Oil Market Supply/Demand Finally Begins To Matter Again As Commodity Funds Withdraw

It’s been a long time since oil market supply/demand was based on physical barrels rather than financial flows:

First, there was the subprime period, when the Fed artificially boosted demand and caused Brent to hit $147/bbl

Then there was QE, where central banks gave free cash to commodity hedge funds and led Brent to hit $127/bbl

In 2015, as the chart highlights for WTI, the funds tried again to push prices higher, but could only hit $63/bbl

Then, this year, the funds lined up to support the OPEC/Russia quota deal which took prices to $55/bbl

As the Wall Street Journal reported:

“Dozens of hedge-fund managers and oil traders attended a series of closed-door meetings in recent months with OPEC leaders—the first of their kind, according to Ed Morse, Citigroup Inc.’s global head of commodities research, who helped organize some of the events.”

These developments destroyed the market’s key role of price discovery:

Price discovery is the process by which buyer and seller agree on a price at which one will sell and the other will buy

But subprime/QE encouraged this basic truth to be forgotten, as commodities became a new asset class

Investment banks saw the opportunity to sell new and highly profitable services to sleepy pension funds

They ignored the obvious truth that oil, or copper or any other commodity are worthless on their own

There was never any logic for commodities to become a separate new asset class. A share in a company has some value even if the management are useless and their products don’t work properly. Similarly, bonds pay interest at regular intervals. But oil does nothing except sit in a tank unless someone turns it into a product.

The impact of all this paper trading was enormous. Last year, for example, it averaged a record 1.1 million contracts/ day just in WTI futures on the CME. Total paper trading in WTI/Brent was more than 10x actual physical production. Inevitably, this massive buying power kept prices high, even though the last time that supplies were really at risk was in 2008 when there was a threat of to hit $147/bbl.