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Naked Oil 2 - the Ghost of Enron

by ChrisCook Thu Mar 8th, 2012 at 10:18:55 AM EST

Here's my second post for the Naked Capitalism blog.

Naked Oil 2: the Ghost of Enron
I outlined in my recent post my view that the oil market price has been inflated twice by passive (inflation hedgers) investors , albeit with short term speculative spikes from active (speculators) investors: once from 2005 to June 2008; and again from early 2009 to date. In attempting to 'hedge inflation' passive investors perversely ended up actually causing it, and allowed oil producers to manipulate and support the oil market price with fund money to the detriment of oil consumers.

A comment thread at the FT Alphaville blog a month ago

Collateralised commodity borrowing: BP edition

shed light on the esoteric subject of collateralised commodity borrowing by BP, who with Goldman Sachs were the heroes of my last post.

While Izabella Kaminska's Alphaville post was as interesting as usual, the real nugget on this occasion lay in the extremely well informed discussion which followed.

The protagonists were firstly, Patrick McGavock - a very clued up former banker whose blog rejoices in the name of the "Complete Banker". The second commenter - whose nom de plume is "Free Again" - not only had technical mastery of a subject that has me reaching for an icepack for my head, but also displayed a  comprehensive knowledge of Enron's modus operandi.

But there has always been a missing link - precisely how has this manipulation been achieved?


Volumetric Production Payment (VPP) versus Prepay
The very name is enough to make the eyes glaze over, but in essence a VPP is a loan secured against a flow of production which remains in the ownership of the producer.

Prepay, on the other hand, is a forward sale of a commodity where the ownership rights to production pass to the financier.

The Alphaville dialogue is instructive as to the difference.

Free Again (to McGavock): Enron did two types of related transactions: Sales of Volumetric Production Payments (described below), which are being done today in much the same way, and Prepay transactions, which were round-trip trades (three parties involved) meant to create the appearance of Funds Flow From Operations, when it was actually funds flow from financing.

McGavock (to Free Again):  Absolutely right. Although VPPs and prepays are essentially the same thing except for the ownership of mineral rights.

A day later came a response which I did not see until recently (my bold).

Free Again (replying to McGavock) Yes, I think we agree, but the most interesting distinction, and what may be relevant to the BP discussion, is the reason a company would choose a particular structure.

A VPP is a form of (acceptable) off-balance sheet financing. In most cases, reserve risk is transferred to the buyer (though the seller usually retains the operating risk).

A Prepay transaction is a little more insidious. It is a form of financing, but if structured as a commodity trade, can be made to look as if it is cash flow from operations.

This is particularly important to companies that use mark-to-market accounting, as there usually exists a huge gap between earnings and cash recognition. In order to maintain credit metrics when using MTM, the companies will structure misleading FFFO transactions, as a key rating agencies focus is FFFO/Interest Expense.

Prepay
Prepay does not move the oil, which stays where it is in the ground or in tank.  What prepay does is to create an ownership claim over oil which may be sold either temporarily (Enron-style) as an 'oil loan' to investors, or to refiners, who take delivery in due course of oil for which they have fixed the price by 'paying forward'.

Investors prepay for physical oil which goes nowhere and stays in the custody of the producer, who has an  agreement to buy the oil back from the investor, typically a month later in a forward contract that looks just like a futures contract. The outcome is that - facilitated by an investment bank intermediary - the producer lends oil to the investor, and the investor lends dollars to the producer.

The temporary ownership rights created and sold to investors via intermediaries such as Goldman Sachs essentially enable a producer to act as a private oil bank 'printing oil'.

How does printing oil affect the market?  First we'll look at the printing process as dollars flow in to the market, and the Dark Inventory which it funds. Secondly, we'll look at what happens when funds flow out and this paper oil is redeemed by the issuer.

Printing Oil
In early 2009, risk averse money poured into the commodity markets, and a large portion of it flowed in to passive funds such as Index Funds and Exchange Traded Funds investing wholly or partly in oil. Units in these funds are created, and some unit issuers then entered, via investment banks, into prepay agreements with producers.  

