Energy Quantamentals: Who is Who in Financial Barrels?

For many years, the primary focus of oil market analysis has been on estimating the production and consumption of oil and forecasting their short-term evolution, as even subtle imbalances between supply and demand were widely perceived to determine the direction of oil prices. The focus, however, started to widen over the course of the last decade as new financial market participants entered the oil market. To model their behavior, an additional type of analysis has become essential: the analysis of supply and demand for financial barrels which are traded in the derivatives market.

To put things into perspective, the world currently consumes approximately one hundred million barrels of crude oil per day. In comparison, the daily trading volume of petroleum futures, options, and over-the-counter derivatives now exceeds five billion barrels per day. Furthermore, the combined trading volume of futures traded on other exchanges, such as Shanghai International Energy Exchange (INE), futures on other types of oil, such as Dubai and Murban, futures on  refined products, such as gasoline and diesel, options, and over-the-counter derivatives is equally large. While we fully acknowledge that a direct comparison of physical consumption to daily trading volumes in derivatives markets should be taken with a grain of salt, it nevertheless highlights the growing importance of financial barrels in the oil market.

The rapid growth in oil derivatives has been mostly driven by proliferation of quantitative and algorithmic trading which now makes up to 70% of the daily trading volume in futures market. While the volumes of financial barrels are already very large relative to physical barrels, the oil derivative market pales in comparison to other financial markets, such as equities, foreign exchange and interest rates, which are also dominated by quantitative traders. As a relative newcomer to the world of quantitative trading, oil derivatives market still retains a significant growth potential. This growth could occur regardless of the pace of the energy transition for physical barrels. In fact, if the pace of the energy transition accelerates and the consumption of petroleum products starts declining, the relative importance of algo-driven financial barrels could further increase.

To better understand the behavior of non-fundamental oil traders, this paper launches a series of articles devoted to the analysis of financial barrels. Given the growing role of technology and quantitative trading in the oil market, these barrels evolved into “virtual barrels”, as described in the author’s recently released book on this topic. In this Energy Quantamentals series, we aim to further advance the understanding of this subject and illustrate applications of more technical concepts presented in the book to current market conditions.

By: Ilia Bouchouev