The "geopolitical risk premium" is a vague concept that, in today's oil market, is roughly equivalent to the 6 billion barrels of "virtual" oil traded every day, and this premium makes the price of a barrel of oil $5 higher.

The world consumes (only) 100 million barrels of oil every 24 hours, which means that the oil market is controlled by speculators. This explains why the price of oil has been so volatile in the past few weeks.

The conflict between Israel and Iran and the launch of China's economic stimulus plan pushed Brent crude oil to its biggest five-day gain in more than a year last week. Oil prices rose to more than $80 a barrel on Monday, but fell sharply on Tuesday, falling 5%.

Tom Skingsley, commodities futures and options strategist at JPMorgan, wrote in a note to clients that the initial rebound was "caused almost entirely by (justified) risk premiums," but added that investor "positioning" was also an important factor.

Perhaps the biggest news in the oil market over the past few months has been that algorithmic selling has reached historic extremes.

Speculative trend-following hedge funds, also known as commodity trading advisors, or CTAs, which analyze complex technical factors such as the term structure of Brent and WTI prices rather than fundamental factors such as macroeconomics or geopolitics, have never been so big recently.

Ryan Fitzmaurice, commodities portfolio manager and strategist at Marex, told FTAV: “CTAs have been the dominant force this year. Historically, there has been a lot of sticky money in the oil market, both from passive longs at index managers and people looking for inflation hedges. But a lot of that sticky money left the market in April and May.”

As OPEC prepared to increase supply in December and global demand weakened, Brent crude oil prices fell from above $90 a barrel in mid-April to below $70 in mid-September. Trend followers actively buy when prices rise and sell when prices fall, which accelerates the sell-off.

Then, China’s initial fiscal package and escalating tensions between Israel and Iran turned the market upside down. Eager to hedge their broader portfolios, discretionary investors who had sat on the sidelines for months began buying oil futures and call options, breaking the negative momentum that had driven CTA selling.

Ilia Bouchouev, former president of Koch Global Partners, explained that the shift in sentiment was not profound, but it was enough. Bouchouev said:

“Liberal investors are turning bullish but they don’t really want to buy and they have no incentive to buy ahead of the U.S. election. If Trump wins and we get tariffs, that’s an added risk, why put money into it now when they can do the same thing on November 6th?”

A month ago, producers were buying so many put options that traders had to sell futures to hedge the risk. But a few weeks ago, that bearish trend faded and started to move in the other direction as retail investors suddenly bought a lot of call options through ETFs such as the United States Oil Fund (USO) and macro hedges.

“Given that no one really knew what was going to happen in the Middle East, people were actively buying $100 call options as a form of insurance. What people knew was that if oil prices did go to $100, the Fed’s plans would be derailed and other assets would be greatly impacted.”

Bouchouev added that the “biggest shorts” — momentum-driven CTAs — were forced to mechanically cover their positions.

“Historically, their positions tend to reverse. So if they’re already at an extreme, there’s nowhere to go but to turn around. CTAs are covering 10% now, so there’s 90% left. The problem with CTAs is…if momentum is negative, they keep selling. But if the market settles for a week or so, or there’s a little peak, then all of a sudden that negative momentum is broken. Momentum doesn’t have to be positive, it just has to stop being so negative that it’s enough for CTAs to start buying back. We don’t have positive momentum yet, but they’re starting to cover.”

However, in the past few days, as concerns about Israel's potential strikes on Iranian energy facilities have receded, the market has once again turned around. JPMorgan's Skingsley said in a report published Tuesday morning:

“There is a polarized flow on the trading desks, it feels like more and more discretionary money is starting to lighten up at these levels, or at least take profits, while systemic money continues to close out a lot of shorts… With that in mind, what’s the next move?

Until Israel takes clear action it’s still hard to tell, but given the magnitude of the rally we’ve seen, and the fact that it’s almost entirely driven by (justified) risk premiums and positioning, there’s now a lot of downside if Israel’s response is “disappointing” (doesn’t affect oil balances/doesn’t target nuclear facilities), a view that didn’t exist a week or so ago, but now offers a much greater risk reward…”

Some interesting people also joined the sell-off, according to research analyst Martha Dowding and market design expert Jorge Montepeque, both of whom work at Onyx Capital Group, an oil derivatives liquidity provider that almost certainly made a fortune from the recent volatility.

Trafigura, TotalEnergies and others have been selling on Tuesday. Exxon has been selling for months. But they could turn into buyers at any time. Total turns from buyer to seller every few weeks...

On Tuesday, Austrian group OMV sold a North Sea cargo to Total. BP sold about 700,000 barrels of oil to Mercuria. OMV is not a typical seller, they don't usually sell publicly, so this is unusual. It's also unusual for Exxon to sell oil for two months in a row.

When the next market flip will happen is anyone’s guess. “It’s a never-ending cycle,” said Marex’s Fitzmaurice. “CTAs aren’t necessarily that worried about the outlook for OPEC or the Middle East. They’re just trying to cash in on the momentum, and geopolitics is just another number on the screen.”

Article forwarded from: Jinshi Data