As production stays high, the oil price drops, the volatility picks up so investors pull out. If investors pull out, then the oil price might drop more, right? WRONG!
The supply and demand should be unaffected by commodity futures investing since there is no physical delivery from commodity futures investing. Remember, though, that speculators play an important role in risk transfer. As the volatility spikes, investors no longer are motivated to take the risk (go long futures contracts) of supplying insurance to the producers (who are short the contracts to protect against oil price drops.) The result is a collapse in open interest as shown in the charts below that compare volatility spikes with open interest (they are time period close ups of the above graph):
Chart 3
From the charts 2 and 3, one can observe that oil price spikes precede high volatility that causes open interest to collapse. Once investors take risk off the table and open interest collapses, then producers are less motivated to produce and store since insurance is more expensive. Then supply diminishes and the problem of low oil price solves itself as demonstrated in chart 2.
Where are we in this cycle? It appears from the 2015 oil volatility in chart 3 that the open interest has not collapsed yet. This means there may be further increased volatility until more money exits the futures market. OPEC’s decision to continue production may accelerate this exodus. When we finally see open interest collapse, then we may find the bottom of oil prices.
Finally, one tidbit that has been pointed out before is that VIX is the performer during this type of environment of high oil volatility, especially post the global financial crisis. Just this month as oil crossed into negative territory, VIX is up 1.6%.
This article was written by Jodie Gunzberg, global head of commodities, S&P Down Jones Indices.
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