17 Aug What drives oil? Financial Markets.

Points to be taken from this read

Before and after world eco­nom­ic slow­down, there were observ­able increas­es in cor­re­la­tions between com­mod­i­ty prices.

There is a neg­a­tive cor­re­la­tion between the USD and crude oil.

Stocks and crude oil prices tend to move in the same direc­tion dur­ing finan­cial crises and recovery.

Bond prices and inter­est rates move in oppo­site direc­tions. U.S. Trea­sury bond prices and crude oil prices would tend to move in oppo­site direc­tions in times of chang­ing eco­nom­ic conditions. 

Inverse rela­tion­ship between the exchange val­ue of the dol­lar rel­a­tive to oth­er cur­ren­cies and crude oil prices.

Disclaimer

Most of the infor­ma­tion here comes from the U.S. Ener­gy Infor­ma­tion Administration’s web­site (EIA) and some from Wikipedia. I am not pre­tend­ing to come up with all this infor­ma­tion myself. The only thing I did was go through the infor­ma­tion and put togeth­er pieces of it to make it eas­i­er to under­stand and access for myself. This, I want to share with you and I hope it ben­e­fits you in some way. All the praise goes to the good peo­ple that put this up on the EIA and Wikipedia website.

Please go over to these respec­tive web­sites for a lot more information:

EIA on the bal­ance of ‘What dri­ves Crude Oil?’ finan­cial markets

https://www.eia.gov/finance/markets/crudeoil/financial_markets.php

Keep­ing it simple

As I tried explain­ing in the dis­claimer this post is just going to be the sum­ma­riza­tion of ‘facts’ I have found on the inter­net. Sort of like a cheat sheet for any­thing on the finan­cial mar­kets that are involved with crude oil. Above you can find the sources for the infor­ma­tion list­ed here so head on over and look up more details if you wish.

So here it goes…

Mar­ket participants

• Mar­ket par­tic­i­pants not only buy and sell phys­i­cal quan­ti­ties of oil, but also trade con­tracts for the future deliv­ery of oil and oth­er ener­gy derivatives. 
• One of the roles of futures mar­kets is price dis­cov­ery, and as such, these mar­kets play a role in influ­enc­ing oil prices.
• Oil mar­ket trad­ing activ­i­ty involves a range of par­tic­i­pants with vary­ing moti­va­tions, even with­in indi­vid­ual participants. 
  • Some, such as oil pro­duc­ers and air­lines, have a sig­nif­i­cant com­mer­cial expo­sure to changes in the price of oil and petro­le­um-based fuels, and may seek to hedge their risk by buy­ing and sell­ing ener­gy deriv­a­tives. For exam­ple, an air­line may want to buy futures or options in order to avoid the pos­si­bil­i­ty that its future fuel costs will rise above a cer­tain lev­el, while an oil pro­duc­er may want to sell futures in order to lock in a price for its future output.

• Banks, hedge funds, com­mod­i­ty trad­ing advi­sors, and oth­er mon­ey man­agers-who often do not have inter­ests in trad­ing phys­i­cal oil-are also active in the mar­ket for ener­gy deriv­a­tives to try to prof­it from changes in prices. 
  • In recent years, investors have also shown inter­est in adding ener­gy and oth­er com­modi­ties as alter­na­tives to equi­ty and bond invest­ments to diver­si­fy their port­fo­lios or to hedge infla­tion risks. 

• Every trans­ac­tion must involve both a buy­er and a sell­er, and the desired “long” buy­er and “short” sell­er posi­tions of those with direct com­mer­cial inter­ests in the oil mar­ket do not nec­es­sar­i­ly equal one another. 
  • Banks, hedge funds, and oth­er “non-com­mer­cial” investors can add liq­uid­i­ty to futures and deriv­a­tive mar­kets by tak­ing the oth­er side of trans­ac­tions with com­mer­cial participants. 
  • On the oth­er hand, con­cerns have been raised that non-com­mer­cial com­mod­i­ty trad­ing and invest­ment may “use up” liq­uid­i­ty and ampli­fy price move­ments, par­tic­u­lar­ly at times when momen­tum is run­ning strong­ly in a par­tic­u­lar direction.

