BIS says financial flows partly to blame for oil collapse

 

 

 

 

Neil Hume, Commodities Editor

 

©Reuters

The near 50 per cent fall in oil prices since mid-June cannot be solely explained by changes in consumption and production, according to the Bank for International Settlements, which says heavy trading on commodity futures markets has also played a part.

In a preliminary analysis of the oil market rout, BIS, known as the central bankers’ bank, says financial flows have contributed to the rout along with changes in supply and demand balances.

The comments will add to the debate about the “financialisation” of commodity markets and the extent to which investors, big banks and hedge funds are driving prices of raw materials.

BIS says the last two comparable oil price declines in 1996 and 2008 were associated with a large drop in consumption, and in 1996, a surge in production. But this time changes in supply and demand — which BIS says have not differed markedly from expectations — fall short of providing a satisfactory explanation for the abrupt collapse in prices.

“Rather, the steepness of the price decline and the very large day-to-day price swings are reminiscent of a financial asset,” BIS said in its analysis. “As with other financial assets, movements in the price of oil are driven by changes in expectations about future market conditions.”

Oil prices have gyrated wildly over the past week, rising and falling by as much 9 per cent a day in response to news flow that has ranged from data on US oil rigs to storage levels.

Trading in Brent and West Texas Intermediate futures contracts dwarfs physical volumes and many traders say it is the supply and demand for futures which determines the price of oil.

According to PVM, a brokerage, daily futures volume in oil has risen from 3.4 times global demand in 2005, when the International Petroleum Exchange went electronic, to 17 times at the end of 2014 and has ratcheted up even further to over 20 times since the beginning of the year.

BIS also says the substantial increase in debt borne by the oil sector could also have contributed to the price slump.

A greater willingness on the part of investors to lend against oil reserves and revenue has enabled oil companies to borrow large amount of debt, much of it in the form of high yield bonds. This has been a key financing tool for many US shale producers.

“Against this background of high debt, a fall in the price of oil weakens the balance sheet of producers and tightens credit conditions, potentially exacerbating the price drop as a result of sales of oil (for example, more production is sold forward),” BIS said.

However, the Basel-based organisation says producers could find it increasingly difficult to hedge their exposure to volatile oil prices because banks may not be willing to take on the business.

“At times of heightened volatility and balance sheet strain for leveraged entities, swap deals may become less willing to sell protection to oil producers,” said BIS.