Assurances that the futures and physical markets are becoming separate are not new. They’ve been around for decades. When oil prices were rising in 2007-2008, oil ministers from members of the Organization of the Petroleum Exporting Countries (OPEC) lined up to complain that futures markets were getting too big. The volume of oil traded, often by people who had no intention of dealing with a single barrel of black matter, was many times greater than the world trade in physical crude oil. These “speculators” have been driving oil prices to record levels, while physical supplies, the producers said, are plentiful.
Now we are being told the opposite by Saudi Energy Minister Abdulaziz bin Salman and others. There are not enough people trading oil futures, and the paper market, as is known, does not reflect the real tightness of crude oil supplies. This time it is not the speculators’ fault, but very few producers seek to hedge the value of their future production by buying futures contracts.
Activity in the crude oil futures markets is measured by open interest, or the number of contracts open at any given point. While it is true that the combined level of open interest in the Brent and WTI markets has fallen sharply from its 2017-2018 highs and again last year, open interest is not historically low. It is back to where it was in 2013-2014 and well above the levels seen in 2007-2008, when paper markets were very large.
One thing is undoubtedly true: the crude oil market is extremely volatile. The first nine months of 2022 have already put the year in the first six months of the last 30 years for Brent crude’s daily movements of over 5%. The three most volatile years on this scale were the 2008 financial crash, the COVID-19 pandemic, and the year Iraq invaded Kuwait.
But a 5% price swing in an era when oil was around $20 a barrel, as in 1990, is very different from a 5% swing now that the price is near $100 a barrel. Looking at absolute values, taking price movements in excess of $5 a barrel and 2022 already tops the list of the most volatile years for crude oil since at least 1988.
But volatility does not necessarily mean a market break. The most volatile years for oil were those when major events disrupted the markets, and this was no different. Russia’s invasion of Ukraine and the threat of sanctions on its oil exports, the post-pandemic recovery in travel in many parts of the world, the lockdowns imposed as part of China’s non-spreading COVID policy, and now looming fears of a recession in North America and Europe turbulent markets in 2022.
Yes, global oil stocks are down after massive drawdowns last year, when OPEC+ producers failed to raise production fast enough to keep pace with a recovery in demand. Yes, years of underinvestment in new oil production capacity, both inside and outside OPEC, dwarfed the spare capacity of a small segment. Yes, sanctions on some Russian oil exports could take millions of barrels per day of crude oil off the market in December, followed by millions more barrels of refined products early next year.
But these legitimate concerns are, for now, overshadowed by expectations of recession and demand for destruction in some of the largest oil consuming countries. And if Europe and the US fall into a recession, if they haven’t already, the detrimental effect on reduced imports of consumer goods from China is likely to slow the recovery in oil demand there when Covid restrictions are finally lifted.
Paper oil markets are looking beyond the supply-side issues afflicting OPEC+ oil ministers. I am still puzzled that their response to the tight oil market is to threaten to make it tighter by cutting production again.
Will oil prices rise again towards the end of the year, as futures markets inflict material distress? That could happen, especially if EU sanctions severely impact Russian oil exports. But prices could just as easily continue their downward trajectory if a recession destroys demand on a large scale.
Hold on to your hats, the 2022 wild oil journey isn’t over yet.
This column does not necessarily reflect the opinion of the editorial staff or Bloomberg LP and its owners.
Julian Lee is an oil strategist at Bloomberg First Word. Previously, he worked as a Senior Analyst at the Center for Global Energy Studies.
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