When oil prices surged to a record $147 per barrel in July 2008, the meteoric rise was not due to structural changes in the physical market that would have warranted such high volatility. The prices of oil traded on the New York Mercantile Exchange (NYMEX) had shot up from around $90/bbl in January to set a new record by July. Prices then fell sharply, shedding more than $100/bbl to settle below $40 by the end of that year. The high level of volatility witnessed at the time was due to factors that had little to do with supply and demand fundamentals and more with market psychology and the role of speculators in the derivatives market.
Geopolitical tensions and market volatility
There are similarities with today’s market conditions in that there were geopolitical tensions in the Middle East that contributed to bullish sentiment. However, back then, there was very little spare production capacity available. U.S. shale oil had not yet made an impact on global supply, but that was the year when U.S. production began its rapid growth to levels above 13 million barrels per day. Market volatility returned in 2012, again driven by geopolitical worries that emerged as the Arab Spring revolutions took hold across some countries in the region. Oil prices climbed above $100/bbl, reaching a high of $125/bbl.
It was estimated at the time by banks and financial institutions that speculative activity by players betting on price direction had added roughly 15 percent to the prices of oil in 2018. Goldman Sachs calculated that for every million barrels of non-commercial, speculative oil contracts (or paper barrels), the price increased by 10 cents.
Evolution of financial trading in oil markets
As the trading business has evolved and technology has become more sophisticated, the number of financial players has multiplied.
Ilia Bouchouev, senior research fellow at the Oxford Institute for Energy Studies (OIES) and former president of Koch Global Partners, explained in a recent podcast hosted by the OIES that as recently as the early 1990s, the ratio of paper barrels to physical barrels traded on the futures market was roughly one to one. Today, it has ballooned to 60-1. The world currently consumes more than 100 million b/d of oil. So, if multiplied by 60, the volume of trades in petroleum futures, options, and over-the-counter derivatives comes up to 6 billion b/d, he says. Virtual barrels, as he calls them, have replaced paper barrels.
Apart from that, there’s the combined volume of futures traded on other exchanges (such as the Shanghai International Energy Exchange), futures on other types of oil (such as Dubai and Murban), gasoline and diesel futures, and over-the-counter derivatives that are equally large, Bouchouev wrote in a paper published by OIES in January.
An example of this expansion in futures trade came with the launch of Abu Dhabi’s Murban futures contract on the Intercontinental Exchange (ICE) years ago. The Murban contract has since reached record levels. ICE has said that on June 5, the volume of trade rose to a record 37,887 contracts, equivalent to more than 37 million barrels. Volumes of the UAE’s flagship crude grade are set to rise further in anticipation of higher production after Abu Dhabi secured a higher OPEC+ quota from January 2025.
Speculative trading and market dynamics
While the OPEC+ producers’ alliance can influence the physical market with supply management policies, the virtual market does not always follow the rules of supply and demand fundamentals.
According to Bouchouev, when eight producers in the OPEC+ alliance decided to make a voluntary output cut of 2.2 million b/d late last year, around 250 million barrels were traded by financial speculators over the following month. This amounts to 8 million b/d. The result was a decline in oil prices rather than the increase that was intended by the OPEC+ action.
“Everything is somewhere in the cloud. The deals are basically being driven by computers,” he said in describing what is meant by virtual barrels. It’s hard to determine to what extent speculators have influenced oil price movements. The last serious investigation on the role of speculators was conducted in the aftermath of the 2008 global financial crisis, Bouchouev noted.
“The sharp movements in oil prices could not be fully explained by using fundamental data alone. While the invisible hand of speculators was clearly present, proving it empirically has been difficult, and oil experts have largely disagreed on the impact and the mechanisms through which speculators could impact oil prices,” he wrote in the paper.
Analysts did not agree on the reason for the volatility, and a lack of relevant data at the time made it difficult to draw definitive conclusions. Bouchouev says the market has changed dramatically since then, and what happened in 2008 has no relevance today “because financial volumes have more than doubled since then, due mainly to quantitative algorithms.”
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‘Energy Quantamentals’
“The rapid growth in oil derivatives has been mostly driven by the proliferation of quantitative and algorithmic trading, which now makes up to 70 percent of the daily trading volume in the futures market,” Bouchouev wrote in the paper titled “Energy Quantamentals”.
In the podcast, he said that the term refers to the development of a type of hybrid market, where quantitative speculators are trying to use fundamental signals.
“The idea is really the quantum is a hybrid….It applies to quantitative speculators who are trying to use fundamental signals, but it also applies to physical speculators who are beginning to use quantitative signals,” he continued.
But what all the technology in the world cannot predict is geopolitical risk and unforeseen shocks like the wars in Ukraine and Gaza. It’s because computers do not have the capacity to understand geopolitical risk.
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