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Markets
The Big Take
OIL’S WILD RIDE IS DRIVEN BY A DISRUPTIVE BAND OF BOT TRADERS
An opaque group of algorithmic money managers have seized control of the oil
market.
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By Devika Krishna Kumar and Julia Fanzeres
December 1, 2023 at 1:00 AM GMT+1
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Trading oil has perhaps never been more of a roller coaster ride than it is
today.
Just in the past two months, prices threatened to reach $100 per barrel, only to
whipsaw into the $70s. On one day in October, they swung as much as 6%. And so
far in 2023, futures have lurched by more than $2 a day 161 times, a massive
jump from previous years.
What’s happening can’t be entirely explained by OPEC’s machinations, or war in
the Middle East. While supply-and-demand fundamentals still dictate overall
commodity price cycles, the day-to-day business of trading crude futures is
increasingly dominated by speculative forces, fueling volatility and driving a
disconnect between physical and paper markets.
And it’s not just speculators in general — traders are pointing the finger at an
opaque group of algorithmic money managers known as commodity trading advisors.
Despite their mundane name, CTAs have emerged as a powerful force in the oil
market. Though they comprise just one-fifth of managed money participants in US
oil, CTAs made up nearly 60% of the group’s net trading volume this year by some
measures, according to Bridgeton Research Group, which provides analytics on
computer-generated trades. That’s the biggest share the group has held in data
going back to 2017.
Read More: What Does OPEC+ Production Cut Mean for Gas Prices? (Quick Take)
While it’s hard to quantify how much of total trading volumes are controlled by
CTAs, algos more broadly are responsible for as much as 70% of crude trades on
an average day, according to data from TD Bank and JPMorgan.
“You would be absolutely shocked how large their positions are,” said Ilia
Bouchouev, a former trader and managing partner at Pentathlon Investments who
teaches at New York University. “They are probably bigger than BP, Shell and
Koch combined.”
This year’s volatile price swings are being intensified by these bots, according
to interviews with more than a dozen traders, analysts and money managers who
work in the oil market. They’ve roiled commodities from gasoline to gold,
sidelined traditional investors, drawn the ire of OPEC and even raised eyebrows
at the White House.
CTAs are loosely labeled as an individual or organization that advises on the
trading of futures, options or swaps. But those in the know say most are defined
by their trading strategies: computer-driven and rules-based, with relatively
limited time horizons.
What makes algorithmic CTAs so destabilizing is that they’re typically trend
followers — and trend exaggerators. When prices go down, they sell, driving them
even lower. And, more troubling for consumers, the same is true on the upside.
Some analysts say CTAs contributed to overvaluing oil by as much as $7 a barrel
during a recent rally. And White House officials believe they played a
significant role in price run-ups during the course of 2023, according to a
person familiar with the matter.
Even $1 or $2 added to the price of a barrel filters down to consumers through
higher fuel costs at a time when energy-driven inflation is among the biggest
obstacles for the world’s central bankers. In August, for example, higher prices
meant that gasoline costs accounted for half of the increase in the US consumer
price index.
“The Federal Reserve should be aware of them and their influence in markets,”
said Rebecca Babin, a senior energy trader for CIBC Private Wealth in New York.
“CTAs can create these fractures — periods of time when we’re trading away from
fundamentals,” Babin said. And while those moments may be short-lived, the
ensuing price swings “read through into the broader economic world in a lot of
different ways,” she said.
Big Swings, Big Profit
While algorithmic CTAs add much-needed liquidity to the market, their trading
strategies can amplify daily swings to an extreme. In 2022, when CTA trading
volumes rapidly expanded, New York oil futures posted a more-than $2 daily move
242 times. That’s 150% higher than the historical average since 2000, according
to Bloomberg calculations.
But what’s so surprising about the continued volatility in 2023 is that it’s
come without the major shock to supplies that followed Russia’s invasion of
Ukraine. While Israel’s conflict with Hamas set markets on edge, it’s not yet
had any major impact on oil flows. And rallies buoyed by production cuts from
the Organization of Petroleum Exporting Countries and its allies have been
undercut by CTA activity.
The unpredictability of this year’s market swings haven’t been kind to human
traders, many of whom are making less money on oil than they did last year when
they raked in record gains, according to market participants.
CTAs, by contrast, have been booming — notching three straight years of gains in
energy markets, according to Stephen Roseme of Bridgeton.
