If anyone still doubted that the positions held by major market players as well as fundamentals are a powerful driver of oil prices, the enormous surge in Brent and US crude prices on June 29 should put the matter beyond dispute.
The 9.4 percent jump in front-month US crude futures and 7.0 percent rise in the equivalent Brent contract last Friday were among the largest one-day rises on record.
Coinciding with the announcement of another euro zone bailout, the entry into force of EU sanctions on Iran's oil (including insurance of cargos to third countries) and more hawkish rhetoric from both sides to the conflict, it is tempting to ascribe the price surge to a bullish reassessment of the fundamentals, but it would probably be wrong.
For one thing, the scale of price rises for WTI (nearly 3.9 standard deviations) and Brent (3.1 standard deviations) were much larger than for S&P 500 US equities (2.4 standard deviations) (Charts 1-2). Rising oil prices were part of a broader "risk-on" trade, but the cautious welcome for the euro zone deal in other markets cannot explain more than a small part of the increase in oil prices.
For another, EU sanctions have long ago been felt in the market. In other words, no single event can account for the size of the oil rally. Even a combination of several minor bullish factors does not seem to be a sufficient explanation for one of the largest rallies in history.
Instead, the rally owes much to market positioning. It came after a long period of steadily falling prices and the build up of the largest speculative short position in US crude futures and options since September 2011.
By June 26, hedge funds and other money managers had accumulated short positions equivalent to almost 83 million barrels of light sweet crude, compared with just 47.5 million at the end of April, according to the US Commodity Futures Trading Commission (CFTC).
Hedge fund shorts were still dwarfed by long positions, amounting to 225 million barrels, but the net long position, at 142 million barrels, was the lowest since November 2010. The ratio of long to short positions, at 2.83:1, had fallen by more than half since the end of April, to some of the lowest levels recorded in the last two years.
With prices already down sharply over the past three months, the market had simply got itself too short. It was the inverse of a bubble on the long side.
In these circumstances, even a modest amount of buying interest was likely to generate an outsized reaction in prices, and that appears to be precisely what happened.
Prices surged on rather ordinary volume, as my colleague Olivier Jakob at Petromatrix pointed out in a research note published on July 2.
NO PHASE CHANGE
The surprise rally also came after a long period of unusually low daily volatility in the oil market. In the first six months of the year, there had been fewer large daily price moves than at any time since 1995.
Most algorithmic trading programs, and many human traders, use volatility as an input into trading strategy, either formally or in a more heuristic way.
It helps determine whether a price movement marks a significant shift or is simply noise.
In another indication that the price jump on June 29 was isolated rather than a sign of regime change in the market, volatility has quickly returned to the low levels experienced previously.
Volatility is itself volatile, as French mathematician Benoit Mandelbrot pointed out. Periods of high volatility alternate with periods of low volatility. The market transitions from a wild to a mild state and back again.
In this instance, the "wild" state seems to have lasted little more than a single session. Volatility has fallen back much more rapidly than after the flash crash on May 5, 2011, when the market remained in spasm for several weeks.
Periods of higher than normal volatility often coincide with a reappraisal of fundamentals, as one dominant market narrative gives way to another.
The fact that the June 29 price jump appears to have been an isolated incident suggests that it was due to market positioning (over-extension by traders betting on further price falls), limited liquidity, and technical factors, rather than a wholesale shift in sentiment and the way fundamentals are assessed.
The conclusion is shared by the technical analysts at Barclays Capital. In a note, the team argues "near-term upticks in crude provide better levels to sell" and remains bearish, expecting prices to retest recent lows.
It is not necessary to subscribe to the predictive power of chart analysis (which is strongly disputed) to agree the sudden price gain on June 29 has limited analytical significance. And it is a brave call to encourage further shorting when prices have already fallen so far.
But the big one-day price gain does not point to a significant change in the fundamental supply/demand outlook, and probably does not portend a sea-change in sentiment.