Who and what causes oil price volatility

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A “geopolitical risk premium” is a nebulous concept, roughly equivalent in today’s oil market to a $5 surcharge on each of the roughly 6 billion “virtual” barrels traded each day.

That the planet consumes (only) 100 million real barrels every 24 hours shows how dominated by speculators the oil market has become. This in turn explains why, along with many other obvious catalysts, prices have been as volatile as they have been in recent weeks.

Israel’s missile exchange with Iran and the launch of China’s stimulus package sent Brent crude last week to its biggest five-session gain in more than a year. Prices briefly rose above $80 a barrel on Monday, only to fall 5% on Tuesday after the National Development and Reform Commission’s latest press conference turned out to be a wet squib.

The initial rally was “almost entirely driven by the (justified) risk premium,” JPMorgan commodity futures and options strategist Tom Skingsley wrote in a note to clients — but investor “positioning” was also a major factor , he added.

In recent months, perhaps the biggest story in the oil markets has been algorithmic selling to historic highs. Net positioning among trend-following hedge funds (aka commodity trading advisors) – which look at complex technical factors like the futures structure of Brent and WTI prices rather than fundamentals like macroeconomics or geopolitics – was not never so short until recently.

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“CTAs have been a dominant force this year,” Ryan Fitzmaurice, commodity portfolio manager and strategist at Marex, told FTAV. “Historically, there’s been a lot of sticky money in the oil markets, from index managers running passive longs and people looking for inflation hedges.”

But China’s economic slowdown and falling US inflation meant a lot of that “sticky money” left the market in April and May. With OPEC poised to boost supply in December and global demand looking weak, Brent prices fell from above $90 a barrel in mid-April to just below $70 by mid-September. Trend followers, who buy aggressively when prices rise and sell aggressively when prices fall, accelerated selling.

China’s initial tax package and escalating tensions between Israel and Iran have rattled the market. Eager to protect their broader portfolios, discretionary investors, who had been watching from the sidelines for months, began buying oil futures and call options as a result, breaking the downside momentum that led to the CTA selloff.

The change in sentiment was not profound, explains Ilia Bouchouev, former chairman of Koch Global Partners. But that was enough.

Discretionary investors “became bullish, but they don’t indeed they want to buy — they have no incentive to do so before the (US presidential) election,” Bouchouev told us. “If Trump wins and we get tariffs, that’s an added risk, so why bother putting money now when they can do the same on November 6?”:

A month ago, a lot of put options were being bought by producers, and dealers had to sell futures contracts to hedge against this risk. This flow subsided and started to go in the other direction a few weeks ago when there was suddenly a lot of buying of call options from retail investors through ETFs like USO and macro-hedgers. There has been aggressive buying of $100 calls as a form of insurance given that no one really knows what will happen in the Middle East. What people do know is that if oil hits $100, the Fed’s plan would be derailed and other assets would suffer massively.

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Momentum-driven CTAs that were “max short” were mechanically forced to cover their positions, Bouchouev added. “Historically, their positions tend to mean comebacks. So if they’re already at an extreme, they have no way to go but up.”

CTAs are now at 10%, so they have 90% to go. The problem with CTAs…with momentum, if it’s negative, they’ll keep selling. But if the market stabilizes for a week or so or you get a small rally, then all of a sudden that negative momentum breaks. The momentum doesn’t need to become positive, it just needs to stop being too negative. It’s enough for the CTA to start buying back. We don’t have positive momentum at the moment, but they are starting to cover all the same.

In recent days, however, the market has been tossed around again as fears that Israel could strike Iranian energy facilities have eased and Beijing has been dissuaded from further stimulus.

According to JPMorgan’s Skingsley in a note published Tuesday morning:

Flows on the desk have been polarized for much of yesterday, there appears to be increasing interest from the discretionary community to start fading the move at these levels, or at least take profit, in while systematic money continues to take the other side. trade as their extended short continues to unwind…

With that in mind, where next? It’s still very hard to call until we get definitive action from Israel, but given the magnitude of the rally we’ve seen and the fact that it was almost entirely caused by (justified) risk premium and positioning, in if the Israeli response “disappoints” (read doesn’t affect oil balances/target nuclear facilities) there is now significant room to the downside here and the risk reward for such a view that was non-existent a week or so ago is much more existing now…

Some interesting sides have joined the sell-off, according to research analyst Martha Dowding and market design expert Jorge Montepeque — both of whom work at Onyx Capital Group, a liquidity provider for oil derivatives that has almost certainly made a killing from all the recent volatility .

Trafigura, TotalEnergies, people like that kept selling (Tuesday). Exxon has been on the sell side for several months. They read the fundamentals and sell their surpluses, but they could convert buyers at any time. Total flips from buyer to seller every few weeks….

(Tuesday) Austrian group OMV has sold a North Sea cargo, Ekofisk, to Total. And BP sold something like 700,000 barrels to Mercuria. OMV is not a regular seller – they don’t usually sell publicly so this is unusual. It’s also unusual to see Exxon sell off for two months in a row.

When the market turns is anyone’s guess. “It’s a never-ending cycle,” says Marex’s Fitzmaurice. “The CTAs are not necessarily that concerned with OPEC or the outlook in the Middle East. They’re just trying to monetize momentum” — geopolitics being simply another number on the screen.