In the space of a few short months oil markets switched from scarcity to abundance. This article explains what happened and highlights how oil traders seek to gain an edge by considering how other participants in the market react, thinking through what the second order consequences could be, changing your time perspective to find the best value bets, and finally employing big data and systematic strategies to gain insight and taking the emotion out of trading.
Cast your mind back to early January 2020. The United States had just launched a drone attack near Baghdad’s airport. An Iranian major general, Qassem Soleimani was killed in the strike. Trending on Twitter at the time was the hashtag #WWIII.
As so often happens after a monumental shock it now feels like a world away.
As reports of the coronavirus emerged in early 2020 and Chinese authorities locked down some of their largest cities in a bid to control the virus. After surging to just over $70 per barrel in early January, Brent crude oil prices began to slump as oil traders began to worry that the economic cost in curtailing the virus would dampen oil demand growth.
In the wake of the spread of the virus, governments across the globe enacted strict lockdowns to try to stem the spread. Flights were grounded. Commuters worked at home, leaving their cars parked outside. Non-food manufacturing came to a halt, reducing demand for energy.
By mid-April Brent oil price has dropped by a staggering 75%. The largest and most rapid decline in oil prices ever recorded. It was far from over.
At this point it’s worth noting that there isn’t one single oil price. The main global benchmark is known as Brent, but the other benchmark is known as WTI and has specific characteristics relating to the North American oil market.
In betting markets it is always important to know your maximum possible loss in any trade you enter. The same is true in the commodity markets. For many investors – including successful, experienced ones like Jim Rogers – the assumption that oil prices could never go below zero was built in. Surely it could never happen to oil.
On Monday 20th April WTI oil prices fell below zero. At one point that day the May futures contract (oil traders bet on the price of contracts linked to the value of oil) fell to a low of minus $40.32 per barrel. For a commodity that just three months ago was being bid up on fears over war it was a humiliating fall from grace. Now traders were having to pay for the oil to be taken away.
Those same contracts traders were betting on also included some rather important information in the small print. If you hold them right up until the contracts expire (something that happens every month), you must be ready to take delivery of the physical oil. With US oil consumption at a 50-year low, storage was filling up fast and likely to be very close to its limit. Fear over what to do with oil that had nowhere to go meant that traders were so willing to offload their positions that they sold oil at a negative price.
Oil prices swiftly rebounded. By the end of the week WTI oil prices had recovered to $17 per barrel while Brent crude finished trading at almost $22 per barrel. There was little cheer among oil producers in the US. Oil prices remain a long way below the level that is economical for them to continue to produce, and of course negative oil prices could return.
There are two sides to every story
You cannot just consider the recent form of one team in a football match when deciding whether it is worth backing them to win – you must consider how the opposing team is likely to perform. The same dynamics work in the oil market. Oil traders consider both demand and supply, and importantly how each react to the current price of oil and expectations over how it will change in the future.
The cure for low oil prices, is low oil prices. Low oil prices encourage producers to stop existing production and delay the introduction of new output. That’s what market lore suggests will happen anyway. Oil output in the US is already thought to have declined, with estimates suggesting production could decline by 2 million barrels per day by the end of 2020. Producers scared at the prospect of dwindling storage and the risk that they may have to pay someone to take their oil and transport it to a crude tanker off the coast, will be more incentivised than ever to cut production.
Of course, no individual producer of oil wants to be the first one to cut supply. Oil producers face a game theory face-off where the one that can hold out while others have folded, stands to scoop the reward when (or if) oil prices rebound. This game of bluff and double bluff often means it takes much longer than simple economics suggests should happen.
Oil traders must factor all of these factors into their decisions about whether to go long oil futures (to buy in anticipation of it going up in value), or to go short (selling oil in order to buy it cheaper later).
V, W, L or even I
History does not repeat itself, but it often rhymes. Extreme events shock our foundations in which we understand the world. Sometimes the only way we can find structure in the world is to search back through time for examples in which similar events took place – recessions, financial crisis, and pandemics. That has been the case for oil traders trying to gauge the strength of demand and supply over coming months, and what it means for the probability that oil prices will be higher, or lower and the speed and shape of any recovery.
The driving force behind previous price falls have also been what makes the difference in the recovery. Previous demand shocks (1997, 2001 and 2008) tended to result in oil prices returning to pre-shock levels within 20 months. Supply shocks (1985-87, 2014) on the other hand tend to mean that oil prices take much longer to return to pre-shock levels. Although the pattern was disrupted by the First Gulf War it took a decade for oil prices to recover to pre-supply shock levels brought on by the North Sea and a hike in Saudi output in the late 1980s. The 2014 oil supply shock led by US shale oil and the breakdown in OPEC has yet to see prices recover.
