Through the Looking Glass- Trading Oil in Risk off Markets

The mood in oil markets have moved away from shock now, to no idea where we go next. That mood is best defined in market terms as “risk-off”, and the recent price action and positioning supports that sentiment.

If you are a seller of the outright price and active on the Exchange open, it is sensible to wait to see where the market opens and is set by the Eastern market before pulling the trigger. Consequently, we have consistently gapped up on the open in recent weeks, and this will likely continue. At the same time, we have also had steady sell-off into settlements. The outright price, in the face of a full-blown conflict, is not accelerating out of control like the TTF contract did last year. 10% of the world’s production is at threat, whilst we were already in a tight market, and the prospect of a global conflict is genuine now, so how can this be? An WSJ article yesterday quoted traders bemoaning the lack of response given the news, who just cannot understand and say traders are underestimating the impact.

This is where we aim to stay true to our principles for analysing markets. It is about evaluating the current market positioning, analysing the real flows, and predicting behaviour as a consequence of the two against the prevailing market price. The price is set by buyers and sellers coming together, so we cannot think of a “fair value” for where it should be. This will get you nowhere, just riddle you with bias and leave you ignoring signals the market is trying to give you.

Supply and demand do not play out in the front month contracts. By trading these futures and swaps contracts into expiry, traders are taking a view on whether they are comfortable holding or not holding oil vs leaving it to the prompt delivery. We do not see the evidence of the market wanting to take a view on supply and demand right now. Look at the Brent Index yesterday. Where the cash spread settles reveals the physical differential North Sea traders believe will be achieved come April loading barrels. There has not been a more bullish environment ever, yet the cash spread moved steadily down from the highs during the day with confident selling emerging. This is after news over the weekend that Russian oil will irrefutably be affected after Russia’s removal from SWIFT, and it is hugely telling. It is saying that oil traders do not feel strongly that physical differentials will be much beyond $2/bbl in the next two months, despite 30 day forward differentials in the North Sea trading right now at $3/bbl.

This risk off mood on the back of extreme uncertainty is nothing new in financial markets, nor in oil markets. During the Gulf War, leading up to the conflict, flat price rallied 12.5%, before collapsing 33% once there was US intervention. 9/11 saw a huge rally before traders took stock and realised flights would be grounded and it was bearish. Sterling prices were the same during the run up to Brexit, where every piece of news was fuelling fears of a recession and sent sterling prices lower, only for the contract to rebound when the UK left the EU.

It is the cliché that there is nothing worse than fear itself. When the event actually happens, it is a feeling of acceptance, and this plays out in trader psychology. Putin and China have in the past year or two played the fear game very well. We are suckers for it in the West. We created a petrol shortage in the UK on the back of a headline, and no supply disruption was recorded. It is all hype and people talking their view or trading position. But when the fears turn into reality, our psychology, and therefore the market’s psychology, plays out differently. We look at the actual impact with more certainty and it is inevitably more controlled and less soaked in hyperbole. The market is like the White Queen in?Through the Looking Glass?saying “Why, I’ve done all the screaming already. What would be the good of having it all over again?”

Timespreads and product cracks are now correlated to the outright price, which means everyone is using flat price as an indicator of where we go from here. The problem is that right now, no one can have high conviction in the outright price, and therefore traders are adopting a wait and see approach. But if we completely avoided markets in uncertain times, none of us in the trading world would have a living. The more uncertain the times, the more we need to dive into the minutiae, and find safe haven in short-term strong risk reward trades. Ultimately, that is what our research and trade ideas are all about- finding opportunity in the still developing and largely untapped oil swaps market.

