Financial market turbulence has weighed on oil prices, with Brent down more than USD 10/bbl in the last ten days.

Some might wonder why a banking crisis is hitting oil so hard, as it is unlikely to impact crude demand and production. But during periods of elevated volatility, investors tend to pull out of risky assets like oil and invest in safer corners of the market. Oil prices have been very sensitive to the recent shift in risk sentiment, particularly due to the lack of supportive price fundamentals, with US oil inventories building this year.

What is intensifying the drop in prices is the options market, through so-called delta hedging. Financial institutions sold downside protection instruments (put options) to oil market players, for instance producers. With the oil price falling below the level where the protection kicks in (strike level), those financial institutions now need to avoid having a price risk on their balance sheets. So, they are selling crude futures to offset the risks, amplifying the rout.

In the near term, uncertainty in financial markets will need to fade before we can see a stabilization followed by a recovery in oil prices. So, investors will need to look at how governments and central banks are tackling the market pressures. Other factors of importance in the short run include whether the US government will issue a tender to refill its strategic stocks, and whether China will step up its crude purchases due to lower prices.
Source: UBS