The Oil Drum
January 20, 2012
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.
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.
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