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Flurry of factors combined to trigger greatest rout.

SPECIAL REPORT By Joshua Schneyer

When oil prices fell below $120 a barrel in early New York trade on May 5, a few big companies that are major oil consumers started buying around $117. It looked like a bargain. Brent crude had been trading above $120 for a month. But the buying proved ill-timed. Crude kept on falling.

"They were down millions by the end of the day, trying to catch a falling piano," an executive at a major New York investment bank said. Never before had crude oil plummeted so deeply during the course of a day. At one point, prices were off by nearly $13 a barrel, dipping below $110 a barrel for the first time since March. The rout unnerved some commodity investors.

Oil just doesn't fall by 10 per cent in the course of a normal day, though. In commodities markets, oil is king, and its daily contract turnover, typically around $200 billion, is usually able to absorb even large inflows or outflows of investment.

The rare moves of $10 a barrel usually are set off by dramatic events -- the outbreak of the first Gulf War in 1991, or the collapse in 2008 of Lehman Bros bank, which both led to recessions.

Of course, there was major news last week. But the daring Pakistan raid that killed Osama Bin Laden had done little to shift the balance of oil markets. In interviews with more than two dozen fund managers, bankers and traders, no clear cause emerged for the plunge in price. Market players were unable to identify any single bank or fund orchestrating a massive sale to liquidate positions, not even an errant trade that triggered panic selling, as seen in the equities flash crash last May.

Rather, the picture pieced together is one of a richly priced commodities market -- raw goods have been on a five-month winning tear over all other major investment classes -- hit by a flurry of negative factors that individually could be absorbed but cumulatively triggered a maelstrom.

Computerised trading kicked in when key price levels were reached, accelerating the fall. "It was a domino effect," said Dominic Cagliotti, a New York-based oil options broker.

The negative factors -- prominent cheerleaders turning bearish, some weak economic data, cheap money from the US Federal Reserve ending by July, a lessening of political risk -- merely provide a backdrop for the waves of selling.

What stands out is the way computers turned readjustment of positions in a huge and deep market into a rout. Stunningly large jolts from so-called stop-loss trading amazed market traders.

The automated sell orders were generated as oil crashed through price points that traders had programmed in advance into their supercomputers. In many cases, computer algorithms sold for technical reasons, as oil dropped through levels that, once breached, could trigger ever larger waves of selling yet to come.

The machine trading, based on subtly different but fundamentally similar, algorithmic models, eliminates the white-knuckles and potential human error involved in actively trading a volatile market, and increases anonymity.

Instead of breeding hesitation, abrupt price drops can quickly prompt these machines to unload a bullish long position in oil, and build up a bearish short one instead.

Machine-led trading is one plausible thesis for another apparent market anomaly that occurred last week. Exchange data shows that the total number of open positions in the oil market -- a number that would typically fall in a selloff -- instead rose.

Normally, panicky funds selling oil en masse would cause total "open interest" numbers to shrink, as exiting investors closed out contracts. But some machines, following the market trend, may have gone further, by dumping long positions and quickly amassing sizable short positions instead.

"Computers don't care. Momentum just increases until nobody wants to stand in front of it," said Peter Donovan, a floor trader for Vantage on the New York Mercantile Exchange.

Some big Wall Street traders watched their own systems sell into the down trend but couldn't know for sure who had initiated the selling spree. They only knew that similar machines at other firms, from New York, to London, Geneva and Sao Paulo, would be automatically selling in much the same manner.

During the crash, such selling locked in profits that high-flying commodities traders have been accumulating for months.

Some of the rout appears to have been more a product of the wisdom of crowd computing than of widespread human panic. "We believe the magnitude of the correction appears in large part to have been exacerbated by algorithmic traders unwinding positions," Credit Suisse analysts wrote in a report.

High frequency trading and algorithmic trading accounts for about half of all the volume in oil markets.

Some of the seeds for the rout were sown earlier. In April, Goldman Sachs' bullish team of commodities analysts, led by Jeff Currie in London, issued two notes to clients in rapid succession recommending they pare back positions. In one, the bank called for a nearly $20 dollar near-term correction in Brent oil, while maintaining a bullish longer-term outlook.

A range of factors, both economic and political, were also at play. The political risk premium built into oil prices came under scrutiny. The unrest sweeping through the Arab world - home to over half of world oil reserves - has boosted oil this year. The only major supply disruption so far is from Libya, where war has cut off at least 1 million barrels a day.

"We've been in a world thinking there's more risk, more risk, more risk," said Sarah Emerson of Energy Security Analysis Inc. "People took this week, and the news of bin Laden's death, to simply reflect. They stopped and said, maybe there's less risk."

In the space of just hours, the drop in the price of crude oil had shaved nearly $1 billion off the cost of supplying the world's daily oil needs.

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Publication:Oil & Gas News
Geographic Code:1U2NY
Date:May 16, 2011
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