For a purely speculative trader, the opportunity is in the contracts that have dislocated and become decorrelated with this move. Going long the FOGO is an opportunity we highlighted earlier this month, as it has barely moved down despite all the volatility and the short flat price and gasoil crack exposure. It is finding natural support from being way beyond historical lows and US flow buying up VLSFO as the prompt prices strong. But there are plenty more trade ideas and opportunities that we have laid out in this report and will continue to reveal through analysis of our Commitment of Traders data and analysing the market’s flow. Brent/Dubai was and is another, which has performed in the new environment with so much of the market positioned short going into this crisis. Now the fundamentals unexpectedly have shifted the other way, the differential was skewed to the upside. The move down was largely priced in with shorts having already positioned, and the market is now able to move up aggressively before traders have fully closed out their shorts, let alone participants getting long. There are also niche pricing trades,?with forward oil transactions relatively set in stone, such as buying the prompt CFD week roll. Then there are the pattern trades intraday. Holding flat price and spreads from TAS to market open has been highly profitable as a trade. We expect the market to continue to move in herds, so these kinds of trades will be plentiful for the paper trader who is free to look for short term opportunities.

For hedgers there is also a clear message from how we look at markets. The price of contracts is here because of traders’ interpretation of market events. It cannot be about an arbitrary number. If Brent crude futures are $101/bbl in May right now, it is at that level with everyone more than aware of every detail of the Russian invasion and blocks on Russia to the global financial system. So, relying on opinions that oil goes to $120/bbl+ is more reckless than ever. I can give you an argument for $70 or $150, and you cannot tell me one or the other cannot happen. Aggressive execution is what is needed, no matter what direction from which you are coming. For physical oil traders, it is about understanding the exposure to Russian oil delivery, and how they will navigate the sanctions in the new world. But this should become the perfect market for a physical oil trader. With contagion spreading after BP pulled out of Rosneft, Shell and now probably Exxon will leave the region and oil needs to be moved around the world to replace staple flows.

As for where we will go this year in the outright price with the news accounted for, we still have a house view of course. Prices right now are highly vulnerable but, as ever this year, the market is already positioned heavily long, with new buyers evidenced by the CFTC report for last week’s trading, and undoubtedly more in the last few days. New buying flows are needed to overwhelm, and the move upwards like we have had in gas needs to come from the absence of sellers rather than the weight of buyers. Right now, as the market has shown, short term traders in flat price are fearful, exiting with retracements and keeping volatility high. As I mentioned above, you would be mad not to hedge right now if you are in a position to do so, so that selling flow is likely to stick around for now. It will need further escalation and new fears of ensuing global conflict for the sellers to run for the hills.

On the geopolitical front, we see it that Putin has overplayed his hand. Now the world needs to actually respond in action rather than negotiation. Firstly, it is damage limitation. OPEC can surely be convinced to finally drop their supply cut now, but first signs are that they are reluctant. OPEC Secretary General Barkindo recently said "the oil industry is under siege" in an energy summit.?Biden may have been pressuring OPEC before, but now resisting calls could be taken a lot more politically and the justification of supply and demand steadiness and the rest will not hold going forward. The SPR in the US was designed exactly for this purpose. Germany has sworn to diversify away from Russia as has the UK, which has already made moves to indicate legislature changing, so perhaps we will see the Cambo field approved after all. US producers can openly produce as much as they possibly can - even with the approval of Wall Street which was their fear last year and so far this year. This is an enormous victory for the US oil industry, which can simply work to replace the oil the US and Europe import from Russia and, on the face of it, not have much consequence for market share. China looked to have secured their oil leading up to this conflict, whilst we had the first sign they will take Russian oil, just at a heavy discount, with a Chinese company buying Urals for March delivery recently. Iran, of course, is now in a great position to come back, but it is really about OPEC as a whole. Will they want to feel the wrath of the global media like Putin has done?

So by Q3 we still see the same thing. We will have supply back with a vengeance. And this is all on the basis that Russian oil is gone from markets but of course, like Iran, a lot of it will finds itself on the open market. Whilst analysts and some traders will scratch their heads, a de-risk move if the world realises it can manage long term without Russia will combine new confidence in physical markets and long derivative positioning that could set the market on a rout.

For now though, it is all about short-term, strong risk-reward trades that avoid prolonged exposure to the outright price. Good luck.

The above has been taken from the "CEO Report" section of the Onyx Insight research service. To see this report and more head to our website or email us directly:

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