Claims that the futures and physical markets have become disconnected are not new. They have been around for decades. When oil prices soared in 2007-08, oil ministers from members of the Organization of the Petroleum Exporting Countries lined up to complain that futures markets had become too big. The volume of oil traded, often by people who never intended to handle a single barrel of the dark stuff, was many times greater than the global trade in physical crude. These “speculators” were pushing the price of oil to record highs, while physical supplies, according to producers, were plentiful.
Today, Saudi Energy Minister Abdulaziz bin Salman and others are telling us otherwise. There aren’t enough people trading oil futures, and the paper market, as it’s called, doesn’t reflect the real shortage of crude. This time it is not the fault of speculators, but too few producers seeking to hedge the value of their future production by buying futures contracts.
Activity in the crude futures markets is measured by open interest, or the number of contracts open at any given time. While the combined level of open interest in the Brent and West Texas Intermediate crude markets has fallen sharply from its highs, reached in 2017-18 and again last year, open interest n is not weak in historical terms. It is back to where it was in 2013-14 and well above the levels seen in 2007-08, when paper markets were too big.
One thing is undoubtedly true, however: rough markets are extremely volatile. The first nine months of 2022 have already placed the year in the top six of the past 30 for daily Brent crude movements above 5%. The three most volatile years by this measure were the financial crash of 2008, the year of the Covid-19 pandemic and the year of Iraq’s invasion of Kuwait.
But a 5% price change at a time when oil was around $20 a barrel, like in 1990, is very different from a 5% change now that the price is near $100 a barrel. In absolute terms, take price moves above $5 a barrel and 2022 has already topped the list of the most volatile years for crude since at least 1988.
But volatility doesn’t necessarily mean a broken market. The most volatile years for oil have all been those where major events rocked the markets, and this one is no different. Russia’s invasion of Ukraine and the threat of sanctions on its oil exports, the post-pandemic resumption of travel to many parts of the world, the lockdowns imposed under China’s zero-Covid policy, and now looming recession fears in North America and Europe have all disrupted markets in 2022.
Yes, global oil inventories are low after huge draws last year, when OPEC+ oil producers failed to ramp up production fast enough to match the recovery in demand. Yes, years of underinvestment in new oil production capacity, both inside and outside OPEC, have reduced spare capacity to a sliver. Yes, sanctions on some Russian oil exports could take millions of barrels of crude a day off the market in December, followed by millions more refined products early next year.
But these legitimate concerns are offset, for now, by expectations of recession and demand destruction in some of the biggest oil-consuming countries. And if Europe and the United States fall into recession, if they haven’t already, the ripple effect of lower imports of consumer goods from China should dampen the recovery of the demand for oil there when the Covid restrictions are finally lifted.
Paper oil markets are looking beyond the supply issues that are captivating OPEC+ oil ministers. I remain baffled that their response to a tight oil market is to threaten to make it even tighter by cutting production again.
Will oil prices pick up again towards the end of the year, as futures markets catch up with physical tensions? They might, especially if European Union sanctions hit Russian oil exports hard. But prices could just as well continue their downward trajectory if the recession leads to widespread demand destruction.
Hold on to your hats, the wild oil ride of 2022 isn’t over yet.
This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.
Julian Lee is oil strategist for Bloomberg First Word. Previously, he was a senior analyst at the Center for Global Energy Studies.
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