And many CTAs are expanding. Paris-based Capital Fund Management says its CTA’s
assets under management jumped to $3.8 billion in July 2023 from $2.4 billion in
December 2021. Amapa Capital Advisors LLC and Skylar Capital Management are
among CTAs that have doubled or tripled assets under management in less than two
years, CTA advisory firm IASG reports. The largest CTAs in energy are Man AHL,
Gresham, Lynx and AlphaSimplex, according to BarclayHedge, but their exact
volumes are difficult to quantify.
Man Versus Machine
The beauty of algorithmic CTAs, according to the humans behind them, is that
they’re untainted by bias and impulse — they’re predominately mathematical. That
approach, of course, is anathema to many in commodities, where man’s dominion
over nature, and markets, is foundational.
“Every trader thinks they’re the best. Every trader thinks they have the edge,”
says Brent Belote, who gave up an oil trading career at the biggest US bank, JP
Morgan Chase & Co, to launch his own CTA in 2016.
Trusting a machine didn’t come naturally to Belote. Although he’s built six
algos, he initially found himself trading alongside them. After all, he had
years of expertise that the computer did not.
When Russia invaded Ukraine in early 2022 and Brent crude futures skyrocketed
35% to trade above $120 a barrel, Belote wanted desperately to direct his algos.
It was a subzero morning in Jackson, Wyoming, when he rose to check on his
models – but he decided not to intervene. In the aftermath of the invasion, his
firm, Cayler Capital, returned 25% to investors, he said. That compares with 1%
for Bloomberg’s hedge fund index.
“The numbers don’t lie,” said Belote.
Expand
Brent BelotePhotographer: Natalie Behring/Bloomberg
Not ‘Flash Boys’
CTAs themselves aren’t new — they’ve been around since the early days of futures
trading. And since 1984, they’ve had to register with the National Futures
Association. They typically enjoy a lower barrier to entry than hedge funds,
which can trade a wider variety of securities and require more initial capital.
They’re not really the “Flash Boys” of futures, though. CTAs, unlike
high-frequency traders, aren’t typically profiting from the speed at which they
move. Instead, they mostly make money on indicators fueled by trends. And
they’re active in equities and commodities alike through futures and options.
Markets for commodities, however, differ from equities in many important
respects. For example, while the stock market evolved as a way to raise capital,
commodities futures markets have traditionally been a place for producers and
buyers to hedge their price risk.
Born From the Crash
How did CTAs come to become so dominant? Like many current phenomena, the answer
starts in the depths of the pandemic.
As shutdowns engulfed the world in 2020, fuel consumption collapsed by more than
a quarter. All hell broke loose in the crude market. The benchmark US oil price
briefly dropped to minus $40 a barrel and investors were in wholly new
territory. Some funds that took longer-term views based on supply-and-demand
fundamentals quickly pulled out.
Such bear markets proved to be “extinction events” for traditional funds, which
made way “for algo supremacy,” the bulk of which are CTAs, said Daniel Ghali,
senior commodity strategist at TD Securities. Russia’s invasion of Ukraine gave
the CTAs another foothold. Spiking volatility in the futures market drove many
remaining traditional investors to the exits, and open interest in the main oil
contracts tumbled to a six-year low.
That coincided with the collapse of another source of futures and options
trading: oil-production hedging. During the heyday of shale expansion about a
decade ago, drillers would lock in futures prices to help fund their growth. But
in the aftermath of the pandemic-induced price crash, a chastened US oil
industry increasingly focused on returning cash to investors and eschewed
hedging, which can often limit a company's exposure to the upside in a rising
market. By the first quarter of this year, the volume of oil that US producers
were hedging by using derivatives contracts had fallen by more than two-thirds
compared with before the pandemic, according to BloombergNEF data.
The recent wave of dealmaking by US oil producers threatens to further
accelerate the decline in hedging. And it’s highly likely that CTAs will
continue to fill the vacuum left by those traditional market players.
In some ways, the rise of the CTAs is just starting. That’s evident to Bouchouev
of NYU, who says that his students consider working at the funds a “dream job.”
“CTAs are an example of how technology is getting into our space,” he said.
“You’d be a dinosaur after a while if you reject it.”
— With assistance from Jennifer A Dlouhy and Michael Roschnotti
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