If there has ever been a better example of the tail wagging the dog, I haven’t seen it.
As you’ve seen me say before, swings in oil prices often have less to do with market dynamics and more to do with paper traders – people trading futures, options, and other hedges. Of course, what does happen in the actual market may be the initial prompt for how such derivatives are played.
This time, however, we had an avalanche of events that magnified the impact.
Here’s what happened – and where oil is heading next…
The Concerns Used to “Justify” the Crash Have All Been Answered
It began in the U.S. markets as main trading support levels weakened, prompting the unwinding of long positions.
Now, there were no new developments to bring this about. Questions over whether OPEC would extend production cuts/caps in June for another six months, a rise in U.S. extraction rates, and concerns over demand levels remained.
But all these concerns have been in vogue for some time.
And all of them have already been answered…
The OPEC restraint will almost certainly continue for at least the rest of this year. Some discussion has emerged over whether the cartel and main non-member producers like Russia would increase the reductions. But that (however unlikely) has nothing to do with maintaining the current floor for prices.
Meanwhile, U.S. production has been increasing. Yet the levels reached by the beginning of May have also resulted in something beyond pressuring prices. The current level is once again putting the very companies raising production under the threat of a renewed round of debt default.
In other words, the production growth is not sustainable.
The operators most fueling the aggregate production rise are almost literally one step ahead of the sheriff, producing and selling to stay afloat. However, the cash flow is eaten up (and then some) by the increasing cost of the debt load.
At current prices, there is no basin in the U.S. where wellhead prices (the first level when production comes out of the ground and the price received by the operator) are profitable. Wellhead prices run about 15 percent or more below market price. With market prices south of $50, these companies leading the production rise are once again facing revenue levels insufficient to survive.
Finally, the angst being expressed about oil demand not growing is a chimera. Demand continues to be well within seasonal margins in the American market and is once again expanding elsewhere.
In short, the price collapse last week had little to do with oil – but a lot to do with paper cut on oil. That makes for a textbook example of a flash. This was all about technical hijinks.
Here’s how it all went down…
Once the Computers Took Over, the Dip Turned Into a “Flash”
Antsy traders overreacted to crude approaching some technical support levels. After a tug-of-war between bulls and bears over several weeks, WTI breached its 200-day moving average. Given the large number of long positions in the market, traders started selling those out of fear. That added additional pressure downward.
Two matters then took over.
First, the year’s low for oil prices came to be seen as the next solid support level. Second, a series of esoteric indicators derivative traders use to handicap market moves came into play. Called “Fibonacci retracements,” they comprise taking extreme pricing points (a peak high and a trough low), and then divisions of the vertical distance between them by the key Fibonacci ratios of 23.6 percent, 38.2 percent, 50 percent, 61.8 percent and 100 percent. The statistical result is then applied to other factors in arriving at optimal buy and sell levels.
Don’t worry if you have no idea what this means.
Many of the guys using them don’t really understand them either. But here’s the issue…
These “Fibonacci retracement” price levels are used as triggers for automated computer trades. Once the price of oil hits one of them, a computer performs the pre-determined trade, no matter what else is happening.
These “retracements” are static figures, not moving averages. That means they cannot compensate very well to either rising trading volume or artificially exaggerated pricing.
The problem last week was then compounded by foreign trading overnight and a rush into options contracts to cover the moves from long to short positions. Those options represented at least 520 million barrels of underlying oil by the time the frenzy had subsided early on Friday.
That’s the third highest level on record, and represented far more than the entire global amount of actual crude trading for the entire day.
But that wasn’t the end of the over-exaggeration…
Options Traders Added Insult to Injury
Things were blown even more out of proportion by the frequency of trade.
Initial estimates had NYMEX data showing WTI open interest (the amount of open options contracts) rising to a record 2.27 million contracts on Thursday. That merely accentuated the action overnight.
The number of WTI contracts traded in a minute, typically in the hundreds early in the trading day, surged above 7,000 by 4:30 AM London time.
One trigger tripped another as computers around the world magnified nonevents into a major downward result. The artificial technical ways in which traders attempt to find points at which to make transactions just before the markets move ended up distorting the market itself.
The computers controlled the market, rather than the other way around. The tail wagged (more like hammered) the dog.
This reminds me of a well-known phrase – to err is human. But if you really want to screw things up, throw in a computer.
There is no better way of indicating the overreaction than to realize what is happening right now…
Where Oil is Heading Next
As I write this, WTI prices are surging 4 percent, virtually reversing all the dive from Thursday and Friday last week.
The rationale given by the pundits, the same guys who were touting oil’s free fall only a few hours ago, is a decline in production (more than 5 million barrels in the U.S.) and rise in demand.
Of course, as you’ve already seen, these signs were never really the cause of the problem to begin with.
So, don’t worry about last week’s “oil flash.” Prices will recover.
The United States Oil Fund LP ETF (NYSE:USO) closed at $9.95 on Friday, up $0.01 (+0.10%). Year-to-date, USO has declined -15.10%, versus a 6.91% rise in the benchmark S&P 500 index during the same period.
This article is brought to you courtesy of OilPrice.com.