When oil prices fell below $120 a barrel in early New York trade last Thursday, a few big companies that are major oil consumers started buying around $117. It looked like a bargain. Brent crude had been trading above $120 for a month. But the buying proved ill-timed. Crude kept on falling. “They were down millions by the end of the day, trying to catch a falling piano,” an executive at a major New York investment bank said. Never before had crude oil plummeted so deeply during the course of a day.
At one point, prices were off by nearly $13 a barrel, dipping below $110 a barrel for the first time since March. Oil’s descent followed the biggest one-day price drop in silver since 1980 on Wednesday, after hedge fund titan George Soros was reported to be selling. Exchange operators raised silver’s margin requirements, making it more costly to trade the metal and sending investors out of the market. Silver plunged by 20 percent, more by week’s end. The rout unnerved some commodity investors.
Oil just doesn’t fall by 10 percent in the course of a normal day, though. In commodities markets, oil is king, and its daily contract turnover, typically around $200 billion, is usually able to absorb even large inflows or outflows of investment. The rare moves of $10 a barrel usually are set off by dramatic events – the outbreak of the first Gulf War in 1991, or the collapse in 2008 of Lehman Bros bank, which both led to recessions. Of course, there was major news last week. But the daring Pakistan raid that killed Osama Bin Laden had done little to shift the balance of oil markets on Monday.
In interviews with more than two dozen fund managers, bankers and traders, no clear cause emerged for the plunge in price. Market players were unable to identify any single bank or fund orchestrating a massive sale to liquidate positions, not even an errant trade that triggered panic selling, as seen in the equities flash crash last May. Rather, the picture pieced together from interviews on Thursday and Friday is one of a richly priced commodities market – raw goods have been on a five-month winning tear over all other major investment classes – hit by a flurry of negative factors that individually could be absorbed but cumulatively triggered a maelstrom.
Computerised trading kicked in when key price levels were reached, accelerating the fall. “It was a domino effect,” said Dominic Cagliotti, a New York-based oil options broker. The negative factors – prominent cheerleaders turning bearish, some weak economic data, cheap money from the US Federal Reserve ending by July, a lessening of political risk – merely provide a backdrop for the waves of selling. What stands out is the way computers turned readjustment of positions in a huge and deep market into a rout. THE COMPUTERS
Stunningly large jolts from so-called stop-loss trading amazed market traders. The automated sell orders were generated as oil crashed through price points that traders had programed in advance into their supercomputers. In many cases, computer algorithms sold for technical reasons, as oil dropped through levels that, once breached, could trigger ever larger waves of selling yet to come.
The machine trading, based on subtly different but fundamentally similar, algorithmic models, eliminates the white-knuckles and potential human error involved in actively trading a volatile market and increases anonymity. Instead of breeding hesitation, abrupt price drops can quickly prompt these machines to unload a bullish long position in oil, and build up a bearish short one instead. Machine-led trading is one plausible thesis for another apparent market anomaly that occurred on Thursday. Exchange data shows that the total number of open positions in the oil market – a number that would typically fall in a sell-off – instead rose.
