London, 13 May 2011: Reuters

Most analysts have downplayed last week's sudden drop in oil prices and reiterated or even raised their bullish forecasts for the remainder of the year.

But just because a sudden price crash does not appear to have a rational trigger does not mean it is safe to ignore it and assume fundamentals and therefore the price outlook have not changed.

While the flash crash may not reveal new information about physical supply and demand, it reveals quite a lot about the positioning of major market participants. To the extent market positioning is also a fundamental determinant of prices, as most behavioural analysts believe, the flash crash should prompt analysts and investors to reassess their outlook.

In particular, the flash crash probably heralds a period of significantly increased volatility in the petroleum complex and other commodity markets.

VOLATILITY IS A FUNDAMENTAL

It is known daily price changes for crude and other commodities  do not follow a normal distribution. Large price increases and falls occur far more frequently than the normal distribution allows. Price changes exhibit fat tails or excess kurtosis.

Nor do prices follow a random walk. The scale of price change on one day is not independent from the scale on previous sessions. Instead volatility tends to cluster. Large price changes are more likely to follow large price changes. Markets appear to move through phases of high and low volatility (Chart 1). In late 2009 and through the whole of 2010, oil market volatility was unusually low, with big price moves happening much less often than expected. But the market has been jolted by three large moves in the last five sessions (Chart 2).

Chart 1: http://graphics.thomsonreuters.com/ce/LCO-VOL1.pdf

Chart 2: http://graphics.thomsonreuters.com/ce/LCO-VOL2.pdf

If movements were normally distributed and independent, the chance of any one of these moves occurring would be low, and the chance of three in the space of five sessions would not have happened in thousands of years.

The correct conclusion to draw from the flash crash on May 5 was that the market had witnessed a phase transition from a calm to a more agitated state. Past experience suggests higher than usual volatility may persist for some time.

The dramatic rebound on May 9, and the almost equally dramatic second fall on May 10, as gasoline prices plunged to their down-limit, spreading weakness to the rest of the petroleum complex, showed exactly the sort of volatility clustering mathematician Benoit Mandelbrot and behavioural theorists would have predicted after the first flash crash.

FROTH AND INVESTOR TOURISM

In a video conference with potential investors in Hong Kong, Glencore Chief Executive Ivan Glasenberg dismissed the recent declines as "due to some froth." His comments echoed the views of Liongate Capital Managing Director Jeff Holland, who told the Financial Times earlier this week "To have flushed out a lot of retail money, or so-called tourists, from the space is healthy for commodity markets and for professional, institutional investors with dedicated commodity investment programmes."

Barclays Capital has noted fundamentals remain "exceptionally strong." In a note to clients, analysts at JP Morgan actually raised their price forecast for Brent in the third quarter from $108 to $130 in the wake of the first sell off.

It is eerily reminiscent of American economist Irving Fisher's prediction just before the 1929 Wall Street Crash that stock prices had "reached a permanently high plateau." In the wake of that first astonishing wave of selling, Fisher insisted it was "only shaking out the lunatic fringe" and prices had still not caught up with their real value and should go much higher.

Predicting price moves after "clear blue sky" crashes is difficult. In many instances, prices have recovered as fundamentals reasserted themselves (U.S. equities after the flash crash in May 2010) but in others the recovery has taken a considerable period (October 1987) and in some cases prices never really recovered and the sudden break marked a real turning point and caused the fundamentals to be reassessed (October 1929).

It may even be harder to predict prices after a crash than in normal times. In any event, it is brave to forecast prices must rebound simply because there was no apparent cause for the crash and none of the fundamentals seem to have changed.

CROWDED TRADE IS NOT FROTH

Glasenberg's argument this is just froth blowing harmlessly off the top of the market deserves closer examination. Sharp price moves are often symptoms of popular investment strategies that have become crowded trades leading to accelerating price gains (bubbles) and declines (crashes) -- as described by billionaire hedge fund operator George Soros and professors Robert Shiller and Didier Sornette.

The long list of commodity-focused and macro hedge funds revealing large losses following the first oil crash on May 5 has put a spotlight on just how many large institutions are betting on a further rise in oil prices and a whole range of other commodities, even though they have already hit historically high levels in real terms.

Reports from the U.S. Commodity Futures Trading Commission (CFTC) show hedge funds and other money managers running record net long positions in WTI-linked futures and options prior to the May 5 crash.

It is tempting for commodity market professionals to describe these positions as "froth" and their owners as "tourists" chasing the momentum, employing naive trendfollowing strategies without any real understanding of the supply-demand picture.

But the losses revealed in the wake of the rout suggest a good part of that record net long position -- perhaps most of it -- is due to a relatively small number of very large investment funds all employing essentially the same strategy. These are precisely the conditions which create crowded trades and the risk of sharp volatility and reversals.

FUNDAMENTALS AND POSITIONING

In contrast to fundamentalist analysts, behaviouralists believe positioning and expectations can influence commodity prices just as much as "objective" supply, demand and inventory factors, especially in the short and medium term.

If the upsurge in volatility, with any apparent single cause, is a sign the trade is crowded and running out of steam because it is struggling to pull in fresh money, then the two crashes on May 5 and 11 reveal important information that will have a bearing on prices in the remainder of the year and cannot safely be ignored.

In any case, the fundamental picture is much less clear than some analysts suggest. Official forecasts published by the International Energy Agency and the Energy Information Administration in the United States, all show gasoline demand trimmed in response to soaring prices.

Crude and gasoline prices have risen around 50 percent in the space of less than nine months. Such big price movements put all fundamental factors in play, even if the effects take time to become evident because of lags in the data.

So it does not seem justified to conclude:

(1) Fundamentals have not changed despite a 50 percent price increase; and

(2) The sharp falls on May 5 and May 11 were wholly irrational and must therefore be reversed because it is not possible to pinpoint a single sufficient cause.

The triggers for the crashes on May 5 and May 11, and the surge on May 9, were not grounded in any one fundamental factor, and seem to have come from within the market eco-system.

But that makes them more significant, not less. No one can predict what will happen to prices in the next few days and weeks, as bullish and bearish narratives battle it out, and the market hunts for better information about demand destruction.

But ignoring the sudden surge in volatility and arguing it does not really change anything flies in the face of experience.

Ends --

By John Kemp, Reuters market analyst – for Commodities Now.

The views expressed here are his own.