High­er inter­est in commodities

• Activ­i­ty in com­mod­i­ty exchange con­tracts has risen in recent years. One mea­sure of activ­i­ty in futures mar­kets is open inter­est on exchanges, which indi­cates the num­ber of con­tracts in a trad­ing ses­sion that have not been set­tled or closed. 
  • Open inter­est (click here to find out what it is) on exchange-trad­ed crude oil futures con­tracts increased sub­stan­tial­ly over the past decade, as mea­sured by the New York Mer­can­tile Exchange (NYMEX)  , the main com­modi­ties exchange for ener­gy prod­ucts in the Unit­ed States. 
  • Both com­mer­cial par­tic­i­pants (those that have a direct inter­est in phys­i­cal oil pro­duc­tion, con­sump­tion, or trade) and non-com­mer­cial investors (mon­ey man­agers and funds that are inter­est­ed in trad­ing con­tracts for invest­ment and diver­si­fi­ca­tion pur­pos­es) have shown increased trad­ing activity. 
    • Care must be tak­en in inter­pret­ing these data, how­ev­er, because the vast major­i­ty of posi­tions are held in the less trans­par­ent over-the-counter (OTC) mar­ket rather than on exchanges. 
    • In addi­tion to futures con­tracts, anoth­er way for mar­ket par­tic­i­pants to invest in crude oil is through the buy­ing and sell­ing of options contracts. 
    • Options allow for invest­ment expo­sure with lim­it­ed poten­tial for loss­es and pro­vide an insur­ance-like instru­ment against adverse com­mod­i­ty price movements.

Activ­i­ty publications

• The Com­mod­i­ty Futures Trad­ing Com­mis­sion pub­lish­es a week­ly activ­i­ty report on oil trad­ing that occurs on exchanges (e.g., NYMEX), the Com­mit­ment of Traders Report .
  • In this report, the activ­i­ties of mul­ti­ple trad­ing cat­e­gories are detailed, includ­ing phys­i­cal par­tic­i­pants (pro­duc­ers, mer­chants, proces­sors, and end users), mon­ey man­agers (usu­al­ly hedge funds or oth­er sophis­ti­cat­ed traders), and swap deal­ers (tra­di­tion­al­ly invest­ment banks or com­mod­i­ty broker/dealers).
    • On a net basis (sub­tract­ing short posi­tions from long posi­tions), phys­i­cal par­tic­i­pants tend to be net short while traders in the mon­ey man­agers cat­e­go­ry tend to be net long.

• Dur­ing the world finan­cial cri­sis that occurred in the lat­ter half of 2008 and 2009, mar­kets saw a dra­mat­ic increase in the cor­re­la­tion between crude oil and oth­er com­modi­ties as demand decreased for raw materials. 
• How­ev­er, both before and after the world eco­nom­ic slow­down, there were observ­able increas­es in the cor­re­la­tions between com­mod­i­ty prices. At the same time as this rise in cor­re­la­tions was a rise in inter­est in gen­er­al com­mod­i­ty exposure. 
• A grow­ing num­ber of investors have gained expo­sure to com­modi­ties by invest­ing in index funds-mar­ket instru­ments that pro­vide expo­sure to bas­kets of commodities. 
• These index funds usu­al­ly estab­lish shares of var­i­ous ener­gy and oth­er com­modi­ties to pro­vide diver­si­ty across a range of commodities. 
• Also, exchange trad­ed funds (ETFs)-which can be bought and sold through­out the day like indi­vid­ual com­mon stocks-are an increas­ing­ly pop­u­lar means for investors, includ­ing indi­vid­u­als, to gain expo­sure to com­modi­ties as an asset class.

