All is not as it appears in the global oil markets, which have become
entirely dysfunctional and no longer fit for its purpose, in my view. I
believe that the market price is about to collapse as it did in 2008,
and that this will mark the end of an era in which the market has been
run by and on behalf of trading and financial intermediaries.
In this post I forecast the imminent death
of the crude oil market
and I identify the killers; the re-birth of the global market in crude
oil in new form will be the subject of another post.
Global Oil Pricing
The “Brent Complex” is aptly named, being an increasingly baroque
collection of contracts relating to North Sea crude oil, originally
based upon the Shell “Brent” quality crude oil contract that originated
in the 1980s.
It now consists of physical and forward BFOE (the Brent, Forties,
Oseberg and Ekofisk fields) contracts in North Sea crude oil; and the
key ICE Europe BFOE futures contract, which is not a deliverable
contract and is purely a financial bet based upon the price in the BFOE
forward market.
There is also a whole plethora of other ‘over the counter’ (OTC)
contracts involving not only BFOE, but also a huge transatlantic
“arbitrage” market between the BFOE contract and the US West Texas
Intermediate (WTI) contract originated by NYMEX, but cloned by ICE
Europe.
North Sea crude oil production has been in secular decline for many
years, and even though the North Sea crude oil benchmark contract was
extended from the Brent quality to become BFOE, there are now only about
60 cargoes each of 600,000 barrels of BFOE quality crude oil (and as
low as 50 when maintenance is under way) delivered out of the North Sea
each month, worth at current prices about $4 billion.
It is the ‘Dated’ or spot price of these cargoes – as reported by the
oil price reporting service Platts in the ‘Platts Window’– that is the
benchmark for global oil prices either directly (about 60%) or
indirectly, through BFOE/WTI arbitrage for most of the rest.
It will be seen that traders of the scale of the oil majors and
sovereign oil companies do not really have to put much money at risk by
their standards in order to acquire enough cargoes to move or support
the global market price via the BFOE market.
Indeed, the evolution of the BFOE market has been a response to
declining production and the fact that traders could not resist
manipulating the market by buying up contracts and “squeezing” those who
had sold forward oil they did not have, causing them very substantial
losses. The fewer cargoes produced, the easier the underlying market is
to manipulate.
As a very knowledgeable insider puts it….
The Platts window is the most abused market mechanism in the world.
But since all of this short term ‘micro’ manipulation or trading
(choose your language) has been going on among consenting adults in a
wholesale market inaccessible to the man in the street, it is pretty
much a zero sum game, and for many years the UK regulators responsible
for it – ie the Financial Services Authority and its predecessor - have
essentially ignored it, with a “light touch” wholesale market regime.
If the history of commodity markets shows us anything, it is that if
producers can manipulate or support prices then they will, and there are
many examples of which the classic cases are the 1985 tin crisis, and
Yasuo Hamanaka’s 10-year manipulation of the copper market on behalf of
Sumitomo Corporation.
When I gave evidence to the UK Parliament’s Treasury Select Committee
three years ago at the time of the last crude oil bubble, I recommended
a major transatlantic regulatory investigation into the operation of
the Brent Complex and in particular in respect of the relationship
between financial investors and producers, and the role of
intermediaries in that relationship.
I also proposed root and branch reform of global energy market
architecture, which in my view can only come from producer nations and
consumer nations collectively, because intermediary turkeys will not
vote for Christmas.
A Meme is Born
In the early 1990s, Goldman Sachs created a new way of investing in
commodities. The Goldman Sachs Commodity Index (GSCI) enabled investment
in a basket of commodities – of which oil and oil products was the
greatest component – and the new GSCI fund invested by buying futures
contracts in the relevant commodity markets which were 'rolled over'
from month to month.
The genius dash of marketing fairy dust that was sprinkled on this
concept was to call investment in the fund a ‘hedge against inflation’.
Investors in the fund were able to offload the perceived risk of holding
dollars and instead take on the risk of holding commodities.