Producers obtain dollars interest-free in exchange for transferring title to oil inventory to the investment bank, and what this means is that the producers do not need to sell as much physical oil to refiners, who must therefore raise their bid price to secure supply from producers, and this is why the price rose rapidly in early 2009 even though the market was not under-supplied.

The second effect was that the demand for forward contracts for the producer to buy the oil back again drove the forward price higher, and this created what is defined as a 'contango' market. In fact, it was so pronounced it was called a 'super-contango'.

What happened as a result was that traders began to buy oil, and to sell it forward, since the contango difference in price enabled them to pay to insure and finance the oil; to lease tank storage, and even to charter the fleets of tankers which sat as floating storage off the UK coast through spring and summer 2009.

Passive investors, for their part, lose money in such a contango market, because the oil lease contracts are rolled over from month to month at a loss to them, since they would (say) sell June delivery oil contracts which they are in no position to perform, and have to buy July delivery oil contracts at a higher price.

It is this continuing loss to long term fund investors which funds the 'contango trade' of the arbitrageur traders who charter the tankers.

"De-Pay" - Fund liquidation
When risk-averse investors ask for their money back, what happens is that the oil leasing agreement comes to an end, the fund units are liquidated, and the dollars are returned to the fund investors.

So, when the oil is repurchased by the producer from the investment bank, the position is no longer 'rolled over' and no further contract purchase is entered into in the next delivery month. This depresses the forward contract price relative to today's price, a state of affairs which is known as a 'backwardation'.

Moreover, the producer now has fewer dollars and more oil, and is exposed to a fall in the price of the inventory which he now owns once again.  Of course, the producer could sell to refiners on a prepay basis, which a refiner would be happy to do at a suitably discounted price.  Or alternatively, the producer could sell futures contracts to speculators who for some reason expect that prices will increase.

There have been two outflows of passive investment from the market, firstly in September 2011 when sentiment turned in favour of T-Bills as safe haven. The second was in December 2011, following the MF Global problem, which demonstrated that unit issuers come with a counter-party risk, since though the issuer may not be taking market risk themselves, they may nevertheless be playing games with the asset.

In each case we have seen the physical market go into backwardation, and in my view the record deliveries by the Saudis may be explained by an urgent desire to sell inventory returned to their ownership at high prices before the collapse they know is on the way.

But the exit of passive investors from the market has yet to have the effect it did in late 2008 when the price collapsed to $35/barrel from the high of $147/barrel. The reason is that the current noise and rhetoric re Iran has firstly attracted refiners, who have purchased oil forward, and possibly even prepaid, because they fear prices will rise.

This forced up the physical price of oil in the current 'spike' which will further kill off demand, while speculators have poured into the market to buy futures contracts, which producers have been only too happy to sell, in order to lock in high prices and insure against a collapse.

It is only a matter of time before this spike ends as the market turns, and at this point there is literally nothing holding the market up.

Inventories
Private inventories are at record lows, and this is mistakenly taken by commentators as a sign of demand. The reality is that traders will only store oil if they are able to afford to store it and sell it at a profit. The problem is firstly that many traders are being starved of credit by the banks, which will make it difficult for them to act as a 'buffer' through buying surplus oil

Secondly, the market is in fact in backwardation, which means that holding oil costs traders money, and if producers have cash flow problems, they too have an incentive to sell at a discount.

Refiners' Demand for Oil
No investment bank with oil funds to sell you will ever come up with any reason why oil prices will ever go down, but their faulty economic logic can reach laughable proportions.

For instance, falling demand for products in the US and EU has seen massive closures of refineries, to the extent that some 2m barrels per day of US East Coast refining capacity has closed.  This is of course good for the refineries left standing since it can create local shortages and opportunities for high margins and profits.

A very well respected investment bank analyst recently suggested in the FT that the resulting higher US gasoline prices would increase the demand for crude oil and hence - surprise, surprise - was bullish for oil prices. What he was ignoring was that all of the crude oil which used to go to the refineries which had shut will be looking for another home.

