Lessons from (Another) Crude Oil Price Collapse

This commentary draws on analysis of oil futures markets contained in the Centre for Future Work’s recent report, Counting the Costs: Impacts of the 2022 Oil Price Shock for Canadian Consumers and Workers, by Jim Stanford and Erin Weir. That report computes the costs of the 2022 oil price spike for Canadians: directly & indirectly it cost the average Canadian household $12,000 over 3 years.

At time of writing, crude oil prices are down $14/b (20%) in the last week. Apart from acute embarrassment for Danielle Smith (who called Trump’s tariffs last week a “big win for Alberta & Canada”), there’s an important lesson to be learned here about how crude oil futures markets work.

Prices for various specific crudes are set in relation to key benchmarks (mostly WTI & Brent) which are set on futures markets. Futures markets are financial markets. They don’t trade in oil; they trade in contracts which are promises to deliver oil at some time in the future.

There are far more futures contracts than there is physical oil produced in the world. On average, each barrel of physical oil produced is traded 14 times on futures markets. Normally, only about 1% of futures contracts are settled with delivery of physical oil.

Crude oil futures trading is worth $25 trillion (U.S.) per year—or $100b (U.S.) each trading day. Futures trading is driven by the same forces as other speculative financial markets: investors trying to predict where the price will go next, and thus make a trading profit.

Typical open contracts on the 2 big futures markets (10m contracts for 1000 barrels each) are equivalent to 100 days of global oil production at any moment. If traders sense a big change in prices one way or the other, 100 days of ‘supply’ can enter or leave at once.

This is why futures markets are so volatile, and always overreact to any shock in investor expectations. This has almost nothing to do with real supply and demand of oil, and almost everything to do with speculative psychology & herd dynamics.

We last saw this in 2022 when futures prices shot up $50US/bbl (65%) in weeks, sparked by FEARS about the Russian invasion of Ukraine. Those FEARS alone caused the spike in worldwide oil & related prices that were the biggest single initial cause of post-pandemic inflation.

But there was NEVER a ‘supply shock’ from that invasion: world oil supply kept growing throughout. And in Canada, of course, we kept setting new oil production records each year. It’s wrong to blame the 2022 price spike (and resulting inflation) on ‘supply and demand.’

Within 6 months prices came back down. But the damage was done: global inflation was set off and we suffered from it for the next 2+ yrs. A previous instance of futures market overreaction was the initial months of the pandemic, when prices fell too much (even below 0 for a time!).

There was no ‘supply & demand’ justification for the 2020 price collapse, any more than there was for the 2022 price spike. Global oil demand fell only 9% in 2020, and quickly recovered. That cannot explain such an extreme price collapse.

Some may think a sudden decline in oil prices is a good thing (for oil consumers, anyway). Not so. The collapse never lasts. It contributes to deflationary expectations during an economic crisis. And it sets the stage for unusually fast ‘inflation’ when prices simply recover.

In short, the speculative overreactions of oil futures markets, driven by fear & greed of gamblers, amplifies global financial instability. We’re seeing this again right now. We should question whether the price of such a central commodity should be set this way.

The “Counting the Costs” report recommends buffering these pointless, destabilizing shocks in futures markets: circuit breakers & limits on downstream price movements, greater regulation, and stronger royalties & taxes.

It’s challenging to imagine & implement a more rational, stable method to price oil. We’ve done it for other forms of energy (electricity prices in most of Canada are carefully regulated & quite stable). At any rate, we should stop pretending that this is either natural or efficient.