By manipulating sentiment through both verbal intervention and physical supply cuts, OPEC members have effectively used speculative money in the futures markets to their advantage. As of now, bets on higher prices among non-commercial players in the main petroleum futures markets are near a record, helping push ICE Brent to the mid-$70s and NYMEX WTI to near $70. OPEC has successfully drawn down commercial inventories and its agreement has facilitated supply cuts, but another important factor underpinning the rise in prices is the effectiveness of OPEC’s efforts over the past couple of years to meet with financial players in an attempt to better understand their role in oil futures, and leverage these connections to create mutually favorable market conditions.
OPEC has successfully leveraged connections with financial investors to create mutually favorable market conditions.
Hedge funds and other money managers last week increased their net long positions in crude and products on both ICE and NYMEX by 45 million barrels, notes Reuters analyst John Kemp. Current net length is equivalent to 1.411 billion barrels of crude and refined products, slightly below the record set in January. “Hedge fund managers have never been so overwhelmingly convinced prices are set to rise further rather than fall back,” Kemp wrote, highlighting limited short positions.
OPEC initiated an active dialogue with hedge funds and other speculative traders to better understand how its moves impact the market and price volatility, and anticipate how its actions—either production cuts or rhetoric—will play out through an increasingly financialized oil market.
A number of key meetings have taken place since 2016. In November 2016, for instance, ahead of the OPEC ministerial meeting, leading oil traders from Vitol, Lukoil, and Andurand Capital flew to Vienna to meet with Saudi representatives. Early last year, before the CERAWeek conference in Houston, OPEC Secretary-General Mohammad Barkindo met in private with a number of hedge funds. Other meetings followed, including another gathering at CERAWeek this year.
OPEC’s commitment to production cuts since the beginning of 2017, along with growing geopolitical instability, has made oil, for the most part, a one-way bet.
The full story of what was included in the dialogues has not been made public, but members from both sides appeared to have gained valuable market information from each other. As The Wall Street Journal reported traders “quizzed Mr. Barkindo on whether OPEC will extend its production agreement at its next meeting in May.” One hedge fund manager emphasized to Barkindo about the importance of continuing the production cut: “An extension would cause him to shift his views and bet that oil prices would keep rising, the sources said.” Such messaging conveyed to OPEC the importance of properly telegraphing its actions and continuing with supply cuts to receive support from the financial sector.
OPEC’s commitment to production cuts since the beginning of 2017, along with growing geopolitical instability, has made oil, for the most part, a one-way bet and kept financial traders from betting on a price fall. Even in 2016 before the cut, OPEC managed expectations through verbal intervention in order to influence investor sentiment, adding to a stronger market. Throughout 2016, whenever prices were falling, OPEC officials conveniently talked about taking action to freeze output or reduce supply. Without a coherent strategy, OPEC resorted to “jawboning” prices higher, and it worked.
Previously puppeteers, now a good friend
OPEC’s meetings with hedge fund managers, and using them to advance their interests, are a break from the past. For the most part, OPEC officials would blame speculative money for increasing prices and causing excessive volatility, notably in 2008 when prices hit $147 per barrel. When prices collapsed in 2014-15, OPEC again pointed the finger at speculators for creating the market distortion. In its monthly commentary in April 2015, OPEC painted a picture of hedge funds and other investors as a bogeyman. OPEC wrote:
“When the conditions in the market are ripe, they ghost onto the trading stage. Like puppeteers, they pull the strings from the wings, manipulating positions and unsettling what are already delicate and often precarious trading environments. Prowling the exchanges, they are quick to exploit any situation that can bring them the desired big pay day that feeds their burning ambition and bank balances. They can be unscrupulous, at times ruthless, especially when the stakes are high.”
This statement is, of course, ironic: An organization that manipulates supply for its own interests complains about another group interfering with price-setting. The influence of speculative money has received widespread attention since financial players gained increasing market power in oil futures markets in the mid-2000s and prices rose sharply. Investors such as hedge funds, commercial banks, commodity trading advisors, and private equity firms have been attracted by the deep liquidity and volatility in oil futures, and their participation has surged. While there is disagreement over their exact role and impact, most experts acknowledge that speculators exaggerate short-term price swings but over the long term, the market is determined by supply-demand fundamentals. Higher prices signal that in order for the market to find an equilibrium, more supply needs to come online or demand needs to slow.
While there is disagreement over their exact role and impact, most experts acknowledge that speculators exaggerate short-term price swings but over the long term, the market is determined by supply-demand fundamentals.
The main reason investors are currently continuing to bet on higher prices is based on shifting fundamentals and OPEC remaining vague on its final goal and failing to articulate an exit strategy. If OPEC and other producers say their commitment is open-ended and so far they have cut more than anticipated, why would any investor bet on lower prices? The inventory overhang has been reduced to OPEC’s target levels, according to the International Energy Agency and the OPEC Secretariat, but the cartel and its partners are “shifting the goalposts” and could be eyeing $100. They appear emboldened by the fact that the rapid growth in U.S. shale has not stifled the price rally. The $100 level is becoming a stark possibility with rising geopolitical risks and the possibility of the market moving into a deficit. In this context, it would not be surprising if speculators will continue to help OPEC push prices higher.
Could the alliance break down?
Investors leaving the market en masse, as we saw in 2008 and 2014 after prices peaked, would prompt a sharp correction and leave OPEC desperate to figure out its next move.
What could cause the symbiotic relationship between investors and OPEC to unravel? A slowdown in oil demand growth from an economic recession or other factors would likely precipitate liquidation and cause traders to bet on lower prices. A rebound in petroleum inventories as a result of rapid growth in non-OPEC supply could also undermine speculators’ faith that OPEC can continue to put a floor under prices. Investors leaving the market en masse, as we saw in 2008 and 2014 after prices peaked, would prompt a sharp correction and leave OPEC desperate to figure out its next move. The relationship between financial players and the producer group may not end well even though both sides are enjoying current market conditions. “The oil-futures market, which got going in the early 1980s, generally works against those seeking to set oil prices by fiat,” wrote Liam Denning in Bloomberg. “For OPEC, symbiosis with speculators is an unnatural state of affairs.”