Publications: Notes at the Margin

Rethinking Market Fundamentals III: Quantifying the Hedging Impact and Defining the Range of Instability (December 17, 2018)


Today, the computers at the firms who write swaps and options need to hedge up to five hundred million barrels of oil, almost sixteen times OPEC's daily production, to maintain hedges when the WTI Cushing price drops below $60 per barrel. The hedging of the full five hundred million must be complete when prices reach $50. On the other hand, little oil needs to be hedged when the price rises above $60. The hedging imparts instability to the market between $50 and $60 per barrel.


This means that oil markets as measured by WTI can only be stabilized at price levels above $60 per barrel or below $50 and that Brent must trade at prices above $66 to $70 or below $56.The price range between $50 and $60 for WTI at Cushing is a "range of instability."

This range of instability is tied to producers' hedging activity. It is the range in which the computers at the financial firms that write swaps and put options to producers become hyperactive. These "algorithmic" traders will buy and sell at almost every price tick. Volatility will increase in these ranges.



The figure above offers evidence of this conclusion. The graph compares the CBOE index of crude oil price volatility (graphed against the vertical axis) to the price level (graphed against the horizontal axis). We have shaded the area from $50 to $60 per barrel.


A statistical test produces results that emphasize our point. The standard deviation of volatility for prices below $50 per barrel and above $60 is around 2. The standard deviation of volatility for prices in the $50 to $60 range is 8.9, almost five times as large.


The message, then, is that it is impractical to try to stabilize oil markets in a range that confines WTI at Cushing to between $50 and $60 per barrel. The computers will overwhelm any effort to put and/or keep prices in such a range.


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