(John Kemp is a Reuters market analyst. The views expressed are his own)
By John Kemp
LONDON, Dec 8 (Reuters) - Like a rabbit trapped in the headlights of an oncoming car, Brent prices have remained static in the past fortnight despite an exceptionally heavy news flow.
The market has been hit by a series of large shocks ranging from the deepening debt crisis in Europe to possible sanctions on Iran’s exports and speculation about a military strike on the country’s nuclear facilities.
News that would normally have a significant impact has had none at all, however. Instead the market is paralysed by informational and analytical overload, unable to process the unusually large number of economic and political risks. “Forward visibility” has shrunk from the usual months to just weeks or even days.
Daily price movements have been unusually small. Realised volatility has fallen to 22.6 percent over the last 30 trading days, down from more than 35 percent in October, putting it in the 23rd percentile of the 2006-2011 distribution, and the trend is still lower.
Front-month Brent futures prices have ranged less than 2.25 percent a day in the last fortnight compared with an average of more than 3 percent since the start of 2006.
The market’s steadiness in the face of a string of larger-than-usual shocks has several causes:
(1) Seasonal factors. Risk appetite is traditionally low at this time of year as traders and hedge funds square up positions ahead of the year-end and the final calculation of profits, losses and bonuses.
(2) Balance of risks. Bullish influences on oil prices (escalating tensions in the Middle East) are matched by large offsetting risks on the downside (worsening economic slowdown in Europe now spreading to emerging markets).
(3) Multiple uncertainties. The number of potential major price-drivers has multiplied so much and the range of uncertainty surrounding them has grown so wide that it has become impossible to forecast more than a month or two ahead with any degree of confidence.
Markets are complex social and financial systems characterised by strong non-linearity. They thrive on differences of opinion, which is what provides liquidity and the incentive to trade.
But most market participants prefer simple narratives and want to focus on a relatively limited range of risks that polarise around just two or three scenarios. The repeated inflation/deflation debates in 2009-2011 are a good example of polarising but fairly simple narratives that generated significant trading activity and volumes. The risk on-risk off debates earlier in 2011 are another.
Markets prefer a carefully controlled amount of uncertainty. Too much uncertainty, and everyone moves to the sidelines.
At the moment, there are simply too many major factors in play to organise the outlook into a small number of well-defined scenarios or narratives. Tremendous uncertainty about any one of those factors swamps the entire forecast outlook.
If Europe slides into recession as a result of the deepening debt crisis and takes the United States and emerging markets with it, the resulting drop in oil consumption would easily swamp forecasts about growth in non-OPEC supply and the resumption of Libya’s exports.
Equally, if escalating tensions in the Middle East cannot be controlled, they have the potential to trigger the largest disruption in oil supplies for more than a decade.
On a smaller scale, the market is coping with more run-of-the-mill uncertainties: the speed of Libya’s output recovery; production problems in the North Sea and erratic growth in non-OPEC supply; the cartel’s unclear production policy; and a rapidly changing long-term outlook as a result of tight oil from the North Dakota’s Bakken formation and elsewhere.
While analysts are unable to predict the outcome of any one of these risk factors with any confidence, it is impossible to produce a credible forecast. The only attractive strategy is one that keeps all options open.
In normal times, market participants can subsume the wide range of uncertainties into a simple over-arching narrative. During 2005-2008, that was concerns about peaking oil production and burgeoning emerging market demand. In 2009-2011, it was the pace of recovery in the advanced economies and continued growth in developing countries.
These are oversimplifications. Most market participants willingly fool themselves about the predictability of the future and underestimate the degree of uncertainty and variability in the outlook. But such simplifications are needed to give participants the confidence to trade and take risk.
In the current environment, the sheer range and scale of uncertainties defies easy categorisation and has shattered any illusion of predictability. There is no dominant narrative.
As a result, many participants are on the sidelines, waiting until some of those uncertainties resolve themselves before taking more risk. (editing by Jane Baird)