Tuesday, February 23, 2016

Economy: Why Is Oil So Volatile?

(Drivebycuriosity) - The price of oil moves like a yo-yo. One day it jumps 6% and more, the next day it drops at least 4%. Since summer 2014 through today oil lost more than 70% but this drop was interrupted by sharp rallies: Last year between February and May the oil price jumped about 50% and in August the oil price leaped of almost 30% - even that the markets were still flooded with oil.

Why is oil so volatile? Economists try to explain the wild price swings with the behavior of Opec and the scarcity of the fuel (scottgrannis). But, that doesn´t explain the daily yo-yo movements and not the speed of the price swings.

I think the volatility is not surprising because oil is traded on financial markets like stocks and other assets - and behaves therefore similar. Many hedge funds and other speculators are buying and selling futures and other other financial instruments based on oil (bloomberg). The most important oil instruments are the front-end futures (contracts for next delivery date) for Brent Crude (the international type of oil) and WTI ("West Texas Intermediate" or just "Crude Oil", the American type). These futures represent the price of oil. So the oil price is strongly influenced by financial actors (hedge funds and other speculators) and their behavior. This makes the price of oil virtual and almost independent from physical supply & demand - at least temporarily.

The speculators are betting either on rising (long position) or falling prices (short position). Very often hedge funds and others trader act like a herd, they are buying when others are buying and they are selling when others are selling. Last year´s rallies were caused by bets on a v-shaped price recovery (like in 2009). The recent rally was driven by bets on production cuts and on a falling US oil production. Rising oil price often attract more speculative buyers, the so-called momentum traders, who want to benefit from price trends and jump onto the "bandwagon". Otherwise falling prices animate to "jump from the train" or even to bet on lower prices (shorting).

History shows that crowds often behave unpredictable, irrational & dangerous (driveby). People can easily be scared into a stampede like a herd of cattle. In the short run the price of oil is influenced by the behavior of the traders on the financial markets and the laws of mass psychology and rather by the fundamental factors (physical supply & demand).

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