By way of example, Hovensa joint venture refinery at St. Croix in the US Virgin Island, which use to receive 350,000 barrels per day from the Venezuelan state oil company PDVSA, has now closed. It is hardly likely that the PDVSA will now increase the price of their heavy crude oil when offering it to (say) the Chinese. The point being that oil refiners have been caught between the rock of a manipulated and inflated crude oil price and the hard place of cash-strapped consumers.

So in a nutshell, demand in the West is dropping like a stone. I do not believe for a minute that demand for consumption in the East will make up the slack. In my view much of that demand (if not wishful thinking and hand waving by analysts) is financial, being the building of strategic reserves and refinery stocks as a physical hedge.

It will be seen that the effect of Prepay on the oil market has been to create a parallel financial market in 'paper oil' which means that most participants are completely misled as to the true state of the market.
In summary, as I previously outlined, my analysis is that the oil market stands like an Oil-e-Coyote - running hard beyond the edge of a cliff, but not having yet looked down.........

Window Dressing Enron
For those with short memories Enron fraudulently concealed their financial position from investors and the rest of the world through a variety of sophisticated techniques.

One of the most egregious was the use of prepay transactions with investment banks via a special purpose vehicle in a tripartite agreement which essentially misrepresented what was in reality a loan as a forward commodity purchase and sale.

In other words, Enron - facilitated by investment banks - was window dressing its balance sheet and fraudulently misleading investors and counter-parties alike.

Window Dressing the Oil Market
It appears to be the case that BP and Goldman Sachs have for many years been directly or indirectly enhancing BP's balance sheet and cash flow through enabling BP to lend oil to passive inflation hedger investors and in return obtain interest free dollar funding and literally monetising oil.

Possible accounting legerdemain by BP is one thing, but the greater problem by far has been the effect of passive investors entering the market en masse via this route.  As I explained, these transactions have eroded the foundations of the oil market, which have become entirely financialised and have lost touch with the reality of physical production, consumption and storage.

The fact that oil market inventory has been prepaid in this way creates a two tier physical market, where the tiny minority who have knowledge of the resulting 'Dark Inventory' of oil in temporary investor ownership have a massive advantage over the majority who do not and who enter into derivative contracts upon a completely false assumption as to physical supply and demand.

Whether or not this is illegal, and if so, in what country, is an interesting question.  But as a former head of regulation of a global energy exchange I have no hesitation in saying that the result has been a complete perversion of the oil market, which has become, for maybe as long as ten years, in every sense a 'False Market'.

The sheer scale of this oil market manipulation, and the staggering sums involved, make Yasuo Hamanaka's ten year $ multi billion copper market manipulation for Sumitomo look like a car boot sale.

If my analysis of the oil market is correct, many if not all prepay transactions have been terminated in recent months as passive investors have pulled out and the market has become free again of Dark Inventory. However the oil price has been kept inflated by a massive wave of speculative buying attracted by rhetoric and noise re Iran.

With the market's underpinnings eaten away by fulfilment of these pre-paid contracts (which will temporarily depress physical demand), a collapse in the oil price is inevitable once speculators exit.  After this, perhaps steps may then be taken by producers and consumers collectively to free the oil market from the pernicious control of middlemen, and to completely reconfigure the market through a new settlement.

I'm not holding my breath, but I do live in hope.

Author's Note:

Before once again being assailed by Peak Oil proponents as a 'denialist', I am completely convinced of the proposition that crude oil is finite and that there is a maximum level of crude oil production, which we have either reached or approached.

The problem is that current markets are operated and manipulated by and on behalf of intermediaries with a vested interest in volatility and extraction of profit at the expense of producers and consumers.

The requirement is for a new and equitable dis-intermediated market architecture where carbon fuel prices are maintained at the level where demand destruction sets in, but where part of the surplus is reinvested in renewable energy and energy savings with a view to reducing future demand for carbon fuels.

Display:
A very interesting post on Tuesday demonstrates a classic spike as Managed Money goes long oil.

These 'smoking gun' figures show the ratio of long vs short open interest in the CME's (formerly NYMEX) US West Texas Intermediate crude oil contract which is held by 'managed money'.

A few comments.

Firstly, financial investors have never had an investment position more skewed in favour of gambling that the WTI oil price is going up.

