We've entered a "new era in the oil market," where price volitility is driven by traders with limited knowledge of the oil industry and a reliance on incomplete data, according to a report published this week by RBC Capital Markets.
The report, Oil Strategy: The Tale of the Tourist, by RBC's director of global energy strategy Michael Tran, has been making the rounds in oil trading circles since it was published on Monday. The heart of his argument is that oil prices are departing from fundamentals of supply and demand more frequently and for longer periods of time, due to a decline in the number of professional oil traders and a rise of non-specialized "tourist traders," who dabble in the oil market using algorithms or financial instruments such as exchange-traded funds (ETFs) and index funds.
"We've seen several false starts in this market over the course of this year, i.e. prices going to $55 a barrel, and then faltering back into the mid-$40s each time," Mr. Tran told The Globe and Mail. "It seems like a lot of investors are, to a certain extent, waving the white flag and saying these price moves just simply don't make sense."
Skittish prices are making it hard for investors to make informed decisions, he said. "Historically, when you looked at this oil market, you could count the barrels and you'd come up with a fundamental view of how something should play out. … Now you're in a situation where if you're early and the market moves against you, being early is almost the same as being wrong."
The market volatility, by Mr. Tran's estimation, is due in large part to non-specialized traders misinterpreting oil data or making investment decisions based on media headlines.
"When you see the volumes [of derivative contracts] traded per month that are at an all-time high, this ultimately means that more people are headline-driven, less people are counting barrels," he said. "There's a higher volume being traded, changing hands at a faster pace, by people who spend less time understanding the inner workings of the oil market than was the case five, 10 years ago."
His report highlights two data sources that he says are "frequently misinterpreted" by tourist traders, causing prices to skew away from market fundamentals: Bloomberg's "street consensus" and the American Petroleum Institute's oil storage estimates.
With Bloomberg, the problem is sample size. The "street consensus" is meant to provide an estimate of oil stock movement by surveying industry analysts. So far this year, however, an average of only 4.3 people replied to the company's weekly surveys estimating the change in oil supply stored at facilities in Cushing, Oklahoma – a major hub for the North American oil trade – according to Mr. Tran.
"Simply put, these four individuals set the consensus that is watched by an entire market," Mr. Tran writes in the report. "By nature, quants [numbers people in finance] should understand the potential pitfalls of data integrity, but without a look behind the curtain, many market participants are not aware that the law of large numbers simply does not hold with Bloomberg's consensus forecasts."
Bloomberg did not respond to a request for comment.
Similarly, Mr. Tran points to data from the American Petroleum Institute (API) as a potential pitfall. The organization provides widely watched estimates for U.S. oil stock, based on surveys of oil refiners and storage facilities. However, the number consistently falls short of the actual storage of oil as registered by the government-run U.S. Energy Information Administration.
"On a year-to-date basis, API stocks have, in aggregate, underestimated total U.S. crude stock builds by some 12 [million barrels]," Mr. Tran writes. "The questionable coverage universe can often leave blind spots, sway sentiment, and misrepresent reality."
With more non-specialist traders trading oil-based financial derivatives, the risk of one person misreading data is heightened by an increased "herd mentality" among traders, said Mr. Tran.
"There is no silver bullet to rectify the structural change in the market, but keen awareness is a step in the right direction," he writes in the report.