White House diplomatic discussions this week focused on Ukraine and the threat of war, and in the midst of it, US President Joe Biden found time for a call with Saudi King Salman bin Abdulaziz to underscore their shared commitment to ensuring stable energy supplies.

In a report published by the British Financial Times, writer Gillian Tate said that oil prices recently jumped to more than $90 a barrel, for Brent crude and West Texas Intermediate crude, reaching its highest level in 7 years.

But these indicators exacerbate the risks of inflation, which is already high, and with gasoline prices reaching $3.47 per gallon - the highest since 2014 - this poses an increased political risk for Biden, which is the reason for his call with King Salman.

Amid this focus on spot oil prices, politicians and investors must watch what traders are now doing with derivatives contracts, and this issue usually doesn't get much attention because derivatives trading is a very opaque process, yet this area of ​​financial transactions is currently producing staggering numbers in excess of $90 per barrel, with the potential to push spot prices above $100 over the coming months, and cause a dramatic crash ahead.

The writer cautioned that futures prices are currently facing what analysts call “ultra-delay”, that is, there is a high-level gap close to the record level between short-term (high) oil futures contracts and (lower) long-term contracts, however, there is another indication of An imbalance is the size of bets on oil futures prices via the options market.

And according to what oil analyst Philip Verleger indicated in a recent report, the number of purchase options contracts with execution prices of more than $100 per barrel has recently increased, and Verliger calculated the volume of these contracts for June and December 2022, which is currently equivalent to 714,000, according to the data of the Committee commodity futures trading, this is several times more than the “normal” level;

This creates an "unprecedented" level of "open interest" (ie bets).

There is a near-record high gap between short-term and long-term oil futures contracts (Shutterstock)

automated trading

The reason for this discrepancy is likely to be due to economic fundamentals, specifically the lack of supply accompanying the increased demand, which prompted Biden to contact King Salman, but Verliger believes that the imbalance has exacerbated significantly for another reason that is rarely discussed, which is the sharp rise in automated trading by investors who use strategies Computational tools often based on artificial intelligence.

In its most recent study on the issue in 2019, the CFTC found that about 80% of energy deals are executed via automated input rather than manual transactions, down from 65% 6 years ago (and much lower in contracts). previous).

To analyze and react to market momentum, these automated strategies usually use AI programs rather than fundamental economic factors per se, exacerbating the impact of herd behavior not only in commodity markets but also in other asset classes.

Since institutions selling these financial derivatives need to hedge their risk using other instruments, reliance on automated trading creates distortions across markets that can unravel suddenly causing extreme volatility.

A similar thing happened in November 2021, when oil prices suddenly fell, and again in March 202, and Verleger believes that this may happen for the third time if oil prices exceed $ 100 a barrel, which would cause spot prices to rise. Today, he says, "Algorithmic strategies are driving oil prices. There is no clear end to the price increase caused by artificial intelligence at this point."

Verleger stresses that history shows that this kind of massive recovery is usually followed by a significant drop in prices.

Fifteen years ago, Brent crude prices moved from $54 a barrel at the beginning of 2007 to $132 in July 2008, before prices collapsed to $40 in December of the same year in the wake of the financial crisis. Today, a cycle is possible. Similar, but at a faster rate due to automated trading, especially if inflation fears undermine growth hopes.

However, what policy makers and investors must realize at the moment is that the possibility of oil reaching $100 per barrel is not only governed by the behavior of speculators and oil cartels, but also that automated trading has a role to play, but that it is too late to ban algorithmic trading.

As the CFTC report makes clear, there is less automation in the energy markets than in other areas such as stocks, but this pattern suggests that investors and regulators need to prepare for some extreme volatility and watch for market risks.

The author believes that we live in a world in which human-computer trading strategies are increasingly integrated while the results are doubly unexpected, especially when shocks such as the Ukraine crisis occur.