This Is What It Looks Like When 'No Brainer' Trades Go Spectacularly Wrong

With Islamic State militants gaining ground in Iraq, Russia going head-to-head with the West over an uprising in Ukraine and chaos in Libya earlier this year it looked inevitable that a number of key oil producers were set for a squeeze. This presented one clear and compelling conclusion — oil prices were set to rise.

The only problem was that it proved completely wrong.

And so the money flowed — and flowed — into the trade. In fact bet by traders in the oil market that prices would rise reached their highest level in over a decade:

Well it didn’t turn out too well. Rather than climbing the oil price has collapsed from around $US115 a barrel in June to $US87 a barrel as at Friday.

Traders have flooding out their positions with “liquidation in net speculative length…such that Brent is outright short with WTI net spec positions far off their highs” according to a note from Goldman Sachs.

The reason for the collapse? Almost every story traders were telling themselves about why oil prices just had to rise turned out to be wrong.

The Libya story

Libyan rebel fightersBob Strong/ReutersLibyan rebel fighters with the Tripoli Revolutionary Brigade raise their weapons after a live firing exercise during a graduation event near Nalut in western Libya, August 6, 2011.

Crude oil supply disruptions in Libya became a big problem again in 2013 with the US Energy Information Administration reporting that “from the end of July to the end of August, crude oil supply outages in Libya more than doubled” as the country fell back into civil war. This helped push prices higher and increase concerns about the prospect for further supply disruption.

Little in the developments of 2014 seemed to count against those fears. In August Islamist rebels captured the airport in the capital Tripoli and last month the Libyan parliament was forced to flee to the small town of Tobruk where they took refuge on a Greek car ferry.

Nevertheless, despite the huge disruption to the political and social life of the country the oil continued to flow against expectations.

The Russia story

Vladimir PutinREUTERS/Mikhail Klimentyev/RIA Novosti/KremlinRussian President Vladimir Putin.

Following protests in Kiev that saw the Ukrainian president flee the country and his government collapse, a secession movement in the east of the country has been fighting with the new Ukrainian state. These rebels have the political support of Russia, and many believe that Moscow has also been supplying them with on-the-ground support including military hardware and personnel.

In response, the US and the European Union have imposed sanctions on Russia targeting the country’s banks, oil and gas industries and imposing travel bans on a number of Russian citizens. Again, it seemed clear that Russia would either impose limits on oil exports itself as a tit-for-tat measure or would struggle to maintain the same level of trade with the West while the crisis continued.

And yet, as Reuters reports:

Output of oil and gas condensate in the world’s largest producer rose 0.9 per cent to 10.61 million barrels per day (bpd) last month [in September] from August, a touch under the post-Soviet record-high of 10.63 million bpd reached in December, Energy Ministry data showed.

The Iraq story

Islamic State militants operating across the porous border between Syria and Iraq have seized control of large swathes of land in Iraq.

The group’s early success against Iraqi government forces caused many to worry that the country’s oil producing infrastructure could ultimately be taken or damaged if fighting continued.

However, Iraq was also able to shrug off international fears adding 134,500 barrels a day to take its total production to 3.164 million barrels a day in September. Output rebounded due to higher exports from the south of the country and increased output from fields in Kurdistan, according to Reuters.

Small wonder then that traders are panicking. Once again we have seen the difficulty markets face when trying to price in geopolitical risk.

Unfortunately this works both ways — widespread overconfidence about price rises can quickly become overconfidence in the likelihood of further price falls. As Goldman said in its note:

If the market does go much lower, we could see the mirror image of what occurred in the 2000s in that lower deferred prices kill off supply growth and stimulate demand.

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