Dealing rooms drive prices
Oil prices have never been as volatile as in the past few years. This price instability is giving a lot of people in the world a lot of bad headaches. Governments (of oil exporting and oil importing countries) can’t properly budget. Energy companies are uncertain about when and how much they should invest – not only oil companies, but also producers of renewable energy who compete with oil and gas suppliers. Big energy consumers are uncertain about their production costs.
Paolo Scaroni, CEO of Italian oil and gas major ENI, is so troubled by the oil price instability that he recently came up with a far-reaching proposal to reform the oil market. He is pleading for the establishment of a Global Stabilization Fund and coordinated management of global oil stocks. In other words, a cartel not just of energy producers, but of producers and consumers combined!
So why have oil prices become so volatile? This has to do with how commodity markets have evolved in recent years. More and more market participants have become active in energy trading: from oil and gas producers to power producers, large energy consumers, such as producers of industrial goods, and trading firms, such as banks or hedge funds.
Most of the physical players (those who deal with concrete energy products) start as hedgers, that is, they trade in order to mitigate the risks they are exposed to. A refinery is exposed to risk that the price of crude oil (input) goes up and the price of the refinery products (output) goes down. Similarly, a power producer is exposed to the risk that the price of its fuel (gas or coal) goes up, as well as the risk that the price of power goes down. To protect against losses, these parties use specific financial instruments (i.e. derivatives, like futures, options and swaps).
But they usually don’t stay there. Once they have (or think they have) enough qualified traders, sophisticated risk management in place and sound monitoring tools, it makes sense for them to go a step further and engage in arbitrage. Arbitrage is the process of profiting from price discrepancies. When the same product trades at different prices in different markets, traders buy at the lower price in the undervalued market and sell at the higher price in the overvalued market. The buying and selling should be done simultaneously to avoid risk. Arbitrage in its purest form is considered risk free. Obviously if arbitrage takes place in this way, price differentials cannot remain for long, for they will be arbitraged away.
When market participants are familiar with hedging and arbitrage they often take the next step: they set up a proprietary trading desk (‘prop desk’). Proprietary trading (‘prop trading’) is trading for one’s own account and one’s own risk. In other words, what you make - or lose - is for yourself. ‘For yourself’ usually means for the company’s account.
The purpose of prop trading is the opposite of that of hedging. Whereas hedging means mitigating risk with the objective to avoid losses, prop trading seeks to increase risk (as in opportunity) with the purpose of making money. Prop trading obviously requires a sound risk management system to be in place.
Interestingly, trading firms, such as hedge funds, start at the opposite point of physical traders. They do not start with hedging – they hedge to limit the risks associated with their arbitrage and prop trading. The purpose of hedge funds is not to produce or use a (physical) commodity, but to make money. Therefore they do not start with avoiding risk, but they start with looking for opportunity and seek exposure. They make use of arbitrage opportunities and trade on their prop book. Based on the size of their positions and the (probability of) exceeding their limits on working capital, they will mitigate their risk and/or change their risk profile on a continuous basis. This is why they hedge as well, but only to support their primary activities.
This way of trading is completely different from the activities of physical players. However, many of the physical players increasingly act like hedge funds. They have set up prop desks, use more leverage on their working capital and trade for the purpose of making money on trading instead of solely mitigating risk on their normal business portfolio.
The result of all this is that energy (commodity) markets have increasingly become integrated with the classic financial markets. Eventually, this will lead to one homogeneous commodity and financial market place.
In fact, the major price drivers have probably changed from micro to macro. This, at any rate, is the trend the market is following. What this means is: increasingly less predictable commodity markets. Psychology becomes an important factor to take into account. Sentiment often steers prices to a significant extent. For traditional commodity analysts, life has become a lot more difficult. They will wonder sometimes what their added value is, and how they can adapt to the new situation.
So what does this mean for energy producers, energy users and governments? Prices become more and more unpredictable as markets become more mature. This implies that markets will have to be analysed in quantitative terms more than qualitative – prices are more driven by valuations. Think about in this way. In the past nobody could afford to have NO opinion. Today the opposite is true. Nobody can afford to have an opinion.