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Oil: the End Game Commences

by ChrisCook Mon Feb 27th, 2012 at 08:15:50 AM EST

Asia Times published this piece of mine today.

The End Game

The end game is about to begin.  

On the one hand you have the noise and rhetoric.  Greedy speculators gouging gasoline prices; mad mullahs preparing to wipe Israel off the map; bunker buster bombs and fleets being positioned; huge demand for oil from the BRIC countries; China's insatiable thirst for oil; the oil price will head for $200/bbl and will never fall below $130/bbl again.......

On the other hand you have the reality.

Oil Markets
The oil markets are completely manipulated and orchestrated, and the conductors of the orchestra have the benefit of having already held a rehearsal in 2008.

Of course, history never repeats itself, but it does rhyme.  This time around it is not US demand which is collapsing, but EU and UK demand, as oil prices in € and £ have never been higher.  In the meantime the US is awash in oil as domestic production quietly increases, flushed out by the high prices.

As I have outlined in previous articles, the culprit for the high oil prices between 2009 and 2012 - with the exception of the speculative 'spike' between March 2011 and June 2011 driven by Fukushima and Libyan price shocks - has been passive investment by risk averse investors, which enabled producers to support oil prices at high levels.

Much of this passive money underpinning the market and enabling producers to monetise inventory pulled out of the market in September 2011, and another wave pulled out in December 2011.  

What is now happening is the End Game: an orchestrated wave of noise which is drawing in speculative money. This is enabling the producers who are actually in the know to hedge by selling production forward during what they confidently expect will be a temporary -and pre-planned - managed fall in the oil price.

The Game Plan
The smartest kids on the block know that gasoline prices much over $4 per gallon will be both deflationary and lethal to President Obama's re-election chances.

So that won't happen other than briefly.

I am by no means the only commentator who has pointed out the complete counter-productivity of these oil sanctions. The smart kids are well aware that oil sanctions are completely useless, and simply enable China to fill their strategic reserves at a discount to the market price at the expense of Greece and Italy in particular.

But the US has been quite happy to let the EU - as useful idiots - take the economic hit. The high oil prices caused by all this noise and nonsense are actually a net benefit to Iran - who rattle their sabre loudly as elections approach.

The effect of a managed decline in oil prices to, and probably over-correcting well through, $60/bbl - which is coming fairly soon - will be extremely beneficial to the US in two ways.

Firstly, it will be catastrophic in particular for Iran, Russia and Venezuela - not exactly on the White House party list - whose hugely oil-dependent revenues will collapse. The ensuing economic mayhem will open these countries up to regime change and to rescue plans which Wall Street will be dusting off.

Secondly, the US population will be laughing all the way to the gas station as gasoline prices fall - at least temporarily - below $2.50/gallon and release purchasing power into the economy, thereby doing the President's re-election chances no harm at all.

What will then happen is that OPEC members will panic and genuinely reduce their production.  The Saudis/GCC will again orchestrate the inflation of the oil price, - as they did in 2009 - comfortable in the knowledge that they have been able to hedge against this temporary fall in prices at the expense of the speculators currently pouring in to the market.

That's the game plan as I see it of the smartest kids on the block. What could ever go wrong?

A Buyer's Strike
Quite clearly, consumer nations, like everyone else, are in the dark in relation to what has been going on in the oil market and have swallowed the populist 'greedy speculator' meme.  They are simply unaware of the nature and cosmic scale of the oil market manipulation which has been taking place, and as a result have been happily overpaying for oil for years.

What happens if they simply refuse to pay these prices?

Possibly a 'buyers' strike' by China would be enough to crater the market.  We've already seen the effect of that on Iran, who have clearly agreed new terms with China after they held back purchases earlier this year.

Or possibly speculative short selling of crude oil by hedge funds funded by Chinese investment?  I pointed out at a rather spooky conference on "Economic Terrorism" a few years ago in Lausanne - which examined ways in which terrorists might make economic rather than physical attacks - that the only difference between an economic terrorist and a hedge fund is motive.

System Fragility
The markets in oil have never been so fragile and susceptible to shocks.  Private inventories of oil are low. The investment banks interpret this - as they interpret everything - as a sign of physical demand and therefore as bullish for the oil price......oh, and by the way, here are some oil funds they have to sell you.

The reason inventories are low is that private intermediary buyers will only store oil if they can both finance it and lock in a higher forward sale price. Bank financing is scarce and getting scarcer, while forward prices are below current prices, and the result is that inventories are low.  

The systemic shortage of finance capital means that neither physical oil traders nor the remaining proprietary traders of banks can afford to take into storage much of the approaching flood of oil onto the market.  

