Oil has long been one of the main drivers of the worldwide economy and for this reason it is closely watched by all investors and traders. The central role of what, back in the days, was called the “Black gold” is given by its high cross asset correlation. It has the power of leading the main indexes into bullish or bearish sentiment, to keep awake central bankers around the world trying to find a way to boost inflation in their countries through QE programs not appropriate for a low oil price environment, and to worry investment banking analysts carrying out valuations for possible M&As or bonds issuances, depending on the stage of the business cycle within the energy sector.
Therefore, we would like to analyse what stands behind the wide swings that affected the price of oil in the last few years, look at the fundamentals on which oil is traded, and try to understand if the actual price is in line with them or if it is affected by other exogenous variables. For this purpose, we had the opportunity to discuss with Francesco Martoccia, crude oil derivatives trader for ENI in London, who gave us a real-world insight about this uniquely complex industry.
First of all, to determine the price of oil we have to find out which fundamentals are closely watched by traders.
Apart from the widely used fundamentals that affect main asset classes, like specific countries’ GDP or expectations about growth, fundamental sources of information come from statistics about the daily production of barrels of oil, the level of retail sales, and sales in the automotive industry (more specifically sales of SUV and commercial vehicles, as they represent the main driver for the demand of gasoline). In addition, another closely watched metric for physical traders of oil comes from the cargo tracking. Traders watch at the number of contracts that are bought by oil producers to fill tanks and by comparing with historical data, they can determine whether there is over or under production.
For example, with a focus on the American production of oil, the most important indicator is the level of barrels that are stored in the Cushing region, Oklahoma. This is the main on-shore storage point in the US. It sits on the conjunction between the pipelines coming from drills all over the country. At the peak of the shale boom, roughly one year ago, the inventory level was around 66-67M barrels, with no possibility to increase that level, as the maximum threshold in terms of storage capacity had been reached. This glut in on-shore storage capacity in the US resulted in a sharp contango in WTI futures, which was subsequently called super-contango. The annualized basis for front-month futures contracts approached 100% of the current oil price, which lead to an unprecedented situation: combined with decreasing prices for oil tanker capacity (due to excessive supply of ships), oil traders opted for hiring tankers and using them for off-shore oil storage, rather than for transportation, thus locking profits from the enormous contango.
For what concerns the gap between demand and supply of oil, we have to take into account several factors, which span from technical to a geopolitical.
In order to understand the current oversupply situation, we should go back in time to 2014, when the innovation in the drilling industry led to a significant reduction in the costs of extraction.
Thanks to the horizontal drilling, a technique which allows extracting oil from the rocks, the supply of oil increased exponentially over a brief timespan. From then on, the development of further and more efficient cost saving techniques hasn’t stopped. The technological developments and the cost cutting strategys that have been adopted by oil drillers during this low-price environment have allowed for a drastic reduction in the BEP (break-even point) of same shale drillers in the main basins in US. For instance, from around $70/barrel in 2014 to $50 in 2015 and around $40 today. This has allowed oil drillers to survive in an environment characterised by low oil prices and over-production as we see today.
This is possible thanks to the high speed with which oil drillers can stop and re-start to pump oil out of these rocks deposits; that is around 30 days for an existing drill and 60 days to build a new one. This allows them to get quickly back into the market when prices rise past their BEP.
This has effectively put a maximum threshold on the price of oil.
On the other hand, another important role is played by geopolitics. In fact, there are some countries, like Russia and Saudi Arabia, for which the BEPs are drastically lower than shale oil producers in US. These countries are more focused on gaining market share rather than avoiding lost revenues from a low oil price.
Saudi Arabia is pumping oil and has reached an all time high in its production. The reason is twofold: on one hand they want to gain market share, trying to block the revamp of Iranian production, which has come back into the market after their embargo has been lifted. On the other hand they desire to boost profits to face the high amount of debt they have on their national balance. Recently negotiation of spot contracts with China has started on behalf of Saudi Arabia, which represents a breakdown with the past policy of the Arab country, who used to deliver only through fixed supply contracts.
