For months, pundits have focused on rising production, mostly from US shales, sluggish demand, primarily from European stagnation and disappointing Chinese activity, aided by conspiratorial Saudi/OPEC intentions. And there is no doubt that some of this is true…last year, today, and probably over the near term.
The underlying oil (physical) picture stands, roughly, at 91 million barrels a day of output, and 90-ish million barrels a day of demand, after a year or two of greater production growth, especially from nonOPEC sources, than global demand growth, especially in emerging markets. Historically, energy investors have focused on the ‘call on OPEC’ on the assumption that higher calls mean greater OPEC ‘control’ over output and, on the margin, price.
This is little different from the First Law of Commodities (to paraphrase Charles Dickens*) — as/if margin demand exceeds supply (assuming limited short term response), the value of marginal demand dramatically affects the price — and vice versa. It was worth, perhaps, $110 a barrel to buy and store oil in one environment, at $50 (or less), customers have little fear of shortage and no need to carry inventory, indeed, dramatic liquidation is inevitable in the current market. At some time/point, this psychology is likely to change, in part as inventory shrinks beyond barebones level, but also as reduced investment eventually leads to lower output, but when is anybody’s guess.
No surprise in these observations. But little hot air has focused on how the paper/futures markets, generally dominated by ‘non commercial interests’ (hedge funds, speculators, etc), which dwarf the physical markets. Yes, the “open interest” for near month crude oil contracts (proxy for spot) can run 15-20x the underlying commodity!
The chart below illustrates a portion of this issue – 800,000 contracts, at 1000 barrels of oil each, traded on the The Chicago Mercantile Exchange (additional volumes trade on the NYMEX and ICE) on January 5 — with over 8x daily consumption trading in the ‘paper markets,’ just for this exchange. And this was half of the daily turnover during certain mid-December sessions.
It’s an age old question – is the underlying commodity dictating the paper trade, or vice versa? And, of course, the prices are linked as many participants can arbitrage paper and physical markets. But I would argue, in a heavily momentum-based environment, the power and momentum of a paper trade cannot have an insignificant effect on both the psychology and, therefore, reality, of the commodity price, forcing, eventually, corrective behaviors in the real market.
I’ve become somewhat time-separated from my former expertise in this area, and stand ready to accept constructive comments. Thanks for reading this far!
*”Annual income, 20 pounds, Annual expenditures, 19, 9 and 6, result happiness. Annual income, 20 pounds, annual expenditures 20, ought and six, result, misery.” Charles Dickens. Or, in commodity terms, the difference between shortage and glut can be one railcar, or the PERCEPTION that there is one railcar, on either side of demand.