Oil prices explode then implode
The recent surge and then collapse in oil prices can be explained by a combination of medium-term fundamentals, additional stress caused by the disruption of Russian oil exports and a severe lack of liquidity.
Most bubbles are fueled in their early stages by medium-term fundamentals and then a short-term trigger, before internal market dynamics take over and drive the final unsustainable rally and subsequent correction.
Recent movements in oil prices are consistent with this pattern, which has been observed across multiple financial and commodity markets (“Irrational exuberance”, Shiller, 2005, and “Narrative economics”, Shiller, 2017).
In this case, the medium-term backdrop has been the rapid recovery of the global economy and oil consumption from the first wave of the pandemic, while OPEC+ and US shale companies have slowly resumed production.
The result has been a persistent depletion of global oil stocks and an upward price trend that has lasted nearly two years.
Commercial oil inventories in advanced economies have fallen in 17 of the past 21 months, while first-month Brent futures prices have risen in 18 of the past 23 months.
Global oil inventories were well below the five-year pre-pandemic average and were expected to fall further even before Russia’s February 24 invasion of Ukraine.
The Brent six-month calendar gap traded with a discount of more than $8 a barrel, in the 99th percentile for all trading days since 1990, illustrating how stretched the market was before the start of what Russia calls its “special operation” in Ukraine.
In this context, the invasion of Russia and the subsequent sanctions imposed by the United States and its allies acted as a short-term trigger, with an increase in spot prices and timing differences accelerating to from February 25.
Sanctions on Russia’s oil exports threatened the biggest loss of global production since Iraq’s invasion of Kuwait in 1990 and the Iranian revolution in 1979.
As of March 8, first-month futures were trading at their highest level since 2014, adjusted for inflation, and the six-month calendar spread was trading at a record low of nearly $22 a barrel. .
Traders had begun anticipating war and sanctions could turn existing market tensions into physical shortages (“Oil Market Caught in Biggest Shock Since 1970s,” Reuters, March 10).
The final acceleration in prices and spreads between February 25 and March 8 also exhibited the characteristics of a financial bubble (“Why Stock Markets Collapse: Critical Events in Complex Financial Systems”, Sornette, 2003) .
With prices and spreads increasing at an accelerating pace, most traders tried to avoid going short, resulting in a relative absence of market participants willing to sell.
The increasing volatility has led to a sharp increase in margin requirements, which has made it much more expensive to maintain existing positions or open new ones.
The resulting reduction in market liquidity has further increased volatility, leading to even greater margin demands.
The rising volatility and falling liquidity created a positive feedback loop, greatly amplifying the effect of the initial disruption on prices and spreads.
Like most bubbles, this one turned out to be short-lived and was followed by an equally sudden drop in prices, an implosion that has many of the characteristics of a flash crash.
The short-term trigger for the selloff appears to have been improving prospects for a truce between Russia and Ukraine, or at least a de-escalation of the conflict, which would allow Russian oil exports to continue.
At the same time, the growing number of coronavirus cases in China has led to a proliferation of local lockdowns, threatening a slowdown in oil consumption.
In Europe and North America, rising oil prices are aggravating a pre-existing inflation problem, forcing central banks to raise interest rates and threatening to cause a downturn in the business cycle.
As of March 8, the outlook for global oil production had improved slightly while the outlook for consumption had deteriorated significantly.
Rapid price escalation and extremely imbalanced positioning generally encourage bullish investors to take profits before a likely correction.
In the week to March 8, hedge funds and other money managers had already sold the equivalent of 142 million barrels in the six largest oil futures and options contracts.
Hedge fund sales were the 11th largest weekly since 2013, according to records released by ICE Futures Europe and the US Commodity Futures Trading Commission.
But as some traders began to trim their bullish long positions, the same extreme volatility, lack of liquidity and high margin requirements that had fueled the final sharp rise in prices contributed to a lack of buyers.
While the initial selling was absorbed without disrupting market prices too much, the selling quickly overwhelmed available cash, causing prices to fall at an accelerated rate.
First-month Brent futures prices fell more than 13% on March 9, the seventh largest one-day decline in more than 8,200 trading days since 1990.
In the six trading days between March 8 and March 16, prices in the first month fell more than 23%, the 23rd biggest drop over a similar period since 1990.
The extreme price rally between February 8 and March 8 was followed by an equally extreme crash until March 16, as the momentum fueling the rally reversed.
The round trip has left Brent prices and spreads roughly where they were before the invasion, with very tight supply but traders not fearing an extreme shortage, at least for now.
However, with great uncertainties around the future course of the conflict, disruptions to Russian exports, rising coronavirus outbreaks in China and a slowdown in the OECD business cycle, and still poor liquidity, volatility is expected to stay high in the short term.
Source: Reuters (John Kemp is a Reuters market analyst. Opinions expressed are his own, edited by Kirsten Donovan)