Algorithm Trades Worsened The Oil Price Slump after OPEC's Decision

The market reaction to OPEC's latest production policy announcement was excessively negative, partly due to many executed trades based on trend-following algorithms, analysts say.

While most analysts see the OPEC+ alliance's announcement this weekend as bearish for oil prices toward the end of the year because of the plan to begin unwinding some of the cuts as early as in October – market conditions permitting – the price move in oil early this week was likely overdone, observers and analysts said.  

Algorithmic Traders Drag Oil Prices Too Low

Since algorithmic traders don't follow the fundamentals but rely on rules-based computational formulas for executing trades, they compounded an already bearish sentiment in the oil market.

Algorithmic trading uses algorithms, computer programs that follow a defined set of instructions, to place a trade. And the ever-growing group of commodity trading advisors (CTAs) that have trend-following strategies to trading were prompted by these algorithms to sell oil.

This was partly the reason for oil's rout on Monday and Tuesday, after OPEC announced on Sunday that it would extend most output reductions into 2025, but could begin unwinding some voluntary cuts after the end of the third quarter of 2024—subject to market conditions.

Related: OPEC+ Reassures Oil Markets, Allays Oversupply Concerns

The OPEC announcement was perceived as bearish for the market and negative for oil prices, but algorithmic traders also exacerbated the price move lower.  

As a result, oil prices hit a four-month low, and Brent Crude prices slipped below $80 per barrel for the first time since early February.  

The trend-following CTAs have flipped their positioning in Brent Crude to a net short position – the difference between shorts and longs – this week, from a net long position – in which bullish bets were higher than bearish ones – at the end of last week, according to data from Bridgeton Research Group cited by Bloomberg.

"CTAs are just hammering away the market with massive selling," Scott Shelton, an energy specialist at TP ICAP Group Plc, told Bloomberg earlier this week.

This massive selling added to the bearish sentiment amid fears of weak demand growth to hammer oil prices, which lost 5% in just two days after OPEC announced its production plans for the coming year.

Many CTAs were pushed by algorithms to significantly boost their short positions in crude oil futures, Swissquote Bank's senior analyst Ipek Ozkardeskaya wrote in a note carried by MarketWatch. 

Options trades also worsened the oil price route, according to analysts.

The moves from CTAs "amplify market moves as they tend to sell a bear market and buy a bull market," Ozkardeskaya wrote in the note.

"Therefore the latest selloff may be overdone."

Oil Sell-off Overdone

The sell-off in oil this week is overdone, ING's commodities strategists Warren Patterson and Ewa Manthey wrote in a note on Wednesday.

"The decision from OPEC+ warrants relatively more weakness further along the forward curve (we currently see a small surplus in 2025 with the gradual return of OPEC+ supply), but speculative money will be largely positioned in the nearby prompts," they said.

Technical signals also suggest that the oil market is now entering oversold territory, but weakness in refinery margins remains a concern for the market, ING's strategists reckon.

Commodity analysts at Standard Chartered also pointed out that the oil price rout on Monday and Tuesday was the consequence of markets being dominated by a combination of extreme macroeconomic pessimism, speculative shorts, and over-enthusiastic algorithmic trading that crowded out more fundamentally based traders.

Oil prices rebounded on Wednesday and were higher in Asian trade early on Thursday, as the market shook off the sell-off. Oil rose from a four-month low amid growing optimism in a Reuters poll that the Fed might start cutting interest rates in September. 

Despite a build in U.S. commercial crude and gasoline inventories, oil prices saw an "oversold bounce after finishing lower for the fifth consecutive day on Tuesday," Fawad Razaqzada, market analyst at City Index and FOREX.com, told MarketWatch.

"It remains to be seen whether this recovery will last, given ongoing concerns over demand concerns and over the OPEC+ decision to eventually phase out the voluntary output cuts at a time when non-OPEC supply is on the rise," the analyst added.

Most analysts don't think there would be market conditions for the OPEC+ group to begin gradually adding supply in the fourth quarter of 2024.  

Mukesh Sahdev, Senior Vice President and Head of Oil Trading/Downstream Solution at Rystad Energy, commented that, "The bottom line is that the OPEC+ math does appear to be an OPAQUE math."

Third-quarter demand and market balances could be tempting for a reversal of the cuts from October, but OPEC+ is likely to consider balances for Q4 and beyond, Sahdev says. These balances, according to Rystad Energy, are expected to be flat demand growth in the last quarter of the year, a decline in crude demand at refineries, and nearly 1 million bpd growth in non-OPEC+ supply.

"2025 fundamentals do not provide a strong signal for an OPEC+ strategy reversal," Sahdev noted.

By Tsvetana Paraskova for Oilprice.com

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