Also, derivative market risk has become concentrated - since intermediaries are no longer capitalised to take it - in centralised clearing houses, who have for commercial reasons become fragmented silos.  

In my view, the steep decline which is planned could easily get out of hand in a not dissimilar way to the tin market in 1985 when the price collapsed - literally overnight - from $8,000 per tonne to $4,000 per tonne.

We will then see whether or not the clearing houses are 'too big to fail' - and ask why, if so, such utilities are run for private profit?

When, not If
In my analysis, absent a massive, and sustained, shortfall in oil supplies - which I cannot see occurring, since all involved have every interest in ensuring it does not occur - the oil price will, as I have already forecast, fall dramatically by the end of Q2 2012 at the latest.  It's not a matter of if, but when it will happen.

Finally, as an interesting aside, I have credible reports that Marc Rich - who got on well with both the Shah of Iran and Imam Khomeini, and who sold oil from Iran to Israel for 20 years between 1973 and 1993 - has recently been seen again in Tehran.  I doubt that this is for the night life, or because he prefers Tehran air to Swiss: but as a trusted third party there would be few better placed to act as a go-between.

Let's hope so.  Once the stultifying political uncertainties of elections in Iran and Russia are over, things could get interesting.

Eh. I drove a forklift powered by a kolibri battery last month. KWH rating on that remarkably compact package was kind of silly. As in "Why the fuck is anyone still making combustion engine cars"? And since there are no secrets in the laws of nature, this tech, or something even better will be coming to a car near you. Soon. 60 dollar gas? Try 30. Permanently. Not that anyone outside the chemical industries that use oil for feedstock will give a damn.
by Thomas on Mon Feb 27th, 2012 at 09:14:42 AM EST
The Koch brothers playbook is for Oil prices to continue to rise until AFTER Obama is defeated. If they have manipulated proves thus far, what's another few months? I don't doubt your predication of a crash, just the predictability of its timing. Bubbles can float along nicely for a long time.  Is there any reason why the crash MUST come before Q3?

Index of Frank's Diaries
by Frank Schnittger (mail Frankschnittger at hot male dotty communists) on Mon Feb 27th, 2012 at 11:19:10 AM EST
It's nothing to do with the Koch brothers, Frank. They're hardly a pimple on the arse of the market.

This is about manipulation of the Brent/BFOE complex. The trigger on the collapse has already been pulled in the physical markets where deliveries of 'prepaid' oil have been made, with more on the way.

There is - absent a massive and sustained supply shock - no way of stopping the collapse. The longer the speculative derivative buying continues, and the higher it goes, the faster and more precipitous the price fall.

I have been piecing together a bit of the history of the manipulation, which commenced in earnest in 1999 after the investment banks got more freedom of action courtesy of Phil Gramm.

Like all the most egregious ideas (eg emissions trading) it was the 'smartest kids in the room' (Enron) who dreamt it up in the form of the Prepay commodity transactions with which they window-dressed their balance sheet.

In a typical prepay transaction, therefore, each side assumes commodity price risk.

According to the complaint, the critical difference in the J.P. Morgan Chase/Enron prepays -- and the reason that these transactions were in substance loans -- was that they employed a structure that passed the counter-party commodity price risk back to Enron, thus eliminating all commodity risk from the transaction.

This was accomplished through a series of simultaneous trades whereby Enron passed the counter-party commodity price risk to a J.P. Morgan Chase-sponsored special purpose vehicle called Mahonia, which passed the risk to J.P. Morgan Chase, which, in turn, passed the risk back to Enron.

As in typical prepays, the complaint alleges, Enron received cash upfront. In contrast to typical prepays, according to the complaint, with all elements of the structure taken together, Enron's future obligations were reduced to the repayment of cash it received from J.P. Morgan Chase with negotiated interest.

The interest was calculated with reference to LIBOR. Since all price risk and, in certain transactions, even the obligation to transport a commodity were eliminated, the only risk in the transactions was Chase's risk that Enron would not make its payments when due, i.e., credit risk. In short, the complaint alleges, these seven prepays were in substance loans.

Enron were of course playing a different game to the likes of Goldman, who are using a similar prepay and repurchase tactic to enable ETFs to fund the inventory of producers, who received an interest-free loan.

Goldman make their money out of very short term (they no longer have the capital to hold positions) trading with 'asymmetric' information and 'prime brokerage'.

By way of corroboration, I have seen the written opinion of the Enron author of 'Prepay' - someone with probably more knowledge of how to dress up balance sheets than any man living - that this is precisely what BP, to name one, have been doing.

