Speculators’ Tail Wags Oil Market Dog As Paper Trading Dominates

Trading oil markets used to be hard work.

You had to talk to all the major players all the time (not just message them), and learn to judge whether they were telling the truth or inventing a version of it. You had to watch for breaking economic and political news. And you needed your own supply/demand balances. Plus you had to guess how the fabled ”Belgian or New York dentist” – who traded oil futures to break the tedium of drilling teeth – might be feeling each day.

Today’s trading world is completely different:

More than half of all trading is done by machines at ultra-high speed. These are the “legal highwaymen” described in Michael Lewis’ great book Flash Boys. And they don’t care about the real world of oil markets or the economy, as these factors are irrelevant to their business models

Then you have the hedge funds, and even some pension funds, with quarterly targets for profit. They can’t afford to spend time developing a detailed analysis, and waiting for the market to catch up. They have to play the momentum game of finding a story, and jumping on it as quickly as possible

In addition, of course, there are still producers and consumers, who actually need to buy or sell oil. They used to set the market prices in the past, but are just an also-ran today as their volume is so small relative to the others. But in the “real world” outside of financial trading, they are the only people who matter

New data from the CME highlights the change. It shows paper trading in just WTI futures averaging a record 11 million contracts each day in 2016 (each of 1000 barrels). Actual physical production, by comparison, is around only 92 million barrels per day. The speculative tail is indeed wagging the dog.

The chart above shows the current net position of the speculators, which is at a record 371k contracts. It highlights just how much they love the OPEC production cut story – it is easy to understand, and is easy money for everyone, particularly the momentum traders, as the story seems never-ending.