Crude oil has been cursed by speculation, and there is a lot of blame to go around.
Just a month after OPEC's cut in production, oil is now below where it started. What's the cause? Government money printing, egotistical global politics, and the creation of financial products to bring commodities to the masses have all worked toward the creation of the current chaos. I am not suggesting that derivatives such as micro oil futures are all bad; they are a great way to allow efficient hedging and speculating in the most influential commodity on the planet. But it is challenging to justify commodity ETFs (exchange-traded funds) that pool investment dollars to buy futures contracts, which tend to be most inefficient at the least opportune times.
What happened to crude oil this week? In my opinion, exuberant speculation, and the unwinding of those positions, particularly in oil ETFs, happened. Because ETFs are easily accessible to all, they are prone to attracting far more investment dollars than the underlying commodity market can absorb; on the other hand, when the masses decide to hit the sell button, commodity prices decline in a vicious vacuum to prices that make little sense from a fundamental standpoint.
ETFs are prone to attracting far more investment dollars than the underlying commodity market can absorb. But when the masses decide to hit the sell button, commodity prices decline in a vicious vacuum to prices that make little sense from a fundamental standpoint.
Commodity ETFs are undeniably convenient and comforting. After all, to trade them, one merely needs an open stock account, and investors can sleep at night knowing they can't lose more than the amount invested. Yet, their comfort has been a burden that futures market participants, brokerages, and (to a lesser extent) exchanges have been involuntarily required to bear.
Since March 2020, the oil futures market has been wrought with volatility. To be fair, oil has historically been a treacherous arena for price discovery, but it is reasonable to say that in recent years we have seen some extreme moves that qualify as black swan events. These types of events should unfold once a decade, not twice in three years, yet here we are. The oil market would have undoubtedly experienced a price shock in early 2020 and again in early 2022 without overzealous speculation, but I firmly believe massive amounts of money flowing in and out of ETFs exacerbated what was already a challenging period for commodities. While it isn't something you see in print often because the financial industry is in the business of selling products to investors, the wild selloff that led to negative oil prices in the front-month futures contract was largely made possible by the blow-up of a popular crude oil ETF. While investors in the oil ETF lost most of their investments, the ETF issued a stock split, changed a few details on its prospectus, and continued operation.
Meanwhile, on the futures side of things, the carnage was real. Some unsuspecting futures traders, unaware that commodities could trade below zero, not only lost what they had in their trading account but far more.
Even for those trading the back-month-future contracts, which was the majority of traders at that point due to the proximity of expiration, the selloff was surprisingly steep. In many cases, individual brokers, and brokerage firms, were left with massive holes that needed to be filled to make the exchange whole. Most retail commodity futures traders are unaware, but if their losses exceed their account balance and they cannot fulfill their obligations, it is the broker or brokerage that must pay out of pocket (and later take legal action against the client to recover damages). The exchange is mostly immune from this risk because the client or the broker covers it before losses get into the pockets of the exchange. This is how the exchange can offer leverage without charging interest and simultaneously guarantee every trade.
In the spring of 2022, the oil market felt the exact opposite type of price frenzy. WTI oil rallied from $90 per barrel to about $130 per barrel in a few quick days. I believe this move, although triggered by the war in Ukraine and inevitable, was made even more chaotic by the inflows and outflows of the oil ETF. Some would argue that these speculators could have the same impact on volatility using outright futures contracts or options on futures, and that is partially accurate. But the difference is those with access to futures markets are required to apply separately, fund their account separately, and accept and comply with the risk of losing more than is on deposit, as opposed to shifting that risk to others as the ETF does. These factors act as a barrier to entry that deters the casual and fickle bandwagon trader. More importantly, it prevents unusual cash in and outflows that interfere with natural commodity price discovery.
Chart Source: QST
Perhaps the volatile collapse in oil prices in the face of OPEC's efforts to stabilize can at least partly be explained by breakout trading and news chasing in the ETF. Buyers came into futures and oil ETFs on news of the OPEC production cut in early March, then more stepped in when the OPEC announcement gap was filled, but as the rally failed and sell-stops started to get elected, then came the panic selling, followed by margin call selling. When the masses sell because they must, not because they want to, prices can become distorted and stray from logical market fundamentals. I believe this is what we are seeing now.
From a charting perspective, the low $60s are likely going to prove to be a springboard to the next rally, but it would be naïve to expect anything less than chaos as the market works through the liquidation process.
