WTF happened to WTI?

Commodities had a rough Tuesday, having been led downwards by oil. The front-end US benchmark West Texas Intermediate contract settled at $99.50 a barrel, down 8.2 per cent, having lost more than 10 per cent earlier. Brent was 9.5 per cent lower at $102.77 per barrel, its second biggest one-day absolute fall on record in dollar terms. Both markets are struggling to rally much this morning.

Why? The commentariat was quick to claim that recession fears were curtailing oil demand and knocking the price floor out (an argument set out in easily quotable form by Citigroup that morning, coincidentally).

That there was no reason for recession fears to have redoubled seemed not to matter. No new data had arrived to move the demand side, whereas stories such as Saudi Arabia raising crude export prices and US-Iran negotiations faltering were supportive of the expectation that supply would remain tight. Strike-breaking in Norway, potentially restoring about 130,000 barrels to the market, was positive but not unexpected and not overly significant.

That’s why, beyond the front end, all remained calm. Time-spreads — the price differential between two consecutive futures contracts — were showing no sign of distress, as Goldman Sachs notes:

Front-month Brent timespreads, diesel and gasoline cracks all weathered the fall in flat price, only down slightly on the day. In fact, the most notable move in oil prices in the past few days was the strength in crude timespreads and physical prices, reflective of a market still in deficit. This is consistent with our tracking of oil fundamentals, with an estimated global c.1 mb/d deficit in June, with China back to drawing inventories as well. [ . . . ]

While the odds of a recession are indeed rising, it is premature for the oil market to be succumbing to such concerns. The global economy is still growing with the rise in oil demand this year set to significantly outperform GDP growth, buttressed by the post-COVID re-opening in Asia-Pacific as well as the resumption in international travel.

For most of the year Goldman’s been championing a commodities supercycle argument, which has probably contributed to some crowded positions across the complex. Meanwhile, deteriorating market conditions resulted in sharply increased margin requirements on energy, agricultural and metals derivatives, as per the Bank of England’s Financial Stability report for July:

In that context, Tuesday’s commodities market ripple is as likely to be explained by a risk-off trade that just happened to have oil at the sharp end. Back to Goldman:

As is repeatedly the case with oil, the move lower was then exacerbated by technical factors and trend-following [Commodity Trading Advisor] flows, such as Brent trading through its 100-day moving average, as well as through the strikes of puts with large open interest (where negative gamma effects invariably accelerate large price sell-off). It is important to finally note that this sell-off occurred amidst seasonally low post-July 4 trading liquidity. From this perspective, this sell-off in oil prices is not all that surprising, similar in set-up and magnitude as the one after Thanksgiving 2021, most recently.

It’s a good point. On November 26, 2021, Brent slumped 10 per cent to below $74 a barrel and commentators unanimously blamed worries that a new Covid variant would impact demand. The more technical explanation — that CTAs were selling into holiday-thinned volume after oil breached various moving averages and turned their gamma negative — is probably more plausible, particularly since the same thing can be seen around Thanksgivings 2014, 2016 and 2018.

Add in Tuesday’s stronger dollar and unusually low open interest among oil futures, which has the effect of amplifying the disturbance caused by any trade, and we probably have an explanation:

We should note that Goldman’s team remains wedded to the supercycle argument and is quite keen on oil, maintaining a third-quarter Brent forecast of $140/bbl:

While our view remains that higher consumer prices are required to balance the oil market this summer, we acknowledge that significant and large shocks continue to distort fundamentals. So far, Russian exports have beaten our expectations given the lack of oil sanctions. However, this has been fully offset by production losses in Libya and Ecuador, with Saudi also producing less than expected in June based on ship tracking data. While it is hard to assume such supply disappointments continue, we note that rising social unrest at elevated fuel and food prices make such issues likely to reoccur. Of greater persistence, the rebound in Chinese demand appears to be exceeding our expectation so far, creating upside risks in 2H22 given the ongoing stimulus, as well as loosening Covid restrictions.

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