The smartest kids on the block were not slow to realise that the GSCI
– which was structurally ‘long’ of commodity markets – was taking a
long term position which was precisely the opposite of a commodity
producer who is structurally ‘short’ of commodities because they
routinely sell futures contracts in order to insure themselves against a
fall in the dollar price; ie commodity producers are offloading the
risk of owning commodities, and taking on the risk of holding dollars.
So, in 1995 a marriage was arranged.
BP and Goldman Sachs get Married
From 1995 to 2007 BP and Goldman Sachs were joined at the head,
having the same chairman – the Irish former head of the World Trade
Organisation, Peter Sutherland. From 1999 until he fell from grace in
2007 through revelations about his private life, BP’s CEO Lord Browne
was also on the Goldman Sachs board.
The outcome of the relationship was that BP were in a position, if
they were so minded, to obtain interest-free funding via Goldman Sachs,
from GSCI investors through the simple expedient of a sale and
repurchase agreement - ie BP could sell title to oil with an agreement
to buy back the oil later at an agreed price.
The outcome would be a financial ‘lease’ of oil by BP to GSCI
investors and the monetisation of part of BP’s oil inventory. Such
agreements in relation to bilateral physical oil transactions are
typically concluded privately, and are invisible to the organised
markets. However, any risk management contracts which an intermediary
such as Goldman Sachs may enter into as a counter-party to both a fund
and a producer are visible on the futures exchanges.
Due to the invisibility of the change of ownership of inventory
‘information asymmetry’ is created where some market participants are in
possession of key market information which others do not have. This
ownership by investors of inventory in the custody of a producer has
been termed ‘Dark Inventory’
I must make quite clear at this point that only BP and Goldman Sachs
know whether they actually did create Dark Inventory by leasing oil in
this way, and readers must make up their own minds on that. But I do
know that in their shoes, what I would have done, particularly bearing
in mind that such commodity leasing is a perfectly legitimate financing
stratagem that has been in routine use in the precious metals and base
metal markets for a very long time indeed.
Planet Hype
The ‘inflation hedging’ meme gradually gained traction and a new
breed of Exchange Traded Funds (ETFs) and structured investment products
were created to invest in commodities. In 2005, Shell entered quite
transparently into a relationship with ETF Securities which enabled them
to cut out as middlemen both investment banks and the futures market
casinos, and with them the substantial rent both collect.
Other investment banks also started to offer similar products and a
bandwagon began to roll. From 2005 to 2008, we therefore saw an
increasing flood of dollars into the oil market, and this was
accompanied by the most shameless and often completely misleading hype,
and led to a bubble in the price.
There was (and still is) no piece of news which cannot be interpreted
as a reason to buy crude oil. The classic case was US environmental
restrictions on oil products, which led to restricted supply, and to
price increases in oil products. Now, anyone would think that reduced
refinery throughput will reduce the demand for crude oil and should
logically lead to a fall in crude oil prices.
But on Planet Hype faulty economic logic – the view that higher
product prices are necessarily associated with higher crude oil prices –
was instead used as justification for the higher crude oil prices which
resulted from the financial buying of crude oil attracted by the hype.
You couldn’t make it up: but unfortunately, they could, and they did.
More worrying than mere hype was that a very significant amount of
oil inventory had actually changed hands from producers to investors.
Only those directly involved were aware that below the visible part of
the oil market iceberg lurked massive unseen ‘Dark Inventory’.
Greedy Speculators and Hoarding
The pervasive narrative among people and politicians, and which is
spread by a campaigning press, is of ‘greedy speculators’ who are
‘hoarding’ commodities and ‘gouging’ consumers in search of a
transaction profit.
There is no better example of this meme than the UK’s Daily Mail scoop on 20th November 2009.
Here we saw pictures of shoals of some 54 shark-like tankers loaded
with oil and lurking off the UK coast with millions of barrels of
‘hoarded’ crude oil, some of them having been there since April 2009.
