Quick Thoughts On Oil’s ‘Red Friday’

Earlier this week, I wrote that for something that’s ostensibly driven by relatively straightforward supply/demand dynamics, forecasting oil prices isn’t usually very straightforward.

Even if you master the fundamental drivers and understand the impact of hedging, speculation and the potential for certain investor types (e.g., CTAs) to exaggerate directional moves, you also have to take account of geopolitics.

This week ended up being a crash course (figuratively and literally) in the perils of attempting to make predictions about crude.

The Biden administration managed to orchestrate a coordinated reserve release with other consumer nations in an effort to send a message to OPEC and allied producers who, over the last two months, have been reluctant to stray from an existing plan to gradually increase output.

Although The White House claimed a retroactive victory by citing the recent decline in prices, the concurrent price action (that is, oil’s response to the actual announcement of the SPR release) was underwhelming.

A generous (and probably accurate) interpretation was simply that the market had already priced in the news. In fact, there was an argument to be made that prices had overshot to the downside thanks in part to increasingly dour COVID headlines out of Europe. A less generous interpretation was that Washington scored an “own goal.”

But it mattered little by Friday afternoon. Brent’s one-day plunge, catalyzed initially by demand concerns tied to the new COVID variant, was among the largest on record (figure below).

OPEC+ was already considering how the group might go about offsetting the coordinated reserve release. For months, producers argued that the persistence of the pandemic meant the demand outlook admitted of too much uncertainty to risk dramatic output hikes.

Obviously, that excuse was self-serving — producers lined their pockets as prices rose. Now, though, warnings on the possible reinstitution of travel restrictions and other curbs on activity aimed at containing new virus outbreaks seem prescient. If OPEC wanted an excuse to pause output hikes, the cartel has one in the Omicron variant.

Note that the dynamics mentioned here earlier this week were surely in play during Friday’s collapse. That drop pushed crude prices below technical support, which probably triggered selling from trend-followers. And hedging flows likely helped turn a selloff predicated on demand fears into a historic collapse.

Some years ago, I worked with a fellow who, in many respects, was smarter than me. He was certainly better with numbers. But like many market participants, his understanding of systematic flows and hedging dynamics was non-existent. One day, when the bottom fell out for crude, I gently suggested he avoid attributing the bulk of the price action to fundamentals, even though there was a fundamental justification. He didn’t listen. Less than seven hours later, Bloomberg ran a series of pieces detailing how accelerant flows turned a selloff into a rout.

I run into that time and again. Almost everyone is smarter than me when it comes to crunching numbers. But I’m blessed with a knack for understanding concepts. If you understand what’s going on and why, you can always get someone else to do the math for you. A lifetime ago, when I was still a semblance of humble, I told a prospective employer I wasn’t totally confident in my ability to speak definitively about what he was asking me to analyze. He said something like, “You’ve written about repo specialness. You’ll be fine.”

In any case, the figure (below) gives you some context for the chaos. The annotations show how the spike in one simple volatility gauge compares to those associated with the 2019 attacks on Saudi oil infrastructure and WTI’s absurd spelunking expedition in 2020.

Over the next 48 hours, Wall Street will do the math. In all likelihood, there will be a dozen or more notes penned to explain exactly how demand jitters, hedging, systematic selling pressure, low liquidity and expectations around OPEC+’s next move conspired to manifest in Friday’s epic collapse.

Goldman released a placeholder note headed into the weekend. “The fall in Brent prices [was] exacerbated by low trading activity on Black Friday (with similar moves in 2014, 2016 and 2018), the breach of key support levels (50-, 100- and 200-day moving averages) as well as likely negative gamma effects,” Damien Courvalin wrote.

“At $74/bbl Brent, we estimate, based on our pricing model, that the market is pricing a c.4 mb/d negative demand hit over the next three months, with no offsetting OPEC+ response,” he went on to say, adding that “given the large uncertainties, we await further news on the variant’s development and additional restrictions imposed before refreshing our supply and demand balances and oil price forecasts.”