Secondly, the CFTC does not distinguish between the 'passive' investors - whose long term aim to avoid loss keeps this ratio positive at all times - and the active speculators aiming to make a transaction profit who cause the spikes.

Thirdly, it is clearly seen that there was a speculative spike last year after the Libya supply shock, but that this is less than the spike currently generated by the Iranian noise now.

Note also - the dog that did not bark in the night - it will be seen that there was no speculative spike back in 2008. That spike was purely down to proprietary trading and manipulation by the usual suspects at a time when they still had a balance sheet to gamble with.

So who's now taking the other side of these mug punters suckered into the market?

The answer is that producers are selling futures to lock in this superb price while they can, and they are doing it either directly, or 'over the counter'.

The swap dealers - ie the investment banks, mainly - are, as above, simply no longer capitalised to take market risk themselves: so the record 'short' position they hold will be simply them laying off the risk from the above-mentioned OTC short positions.

This market is - absent massive supply shortfalls - going down. I suspect that the people orchestrating this are hoping to manage the decline over months so that the gasoline price is at comfortable levels in good time for the election.

But I think that there is a significant chance that there could be a collapse which takes down the fragmented clearing houses which are IMHO under-capitalised for the fat-tail risks they actually run.

Especially if buyers like China wake up to the fact that they could - if they wished - actually fill their strategic reserve at $60/barrel or less rather than the current bubble price.

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

by ChrisCook (cojockathotmaildotcom) on Thu Mar 8th, 2012 at 10:45:54 AM EST
So, the spike in long positions in April 2011 is money managers doubling down on their bets, thus feeding the bubble. When they started to liquidate, the price of oil dropped $15 in a few days (early May). This time, mechanically, I suppose the drop has to be bigger (though this also depends on the quantities of money in the game I suppose, not just the ratios)

It is rightly acknowledged that people of faith have no monopoly of virtue - Queen Elizabeth II
by eurogreen on Fri Mar 9th, 2012 at 04:10:37 AM EST
[ Parent ]
Indeed.

Here's John Kemp again recently Sanctions risk return of 2011's flash crash making my point for me.

Interesting wrinkle was that on May 5th, the day of that crash, the exchange was prepared to allow trading to continue through the day's trading limit of a $10.00/barrel price move. ie what they call a 'limit down' price fall.

This essentially favours the insiders against the muppet speculators who exist for them to pillage.

Exchanges run by intermediary insiders for intermediary insiders will always change the rules against outsiders. That's why squeezes like the Hunt Brothers in silver will never work, and why when the price crashes next time they'll let it go as far as they can.

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

by ChrisCook (cojockathotmaildotcom) on Fri Mar 9th, 2012 at 10:59:21 AM EST
[ Parent ]
Is there any difference in the set of players between last Spring and now?  If so, that could tell us a lot about who wants to preserve the spike and what the spike's vulnerabilities are.
by rifek on Fri Mar 9th, 2012 at 02:26:47 PM EST
[ Parent ]
That's an astute question, which I do not have the data to answer completely.

The big difference I am aware of is that a lot of the long term 'passive investment' money underpinning the market has pulled out, potentially releasing inventory onto the market which has now reverted to producer ownership.

Other market vulnerabilities include decreased bank financing for trader inventory and a lot fewer refineries to consume the oil, although some say that new Eastern refinery capacity has taken up the slack...which is true up to a point.

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

by ChrisCook (cojockathotmaildotcom) on Fri Mar 9th, 2012 at 03:44:30 PM EST
[ Parent ]
There was one other item that drove prices up in 2008: The rolling weakening of currencies relative to commodities.  I say "rolling" because everyone initially thought the crisis was a US$ problem.  Then contagion set in as it became apparent how deep the rabbit-hole went.
by rifek on Tue Mar 13th, 2012 at 03:28:54 AM EST
[ Parent ]
Bombing Iran/closure of Hormuz is sure to be a live issue all the way up to the November US Presidential election.  So unless Obama can pull off some deal which dramatically de-escalates that situation, I don't see any inevitability about an oil price crash this side of November.  After November, certainly, but then the Republicans (if they win) will claim the credit...