The Mail’s story was that these tankers were full of hoarded oil whose
greedy owners were waiting for prices to rise before gouging the public.
The reality was rather different.
The motivation of the investors involved was not greed but fear. The
Fed had been busily printing another trillion in QE dollars to buy
securities and the sellers, and other investors aimed not to make a
dollar profit but rather to avoid a dollar loss.
So they poured $ billions into oil index funds and similar products
and the oil leases/loans which accommodated these funds’ financial
purchases of oil had the effect of raising forward prices and of
depressing the spot price, thereby creating what is known as a market
‘in contango’.
When the forward price is high enough in a contango market, what
happens is that traders will borrow money to buy crude oil now, and sell
the oil at the higher price in the future. Provided the contango is
high enough, they will cover interest costs and the cost of chartering
and insuring the vessel and its cargo, and lock in a profit for the
trader at the end.
This is exactly what traders did through the summer of 2009, until
the winter demand by refineries for crude oil and a reduction in the
flow of QE dollars into the market combined to see the stored oil
gradually delivered to refineries and the sharks depart the UK shores.
The point is that the widely held perception of high oil prices being
the fault of hoarders and greedy speculators is – apart from very short
term ‘spikes’ in the price - entirely misconceived. And even when
speculators do dabble in oil markets, they are almost always pillaged by
traders and investment banks with much better market information, which
is probably what is happening right now.
The Bubble Bursts
In 2008 there was an influx of genuine speculators in search of short
term transaction profit. The motivation of inflation hedgers, on the
other hand, is the avoidance of loss, which leads to different market
behaviour and the perverse outcome that they have been responsible for
causing the very inflation they sought to avoid.
The price eventually reached levels at which demand for products
began to be affected and shrewd market observers began to position
themselves for the inevitable bursting of the obvious bubble. But those
market traders and speculators who correctly diagnosed that the price
would collapse were unaware of the existence of the Dark Inventory of
pre-sold oil sitting invisibly like an iceberg under the water.
Traders who had sold off-exchange Brent/BFOE contracts or deliverable
WTI contracts found themselves ‘squeezed’ because title to the crude
oil which they thought would be available at a cheaper price to fulfil
their contractual commitment had been ‘pre-sold’ to financial investors.
This meant that they had to scramble to buy oil at a higher price than
they had expected.
The price spiked to $147 per barrel, and then declined over several
months all the way to $35 per barrel or so, as many of the index fund
investors pulled their money out of the market in late 2008 and joined a
stampede to the safety of US Treasury Bills. What was happening here
was that the Dark Inventory which had been created flooded back into the
market, and overwhelmed the market’s capacity to absorb it.
Convergence and Futures Pricing
The oil market price is – by definition – the price at which title to dollars is exchanged for title to crude oil.
But there is very considerable debate among economists about the
effect of derivative contracts on this spot market price, and whether it
is the case that the futures market converges on the physical market
price or vice versa.
Now, in the case of a deliverable exchange futures contract, a price
is set for delivery of a standardised quantity of a particular
specification of a commodity at a particular location within a specified
period of time. If that contract is held open until the expiry date and
time then there will indeed be a spot delivery and payment against
documents at the original price. In accordance with the exchange’s
contractual terms.
But the key point is that this futures contract will not be held open
to the expiry date at the original price unless the physical market
price – which is set by physical supply and demand – is actually at that
price at that specific point in time. If the physical price is lower or
higher, then the futures contract will be closed out through a matching
purchase or sale and a profit or loss will be taken.
I managed the International Petroleum Exchange’s Gas Oil contract for
six years, which was deliverable in North West Europe, and the final
minutes of trading before contract expiry were Europe’s greatest game of
‘chicken’.