The challenge in applying any scenario analysis to current events is the same – whether commodity, financial or in the betting markets. There may only be less than a handful of ‘similar’ events over the past century to help guide what might come next, and as such it’s important to be aware of other factors simmering in the background that may make today’s market different from the past.
A case can be made that the covid-19 pandemic is both a demand shock, and a supply shock.
Things can always get worse, but even in unprecedented times it can sometimes be worth focusing not on what you think the future holds, but on how confident market participants appears to be. Look for what potential rewards (i.e. asymmetric payoffs) there may be in backing the outcome that the consensus is surprised.
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Magazine covers and article headlines in the financial media can offer important clues into the state of financial market narratives and the degree of consensus. Far from being prescient they tend to reflect investor sentiment and extrapolate current trends.
A useful corollary to think about this is known as the ‘hot hand’ fallacy. When a sports team or an individual player has had a long run of success – scoring goals, hitting aces – bettors think that the likelihood of the trend continuing is high. The bettor doesn’t consider the role that luck plays in individual outcomes, nor that mean reversion may start to play a role eventually.
In the sports world star players tend to have their picture plastered over magazines clutching an award. Bettors might react to this by backing them but at odds that are too short to reflect the real probability of winning.
The same fallacy happens in commodity markets. In March 1999, The Economist magazine proclaimed the beginning of a new era of low oil prices with the cover "Drowning in oil". Trend extrapolation came to an abrupt halt and went into reverse - it was a good time to buy oil in 1999.
And so it’s important to watch out for terms in the media like ‘forever’ and ‘no end in sight’. That tends to mean that the media and investors are beginning to extrapolate too far. Of course, sentiment can always get even more stretched before the elastic band snaps back.
How big data can give oil traders an edge
Some oil trading companies use infrared cameras to monitor oil levels in storage tanks in the US, or check satellite images for crude tankers leaving Saudi Arabia and other major oil producers. All are set to determine the inventory fluctuations and price discrepancies through which they and their clients can profit from.
This kind of inside edge is outside of the scope for all but the wealthiest people. Nevertheless, there are ways that anyone can gain an edge just by looking for publicly available ‘Big Data’ sources. One source of data that has been invaluable to oil market participants since the covid-19 lockdowns began is TomTom Live Traffic. The website published hourly traffic levels in hundreds of different cities across the globe and – crucially – you can compare today's levels with ‘normal’ traffic levels in 2019.
As ever, context is king when interpreting data. The past few weeks show that weekday traffic in many Chinese cities - such as Chongqing and Guangzhou - has not just returned to last year’s levels, it has gone even higher. What could explain that? Well, pedestrians worried about catching coronavirus have passed on using buses and subway trains, and chosen to travel by car instead.
Beware recency bias
Unimaginable to many of us in the Western Hemisphere still under lockdown, instead of being a drag on demand for transport fuels, the virus could eventually result in an increase in demand for oil.
Known as the recency bias, analysts and traders often give greater weight to very recent events in their outlook and let what could just be random events colour their perception of how the future will evolve.
One such example comes from the summer of 2008. Oil prices had just risen above $100 per barrel. Noting that prices had advanced more quickly than they had forecast back in 2005, the investment bank Goldman Sachs issued a note suggesting that the high end of its forecast range was now $135 a barrel – but they also hinted that prices could go much higher: "The possibility of $150-$200 per barrel seems increasingly likely over the next six-24 months, [in the case of] a major disruption."
In the same way, should oil prices remain low for some time, the entrenched assumption may be that these low prices will persist for the foreseeable future. This recency bias means that people typically expect the future to be like the past and they underestimate the potential for change.
It is very difficult to imagine alternative futures, but that is just what the successful oil trader must do.
The instruments of oil market speculation
Commodity futures contracts expire on specific dates. The most actively traded contract (i.e. the one that has the most liquidity) tends to be the nearest dated contract. Oil futures contracts are traded for every month of the year and expire as the next month draws near.
Even professional traders speculating on the price of oil are very careful to close out their positions well ahead of the contracts expiring. The reason being that – as the example at the start of this article illustrated – a contract with low liquidity can mean the oil price becomes very volatile. Commodity exchanges do everything they can to protect individual investors from this, plus stopping them from risking having to take physical delivery of the oil.
Most retail investors do not take positions in the actual oil futures contracts. Instead they might use spread betting to gain an exposure to the movement in the price (betting that it will be higher or lower) or invest in an Exchange Traded Fund (ETF) that enables a manager to deal with the rollover from one oil futures contract to the next.
