LONDON (Reuters) – Following OPEC’s decision on Thursday to leave production unchanged, Brent crude futures experienced the first three-standard deviation down-move since the flash crash of May 2011 and before that the depths of the recession in March 2009.
With US markets and financial institutions closed for the Thanksgiving holiday, limited liquidity probably exaggerated the scale of the move.
It was nonetheless indicative of the tremendous uncertainty around the market about how OPEC’s members would handle a lose-lose situation:
Cut production and risk losing more market share to shale, or leave output unchanged and face a further decline in prices.
In the event, the organisation opted to defend market share, causing prices to fall abruptly as traders absorbed the strategy’s implications.
It is important not to read too much into a single day’s move.
The sharp drop on Thursday could signal a one-off adjustment to a reduced price level, with volatility then returning to a low level. Or it could signal the start of a prolonged period of greater uncertainty and volatility.
Daily price movements in oil and other commodity markets do not follow a normal distribution.
Instead, the distribution is leptokurtic: there are more days with either very small movements or very large price movements than would be predicted by the normal distribution, and fewer days with medium-sized ones.
Moreover, the level of volatility in oil prices is itself volatile. Periods of low volatility alternate with periods of high volatility, with abrupt shifts between the two states.
Financial markets shift between “mild” and “wild” states, as the French mathematician Benoit Mandelbrot demonstrated, originally with an analysis of cotton prices.
Thursday’s price move signals a shift to a wilder market state after a long period in which volatility has been extraordinarily subdued.
There is no way to know how long the wilder state might persist.
But there are good reasons to think oil prices could be more volatile in the months ahead than they have been over the last three years.
First, there is a much greater dispersion of views about the trajectory of prices over the next two years than at any point since 2010.
The common assumption is that oil prices must fall far enough and remain low long enough to curb the rise in shale output, postpone high-cost oil projects and stimulate faster growth in oil demand.
But there is enormous uncertainty about how low and how long prices might have to fall to shut in excess shale production.
The reaction function of US shale producers is untested and will only be known after the event.
Second, OPEC’s own response remains unclear in the medium term.
Saudi Arabia, Kuwait and the United Arab Emirates, the only members able to make significant production cuts, have revealed that they prefer instead to play a long game, relying on low prices to recapture market share from higher-cost shale rivals.
The core Gulf producers have the financial resources to withstand a prolonged period of lower prices by drawing down reserves. But even their resources are not unlimited. And prices could stay lower for longer than most producers now expect if shale output is more resilient than OPEC forecasts.
Since the start of the shale boom, OPEC and Saudi Arabia have consistently underestimated its disruptive impact on supply and price. It is possible they are now over-estimating how quickly shale output could stop growing.
Third, Iran’s oil exports seem set to rise as the stranglehold of sanctions weakens, even without a nuclear deal with the United States, though the pace at which sanctions become more leaky is hard to predict. Additional Iranian exports will weaken the market further.
Fourth, the global economy is slowing, and on this occasion the slowdown is affecting China and the other Asian countries that were the only source of demand growth for oil exporters in the last five years, adding an extra element of uncertainty.
Fifth, there may have been some structural loss of liquidity in the market as banks and hedge funds scale back in the face of stricter regulations and the lack of profitability in recent years.
Liquidity provision is itself cyclical. After a period of high liquidity, when the oil sector was crowded by lots of banks and hedge funds seeking to speculate or make markets and competing away the profit margin, the market is now in a period of much lower liquidity, and the adjustment may not be over yet.
The upshot is that after three years in which volatility has been abnormally low by historical standards, there are plenty of reasons to think prices might start jumping around more than before as the market struggles to find a new temporary equilibrium.