Crude oil prices declined forty percent between October 1 and Christmas Day in 2018. The decrease has been variously attributed to the United States’ failure to follow through on its tough sanctions on Iran, unexpected increases in US oil production, oil-exporting countries not cutting production sufficiently, and/or realizations that global economic growth was slowing.
These explanations are all relevant. However, none can explain a decline that matches in magnitude the decrease that occurred after OPEC’s November 2014 meeting. At that time, the organization surprised the world by ending its self-imposed limits on its crude oil output. Nothing like that happened in the fourth quarter of 2018.
The best historical precedent for the precipitous drop in oil prices happened in equity markets in October 1987. On Black Monday, October 19, a “flash crash” dropped share prices twenty-two percent in a single day. In a report named for then-Secretary of Treasury Nicholas Brady, financial experts explained that the equity price decline was started by bad economic news but then magnified by futures contract sales made by institutions employing portfolio insurance strategies. Following the parameters of their option-pricing models, the firms that underwrote the insurance policies had to sell futures as prices fell. Their actions pushed share prices down further.
A similar phenomenon caused a “slow flash crash” in oil, one in which prices declined from $85 to $50 per barrel over the last months of 2018. Prices had been bid up during the summer by end users and speculators anticipating the impact of the United States’ renewed sanctions on Iran and the continued expansion of global demand. The expectations of a decrease in oil supply were dampened when forecasters began to lower projections for global growth and then dashed when the US granted greater-than-expected exceptions to its Iran sanctions.
The initial crude oil price decline threatened to put many of the puts written to US independent oil producers, as well as puts sold on the NYMEX and to Mexico, in the money. The parties that had sold the puts responded by selling futures, as dictated by their option-pricing models.
We know now that there were a very large number of these “price insurance policies.” The SEC filings of US independent oil producers reveal that these companies had purchased insurance on one hundred fifty million barrels of oil in the fourth quarter of 2018 and more than three hundred million barrels of 2019 production. In addition, there were perhaps one hundred thousand NYMEX WTI puts outstanding on November 1, 2018. The firms that had sold these instruments did as their financial models dictated when oil prices went down. They sold futures, adding to the downward pressure. Related: U.S. Oil Outlook Slammed By Lower Prices
The price decline accelerated, just as in 1987, because there were few buyers. Investors and speculators that might have jumped into oil saw no opportunities last fall, just as their equity counterparts in 1987 failed to see buying opportunities. In 2018, falling crude oil prices, uncertainty regarding what steps OPEC might take, and the lack of clarity regarding US sanctions on Iran pushed everyone to the sideline. The share prices of all major oil companies declined in concert with the major stock indices and oil futures prices.
The lack of buying interest increased oil price volatility dramatically. The CBOE volatility index tripled from October to November as computers seeking to cover price insurance contracts tried to sell. As volatility rose, the models instructing the computers ordered even more contracts to be sold. It was a vicious cycle, just as in 1987.
The “slow oil flash crash” may have been exacerbated by the oil markets being open on days when traders in the physical market were on vacation. WTI dropped more than $4 per barrel on the day following Thanksgiving and almost $3 on December 24. While oil traders take time off, computers do not. Some of the large declines were recovered. However, the decreases had boosted volatility and thus added more pressure to sell.
Reforms to trade regulations were made in equity markets following the 1987 flash crash. Those interested in more stable oil prices may want to review linkages between financial and physical oil markets. A change in trading rules, however, will not address the basic problem that confronts oil markets today, which is caused by the bilateral nature of commodity markets that dictates there must be one long for every short. The problem is that increasing demand to hedge from independent producers is not matched by increasing demand to buy futures by investors, consumers, and speculators. There is, in short, a “lack of longs.”
The greater demand for hedging can be quantified by comparing the increase in merchant short positions and swap dealer short positions with the rise in oil production published in the US Energy Information Administration’s “Drilling and Productivity” report. In 2007, producers may have hedged four months of production. Eleven years later, at the end of 2018, they may have hedged eight months of production—if one believes all merchant and swap dealer short open interest was taken out to hedge US fracking production, an admittedly extreme assumption. Related: Trump Takes Aim At Maduro, Threatens Oil Embargo
The point, though, is that, on average, producers in 2018 had hedged a higher share of their production than in earlier years. At the same time, production had increased fivefold, which boosted the short side of the futures market for hedging tenfold.
The market’s long side did not expand as significantly over the eleven-year period, although it surged in 2007 and early 2008 at the peak of the commodities super cycle. From 2007 to the end of 2018, the long positions of money managers increased just fivefold.
Such an imbalance becomes a particular hazard for the oil market whenever those holding long positions for speculative reasons are disappointed, as was the case in October 2018. To no one’s surprise, prices usually decline at such times. In this case, though, the computers at the banks and institutions underwriting the price insurance to US independent producers were sitting on the sidelines, just waiting to sell. The consequence of their getting off the sideline became visible at the end of 2018.
The question for the future is how to deal with this development, especially since the increase in US production will create even greater pressure from the computers charged with hedging the price insurance written to the US independent producers. In coming articles, I will offer thoughts on how to assess (and plan) for the impact of increased volatility. I will also offer suggestions on steps oil-exporting countries might take to counteract the actions of the computers.
By Philip Verleger for Oilprice.com
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