For Russian companies the situation is a bit different. The great fall in the price of oil brought a huge devaluation of the Ruble. In a way this was of big help for Russian oil producers as they sell oil traded in dollars, but they pay most of the expenses in Rubles; consequently, the cost cutting policy has been much easier and the impact of a low price oil has been much lighter. As such, if we analyse the price of oil in Russian Rubles, it stands just at a 3 years low. This does not hold for Saudi Arabia, who has its national currency pegged to the US dollar.
The current gap between demand and supply is at 1.7M barrels per day, and for the very near future we can expect this gap to widen even further as the result of current production level. On the other hand, this leads to one very remote possibility; a cut of production by market players. A sluggish economy and stagnant demand would act as a probable counterfactual.
Therefore, looking merely at fundamentals, a reasonable price for oil stands in the low $30-$40 range; consequently, oil traded over $45 appears to be out of fundamentals.
After having analyzed the most important drivers of the oil industry, we want to focus our attention on some of the trading strategies that are widely used by oil traders. The first strategy we want to discuss is technical analysis.
Information gained through technical analysis is mostly directional, and it can help to support or deny a fundamental or a price level. Given the variety of actors in the oil industry in this period, and their different strategies, this method is not very useful because it frequently fails. But why do oil traders still use technical analysis on their day-to-day trades? This is because a less known use of this strategy is the application of some technical indicators to gain insights on momentum. Understanding the momentum of the market is extremely helpful for a trader to understand the right timing to execute a trade and how long that trend is going to last. There are two important oscillators that are, generally, closely watched by traders: RSI and MACD.
The first one, Relative Strength Index, is an oscillator often used on the futures markets. The line produced by this oscillator varies between 0 and 100. If the line is in the 70 to 100 area, the market is overbought, otherwise, if the line is in the 0 to 20 area, the market is oversold. The divergence between the price of the asset and the line of the RSI is a signal for buying or selling. The MACD, moving average convergence/divergence, is another oscillator developed by technical analysts and it shows two lines: the MACD line and the signal line. The crossing of the two lines provides the traders with bullish or bearish signals.
Finally, the study of trading volumes is also highly informative. In fact, looking at the type of buyers and sellers active on the market, and the size of their positions gives a lot of information regarding which trends will last and which, instead, are less relevant.
The second approach to oil trading we want to discuss is news-based trading, and how this strategy is becoming more and more controversial for the oil market.
News-based trading involves reading all the news released by the financial press and news providers, and taking a position based on the bullish or bearish contents of new themselves. This strategy is one of the most used in the oil market right now for at least two reasons: the first one is the distance between the current oil price and its fundamentals, in fact, if you can’t trust the fundamentals because they don’t represent the reality, you can just trade the hot news available.
The second and most important reason is the strong presence on the market of CTAs. A CTA, commodity trading advisory, is a trading advisor focused on buying or selling futures and options within the commodity market. The impact of these CTAs on the oil market is huge as they are able to control, with the 10x leverage they use, $3.3 trillion every day. The peculiarity and the strength of these actors is their use of algorithmic trading. Algorithmic trading is a rules-based trading. The rules into the algorithm are able to understand and interpret all the news made available to investors and to execute a trade in such a short time that a human can’t be faster and can’t beat them. These funds prosper in volatile markets because they can open and close positions suddenly, triggering the stop loss of the human traders and being profitable, the majority of the time. Given the large amount of money they move and the quality of the algorithm these players use, they are probably one of the most important drivers of the divergence of the actual oil price from its fundamentals. Most likely, as long as they are present on this market with such a big amount of money, they will control it.
Given the delicate situation and the bizarre behaviour of the market, it’s very difficult to place a directional trade. This is the reason why derivatives trading volumes are so high on the oil market. The golden rule seems to be “don’t take any position”: play with volatility, or at least make sure your trades are hedged. This is the time when being able to use options combinations such as straddle and strangle becomes fundamental to be profitable because betting on the direction correctly appears impossible. Do you feel lucky? Place your bet.
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