Oil prices fall as recession fears mount

Another turbulent week in oil markets sent crude prices to their lowest since January, with weak trading and a murky outlook for supply and demand leading to an unlikely 30% drop from this year’s highs.

Despite rising 5.9 percent since Wednesday, the main benchmark for U.S. oil has lost about $35 a barrel since peaking above $122 three months ago. West Texas Intermediate closed Friday at $86.79. Brent crude futures, the main international price index, closed at $92.84.

Like what happened earlier this year, the drop in prices has been exacerbated by increased volatility and reduced liquidity in futures markets, which are meant to facilitate the movement of barrels around the world.

Traders and analysts said an overwhelming number of variables – from calculating consumption to be cut by China’s Covid-19 lockdowns to the downside of how many barrels avoided by Russia will reach the market – have made it unusual difficult to predict the direction of prices.

Other examples of uncertainty looming in the market include how long the Biden administration will dip into the US Strategic Petroleum Reserve to bolster domestic supply, whether high gas prices in Europe will prompt utilities to burn oil, and to what extent The Organization of the Petroleum Exporting Countries and its allies in the market are willing to cut output to support prices.

A renewed nuclear deal between the US and Iran could put Iranian oil back on the market. Lately, fears of a recession and reduced consumption have overshadowed concerns about insufficient oil supplies and pushed prices lower.

Analysts at BofA Securities made a case in a recent note to clients that oil prices will rise and fall as much as $20 in the coming months. “There is simply too much uncertainty about the fundamentals going into the winter,” they wrote.

The unpredictability added to the volatility, which drove investors to the sidelines. Open interest, a measure of trading activity, is recently about half of what it was five years ago in the most active U.S. oil futures contract and about 30% of what it was last year.

The drop in trading reduced liquidity – the ability to trade at expected prices without causing large price movements or disorderly trading – in markets already hampered by thin trading and prone to wild swings, traders said.

Bernard Drury, chief executive of Drury Capital Inc., a commodities trading firm that uses momentum investment strategies that follow prices up and down, said that between oil being about twice as expensive as it was before the pandemic and the added risk of increased volatility, speculators including him cannot take as many positions in the futures market.

“We’re going to trade maybe a third of the number of contracts we traded a few years ago, and we’re still going to have the same kind of risk exposure,” Mr. Drury said. “If everyone on the for-profit side of things acts like we do, they might participate more or less fully, but trade fewer contracts.”

This has made it more difficult for companies involved in the production, transportation and consumption of actual barrels of oil to find counterparties to trades that help them manage their own risk.

Traders wary of flipping their arms or making big waves in thin markets have broken trades into smaller trades, making it harder to determine prices, said Shankar Narayanan, head of research at Quantitative Brokers LLC, which uses algorithms for trading on behalf of hedge funds. , banks and asset managers.

High oil prices have been beneficial for OPEC+, an alliance of oil-producing countries that controls more than half of world production. WSJ’s Shelby Holliday explains what OPEC+ countries are doing with the windfall and why they are unlikely to distance themselves from Russia. Illustration: Adele Morgan

The so-called bid size in U.S. crude futures trading has shrunk by about 50% from a year ago and is down more than 70% over the past three years, leading to wider gaps between bids and offers. Wider spreads have helped fuel volatility and cut liquidity by more than half since 2019, Mr Narayanan said.

“Oil prices have been skyrocketing since February, but on a very poor liquidity basis,” he said. “The price is not sustainable.”

Over the past two weeks, hedge funds that follow price trends and trading algorithms that dominate the speculative side of the oil market have piled into short bets or bets that prices will decline, according to Peak Trading Research.

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The Swiss firm has created a mathematical model to gauge the direction traders are betting on and posted a rare perfect bearish score last week for the first time since the emergence of the Omicron variant of Covid-19 roiled energy markets in late 2021. The index Peak’s late August recorded a perfect bullish score, meaning momentum traders were basically all positioned for bullish prices two weeks ago.

“The big hedge funds have been shorting and now they’re playing for lower prices,” said Dave Whitcomb, who runs Peak. “This is a definitive sign that the bull market is over. You can stick a fork in it.”

At an energy industry conference in New York last week, the CEO of rig owner Patterson-UTI Energy Inc.

told investors that rising crude prices have not dented demand for drilling equipment among the Houston company’s customers.

“None of them were really planning on $110 oil. I mean, that was just a bonus for them,” said CEO Andy Hendricks. “The instability has not changed the conversation in the US about our services at all.”

Write to Ryan Dezember at ryan.dezember@wsj.com

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