Explained: Why Banks Are Both Oil’s Best Friend and Worst Enemy

• Recent drop in oil prices was not due to supply and demand, but rather to the actions of investment banks, particularly Credit Suisse
• Banks are an essential component of the oil trade, providing liquidity to exchanges and over-the-counter markets
• Banks remain the go-between, acting as counterparties in trades and bearers of stockpiles in anticipation of customer demand

Probably most hurtful to oil longs this week was that crude’s tumble to below $70 a barrel was triggered not by supply-demand but by the same banking sector responsible for much of the market’s pricing euphoria over the past two years. 

Let’s be honest: Not everyone might feel as strongly about calling oil at $100 a barrel by December had that forecast not originally come from Goldman Sachs.

Thus, the saying “with friends like these, who needs enemies?” feels particularly relevant when considering that the banking industry managed to do within days what China’s COVID crisis couldn’t over months — drive U.S. crude down to $60 territory, that is.

While it wasn’t Goldman that delivered that body blow to oil, troubles at another major investment bank, Credit Suisse (SIX:CSGN) — on top of the collapse of a couple of mid-sized U.S. commercial banks — combined in Wednesday’s biggest selloff in crude since the start of 2023. On a weekly basis, it was oil's worst since April 2020, when the initial outbreak of the coronavirus practically destroyed all demand for energy.

The bottom line for the current crisis is liquidity, and it begins with oil itself being the most liquid commodity, not just in the literal sense.

Open interest — which measures the flow of money in a futures or options market — is highest in oil. An estimated 2.5 million contracts of 1,000 barrels each account for the daily open interest in U.S. West Texas Intermediate crude, or WTI, crude on the New York Mercantile Exchange. Friday’s settlement of $66.74 per barrel makes WTI alone worth nearly $171 billion.

Add to that London-traded Brent crude, which has an open interest of 160,000 contracts of 1,000 barrels each. At Friday's close of $72.97 a barrel, Brent’s value stands at almost $12 billion.

Combined, the oil trade is worth close to $200 billion at current pricing. But here’s the catch — despite being such an enormous trade, not a barrel of crude might move without the funding, or liquidity, provided by banks. Banks are the market makers for all commodities, not just oil, as they bring together buyers and sellers that have different needs, risks, time horizons, and incentives.

The nexus between banks and the liquidity in oil and other commodities simply cannot be understated. Even before the pandemic and sheer demand destruction brought WTI to minus $40 a barrel, the collapse of Lehman Brothers crunched oil’s pricing from a record high of $147 to below $40 in the aftermath of the financial crisis 15 years ago.

More than a decade ago, Wall Street powerhouses Goldman Sachs (NYSE:GS), Morgan Stanley (NYSE:MS), JPMorgan (NYSE:JPM), Bank of America (NYSE:BAC), and Citigroup (NYSE:C) ran huge proprietary trading desks that took positions in commodities for themselves, aside from customer accounts. The 2008 financial crisis ended that as the Volcker Rule barred banks from engaging in speculative trading activities.

Partial changes brought by the Trump administration in 2019 have only made proprietary trading a gray area for banks, making their foray there an exception rather than the norm.

Even if they aren’t buying or selling it for themselves, banks remain the lifeline of the commodities trade. They provide liquidity to exchanges and over-the-counter markets, plus the availability of hedging, financing, and other intermediation services.

And while they no longer take positions in commodity futures and other derivatives like before, banks actually take physical ownership of crude, coal, natural gas and other energy liquids as well as gold, copper, corn and cocoa while executing trades for these.

This is because, as market makers, banks bear the price risk between the arrival of sellers and buyers, which can lead to temporary accumulations of inventory. They are the go-between, acting as counterparties in trades and bearers of stockpiles in anticipation of customer demand.

Due to the illiquidity of many commodities exposures, as well as the construct of some commodity risk management solutions, banks have to accumulate and net off various exposures that can require more time to unwind than a traditional market maker’s position in highly liquid markets, such as, say, U.S. Treasuries.

Because banks are on both sides of the buy and sell proposition, they promote efficient markets and help to maintain pricing relationships. They improve price convergence — the act of futures contracts moving toward spot price at expiry — and price discipline. This is true in both physical and financial commodities markets where banks stand ready to deliver the product or take delivery of the product in the markets in which they are active.

Via their involvement in physical commodity markets, banks create necessary links among regions, products, and delivery that fosters competitive pricing and efficient allocation of resources.

For example, a bank with electricity transmission capabilities between the Midwest and Georgia can use this to “wheel” or move power from an oversupplied and lower-priced area in the Midwest to an undersupplied, higher-priced location in Georgia. This is a low-risk activity for banking entities and helps eliminate price disparities and mitigates supply shortages and price spikes to the benefit of U.S. businesses and consumers. Trading exchanges on their own have a very limited number of products with sufficient liquidity.

Active physical market participation enables banks to be ready to respond to client needs with the expertise and execution capabilities to manage the risks associated with a transaction. This includes understanding local markets, not only to price each hedge and manage risks but also to provide the required power scheduling services.

In order to provide these services, banks need to build an inventory of hedging positions prior to each customer transaction and engage in transactions subsequent to each transaction, to manage the banks’ risk. Given the significant illiquidity of many power markets, these transactions often include a combination of trades in similar but not fully correlated products.

These combined physical and financial commodity trade activities are essential for banks to service wind farm developers. Revenue hedges enable more efficient capital formation for these projects and companies. Without the physical commodity revenue hedges, it is unlikely that wind farms could secure debt financing, and they likely could not be built.

The same applies to U.S. shale drillers, who, without access to liquid, long-dated contracts, would likely see their investments in new production diminish with the corresponding rise in consumer prices and greater volatility.

Other shale-rich countries with large resource potential (e.g., China, Argentina, and Poland) that do not have the same market structure and intermediary presence are struggling to replicate the success of the North American model.

The consequences of impairing the role played by banks in commodities could be far-reaching and negative. The development of new wind farms and natural gas power plants may be curtailed because of the inability of developers to hedge their price risks. Independent oil and gas producers and heating oil dealers would have limited ability to hedge the price risks associated with investment and inventory. Airlines, highly vulnerable to jet fuel prices, could be put at risk.

Refineries could be shut down, leading to higher gasoline prices. Overall, competition would be reduced in energy markets, and smaller players would be disadvantaged. Higher volatility would lead to foreshortening of domestic investment, leading to increased foreign energy dependence. And consumers—and the U.S. economy—would be hurt by higher and more uncertain prices.

In short, if banks aren’t participating in raw materials markets, their ability to serve clients with risk management and financing services would suffer. It is not at all clear who could replace them or to what extent. Some markets would be more opaque, less-transparent entities based outside the United States.

Others could be large competitors to the small- and medium-sized companies being served by the banks. Moreover, all would be much less regulated than banks, which are among the most highly regulated entities in the United States.

I decided to research and write this explainer in response to comments in Investing.com’s oil trading forum this week that it’s ridiculous for crude prices to hit 15-month lows simply on the back of a crisis of confidence in banking. Some argued that it would be more acceptable if such a market downturn was triggered by a demand crisis in China, the world’s largest oil importer.

Yes, an implosion in Chinese demand could get oil to even below $60 a barrel. But there’s something as big as demand, and that’s liquidity. You need to appreciate that and the price discovery role played by the banks, which, while appearing to be this week’s worst enemy for oil, has often been the market’s best friend.

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Disclaimer: Barani Krishnan uses a range of views outside his own to bring diversity to his analysis of any market. For neutrality, he sometimes presents contrarian views and market variables. He does not hold positions in the commodities and securities he writes about.