Moreover, no IPE broker in his right mind would dream (because the
broker was responsible to the London Clearing House for defaults) of
letting a financial investor with no capability of making or taking
delivery hold a position into the last month before delivery. And if a
broker was not in his right mind, it was my job to act under the
exchange rules to ensure such positions were liquidated.
In other markets, the ability to own physical commodities – eg.
through ownership of warehouse warrants – is much more straightforward
for investors. But the logistics of oil and oil products are such that
financial investors are simply incapable of participating in the
physical market. In my view, the use of position limits for financial
investors in crude oil and oil products is of little or no use if the
clearing house, exchange, and brokers are doing their job.
Finally, now that the US WTI contract is just the tail on the
Brent/BFOE physical market dog, this discussion has moved on, since the
ICE Brent/BFOE futures contract is in fact settled in cash against an
index based on trading in the BFOE forward market, with no physical
delivery. It is simply a straightforward financial bet in relation to
the routinely manipulated underlying BFOE physical market price – ie.,
the question of convergence does not arise.
Anything but Dollars
With interest rates at zero per cent, and with the Federal Reserve
Bank printing dollars through QE, a tidal wave of money flowed into
equity and commodity markets purely as an alternative to the dollar, and
they did so through a proliferation of funds set up by banks.
Note here that the beauty of such funds for the banks is that it is
the investors who take the market risk, not the banks, and the marketing
and operation of funds has become a very profitable use of scarce bank
capital.
So a flood of financial purchasers of oil were looking for producers willing and able to sell or lease oil to them.
Producers in Pain
Producing nations who had massively expanded their spending in line
with a perceived ‘sellers’ market’ paradigm where they had the whip
hand, were badly hurt by the 2008 price collapse and OPEC took action to
restrict production.
But might some OPEC members or other producing nations have gone further than this?
What
is clear is that the price rose swiftly in 2009 and then remained
roughly in a range between $70 and $90 per barrel until early 2011 when
twin shocks hit the oil market. Firstly, there was the supply shock in
Libya which saw 1.5m bbl per day of top quality crude oil leave the
market, and secondly, the demand shock of Fukushima, which saw a
dramatic switch from nuclear to carbon-fuelled energy.
My thesis is that Shell directly, and others indirectly, were not the
only ones leasing oil to funds. I believe that it is probable that the
US and Saudis/GCC reached – with the help of the best financial brains
money can rent – a geo-political understanding with the aim that the oil
price is firstly capped at an upper level which does not lead to
politically embarrassing high US gasoline prices; and secondly, collared
at a level which provides a satisfactory level of Saudi/GCC oil
revenues.
The QE Pump Stops
In June 2011, the QE pump which had been keeping commodity and equity
markets inflated and correlated stopped, and price levels began to
decline. Consumer demand – as opposed to financial demand – for
commodities had also been affected not only by high prices, but by
reduced demand from developed nations for finished goods. In September
2011, more than $9bn of index fund money pulled out of the markets for
the safe haven of T-bills.
What happened as a result was that the regular rolling over of oil
leases, and the free dollar funding for producers of their oil inventory
ceased. So the leased oil returned to the ownership of the producers,
while the dollars returned to the ownership of the funds.
Since the ‘repurchases’ were no longer occurring, the forward oil
price fell below the current price, and this ‘backwardation’ was
misinterpreted by market traders and speculators. They believed that the
backwardation was – as it usually is - a sign that current demand was
high and increasing relative to forward demand, whereas in this false
market the current demand is unchanged but the forward demand is decreasing.
As in 2008, speculators and traders were again suckered too soon into
the market, and this led to profits at their expense to those with
asymmetric information, and a ‘pop’ upwards in the price as they were
forced to close speculative short positions. My information is that a
major oil market trader was successfully able to ‘squeeze’ the
Brent/BFOE market on at least two occasions in late 2011 precisely
because they were aware of the true situation of inventory ownership,
and the rest of the market was not.
As an insider puts it……
You can’t have proper price discovery when half of the inventory
is being sold elsewhere at a different price. On exchange physical
doesn’t even exist. Futures are converging to physical, but only the
physical which is visible for Platts assessment.
