Claims that futures and physical markets have been separated are not new. They’ve been around for decades. When oil prices soared in 2007-2008, oil ministers from members of the Organization of the Petroleum Exporting Countries lined up to lament that futures markets had become too big. The volume of oil traded, often by people who had no intention of ever touching a single barrel of the black stuff, was many times greater than the global trade in physical crude oil. These “speculators” drove oil prices to record highs while physical supplies, producers said, were plentiful.
Now we are being told the opposite by Saudi Arabia’s Energy Minister Abdulaziz bin Salman and others. There aren’t enough people trading oil futures, and the paper market as it’s known doesn’t reflect the true scarcity of crude oil supplies. This time it is not the speculators who are to blame, but too few producers who want to secure the value of their future production by buying futures.
Activity in the crude oil futures markets is measured by open interest, or the number of contracts open at any given time. While it is true that the combined level of open interest in the Brent and West Texas Intermediate crude markets has fallen sharply from its highs set in 2017-2018 and again last year, open interest is not low by historical standards. It’s back to where it was in 2013-2014 and well above where it was in 2007-2008, when paper markets were too big.
However, one thing is undoubtedly true: crude oil markets are extremely volatile. The first nine months of 2022 has already put the year in the top 6 of the last 30 for daily movements of Brent crude above 5%. The three most volatile years by this measurement were those of the 2008 financial crash, the year of the Covid-19 pandemic, and the year Iraq invaded Kuwait.
But a 5% price change at a time when oil was about $20 a barrel, like in 1990, is very different from a 5% price change now, when the price is close to $100 a barrel. In absolute terms, it’s making price moves in excess of $5 a barrel and 2022 already tops the list of the most volatile years for crude oil since at least 1988.
But volatility doesn’t necessarily mean a broken market. The most volatile years for oil have all been when major events rocked the markets, and this year is no different. Russia’s invasion of Ukraine and the threat of sanctions on its oil exports, the recovery of travel in many parts of the world post-pandemic, lockdowns imposed under China’s zero-Covid policy and now the looming recession fears in North America and all European markets disturbed in 2022.
Yes, global oil inventories are low after huge withdrawals last year when OPEC+ oil producers failed to ramp up production fast enough to meet recovering demand. Yes, years of underinvestment in new oil production capacity, both inside and outside OPEC, have reduced spare capacity to a tiny fraction. Yes, sanctions on some Russian oil exports could take millions of barrels a day of crude off the market in December, followed by millions more of refined products early next year.
But those valid concerns are being outweighed for now by expectations of a recession and demand destruction in some of the biggest oil consuming countries. And if Europe and the US go into recession, if they haven’t already, the domino effect of lower imports of consumer goods from China will likely dampen oil demand recovery there when Covid restrictions are eventually lifted.
Paper oil markets are looking beyond the supply-side issues that fascinate OPEC+ oil ministers. I’m still amazed that their response to a tight oil market is to threaten to make it tighter by cutting production again.
Will oil prices rebound towards the end of the year as futures markets catch up on physical tightness? They could, especially if European Union sanctions hit Russian oil exports hard. But prices might as well continue their downtrend if the recession leads to widespread demand destruction.
Hold on tight, the wild oil ride of 2022 isn’t over yet.
This column does not necessarily represent the opinion of the editors or of Bloomberg LP and its owners.
Julian Lee is an oil strategist for Bloomberg First Word. He was previously a senior analyst at the Center for Global Energy Studies.
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