Sharp Fluctuations in Oil Prices as Traders Heavily Rely on Algorithms

During the past two months, oil prices were expected to rise to $100 per barrel, but they only reached $70, and then they fluctuated by up to 6% in one day in October.

So far in 2023, futures have swung by more than $2 a day 161 times, a huge jump from previous years, according to Bloomberg.

It cannot be said that the current oil market fluctuations are caused solely by the actions of OPEC or the war in the Middle East. Although supply and demand factors continue to determine overall commodity price trends, the daily movements of crude oil futures trading are increasingly influenced by speculation, fueling volatility and a divide between the physical market and paper transactions.

It's not just individual traders who are responsible for the volatility. Traders also blame a shadowy group of algorithm-driven money managers, known as "commodity trading advisors."

Commodity trading advisors have emerged as an influential force in the oil market, although their names may sound ordinary and do not reflect a strong influence. They constitute one-fifth of participants in managed funds in the US oil market.

Some indicators showed that commodity trading advisors accounted for nearly 60% of the group’s net trading volume this year, according to Bridgeton Research Group, which provides analyzes of computer-aided trades. This is the largest share held by the group in data dating back to 2017.

Although it is difficult to quantify the total volume of trades executed by commodity trading advisors, algorithms are generally responsible for up to 70% of crude trades on an average day, according to data from TD Bank and J.P. "Morgan."

“You would be surprised to learn the size of their positions,” said Ilya Bushuev, a former trader and managing partner at Pentathlon Investments who teaches at New York University. “It may be larger than BP, Shell, and  (Koch) combined".

This year's massive price swings are accelerating thanks to algorithmic trading software, according to interviews with more than a dozen traders, analysts and money managers working in the oil market. The impact of these programs extended to the prices of basic commodities, from gasoline to gold, and they marginalized traditional investors, angered OPEC, and even surprised the White House as well.

Commodity trading advisors are typically classified as an individual or organization that provides advice on trading in futures, options or swaps. But those in the know say most are known by their trading strategies, which rely on computer algorithms and rule-based decisions and focus on relatively limited time horizons.

Algorithmic commodity trading advisors typically follow price movement trends and exaggerate them to make them steeper, and this makes them a disruptive category in the oil market. When prices fall, they sell, causing prices to fall further. What worries consumers even more is that the same applies to rising prices.

Some analysts say commodity trading advisors overvalued oil by $7 a barrel during the recent rally. White House officials also believe they played an important role in the rise in prices during 2023, according to a person familiar with the matter.

Even a rise in the price of a barrel of oil by one or two dollars may have an impact on consumers, because this leads to higher fuel costs at a time when energy-driven inflation is considered one of the biggest obstacles facing global central bankers. In August, for example, higher oil prices contributed to higher gasoline costs, which accounted for 50% of the increase in the US Consumer Price Index (CPI).

While algorithmic commodity trading advisors play a role in providing much-needed liquidity to the market, their trading strategies can dramatically amplify daily price fluctuations. This became clearer when trading volumes rose rapidly in 2022, with NY oil futures recording daily movements of more than $2 more than 242 times, which is 150% higher than the historical average recorded since 2000, according to Bloomberg.

But what is surprising about the continued volatility in 2023 is that it has come without a major supply shock similar to the one that followed the Russian invasion of Ukraine. The conflict between Israel and Hamas has sparked tension in markets, but has so far had no significant impact on oil flows. The activity of commodity trading advisors also undermined the rise in oil prices.

The unpredictability of market volatility this year has not been good for traditional traders, many of whom have made smaller gains from oil than last year when they posted record profits, according to market participants.

By contrast, commodity trading advisors posted huge gains, marking a three-year winning streak in energy markets, according to Bridgeton's Stephen Rosemey.

Many commodity trading advisors are expanding their activities, as Capital Fund Management, based in Paris, explains that the assets of commodity trading advisors under management jumped to $3.8 billion in July 2023, after it was $2.4 billion in December 2021. Amapa Capital Advisors LLC and Skylar Capital Management are among the commodity trading advisors whose assets under management have doubled or tripled in value in less than two years, according to reports from commodity trading advisory firm I. IASG. BarclayHedge indicates that the largest commodity trading advisory companies in the energy sector are Man AHL, Gresham, Lynx, and AlphaSimplex.

The good thing about algorithmic commodity trading advisors is that they are not subject to bias or volatility, they are mainly based on mathematics, according to the people who work on these programs. This approach, of course, represents a crisis for many in the commodity space, where human dominance over nature and markets is fundamental.

“Every trader thinks they are the best, everyone thinks they have the advantage,” says Brent Bilott, who left his job trading oil at the largest US bank, JP Morgan, in favor of establishing his own commodity trading advisory service in 2016.

Trusting the machine was not something that came naturally to Pilot.

When Russia invaded Ukraine in early 2022 and Brent crude futures rose 35% to trade above $120 a barrel, Pilot desperately wanted to gear its algorithms to take advantage of market volatility. Bilott got up on a frigid morning in Jackson, Wyoming, to check on his algorithms, but decided not to get involved. He said that in the wake of the invasion, his company, Cayler Capital, returned 25% to investors. This compares to 1% for the Bloomberg Hedge Fund Index. “Numbers don't lie,” Bilott said.

As lockdowns swept the world during 2020, fuel consumption collapsed by more than a quarter. Chaos erupted in the crude oil markets, as the price of benchmark US oil briefly fell to negative $40 per barrel, and investors were in a completely new position. Some investments that took long-term views based on the rules of supply and demand quickly withdrew.

“These bear markets seemed to spell the extinction of traditional funds, which gave way to the supremacy of ‘algorithms’, most of which are commodity trading advisors,” said Daniel Ghaly, chief commodities strategist at TD Securities.

Russia's invasion of Ukraine gave these companies another foothold, as extreme volatility in the futures market pushed many remaining traditional investors to retreat, and interest in major oil futures fell to a six-year low.

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