‘Bot traders’ defy Opec and determine the price of oil

September 20, 2024, 3:24 AM

Quantitative speculators can anticipate and 'accelerate price changes initiated by fundamentals'

Speculative traders drive price
Algorithms exaggerate rise and fall
Traders ‘rule the roost’

Oil has been trading at its lowest levels in a year, posing a severe challenge to Opec in its efforts to impose a floor on prices.

But analysts say that speculative financial players are also driving price determination, alongside traders who study the fundamentals of supply and demand.

Opec has voiced frustration at what it described as speculators in the past, but has recently become reconciled with the realities of financial markets.

The speculation against so-called “financial barrels” was stoked by the phenomenon of negative oil prices in April 2020 during the Covid-19 pandemic, when falling demand and oversupply filled storage capacity.

Traders holding futures contracts faced delivery obligations and were forced to pay buyers to take the oil off their hands. Oil was priced negatively despite having a tangible value.

Today, quantitative and algorithmic trading makes up more than 70 percent of the daily trading volume in the futures market, according to experts. That can have the effect of exaggerating rises and falls.

For example, after a dramatic sell-off last week, where funds held a net short position never seen before, in the expectation that oil prices would fall, the number of long contracts – where traders think prices will rise – held by swap dealers on the global benchmark Brent jumped by almost 50,000 lots, according to Bloomberg.

Each day the financial barrels, which are traded by hedge funds using quantitative algorithms, play a large part in determining outcomes.

Ilia Bouchouev, partner at Pentathlon Investments, tells AGBI that when markets are fundamentally balanced – when production is approximately balanced with demand – as they are currently, then financial barrels dominate.

“Today, the price is driven by many factors that Opec can’t control,” Bouchouev says.

In the early 1990s the daily trading volume of petroleum futures, options and over-the-counter derivatives was roughly similar to daily oil consumption.

Bouchouev says that today the ratio is 60 to 1, which means that if 100 million barrels per day are being consumed globally, 6 billion financial barrels are traded. “This market is huge and is growing,” he says.

Funds like Bridgewater, one of the world’s biggest hedge funds founded by Ray Dalio who is now based in Abu Dhabi, and Commodity Trading Advisors, algorithmic money managers, are among the main players in the market.

These investors tend to look for mathematical correlations between and within asset classes.

Accessories, Formal Wear, Tie Ray Dalio, the founder of Bridgewater Associates, one of the main players in the market oil trading speculative algorithm — Ray Dalio, the founder of Bridgewater Associates, one of the main players in the market

“Size matters,” says Jorge Montepeque, managing director of the benchmark at Onyx Capital Group, an oil swaps specialist.

“Algorithms analyse the behaviour of the market,” he says.

He explains that the speed of algorithms has affected the market. "With the advent of electronics and the ability to create more credit, pay sooner and cover the position electronically, by definition the speed and size of trading grows and this impacts volatility.”

Matein Khalid, chief investment officer in a private office and an AGBI columnist, says the huge synthetic market is dominated by a few global names such as the investment banks Goldman Sachs and Morgan Stanley.

At the same time, giant commodity trading houses including Vitol and Trafigura trade oil for physical delivery.

“Who rules the roost?” asks Khalid. “It's not the Permian Basin in Texas, it's not Prince Abdulaziz [bin Salman Al Saud, Saudi Arabia’s oil minister]. It’s not Putin in the Kremlin. It's the oil traders. When traders take a position on a commodity, it becomes reality."

Quantitative speculators have become more sophisticated and incorporated fundamental signals in their calculations. They not only follow the curve, but they also anticipate and “accelerate price changes initiated by fundamentals,” says Ole Hansen, head of commodities strategy at Saxo Bank.

Matt Stanley, head of market engagement at Kpler, says connection between the physical and synthetic market could become obscured during periods of intense speculative activity. “Just last week, for instance, I would classify the market as oversold,” he says.

Oversold means that sales were not justified by fundamentals.

Bouchouev says however that algorithmic traders are not investing without insight or guidance.

"They are quite smart and able to find patterns in the historical data that seem to push the price based on the fundamentals.”