November 14, 2014 / 12:31 PM / 6 years ago

COLUMN-Oil market is trapped in a negative bubble: Kemp

(John Kemp is a Reuters market analyst. The views expressed are his own)

By John Kemp

LONDON, Nov 14 (Reuters) - The best way to think about the dramatic slide in oil prices over the last five months, Brent has fallen by more than 30 percent, is that the market is caught in a negative bubble.

The downward lurch in oil prices over such a short space of time is the mirror image of the price spike in the first half of 2008.

In both instances the price movements had some basis in changing market fundamentals: the shortage of light sweet crudes in 2008 and incipient oversupply thanks to shale in 2014.

But in both cases, a modest change in fundamentals has been magnified and accelerated by a shift in speculative positions.

Falling liquidity, the rush to cover hedging programmes, and herding behaviour among market participants then exaggerated the price moves.

For a time, the market becomes essentially a one-way bet.

In 2008, no one could imagine that prices would drop back to pre-spike levels (and certainly no one was willing to back that view with their own money).

In 2014, no one is prepared to forecast a return to the recent highs above $100 per barrel (with the notable exception of Continental Resources chief and majority owner Harold Hamm).

In effect, the market becomes “locked” in a single direction as all participants try to position themselves the same way, either because they genuinely believe or because they want to get out of the way of herd.

The process by which bubbles form, expand and eventually burst has been chronicled by specialists in behavioural finance like George Soros (“The Alchemy of Finance” 1987) and Robert Shiller (“Irrational Exuberance” 2005) whose work remains central to any credible explanation of how real-life asset markets work.

But bubbles can form when prices are falling just as much as when they are rising. In that case they are more familiarly known as crashes, but the basic processes are the same.

The best description of how bubbles, positive or negative, form and end, remains “Why Stock Markets Crash: Critical Events in Complex Financial Systems” by Didier Sornette (2003).

Sornette describes the process by which groupthink and herding comes to dominate a market rather than the normal diversity of views and prices spike or crash, until some participants dare once again to break away from the consensus.

Crashes often take place quickly, sometimes very quickly, such as the stock market crash in 1987 or the flash crashes in the U.S. equity and oil markets in 2011 and 2012 respectively.

But the price movement can be spread out over a longer period of time. The current price move certainly has all the characteristics of a bubble outlined by Sornette, Soros and Shiller.

There has been a real change in fundamentals - in this case the shale revolution and rising U.S. output. But it is too small to explain the enormous shift in prices over such a relatively short period of time.

It is the point Hamm made when he observed “notice how it all happened at once” and insisted “it’s not supply-demand related” and “the market is not in glut” in an interview with Forbes magazine(“Why Harold Hamm isn’t worried about plunging oil prices” Oct 20).

Hamm backed his views by monetising almost all of Continental’s hedges and leaving his oil company fully exposed to any future rise in prices (or indeed a further drop). But most hedging managers and fund managers do not have nearly so much freedom or appetite for taking risks.

With the bulls sidelined (just as bears were sidelined in 2008) oil prices have moved relentlessly lower since mid-June.

In characterising the price movement as a negative bubble, it is important to emphasise what this does not mean.

It does not mean that a reduction in prices was not needed to rebalance the market. With prices above $100 per barrel, the market was clearly out of balance, with a wave of new supply coming onstream and stagnating demand.

It does not mean prices cannot fall further. The essence of a bubble is that in the prices tend to overreact and overshoot the level needed to rebalance the market in the short term.

It does not mean that further declines will not be necessary to curb new investment in shale production as part of the adjustment in supply and to stimulate demand by reducing the pressure for greater energy efficiency.

It does not mean that OPEC might not have to cut its production before the market stabilises.

But it does mean that traders, investors and hedgers should be wary of reading too much about long-term market fundamentals into short-term changes in prices.

It does mean that we should be wary of confirmation bias: interpreting recent price changes to validate long-held views about market equilibrium.

Because oil prices at $80, $70 or even $60 per barrel are no more likely to be sustainable than they were at $147 in 2008. (Editing by David Evans)

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