Saudi arabias energy minister does not want bearish oil speculators living in a la-la land, as he put it last week. prince abdulaziz bin salman reminded them of his ability to make the market jumpy and to hurt gamblers like hell. while the former is in his power, the latter could be harder.
So far the kingdom deserves a nomination for best oil trader of 2020. not because of its pledge to rebalance oversupplied markets, but rather because it recognised the need to adjust and add some dynamism to the supply strategies of opec, the oil exporters cartel.
The shift was subtle but brilliant: adopt a work-from-home mentality, make opec meetings virtualand more frequent and keep the oil market guessing. the strategy increases volatility as needed to unnerve competitors seeking to plan far in advance.
This maximises saudi arabias optionality and the competitive advantage as the worlds low-cost producer. the more volatile or jumpy the market, the higher the value of such optionality. we all learned it in the introductory course on oil trading.
The second part of the strategy is more challenging, and one may need to resort to a graduate-level class on oil derivatives trading. the world consumes 100m barrels of oil a day, out of which only about half is exported from producing countries and trades internationally. the world also trades 2.5bn b/d using oil futures contracts, and much more if we include options, refined products futures, and over-the-counter derivatives.
This means that financial markets are somewhere between 25 and 50 times larger than the market for physical barrels. it does not mean that they are proportionatelymoreimportant,but traders agreethat financial flows are more relevant toshort-term oil price behaviourthan supply and demand imbalances.
What makes punishing speculators a challenge is the fact that only a tiny fraction of them read newspapers or listen to opec meetings. they use algorithms that simply follow rules that have made them money in the past, but they keep the rules nimble enough to change when the environment changes.
The rules are not as dumb as one would think. algorithmic traders learned a long time ago that when oil inventories are high and futures prices are higher than spot prices a market pattern known as contango then holders of physical oil inventories hedge their stored barrels by selling futures and flattening the price pattern.
They also learned that when the pattern inverts backwardation, in commodities jargon and near-term prices are higher than future prices, then storage is no longer economical. humans buy back the futures and push their prices up.
High-speed algorithms mimicked this behaviour and accelerated it, executing the trades ahead of slow-moving humans andthen packaging it as an investable strategy fordeep-pocketed pension funds.
Thestrategywas supported by history, which showed that bearish shorts tend to make money when the market is in contango by essentially selling high and buying low along the futures curve. bullish longs tend to make money when the market is in backwardation by doing essentially the opposite.
Longs have lost an astonishing $100 a barrel by holding and then selling low and buying high when they rollover their futures positions during the contango markets that have prevailed over the last 15 years.
Saudi arabia can threaten to harm speculators with bearish positions, but it could well be because it does not have many other choices to change the status quo. the real test of the kingdoms power is whether it can jolt the market out of the structural contango that has been a killer for the longs and a bonanza for the shorts in recent years.
Yet the bigger problem for the kingdom is with long speculators, including recent retail buyers of oil exchange traded funds, who exacerbate the contango price pattern as they bid up the price of contracts for delivery in the future. contango puts opec at a disadvantage as it lets us and canadian producers to lock in future sales at a higher price via hedging than what opec members could receive in the spot market.
Perhapsthe prince was referring to long speculatorslast week, and we all misread his message as the warning to the shorts.
The author, a former president of koch global partners, is managing partner of pentathlon investments, a consulting company.
The commodities note is an online commentary on the industry from the financial times