Markets by Trading view

Is The Oil Market Broken?


“Our eyes are open to constantly monitor and search for any Israeli ship in the Red Sea, especially in Bab al-Mandeb, and near Yemeni regional waters.”

These words in November from Abdul-Malik al-Houthi, leader of Yemen’s Iran-backed Houthis group of rebels, should have sent shockwaves through global oil markets. He was pledging, in not particularly subtle terms, to launch attacks on commercial shipping in the Red Sea as a response to the ongoing conflict in Gaza. Were oil markets concerned about the serious risk of violence and conflict in a stretch of sea through which about 12% of all seaborne-traded oil passed in the first half of 2023? Not at all.

For several months now, despite al-Houthi proving true to his word and the US-led “Operation Prosperity Guardian” struggling to secure the Red Sea, oil markets have failed to reflect real-world conditions. With many of the world’s largest oil and shipping companies considering the Red Sea to be unviable, billions of dollars’ worth of commodities are being diverted around the Cape of Good Hope – with BP, Maersk, and Hapag-Lloyd just three of the major players that have already committed to using this route for the foreseeable future.

This diversion adds around 6,000 nautical miles to a journey from Asia to Europe and can delay delivery times by up to a month. Approximately 10% of global seaborne crude oil will therefore be spending considerably longer at sea, taking a huge chunk out of the world’s oil supply at any one time. The humblest student of economics would tell you that when demand outstrips supply, prices should rise. However, oil markets disagree.

Not only has the price of oil not increased in light of the Houthis’ violence in the Red Sea, but prices have in fact fallen slightly since the first attack on November 18th. At that time, brent crude was trading at just over $80 a barrel and now is at $76.42. During that time, OPEC also announced plans to cut oil production by over two million barrels a day, further restricting supply. How does any of this make sense? The answer is that it doesn’t.

Philip Pilkington, an investment professional in London, told Disruption Banking that “the oil market has been behaving strangely for a while.”

“A few weeks ago, OPEC+ announced large production cuts and the oil price failed to respond, indeed it fell somewhat. This has led some to speculate that algorithmic trading and hedge fund short-selling may now be dominating the market,” he added.

This trend has been growing for some years. Particularly since the reforms of former Federal Reserve Chair Alan Greenspan in the 1990s, commodity markets have largely ceased to be objective arbiters of value and are instead driven by speculators trading financial assets, such as derivatives, that are completely detached from the physical goods.

As writer Rupert Russell discussed with Disruption Banking in an interview last year, it is a common misconception that prices are based on “scientific rather than emotional narratives.” Markets often act irrationally and in ways that can be contradictory to the actual situation on the ground.

Oil markets have been here before. During the invasion of Iraq in 2003, oil prices barely moved despite major threats to supply in what was then the Middle East’s second-largest producer of oil. When ISIS swept across Iraq in 2014, oil prices spiked, despite the fact the group failed to capture any major oil facilities and had little impact on supply.

What mattered in both these cases was not what was actually happening to global oil production, but the perception of what was happening in the eyes of speculators. Hedge funds and algo-traders are therefore more interested in judging the “mood of the market” – guessing at what other traders are guessing and following subjective trends – than analysing the available data. There is no intrinsic logic to this, but it’s how oil markets in particular now appear to work.

What’s next for oil prices? Pilkington is concerned that there’s not any immediate sign of prices accurately reflecting the fraught environment and believes this could distort economic activity. “Recent data shows that oil tanker traffic moving through the Red Sea has fallen from around 27 million to 18.3 million metric tonnes per week since November and, once again, the oil price has not responded,” he noted.

“The longer the pricing mechanism remains broken in the oil market, the more consumers will be encouraged to overconsume oil at an artificially lower price.”

However, he believes that the oil markets won’t be able to run from reality forever. This means that there could eventually be a sudden price spike as markets recorrect. The potential repercussions, both in terms of market volatility and higher inflation for consumers, are significant.

“At a certain point the underlying realities of physical supply will become too obvious to ignore,” Pilkington said. “The price will whipsaw, creating disruptions to the economy.”

Author: Harry Clynch

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