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Mon Feb 27th, 2012 at 12:10:19 PM EST
[ Parent ]
So you would expect BP, various Oil majors and exploration companies, various hedge funds and banks to be the principle victims of the price collapse? What is the shape of the collapse you would expect.  Are we going to be pressured into bailing out various speculators all over again?  And if so, who?

Index of Frank's Diaries
by Frank Schnittger (mail Frankschnittger at hot male dotty communists) on Mon Feb 27th, 2012 at 05:57:57 PM EST
[ Parent ]
I think the plan is for only a temporary collapse, before the price gets marched back up the hill again.

Hedge funds lose, as do un-hedged producers. Exploration companies see drilling etc fall off a cliff.

The casino operators (exchanges) and those in the know, will make out like bandits.

The danger is that the price fall is so precipitous that hedge funds etc who are long of futures get more than wiped out, and cannot or will not pay losses or variation margin to clearing houses, who then melt down themselves.  

We might then have to bail out the (privatised - they all used to be mutuals) clearing houses, who are IMHO insufficiently capitalised for the 'fat tail' risks they run.

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Mon Feb 27th, 2012 at 06:23:03 PM EST
[ Parent ]
And how will Governments be able to make the case that these hedge funds/clearing houses have to be bailed out because of their strategic importance to the economy? Most people will never have heard of them.Won't it be relatively politically easy to let them go bust? What social value do they fulfil what cannot be otherwise fulfilled?

Index of Frank's Diaries
by Frank Schnittger (mail Frankschnittger at hot male dotty communists) on Mon Feb 27th, 2012 at 07:18:44 PM EST
[ Parent ]
It's not the hedge funds who'd be bailed out, but rather what have become 'for profit' utilities.

I think that the end-users - who hedge production and consumption respectively, and need the risk insurance and management they and the exchanges provide - will lean on the government to bail out the clearing houses in exactly the same way as they bailed out the clearing banks.

In fact, the answer is for the end-users to operate a mutual clearing and risk sharing system like the P & I Clubs which have been quietly operating, and been managed by Thomas Miller as a service provider, for over 135 years.

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Mon Feb 27th, 2012 at 07:50:52 PM EST
[ Parent ]
The biggest obstacle to this dream, Chris, is that the banks and oilers control the guns and law enforcement.  Look what they're already doing and ask yourself what extremes they will go to if their Smaug-like stashes are really threatened.
by rifek on Mon Feb 27th, 2012 at 11:26:03 PM EST
[ Parent ]
Sorry, but those days are over. 1% can no longer enforce their will on a connected 99%and the pragmatists realise this.

Besides, it is not the 99%, but the collapse of their system - which nothing on God's Earth can prevent - which is what is threatening the 1%'s  stash.

If the solution does not threaten their stash, but simply prevents their stash, rather than them, making more stash then I think virtually all of them will opt for a smaller %ge of something rather than 100% of nothing.

It's not a dream. It's an ongoing process. If you can't see it, that's not my problem.

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Tue Feb 28th, 2012 at 04:33:46 AM EST
[ Parent ]

Friends come and go. Enemies accumulate.
by JakeS (JangoSierra 'at' gmail 'dot' com) on Tue Feb 28th, 2012 at 05:22:10 AM EST
[ Parent ]
Completely wrong. My view is entirely pragmatic.

The emerging legal and financial models make it in the interests of participants to co-operate rather than to compete.

The problem with all intermediated structures - whether it is the State or the Shareholder intermediating - is that:

(a) the interests of the intermediary diverge from those of the end-users;

(b) the interests of the management as agent diverge form the interests of the principal.

In a dis-intermediated architecture - within a suitable framework agreement - then the calculus changes.

For completely selfish reasons, people decide it is in their interest to co-operate rather than compete; to be transparent, rather than opaque; and so on.

Collaborative structures are not emerging because I say so: I observe them emerging in use because they work and because those who do not use them are at a disadvantage to those who do.

Capitalism will consume itself, and emerge in a non-toxic, and optimal, form.

You may call that forecast Utopian. It's simply my prediction based upon my observations, and upon pragmatic realism.

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Tue Feb 28th, 2012 at 05:38:26 AM EST
[ Parent ]
Ascribing pragmatism to TPTB is what I referred to as an excessively generous assessment of human nature. We are dealing with the sort of people who will happily make a desert and call it successful adjustment - I can see no reason to expect that they will prefer to have an equal share of something over having 100 % of nothing.

I also think that the fact that people are turning to what are fundamentally gussied-up 19th century financial architectures says more about the state of contemporary financial enterprise than it does about the soundness of gussied-up 19th century financial architectures.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Tue Feb 28th, 2012 at 07:46:36 AM EST
[ Parent ]
Nope. No Victorian baroque, please.

Pre-1700 financial architecture.

And no gussying up.  

