Save for later Print Download Share LinkedIn Twitter Oil producers basked in an atmosphere of high oil prices at the recent CERAWeek conference. Dated Brent reached almost $138 per barrel on its third day. Those in attendance heard forecasts of prices hitting $150 or perhaps even $200. It might have seemed that oil’s salad days had returned, but less than one week later crude oil prices had dropped by 25%. West Texas Intermediate traded under $100. Executives who seven days earlier were thinking high prices would be the new normal must have wondered how their world could change so quickly. Welcome to the digital oil casino.Oil prices in 2022 are being driven not by fundamentals but by those betting that prices will soon exceed $125, $150, or $200/bbl. Some of the punters have even wagered on prices reaching $300 by the end of the year.The computers at the institutions that underwrite these bets have been made responsible for guaranteeing the financial solvency of their owners. They are programmed to buy or sell futures with each minor move in the futures price. The large magnitude of the bets placed on futures oil prices means the computer buying and selling magnifies price fluctuations. Under these circumstances, a change in fundamentals that might have moved prices by 50¢ or $1/bbl will cause a change of as much as $10.One might say a flea on a dog’s tail is now wagging the oil market and the global economy. A more accurate explanation is that artificial intelligence (AI) is driving oil prices.Several factors explain the increase in price volatility. First, those in the physical oil business have cut back on hedging. Second, punters have seized the opportunity to bet on oil, with the result being that we have more wagers on high prices today than in the past. Third, the rules imposed by the exchanges (the casinos) minimize the costs of betting.The decline in hedging activity has decreased the number of futures bought or sold by commercial players. Airlines stopped hedging, cutting their long positions held directly or indirectly through third parties. Many oil producers, burned by their simplistic hedging practices, also stopped hedging.Ironically, an MIT Ph.D. in economics and former finance minister of Mexico, Pedro Aspe, developed a sophisticated way of hedging oil production that has worked for his country for 30 years. Sadly, US producers did not copy his approach, choosing to hedge with inexpensive but ultimately very costly collars. One company, Pioneer Natural Resources, missed out on revenues of more than $2 billion as a result. It then stopped hedging rather than looking to the Mexican example.Robinhood EffectThe decrease in hedging would not have boosted volatility had punters not jumped on oil. However, forecasts of a new supercycle in commodities brought hundreds into the game. This may be the “Robinhood” effect. Robinhood, readers will recall, is the favorite stock trading platform of millennials. Using social media, this group of investors has been able to drive share prices up or down. Millennials have even been able to squeeze hedge funds shorting stocks on occasion by buying equities, frustrating well thought-out short strategies. The effort to short GameStop stands as a classic example.It may be the case that millennials started buying calls on crude oil. Projections of $150 or $200 oil might have attracted these players into the market. Some may have even made large profits. For example, a call option for Brent at $150 delivered in December 2022 could have been purchased for less than $1 over a year ago. Recently, it traded as high as $42/bbl. That’s an attractive casino bet.The rules applied by the key futures exchanges for those selling the options (the croupiers) exacerbate oil price volatility. A firm that sells a call accepts a financial risk because it is required to provide a future to the buyer if the price surpasses the strike price when the contract expires. To hedge its exposure, the call writer will buy a fraction of a future for every call sold. For instance, a bank may buy three December futures contracts for every 100 December $150 calls written.The process creates volatility because additional futures must be purchased when prices rise. These futures can be sold when the price of the futures falls. Thus, as oil prices rise, the financial institutions buy more futures, causing prices to rise further. When prices fall, the institutions sell more futures, exacerbating the decline.This process was in full view this month. When the May Brent futures contract rose by $7.85/bbl on Mar. 4, 2022, the AI-programmed computers at the firms that had written May calls on Brent futures bought 14,900 futures contracts. In contrast, when the May Brent futures contract dropped by almost $17/bbl on Mar. 9, 2022, the AI decreed that firms that had written calls on May futures must sell 33,000 futures contracts. On each occasion, the AI selling accounted for almost all the activity.The price increase on Mar. 4 and decrease on Mar. 9 would likely have been less than $1/bbl had there been no betting on prices. However, it is way too late to close the casino.The Mar. 4 increase and Mar. 9 decrease would have been much smaller had the exchanges required that firms selling calls be fully covered. This would mean that the institution selling the call option would be long one future for every call written. Such a rule would eliminate the AI element in oil price fluctuations. It would also make calls much more expensive.Sadly, one exchange is doing just the opposite. On Mar. 14, the CME announced that it was introducing smaller-size products called “daily options.” A press release explains that the contracts are “designed for the retail audience that will make it easier for everyone to trade their views on daily up or down price moves in some of the world’s most widely quoted benchmark futures markets, including gold, oil, equity indexes and foreign currencies.”This can be put another way. Under the CME’s new contract, a parasite on the wing of the flea will cause the flea to bite the dog, which will shake its tail, possibly bringing down the global economy. Wonderful!Rethinking StrategiesWith this background, executives at major energy companies and financial institutions must rethink their strategic plans because there can be no certainty as to the levels or direction of oil or gas prices. Fundamentals have been rendered almost irrelevant. At this juncture, firms and banks have two choices.First, investments can be limited to those projects that will pay off even if the mobs drive prices to very low levels for a prolonged period. When following this strategy, executives and bankers need to be mindful of John Maynard Keynes’ famous quote: “Markets can stay irrational longer than you can stay solvent.”Alternatively, executives can hedge using the approach perfected by Mexico and commented on in several International Monetary Fund reports. The Mexican technique involves buying average price, out-of-the-money options, not the American-style options traded on ICE and the CME. The cost of these can be minimized currently if the hedge is set not at current prices but rather closer to the price required to sustain operations. Such a strategy would increase lender confidence and might help attract the investment that executives at CERAWeek told banks they required.Absent the adoption of such proactive practices, the oil industry will likely be starved for capital. The casino operators now run the show.Philip Verleger is an economist who has written about energy markets for over 40 years. A graduate of MIT, he has served two presidents, taught at Yale and helped develop energy commodity markets since 1980. Kim Pederson is editorial director of PKVerleger LLC. The views expressed in this article are those of the author.