Index of Frank's Diaries
by Frank Schnittger (mail Frankschnittger at hot male dotty communists) on Thu Mar 8th, 2012 at 02:11:42 PM EST
Frank, in my view a deal has already been struck and been activated now that Khamenei's faction have politically thrashed Ahmadinejad's faction.

Iran's invitation to the 5 plus 1 followed immediately that election was done and dusted, because the current currency wars are really hurting. Forget oil sanctions, which are completely counter-productive, and will benefit China at the expense of Iran, Greece and Italy in particular.

I know that Marc Rich was in Tehran not long ago - and it wasn't to take the air or go clubbing, but because he was a trusted third party bearing messages (at 77 his sanctions-busting days are over I think).

After that - as the excellent M K Bhadrakumar wrote - Obama got Iran right, finally and we saw unequivocal public statements of part of an agreed position.

My reading is that the two sides have agreed firstly that Iran will verifiably ensure no nuclear weapons, and secondly, by way of exchange, the US will have tacitly agreed not to seek to impose regime change, and will wind down the sanctions. The rhetoric noted by Bhadrakumar - who has finely tuned diplomatic antennae - IMHO immediately followed Mr Rich's exchange of the 'red lines' between the two sides.

I think that the US plan is that there will be a managed decline in the global oil price and hence the US gasoline price.  The interesting thing about this strategy is that it not only acts as a domestic US pre-election boost, but also  has the effect of opaquely squeezing Iran, Russia and Venezuela.

It does so in such a way that their populations will blame their governments - and not sanctions - for the economic troubles (and maybe even voluntary regime change) that will follow out of the operation of 'market forces'.

As for Israel, they've benefited from taking the US spotlight off what is essentially a right wing real estate play - backed up by religious fundamentalist  'useful idiots'.

I doubt whether the pragmatist chess players who run Israel Incorporated have ever thought for a minute Iran is after nukes.

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

by ChrisCook (cojockathotmaildotcom) on Thu Mar 8th, 2012 at 04:35:41 PM EST
[ Parent ]
I agree with all of what you say, but see no sign of that reality penetrating the fog of US electoral politics which is all about scaring the shit out of people with talk of a nuclear Iran and squeezing them with gas prices. Obama needs some kind of public reconciliation with Bibi/Khamenei for people to realise there is a new game in town and I'm not sure Bibi/Khamenei can deliver on that...

Index of Frank's Diaries
by Frank Schnittger (mail Frankschnittger at hot male dotty communists) on Thu Mar 8th, 2012 at 05:14:50 PM EST
[ Parent ]
My point is that oil and gasoline prices are going down in the next few months (planned) or much sooner (unintended consequences of an out of control and fragile system).

I think Bibi is bluffing, because I don't think either Big Money or Big Oil dances to his tune, and neither Big Money nor Big Oil IMHO sees economic mayhem and demand destruction respectively from >$4.00 gasoline as Iran IMHO without explicit US pre-clearance.

I think Iran will back off over the next few months with as much face as possible. Obama will take the credit for it, and will not make the 'Real Men Go To Tehran' mistake of insisting on regime change that the neocons did when Iran and Gadaffi both rolled over after US shock and awe in Iraq.

Finally, I think Obama has now made unequivocal statements re military action in the event Iran go towards a bomb and he is now on the front foot against the Republicans, being able to paint them as irresponsible war-mongers.  

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

by ChrisCook (cojockathotmaildotcom) on Thu Mar 8th, 2012 at 06:02:37 PM EST
[ Parent ]
...ooops. Should read.

I think Bibi is bluffing, because I don't think either Big Money or Big Oil dances to his tune, and neither Big Money nor Big Oil IMHO sees economic mayhem and demand destruction respectively from >$4.00 gasoline as in their interests.

Neither do I believe Israel will attack Iran without explicit US pre-clearance.

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

by ChrisCook (cojockathotmaildotcom) on Thu Mar 8th, 2012 at 06:05:08 PM EST
[ Parent ]
I was wondering about that.

