Unlike Wall Street, We're Not Running Scared From Oil's Recent Volatility
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Unlike Wall Street, We’re Not Running Scared From Oil’s Recent Volatility

by | published February 15th, 2018

When oil trading ended at 2:30 PM Eastern yesterday, the West Texas Intermediate (WTI) had moved up 2.4%.

Brent, the other and more globally used benchmark, had risen 2.7%.

Both reversed a downturn that has enveloped the oil trade since the end of last month.

You see, after reaching multi-year highs on January 26, WTI had declined 10.5% through February 13 while Brent slid 11.3%.

Moreover, as the markets begin to show signs of finding a bottom – with four consecutive positive sessions through yesterday’s close – the energy sector has continued to perform weaker than most of the other S&P 500 sectors.

Because of that, analysts have started grasping at straws.

Some are predicting a gradual lowering of prices from current levels…

While others are taking their cues from more immediate production figures, supply levels, and demand estimates.

Fact is, volatility has taken hold of the global oil markets.

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After a 7-month period of remarkably low volatility in oil, the last few weeks been turbulent.

And that has a lot of oil enthusiasts nervous.

However, all of this needs to be put into perspective to understand what’s really at work here.

And that’s exactly what we’re going to do today…

Oil’s “Chicken Littles”

Oil’s meteoric rise over the past year has been extraordinary.

In fact, WTI alone climbed 42.1% from June 21 through December 29.

We had already surpassed my second-quarter pricing predictions for both WTI and Brent… before January was even over.

Normally, at this point, I would comment on the overuse of short positions to profit from pushing oil down.

This has been the normal sequence in the past.

As soon as oil would show some weakness, “Chicken Littles” would populate the airwaves and proclaim the “sky is falling” (i.e., oil going down to less than $40 a barrel) and then, to the extent investors bought it, run all the way to the bank.

A short play profits when an expected decline occurs.

A player borrows a position from a broker and then immediately sells it in the market.

Later, by or before a contracted time, they then go back into the market, buying back whatever the short was based upon, and returns it to the original lender.

If the assumption proves correct, a profit is made on a declining underlying asset.

For example, an investor believes XYZ stock will decline.

It is currently trading at $10; it’s borrowed and immediately sold at market.

Later the stock goes down to $8, the short player enters back into the market, buys back the share, returns it to the original lending broker, and pockets a $2 profit.

Shorts, however, remain quite risky.

If you are wrong and the underlying asset increases in value, there is theoretically no limit to how much can be lost.

Early redemptions of shorts to avoid catastrophic losses will serve to fuel a further spike in price.

OK, absent a major drop in global demand and/or an unexpected (and prolonged) rise in excess supply, it is the yo-yoing of the market via shorts that usually provides the rationale for prices moving south.

Some shorting is inevitable, given the demand/supply dynamic in an environment in which every pundit knows there is plenty of extractable volume available for ready dumping on the market.

The problem at this point, however, is two-fold.

The Two-Fold Problem With Shorting Oil

First, the short is resorted to far more quickly than is warranted.

Proponents appear to have little else in the quiver.

Over the past two weeks, for example, there has been little coming from market fundamentals to justify it.

Second, when the decline in oil prices arises as a “backdoor” effect from a rapidly descending general market, shorts can overemphasize and artificially accentuate the downward pressure.

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Remember, as I have noted here on several occasions, “paper” barrels (futures contracts) drive “wet” barrels (physical oil consignments in actual trade).

On any given day, there are far more paper than wet barrels in the market.

But it is the presumption of the trader that often puts a thumb on the scales.

In an expanding price market, the grader will peg a contract price to the cost of the most expensive next available barrel.

In a declining environment, the calculation is weighted toward the cost of the least expensive next available barrel.

This is necessary to hedge risk, with options taken lessening exposure to larger swings.

A balanced price is set by oil traders in both paper and wet barrels, but often the connection between the two is strained.

When prices were north of $120 a barrel several years ago, traders in physical oil would tell me the price had been inflated by futures contracts well beyond what the actual value of the oil was commanding in the market.

Similarly, more recently, when crude was dipping below $35 a barrel, those same traders were telling me the price based on physical demand was higher.

Now in all cases, the element of arbitrage arises.

Balanced Oil Prices

A balanced price requires that the paper and wet prices converge as the futures contract reaches expiration. For that to take place, participants need to take positions on one or the other of the two sides to even out any divergences.

It is a testament to the changing times that such arbitrage has been difficult to accomplish.

Without the use of derivatives to bridge what is more frequently, a widening gap as futures contract exportation approached.

All of which is a primer to what actually happened last week in what is the most important factor to take from that roller coaster of a ride.

The slide in oil prices was exacerbated not be shorts but by the unwinding of long positions. Put simply, the prevailing attitude of traders moving into February was for oil prices to be rising, not falling.

Sideswiped by the broader market contraction, those long positions (expecting higher prices) had to be sold (or options on contracts exercised, which amounts, in this case, to essentially the same thing) to mitigate losses.

As the oil prices rebalance, therefore, don’t be surprised if the pricing floor begins rising yet again.

Sincerely,


Kent

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  1. James
    March 3rd, 2018 at 08:35 | #1

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