Com­plex matters

• Cor­re­la­tion is not the same as cau­sa­tion, how­ev­er, and the rela­tion­ship between crude oil and oth­er finan­cial mar­kets is complex. 
• Even with observed move­ments in cor­re­la­tion lev­els, influ­ences between crude oil price changes and changes in val­ues of oth­er asset class­es are unclear. 
  • For exam­ple, it is pos­si­ble that high cor­re­la­tions are due to more pri­ma­ry rela­tion­ships with a third com­mon fac­tor, such as eco­nom­ic growth expectations.
  • Anoth­er com­pli­cat­ing fac­tor is that these rela­tion­ships and their strength vary over time. Ana­lysts con­tin­ue to work to bet­ter under­stand the con­nec­tions between these markets.

Index funds

• Most index funds are “long only” funds whose val­ue will increase only when the prices of the under­ly­ing com­modi­ties rise. 
  • Investors in such instru­ments expect com­mod­i­ty prices to rise; mon­ey is lost if the val­ues of the under­ly­ing com­modi­ties in the index decrease. 
  • Many of the man­agers of index-style invest­ments do not trade the indi­vid­ual com­po­nents of an index on a dai­ly basis; instead, they buy and hold these invest­ments over peri­ods of months or years, 
    • rolling con­tracts for­ward to avoid phys­i­cal delivery.

Addi­tion­al info

• Some mar­ket observers believe that increased trad­ing activ­i­ty by investors and long-only index funds in oil mar­kets has had a sig­nif­i­cant impact on the ener­gy price for­ma­tion process. 
  • Although a grow­ing body of research by aca­d­e­mics and secu­ri­ties mar­ket ana­lysts exam­ines this issue, no defin­i­tive con­clu­sion either prov­ing or dis­prov­ing a causal link­age between non-com­mer­cial trad­ing and large ener­gy price swings over the past few years has been reached.
  • Because the vast major­i­ty of posi­tions are held in the less trans­par­ent OTC deriv­a­tives mar­ket, how­ev­er, analy­sis that relies only on read­i­ly avail­able data from the trans­par­ent por­tion of the mar­ket may offer only lim­it­ed insights. 
• Addi­tion­al data and analy­sis are need­ed to bet­ter under­stand the rela­tion­ship between ener­gy deriv­a­tives trad­ing and price move­ments. In addi­tion, the glob­al nature of trade in ener­gy-relat­ed deriv­a­tives adds to the chal­lenges of ana­lyz­ing trad­ing activity.

Oth­er finan­cial markets

• Pri­or to 2007, stocks, bonds, and exchange rates showed only infre­quent, fleet­ing cor­re­la­tions to oil futures prices. 
• In con­trast, the price of crude oil showed pos­i­tive cor­re­la­tions with stocks from 2008–2010.
• Neg­a­tive cor­re­la­tions with the val­ue of the U.S. dol­lar dur­ing most of late-2007 to the present.
• And more irreg­u­lar but often neg­a­tive cor­re­la­tions with bond prices dur­ing 2008–2010.
• For each asset class, there are finan­cial, phys­i­cal, and com­mon under­ly­ing eco­nom­ic fac­tors-such as the eco­nom­ic down­turn and recov­ery-that could be influ­enc­ing these more sig­nif­i­cant correlations. 
  • Finan­cial fac­tors include devel­op­ments such as the grow­ing inter­est over the last decade in crude oil as an invest­ment asset. 
  • This invest­ment inter­est has altered the finan­cial mon­ey flow into and out of commodities. 
  • Phys­i­cal crude oil mar­kets can also be influ­enced by out­side factors. 
  • Exchange rates and eco­nom­ic fac­tors play a role in crude oil pro­duc­tion and con­sump­tion, pos­si­bly lead­ing to price correlations.