….pointing out that transactions in respect of physical ownership of
oil do not take place on an exchange, and that there is effectively a
‘two tier’ market. Only a proportion of spot or physical Brent/BFOE
transactions therefore actually form the basis of the Platts assessment
of the global benchmark oil price.
Enter Iran
In my view, there is little or no chance of military action against
Iran, and having been to Iran five times in recent years, and as
recently as two months ago, there is much I could write on this subject.
While financial sanctions have been pretty smart, and increasingly
effective so far, the medium and long term effect of the proposed EU oil
embargo – which will in fact affect only a pretty minimal and easily
accommodated amount of demand which is evaporating anyway – is more
apparent than real.
While there would undoubtedly be a short term price rise – cheered on
by the usual suspects – in the medium and long term the embargo will
act to reduce oil prices. This is because Iran will necessarily have to
sell oil at below market price to China and others, and since the market
is over-supplied, particularly in Europe, this will undercut market
prices generally.
Mexico has routinely hedged oil production for years, and Qatar – who
are very shrewd operators – began to do the same in November 2011 since
they expect the price to fall this year. In the short term the Iran
‘crisis’ is in my view being hyped for all it is worth to entice yet
more unwary speculators into the oil market so that other producers may
sell their production forward at high prices while they last before the
inevitable and imminent collapse.
Current Position
If you believe the investment banks – who all have oil funds to sell
to the credulous – Far Eastern demand is holding up, supplies are tight,
and stocks are low, so prices are set to rise to maybe $120 or above in
2012, even in the absence of fisticuffs involving Iran.
I take a different view. I see real demand – as opposed to financial
demand and stock-piling, such as in the copper market – declining in
2012 as the financial crisis continues at best, and deepens at worst,
particularly in the EU. Stocks are low because bank financing of stock
is disappearing as banks retrench, and it makes no sense for traders to
hold stocks if forward prices are lower than today’s price.
As for supplies, US crude oil production is probably higher, and
consumption lower, than widely appreciated. Elsewhere, there is plenty
of oil available now that much of the Dark Inventory has been
liquidated, and this liquidation was probably why in November 2011 we
saw the highest Saudi monthly deliveries in 30 years.
Finally, we see North Sea oil being shipped – for the first time
since 2008 – half way around the world to find Far East buyers. We also
see Petroplus, a major independent Swiss refiner, crippled by inflated
crude oil prices, and shutting down three refineries because demand for
its products has disappeared, and it can no longer finance crude oil
purchases now that banks have pulled its credit lines.
In my world, refineries closed due to reduced demand for their
products imply a reduction in demand for crude oil: but not, apparently,
on the Planet Hype of investment banks with funds to sell.
History does not repeat itself, but it does rhyme, and my forecast is
that the crude oil price will fall dramatically during the first half
of 2012, possibly as low as $45 to $55 per barrel.
Then What?
As the price collapses we will see producer nations generally and OPEC in particular once again going into panic mode, and genuinely
cutting production. We will also see the next great regulatory scandal
where a legion of risk-averse retail investors who have lost most or all
of their investment will not be pleased to hear that they were warned
on Page 5, paragraph (b); clause (iv) of their customer agreement that
markets could go down as well as up.
At this point, I hope and expect that consumer and producer nations
might finally get their heads together and agree that whereas the former
seeks a stable low price, and the latter a stable high price, they
actually have an interest – even if intermediaries do not – in agreeing a
formula for a stable fair price.
We can’t solve 21st century problems with 20th century solutions and I
shall address the subject of resilient global energy market
architecture in my next post.
This is a guest post by Chris Cook, former compliance and market supervision director of the International Petroleum Exchange.
By. Chris Cook
Source: The Oil Drum
http://oilprice.com/Energy/Oil-Prices/Why-Oil-Prices-Are-About-To-Collapse.html
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