For April, I am reducing my March forecast for West Texas Intermediate oil (WTI) by $5 to range between $65 to $85 per barrel. As I write this blog post in the evening of March 30, WTI is hovering around $74.40 per barrel.
Last month I mentioned that as long as the general economy remains healthy, prices should strengthen. Of course, that did not take into account the March banking crisis that everyone is now well aware of. It seems when there is an adverse economic development, oil seems to immediately and disproportionately suffer, perhaps because traders remember all too well how oil suffered during the great financial crisis in 2008 and, again, during the initial COVID-19 breakout.
There were other factors, too, however. There was a negative gamma effect heading into options expiry. The negative gamma effect of financial institutions having sold protective puts on WTI oil prices to various producers. As WTI approached key strike prices, those financial institutions needed to sell oil futures to hedge themselves. A March 26, 2023, the Wall Street Journal article “How Options-Hedging Turbocharged Oil Volatility: Trade amplified a price drop to 15-month lows and now could help fuel a rebound” (subscription required) provides a more in-depth explanation.
Earlier this month, oil’s steepest weekly slide in almost three years accelerated as futures approached levels where many producers owned derivatives designed to lock in prices. As declines mounted, banks and trading firms on the other side of those trades had to unload crude to mitigate potential losses, investors said, dragging benchmark prices to 15-month lows.
Now, many expect similar dynamics could add momentum to any rebound if the economic outlook improves—leading to more expensive oil that could increase the cost of gasoline and diesel later this year. It is the latest example of how volatility in financial markets can spill into the real world, shaking an oil industry stretching from the shale basins of Texas to refineries in China.
The recent retreat “in many ways had not a lot to do with oil,” said Ben Luckock, co-head of oil trading at Trafigura Group, at an industry confab hosted by the Financial Times last week. “We got caught up in the macro world again, which happens all the time. It’s OK,” he added. “But it distorts what happens in the future.”
The article displays a graphic from Standard Chartered Commodities Research where it shows the producer put-option volumes skyrocketed from about 50 thousand barrels per day to nearly 300 thousand barrels per day at a strike price of $70. In other words, as WTI approached $70, financial institutions were forced to hedge their short put positions.
As an aside, the article further mentions that Mr. Andurand, who runs a $1.3 billion energy hedge fund, believes oil prices could hit $140 per barrel by the end of the year. He is likely referring to Brent prices, which tend to be $5 to $10 higher than WTI prices.
In addition, there were technical price levels that were breached, and the number of long oil futures was at recent lows. All these factors likely reinforced each other to help drive WTI prices down to the mid $60s before rebounding this week.
Often when oil prices suffer a significant fall, a passage of time is required before traders and investors regain their confidence to push oil prices back to prior levels. Furthermore, the banking crisis will cause some, if not most, banks to scale back their lending as they fortify their financial positions. This scaling back in lending practices will do some of the Fed’s work in slowing the economy, which is likely to be a drag on oil prices.
Regarding the economic effects of contracting credit, Ray Dalio wrote two interesting books regarding how the economic machine works: first, Principles for Dealing with the Changing World Order: Why Nations Succeed and Fail, and second, Principles for Navigating Big Debt Crises. Please note that I have used Amazon affiliate links for both books. Also, I encourage you to view his 31-minute video “How the Economic Machine Works.”
Because of the increased uncertainty caused by the banking crisis and the general skittishness of investors and traders, I have lowered my price range by $5 per barrel for April. In general, I am still bullish on oil and expect prices to strengthen in the second half of the year.