Uncertainty causes market to stumble

The news that Covid-19’s omicron variant could be more virulent and more dangerous has caused strong reactions in the oil market. After 18 months of unprecedented challenges, this is unsurprising, suggests Kay Rieck, an experienced market observer and investor.

Covid-19 has made the last eighteen months phenomenally difficult for the oil market. To be fair to it, after the initial shock of the lockdowns, there was relatively little panic. Prices have risen (they didn’t have much of an alternative) and recovered to a level that a lot of businesses in the sector would consider healthy. The pricing mechanism generally appeared to be coping with the new reality, rising and falling within a reasonable range according to supply.

And then came omicron. The emergence of a new variant of concern appears to sent oil traders into something of a blind panic. According to a reports looking at a Goldman Sachs analysis paper, the responses from the market have been “borderline comical”.

According to the report itself, the fall in the price of oil witnessed at the end of November “…would represent any of these extreme outcomes: (1) not a single plane flying around the world for three months, or (2) half as intense as the 2Q20 global lockdown, or (3) a world even worst-off than before vaccinations: the combination of global jet demand falling to last winter’s level (-1 mb/d), a twice as large hit to EU demand as the Alpha variant last winter (-2 mb/d) and twice as large a hit to Chinese demand as the Delta variant this summer (-1 mb/d). The relatively parallel nature of the sell-off, with back-end prices down $7/bbl, could also be interpreted as the market pricing in a shallower but longer demand hit: a c.4 mb/d hit over 3 months with c.3mb/d of this a permanent impact offset by higher OPEC+ spare capacity.”

In extremis

The problem is that while these are extreme scenarios, it comes on top of a litany of unprecedented shifts in demand as Covid-19 has wreaked its havoc around the world. At the this point at the start of December, pretty much all we know is that the omicron variant exists, it looks like it’s more transmissible, and it has a large number of mutations that could, but might not, impact the efficiency of the current generation of vaccines.

It might be that omicron has the potential to become a more deadly version of Covid-19 than we have dealt with previously, or it could be that it will spread more easily but cause far less severe illness. It is comforting to think that the third wave of Spanish flu in 1919/20 caused fewer deaths than the waves that preceded it, but that is based on very patchy data from over a century ago as well as a fair amount of wishful thinking that Covid-19 will follow the same path. So while it might be nice to think that what happened a hundred years ago will be repeated, Covid-19 and H1N1 are two different viruses.

The challenge for the markets is that they have spent the last three months becoming increasingly optimistic about the recovery of the global economy. This means that some traders have taken long positions on oil futures based on the assumption that relatively tight supply would keep prices high. They are now trying to unwind those positions at speed in response to the changing circumstances. You don’t have to read many books on economic theory to recognise that whenever positions need to be unwound at speed, prices are likely to spiral downwards.

Markets, risk and opportunity

Markets always react strongly to uncertainty, and omicron currently represents a significant additional uncertainty at a point where things were just starting to look optimistic. The thing to keep in mind though is that while the current conditions will be very difficult for some market participants, others will be able to take it in their stride.

What is going to be interesting over the next few weeks however, will be how quickly the falling prices on the global markets translate to better prices for consumers. While there are several reasons why the is a lag between what happens on the market and the prices people pay when they go to fill up their vehicles, there is increasing pressure on the oil sector to do what they can to make prices more responsive. While the current market volatility is short term, the exceptionally high price of oil is likely to represent a long-term threat to the oil sector as the high price of oil makes it easier for consumers to look at their wallets and make the transition to more economically viable modes of transport.

In the midst of it all, the oil sector has both its short- and long-term survival to think about.