Price volatility stemming from the war in the Middle East is now triggering internal risk-management rules that limit the size of traders' positions, in turn reducing liquidity in energy paper markets and helping to reinforce the volatility.
A similar pattern has emerged in at least four major markets — crude, refined products, biofuels and natural gas — since the conflict began, traders said. LPG swaps are traded mostly over the counter, making liquidity harder to gauge.
Monday 23 March was one of the most volatile days of the war for oil and gas futures, after the US and Iran issued contradictory statements about negotiations. Front-month Ice gasoil futures fell by more than 10pc in the half-hour after US president Donald Trump's initial comments about peace talks, before rebounding to settle 4.5pc lower on the day.
As crude and refined product prices have swung rapidly, some biofuel premiums to gasoil or gasoline have moved in the opposite direction, keeping outright biofuel prices more stable. But many biofuel paper contracts are linked to premiums rather than outright values, and at least four traders said Value at Risk (VaR) limits were now constraining their positions. One trader said participants would normally try to counter sharp price moves by taking positions in the opposite direction, but this "natural brake" was slipping because of tighter position limits.
Oil companies, banks and hedge funds manage paper market exposure using VaR, which measures the size and probability of potential losses. Internal rules require traders to shrink positions as VaR rises. Most VaR calculations incorporate recent volatility, so sharp price swings in recent weeks are now feeding back into lower allowable position sizes.
Margin call
Margin requirements are also curbing activity. As volatility increases, exchanges demand larger cash deposits for the same size of position. Traders may be forced to reduce positions to meet those requirements, or be unable to take new ones. Ice now requires cash equivalent to nearly 10pc of the value of an Ice gasoil futures contract for any long or short position. In LNG markets, several participants were seeking additional credit this month to meet margin calls, although they said the situation was not as acute as in 2022. Traders said margin-driven constraints on Ice gasoil liquidity were widespread in 2022 following Russia's invasion of Ukraine, and liquidity only returned to pre-war levels around June 2023.
Open interest in Ice gasoil futures fell to a more than one-year low in the week to 10 March, down by 17pc since the war began, exchange data show. It edged higher the following week but remained 16pc lower. Net long positions held by hedge funds and other money managers were at a 13-week high just before the war started, but have fallen by 26pc since then. One trader said funds may be more sensitive to VaR than oil companies because their entire book is exposed to market risk, with no offsetting physical exposure.
Money managers have increased their activity in commodity paper markets in recent years, a senior paper market participant said, attracted by the profits reported by commodity specialists such as Trafigura and Vitol. But having no physical exposure, funds may move in and out of positions faster than energy companies. Their participation could fall if volatility causes large losses, he said.
Paper market liquidity is likely to remain tight even after the war ends, because VaR models typically look back at recent volatility, a trader said.
As liquidity declines and volatility increases, traders report wider bid-offer spreads. Outside exchanges, competing brokers have simultaneously quoted over-the-counter swap values differing by more than $50/t, while others have stopped quoting certain swap values altogether.
