It’s an old debate: Is it fundamentals or trading that primarily drive oil prices? As John Kingston, previously of Platts and now president of the McGraw Hill Financial Global Institute, explains in this week’s Oilgram News column, Petrodollars, it’s not always an either/or debate.
When oil prices spike — and to a significantly lesser degree, when they collapse — it sets off the same debate almost every time. Did the price rise because of fundamentals? Or did the price rise because of investment flows and trading activities?
At the heart of this debate is the idea that there is essentially no overlap between these two things. It would be almost amusing except for the fact that politics often injects itself into the debate, and of course no political leader wants to tell his or her constituents that they’re paying higher prices for gasoline because of fundamentals.
So the evil actions of traders are blamed, some investigation is launched (which always concludes that it is fundamentals that led to the price rise) and the general public ends up cynical and poorly informed about the price of oil.
People with knowledge of how markets work inevitably fall on the side of fundamentals, but would never deny that trading activities can have short-term impact. But that’s why it was so fascinating to hear Ed Morse, at the Platts Benposium East conference in late August, talk about how the two of them came together in the first half of this year.
Morse is probably the world’s most renowned oil bear, sort of like Paul Horsnell — then with Barclay’s, now with Standard Chartered — was the most renowned bull during the days leading up to the market peaks of July 2008. As a result, Morse, like Horsnell before, is the EF Hutton of today’s oil market. He talks, people listen.
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Morse has spoken for awhile about the possibility of oil reaching into the $20s/b, and has painted a picture for several years of an oil market that was going to be rocked by shale, with impacts far beyond what conventional wisdom was predicting.
So that’s fundamentals. But what Morse told Benposium East is that it was traders who had a big impact on the price of oil this year, lifting it in the second quarter when fundamentals could not justify such an increase. But although that trade-driven move fizzled out — as they always do — it left behind an impact on fundamentals.
According to Morse, the upstream side of the business took the second quarter price increase as a signal: keep on producing, and increase it if you can. (The Platts WTI assessment in the second quarter opened around $49.70/b, finished up near $60/b and averaged about $57.85/b).
“Hot money is significantly responsible for the growth of US shale production,” Morse said in the Benposium East keynote address. “A significant amount of that production, in a rational market, would never have seen the light of day. Investment flows would never have gone into it but for the low interest rate environment.”
That “low interest rate environment” was created by central banks, Morse noted, through quantitative easing and other loose money policies. And that created “hot money,” which boosted prices that in turn signaled to the upstream sector to keep pumping.
Not all investment flows into the oil market that helped support prices in the first half of the year are hot money, in Morse’s definition. He cited rebalancing in commodity funds as one factor in the price surge. But the amount of money that went into commodity-focused ETFs was “remarkable,” he said, and to a degree, somewhat understandable: it was based on “the expectation that the forward curve was telling you it was dumb to not invest in oil over six months or 12 months.” (On April 1, the 12 month curve was out about $8.50/b off a prompt price near $50/b.)
Morse drew the analogy to what happened with ETF money that flowed into natural gas in early 2009, when the steep forward curve of natural gas was seen as encouraging going long. (On the first trading day of February 2009, the prompt month natural gas contract on NYMEX settled at about $4.55/MMBtu on that day, the spread with the 12-month contract was almost a full $2/MMBtu.)
Some of that length came in as “hot money,” and as Morse noted, by June or July, “they lost 90% of their investment through a combination of the contango curve, and secondly, on a prompt contract that didn’t want to go up.”
Based on Morse’s other comments — demand growth isn’t as buoyant as some people would believe, (especially the “remarkable” China story), “not much hope of change” of Saudi output or its quest for market share, the refusal of non-OPEC nations to “roll over” and have their output slide — he doesn’t see the prompt oil contract as “wanting to go up” any time soon either.
But that financially-driven first half surge in prices spilled over to fundamentals, a merger of paper demand and physical supply. It does happen. — John Kingston