Completely straightforward. As simple as possible: but no simpler.

Moreover,can be introduced tomorrow, by consensual agreement.  

So who gives a toss what the powers that be think? They are free to join in as well.....or not.

They're History - the Internet treats them as damage and routes around them

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Tue Feb 28th, 2012 at 09:57:48 AM EST
[ Parent ]
I'm going to have to disagree with you on this.  Bullets and jackboots have great effect, even in small quantities, and history indicates that ruling classes do not get rational until the bus has already launched off the cliff.
by rifek on Tue Feb 28th, 2012 at 10:22:34 PM EST
[ Parent ]
Sadly, we all know that the price of fuel at the pump won't fall in the UK, whatever the price of oil. So why will it fall in the US for the benefit of Obama when it's in the interest of all the oil industrials to put the repug into office ?

keep to the Fen Causeway
by Helen (lareinagal at yahoo dot co dot uk) on Mon Feb 27th, 2012 at 12:59:54 PM EST
They are not called Hedge Fund Democrats without reason. Most of Wall Street supported Obama in '08 and he came through for them big time when it counted most. No investigations. If they turn against him now, with such a divided Republican Party, they would only be giving him reason to go after them, which would be hugely popular if properly presented.

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Mon Feb 27th, 2012 at 03:58:46 PM EST
[ Parent ]
In the UK, most of the price is tax, and a pretty much a cartel, so the gasoline price is relatively 'inelastic'.

In the US there's very little tax, and a lot of competition, so gasoline prices tend to move very rapidly with crude oil prices.

So if crude oil prices crash, so will US gasoline prices.

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Mon Feb 27th, 2012 at 06:26:36 PM EST
[ Parent ]
As an aside, Chris, is there any reason to believe anything Craig Pirrong says, even if he were to say the sun came up in the east this morning?  He seems bought and paid for by Cato and Heartland.
by rifek on Fri Mar 2nd, 2012 at 05:43:13 PM EST
Craig is very, very good.

He probably has a better detailed understanding of commodity market mechanisms than any other academic.

But he is very US-centric, and I think this can lead him astray.

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Fri Mar 2nd, 2012 at 08:18:52 PM EST
[ Parent ]
I think his neoliberal Austro-Chicagoism leads him farther astray than any US parochialism.
by rifek on Fri Mar 2nd, 2012 at 11:21:44 PM EST
[ Parent ]
You may well be right.

"The future is already here -- it's just not very evenly distributed" William Gibson
by ChrisCook (cojockathotmaildotcom) on Sat Mar 3rd, 2012 at 06:39:33 AM EST
[ Parent ]
Very interesting. What would be the criteria necessary to you change your prediction and the timing of the oil price meltdown besides the demand you mentioned?
by An American in London on Thu Mar 8th, 2012 at 05:24:14 AM EST
Well, I've fairly recently posted at Naked Capitalism this this sequel which I might post here shortly.

The only thing that can keep prices up in the absence of a serious cut in supply is continued inflow by managed money 'active' investment by speculators.

This will merely make the collapse that much the greater when it comes. The higher the price spikes, the more demand will shrink.

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Thu Mar 8th, 2012 at 09:22:34 AM EST
[ Parent ]
"Serious cut in supply" you say?  Guess it's time to blast a couple of Iranian pipelines.
by rifek on Fri Mar 9th, 2012 at 01:21:23 PM EST
[ Parent ]
Have Oil Speculators Already Priced In War With Iran? - Businessweek

The last time the price of Brent crude closed below $100 a barrel was Oct. 6, 2011. It's since gone up nearly 30 percent, to a high of $126.20 on March 1. Tensions over Iran's nuclear program have people spooked that a potential attack would disrupt the country's 2.2 million barrels of daily oil exports. And so money has been pouring into oil futures contracts, driving up the price without any significant change in the underlying supply-and-demand fundamentals. Only the threat of one.

So who's buying?

Talk to oil analysts these days and chances are they'll tell you that more than half the spike in the oil price is due to speculators--specifically noncommercial users. That's jargon for investors who are buying up futures contracts not because they intend to use the oil, but because they think it's a good investment. These aren't airlines or refining companies; these are money managers betting that the price will go up. And so far they've been right, thanks to themselves.

When the "Iran war" story is seen to be a bust, the collapse will start. But that could take months, still.

Or perhaps only weeks. With the legislative elections out of the way, perhaps the Iranians are becoming less brinksmanlike and more statesmanlike. Certainly, Obama is being quite public about not being led into war by Netanyahu.

It is rightly acknowledged that people of faith have no monopoly of virtue - Queen Elizabeth II

by eurogreen on Thu Mar 8th, 2012 at 06:00:06 AM EST

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