this year, many industry commentators were quick to lay the blame squarely on growing oversupply in the market. Yes, a surge in non-OPEC supply, during weak demand, was the main culprit. But there was one other important factor that contributed to the downturn, especially as the price decline gained momentum. And that was speculation.

As OPEC Secretary General, Abdalla Salem El-Badri, stressed to the media at recent industry events, the Organization did not believe that actual market fundamentals warranted the almost 60 per cent drop in prices witnessed during that period. He stressed that it was clear that speculators had also played a role in the fall.

But this phantom of the energy markets is nothing new. OPEC has long warned of the actions of speculators as they ply their trade on the various energy exchanges around the world. These playmakers, that comprise many entities, thrive on risk and opportunity and are driven by the prospect of making maximum profit out of minimum exposure. When the conditions in the market are ripe, they ghost onto the trading stage. Like puppeteers, they pull the strings from the wings, manipulating positions and unsettling what are already delicate and often precarious trading environments. Prowling the exchanges, they are quick to exploit any situation that can bring them the desired big pay day that feeds their burning ambition and bank balances. They can be unscrupulous, at times ruthless, especially when the stakes are high.

Commodity exchanges, by their very nature, are complex undertakings. They are extremely active with countless daily toing and froing of positions and prices. But the procedures speculators follow in ‘working’ the market to their advantage fall under one simple aim — to buy at the lowest price, bid it up and sell at the highest. A golden opportunity presents itself to these ‘investors’ when crude oil prices fall suddenly, as has been the case most recently. At the opportune time, they flood into the market and buy up massive quantities of so-called paper barrels, of course at the lowest price possible. It is then a case of sitting patiently on their acquisitions and waiting for the price to rise again — as it invariably does — before selling at a handsome profit. It is not uncommon for such speculators to make millions of dollars on just a single paper contract.

Interestingly, this type of speculator never takes physical possession of actual barrels of oil. It means that in any given trading day the oil futures markets can routinely trade more than one billion barrels of oil — even though actual global supply is a fraction of that at around 92.5m b/d.

Another way speculators are operating today is through the actual purchase of the low-priced crude barrels, which they hold in storage at sea. Then, when oil prices move higher, they sell the oil on, pocketing huge profits.

The actions of speculators can also drive the price lower. As the OPEC Monthly Oil Market Report (MOMR) observed in September last year, while prices were falling, hedge funds and other money managers chose to reduce their net long positions in ICE Brent and Nymex WTI futures trading by a hefty 73 per cent and 45 per cent, respectively, exerting even more downward pressure on prices.

Today, energy exchanges are a hive of activity as speculators seek to take full advantage of the volatility of crude oil, which has increasingly become a new asset class.

Figures from asset manager, BlackRock, show that in the first quarter of the year, investors, chasing an oil-price rebound, channelled more than $8bn into energy exchange traded products (ETPs). This amount is more than what has been seen in the last five years put together!

And a Reuters study in February showed that average trading volume across Brent futures was showing a 42 per cent increase over 2014, while the volume for US benchmark WTI had soared by more than 50 per cent. As a result, oil volatility had jumped to its highest level since the financial crisis, it observed.

All in all, little wonder oil market instability, fragility and price volatility are so rife.

Under the age-old businessman’s creed, one is encouraged to speculate, so as to accumulate. And there is nothing wrong with that. But surely the extent of one’s trading activities should not be to the point where the very structure of the market you are working in is distorted and destabilized.

In the case of the world’s commodity exchanges — whether energy, metals, or agriculture — it is the fundamentals of supply and demand that should be dictating how prices perform. Sadly, under the current trading environment, which is engulfed in the now all-familiar culture of greed and self-interest, this is not the case. And it has not been so for some considerable time.

The other alarming aspect to consider is that it is difficult to gauge just what premium is added to energy prices as a result of speculator activity. Various commentators say it can be anything from $10/b to $30/b, even more when conditions allow.

The fact is that hedge funds and speculators need prices to oscillate to make their profits, which literally run into billions of dollars. The stability that OPEC and other energy stakeholders seek is of no help to them and severely limits their scope for gain.

OPEC’s El-Badri has repeatedly said at international fora that an oil market without some level of speculation will never exist. But there are limits as to what is healthy trading and what is excessive and irresponsible. Perhaps the regulators that govern the world’s energy exchanges need to take another long, hard look at the activities of these moneymen, who it is clear are doing a lot more harm than good in conducting their everyday business.

OPEC for one would certainly welcome such a move.

OPEC Bulletin April 2015

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