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In both cases, to effect the arbitrage needed when paper contracts expired, greater reliance on additional derivatives was required (the paper barrel, after all, is itself a derivative). That resulted in pushing prices higher in the former case and lower in the latter, in both cases beyond what the wet barrels justified.
Earlier this year, when abnormally low prices prevailed, my proprietary algorithms indicated a combination of the derivative pressure plus massive short plays had taken between $8 and $12 a barrel from the actual market value of oil. When oil was selling at over $100, a similar move in the other direction transpired.
Currently, the move is just about flat, although if prices get close to $40 on one hand, or $70 on the other, we may well begin seeing these pressures returning.
The essential balance required for a stable market price has less to do with supply/demand and OPEC/non-OPEC, and more to do with the congruence of paper and wet barrels in the actual trading of oil.
Essentially, this is a matter of expectation…
Once Derivatives Ease Up, Traders Can Rebalance Oil
The balance that must be struck is one of trader’s expectations, not a physical balance in barrels of oil.
In a stable market, traders set the price at the expected cost of the next available barrel. In an accelerating market, that becomes the expected cost of the most expensive next available barrel. In a collapsing market, it translates into the expected cost of the least expensive next available barrel.
Each of these last two accentuate the pricing movement, increase the arbitrage difficulty, oblige the introduction of additional derivatives in the trading exercise, and guarantee an external boost to volatility.
Yes, both supply/demand and OPEC/non-OPEC remain as factors. We can also add the relatively new consideration of effective extractable reserves – after all, knowing there is considerable excess volume that can be rather quickly added to the market (especially in the United States) also becomes a restraining factor on how fast prices can rise.
But the primary balancing requirement has less to do with market dynamics. It’s a creature of the way the oil is traded.
And until the balance between paper and wet barrels is struck and maintained, the problem of determining a fair market value for oil, and the ability to trade on that value, will elude us.
That means you need to be prepared for oil price volatility, like the 2% or more dips and gains we’ve seen in the last few trading sessions, to continue for the time being.
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