In this week’s Oilgram News column, Petrodollars, Ned Molloy asks the question, have emotions and confirmation bias triggered trading mistakes in the maelstrom of oil price news?
How often did one read this year that the oil market is in terrible shape – weak, lackluster, oversupplied, bearish, limp? That there were sharp losses last year as prices collapsed, spiraled down, crashed? Most of the words used to describe oil getting cheaper had a negative connotation.
To any casual observer or consumer of oil, however, the market could be seen in wonderful shape with pump prices more accessible than before. A commodity that is being produced in a far greater quantity than can be consumed has seen its price go down.
So is there a bias in oil journalism focusing more on the potential gains or losses to producers or those ‘long’ oil? A significant place to look is the trend of long-only investors pouring into oil futures contracts in various forms, which began in the mid-2000s.
With the help of indices like the S&P Goldman Sachs Commodities Index (now known as the S&P GSCI), outstanding interest in Brent futures started to climb fast.
The usual story told about this ‘financialization’ of oil markets is that it coincided with a spike in 2008 of Brent futures, widely linked in media reports to market ‘speculation.’
In reality, the price spike appeared to be driven mainly by strength in refined products, which investors did not typically have access to, with soaring gasoline and middle distillate cracks, and rampant demand increases each year from China.
The effect on financial journalism itself was of having ever-increasing numbers of readers who wanted the price of oil to go up, rather than down.
In hindsight, some media coverage may have suffered from confirmation bias, catering to a growing class of commodity investors by describing price rises in positive terms, and falls in negative language.
Perhaps it’s partly a question of the new digital journalism imperative—splashing copy with emotive ‘click-bait’ language which does wonders for boosting your read hits.
But the outcome could have been some bad investment decisions. More money than needed to flowed from long-only investors to the shorts in 2014 who happily took advantage of their irrational price optimism even as shale oil production steadily grew.
Another example of the spread of long-only players is the growth in 401k retirement plans that brought main street to Wall Street, at least in the US.
Suddenly everyone’s retirement was tied up in the market needing to go up, and news reports naturally focused on price falls as something inherently negative, as if functioning markets could ever do without falls as well as rises in price.
The confirmation bias seen in descriptions of financial markets is nothing new of course and the language we use to describe the world colors our perception of it.
For those who see the oil market as a precise weighing machine of current supply and demand, this type of feedback loop from language to trading activity may seem inconsequential.
But at times in the first half of this year, it certainly seemed to many involved in the physical oil market that prices were recovering more on sentiment than fundamentals.
As both Brent and WTI futures ‘rebounded’ in late-January and early February, the one-word explanation heard often in the market was ‘funds’, that is hedge-fund buying.
For many traders used to looking at share price charts, the sight of something appearing to bottom out after a sustained fall proved too tempting to resist, and investors poured into Exchange-Traded Funds (ETFs) betting that the price would bounce.
Unfortunately for them, there was little fundamental reason that prices should rise—global oil production remained higher than consumption and was still growing, and oil prices went down again in March.
There is the element of herd-following in this. Certain ‘momentum’ strategies rely on the fact that many other people believe in the same technical signals and act upon them—in which case an illusion can become self-fulfilling, and potentially profitable. But do such human biases also create opportunities for other more rational traders to take advantage of?
‘Yes definitely,’ one London-based oil futures trader said. ‘For flat price that could be the case as its driven by sentiment or expectations. We do try and find opportunities like that from time to time.’ Taking metaphors literally may be an expensive mistake in the oil markets.
By Ned Molloy from Platts, McGraw Hill Financial