Stocks

• Stocks have tra­di­tion­al­ly been the largest invest­ment mar­ket. Eco­nom­ic con­di­tions can cause prices for stocks and com­modi­ties, includ­ing oil, to move high­er or low­er together. 
• As macro­eco­nom­ic con­di­tions improve (or wors­en), earn­ings for com­pa­nies increase (or decrease) 
• and demand for com­modi­ties as raw mate­ri­als rise (or fall) as well. 
• Eco­nom­ic expec­ta­tions are one pos­si­ble rea­son why a pos­i­tive cor­re­la­tion was observed dur­ing 2008–2010 between the S&P 500, a bench­mark for stock mar­kets, and crude oil, one of the most heav­i­ly trad­ed com­modi­ties in the world.
• In addi­tion, there were sig­nif­i­cant changes in the lev­el and appetite for risk dur­ing 2008–2010.
• Over the past decade, crude oil has shown sim­i­lar risk/return char­ac­ter­is­tics to stocks. As a result, dur­ing peri­ods where risks were ris­ing sig­nif­i­cant­ly (dur­ing the finan­cial cri­sis) and then abat­ing (dur­ing recov­ery), stocks and prices for crude oil and oth­er com­modi­ties could tend to move in the same direction.

Bonds

• As eco­nom­ic con­di­tions improve (or wors­en), inter­est rates on gov­ern­ment bonds will tend to rise (or fall). 
• Since bond prices and inter­est rates move in oppo­site direc­tions, U.S. Trea­sury bond prices and the price of crude oil would also tend to move in oppo­site direc­tions in times of sig­nif­i­cant­ly chang­ing eco­nom­ic conditions.
• In addi­tion, bonds, the sec­ond-largest invest­ment mar­ket, are often viewed as low­er-risk invest­ments than stocks, albeit with low­er aver­age returns. 
• As an asset class, bonds are gen­er­al­ly less volatile and car­ry a low­er chance of los­ing principal. 
  • U.S. Trea­sury bonds, in par­tic­u­lar, are usu­al­ly con­sid­ered a risk­less investment. 
  • As investors become wor­ried about future returns in high­er risk assets, such as stocks and com­modi­ties, they tend to increase allo­ca­tions to bonds in their portfolios.

Cur­ren­cies

• Sev­er­al hypothe­ses have been offered that tend to sup­port an inverse rela­tion­ship between the exchange val­ue of the dol­lar rel­a­tive to oth­er cur­ren­cies and crude oil prices. 
  • The first is sim­ply that because oil bench­marks are tra­di­tion­al­ly priced in U.S. dol­lars, a depre­ci­a­tion of the dol­lar decreas­es the effec­tive price of oil out­side the Unit­ed States. 
  • This decreased cost may increase con­sumers’ demand for oil, adding upward pres­sure to prices.
• A sec­ond poten­tial rea­son is that U.S. dol­lar depre­ci­a­tion will decrease the effec­tive prof­its of non‑U.S. pro­duc­ers, when con­vert­ed into for­eign currencies. 
  • To coun­ter­act this, these coun­tries may tar­get high­er dol­lar prices of oil to main­tain real rev­enue, bud­get lev­els, and pur­chas­ing pow­er in world markets. 
  • Dol­lar depre­ci­a­tion also reduces the returns on dol­lar-denom­i­nat­ed assets, when mea­sured in for­eign cur­ren­cies, which may increase the attrac­tive­ness of for­eign invest­ing in com­modi­ties like oil. 
    • Com­mod­i­ty invest­ment may also become more attrac­tive to U.S. investors as a hedge against infla­tion if dol­lar depre­ci­a­tion tends to increase expec­ta­tions of greater inflation.
• Final­ly, a rise in oil prices also expands the U.S. trade imbal­ance, which can put addi­tion­al down­ward pres­sures on the dol­lar, again yield­ing a neg­a­tive cor­re­la­tion albeit with cau­sa­tion going in the reverse direction. 
• Despite these many pos­si­ble expla­na­tions, the actu­al cor­re­la­tion between oil prices and exchange rates has not been sta­ble over time, and was close to zero for more than half of the last decade.

Thanks for reading

I hope this post helps to make the role of the finan­cial mar­kets in rela­tion to oil prices more clear.

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