The series of futures contracts is known as the futures curve. It stretches from the nearest dated contract for several months, if not years into the future. If the curve is upward sloping it is known as being in contango. If the curve is downward sloping it is known as being in backwardation. Long-term investors in an oil ETF need to be aware of whether the curve is upward or downward sloping. If it is upward (i.e. in contango) then investors may suffer a loss to their portfolio as the futures contracts are sold and have to be bought back at a higher price.
Why is sticking to your time horizon important in finding value bets in the oil market?
Professional oil and commodity market traders analyse millions of data points. This data can be used to discover when a market is under or over-valued relative to where they think the market could go during the few weeks, days or even minutes. That kind of analysis is almost impossible to achieve for the retail investor. But that does not mean that there aren't opportunities.
The financial media are not built to help you find value bets in oil, commodity, or in the financial markets. Very rarely does an analyst appear on TV offering a well thought out reason for why the odds are stacked one way or the other. The financial media tends to be all about entertainment. That comes at a cost to investors looking for value.
Investors in the oil market should take the necessary steps to focus on the time horizon that is relevant to them. If a trade is based on your outlook over the next year, then worrying about opinions in the media on the outlook over the next week are useless; vice versa if you are focused on the short term.
By only focusing on sustainable long-term value propositions investors will have a degree of ‘margin of safety’. This margin – outlined by investors Benjamin Graham and David Dodd – if used properly means that investors are not forced out of a position, even if the market moves against them.
Second level thinking
Most analysts, traders and those in the media tend to focus on the obvious first order impact of an event. For example, the drop in oil prices will lead to increased demand for oil since it is now more affordable.
The world is rarely governed by simple linear cause and effect. Many of the things we encounter everyday are circular and operate non-linearly. Instead, focus on what comes next, and after that. This is known as second level thinking.
Let’s consider the recent dramatic decline in the price of oil. While it is natural to assume that the fall is a benefit to many emerging economies – often more dependent on imported oil than developed economies – that may not be the case. Emerging economies typically borrow in US dollars and so prefer their domestic currency to appreciate against the US dollar to reduce the value of that debt.
The decline in the oil price could force the US dollar to appreciate. This increases the value of emerging market debt, and in doing so acts as a brake on domestic oil demand growth in these same countries. As always, it’s important to consider what the secondary impacts of any event are, as they may be even more potent than the first.
The rise of the machines
It is easy to ascribe human logic to why the oil market moved higher or lower yesterday, yet most of the trades executed are not placed by a living, breathing being. In fact, over 80% of trades placed on the Chicago Mercantile Exchange (CME), the US commodity futures exchange are estimated to have been placed by robots. This represents a 15-percentage point increase over the past five years. In fact, it is part of a longer-term trend that is being seen across other commodity markets as well as equity and foreign exchange markets.
Many of these robots will react to data releases at lightning speed to buy or sell oil contracts. Others might scour sentiment on Twitter for indications of where markets might move next – indeed some may even follow US President Trump (@realDonaldTrump) such is the ability for his tweets to roil the markets. Meanwhile, other automated programs may just look to monitor price action and attempt to get ahead of the investing herd in placing their trades.
The value to the investors in these automated programs is that they are based on systematic strategies. These buy or sell no matter what the investor feels about the market. By taking the emotion out of trading they reduce the risk of the investor getting excited or despondent at exactly the wrong time.
Oil markets have switched from fears over its scarcity to one of an abundance in the space of a few short months. The transition has been unprecedented in terms of its velocity and impact. For the first time ever, oil prices even went negative, if only for one day.
There are so many uncertainties, but oil traders in the Western Hemisphere do have one advantage on their side. Time. In the same way that we only had to look east to see the growth in the coronavirus and the impact it was having on economies, so it may pay to look in the same direction for clues as to what the future could hold.
Oil traders like participants in other markets need to consider how other participants in the market react, and indeed what the second order consequences could be. While others have their gaze fixed firmly in the rear-view mirror, it can pay to look up and peer into the future.
It can often be by changing your time perspective that the best value bets can be found. While others are too busy focusing on the short term, a longer-term perspective can pay dividends.
But it is important for all traders and investors to know that the means by which you are playing your view of the world is right for you. Many retail investors in oil found that out to their cost in the past week.
Big data can give oil traders insights that would have been unimaginable only a few years ago. This coupled with systematic strategies employed by automated programs are becoming increasingly important to the oil market, other commodities as well as other financial markets.
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