Align culture with our nature.
by ormondotvos (ormond no spam lmi net no spam) on Sun Mar 11th, 2012 at 04:04:13 AM EST
[ Parent ]
The PR echo chamber that is the US political media does not turn on a dime.  It has to phase out its drum-beating on Iran while it queues up the next bloody shirt to wave before the public.
by rifek on Fri Mar 9th, 2012 at 02:35:48 PM EST
[ Parent ]
Perhaps Rich was there to reintroduce Shiraz vineyards.
by rifek on Fri Mar 9th, 2012 at 02:29:50 PM EST
[ Parent ]
At least VPP is defined. What the hell is FFFO? I need to know the words that are the basis of the acronym to get this to work in my head. I know it is not your text, but hope you have a better than a guess as to what they are talking about.

As the Dutch said while fighting the Spanish: "It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Fri Mar 9th, 2012 at 01:09:13 AM EST
All that comes to mind for the third 'F' is some form of the obvious obscenity.

As the Dutch said while fighting the Spanish: "It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Fri Mar 9th, 2012 at 01:11:46 AM EST
[ Parent ]
Actually FFFO is the 'Funds Flow From Operations' Free Again referred to earlier. By the way, I have a sneaking feeling that this commenter may well have been an Enron insider (in every sense). The clue may be in the nom-de-plume.

"The future is already here -- it's just not very evenly distributed" William Gibson
by ChrisCook (cojockathotmaildotcom) on Fri Mar 9th, 2012 at 05:06:58 AM EST
[ Parent ]
Of course you are citing a discussion between insiders on FT Alphaville, and they all know the terms they are using. I was imagining Forward Finance Operation as three of the Fs and I skimmed over the body of the text twice trying to find something that defined the term - to no avail, obviously. It is a personal opinion, but when writing for non specialists it is advisable to explicitly spell out acronyms at the first mention, not just to use the term once prior to using it a paragraph later as an acronym. In the above case the author presented it as a phrase with caps. Had that been followed by (FFFO), thereby signaling that it was to be used as an acronym, it either would have stuck or could have more easily been caught in a re-read. Perhaps I am more dense than most, but it is a recurring irritant. :-)

It was annoying as the whole post was fascinating and illuminating to me, otherwise. Thanks for putting it up and your subsequent patience.

As the Dutch said while fighting the Spanish: "It is not necessary to have hope in order to persevere."

by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Fri Mar 9th, 2012 at 07:48:12 PM EST
[ Parent ]
In early 2009, risk averse money poured into the commodity markets, and a large portion of it flowed in to passive funds such as Index Funds and Exchange Traded Funds investing wholly or partly in oil. Units in these funds are created, and some unit issuers then entered, via investment banks, into prepay agreements with producers.  

Producers obtain dollars interest-free in exchange for transferring title to oil inventory to the investment bank, and what this means is that the producers do not need to sell as much physical oil to refiners, who must therefore raise their bid price to secure supply from producers, and this is why the price rose rapidly in early 2009 even though the market was not under-supplied.

The second effect was that the demand for forward contracts for the producer to buy the oil back again drove the forward price higher, and this created what is defined as a 'contango' market. In fact, it was so pronounced it was called a 'super-contango'.


Back in April and May of 2008, when commodity investment portfolios were all the rage and people were being urged to put their money into something real and physical, such as oil, agricultural goods, gold, etc. it seems obvious to me that this would raise the price of the commodity in proportion to the inflow. I just didn't know the precise mechanism. This seems likely to be the substance of it.

To paraphrase Charles Gaylord Parkinson: "Prices will rise so as to absorb the money available for 'investment'." Unfortunately for many 'investors', including CALPERS, this proved a 'roach motel' for investments, but, fortunately, it was less than 50% efficient, so they only got a serious haircut in July and August of 2008. But it did serious damage to many retirement funds. We do a better job of preventing children from getting into unattended swimming pools.  

As the Dutch said while fighting the Spanish: "It is not necessary to have hope in order to persevere."

by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Fri Mar 9th, 2012 at 01:25:03 AM EST
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.

Since October, money managers have bought the equivalent of 372 million barrels of oil through a variety of futures contracts, essentially doubling their oil exposure.

Surprisingly thoughtful, coming from Bloomberg.

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

by eurogreen on Fri Mar 9th, 2012 at 04:14:22 AM EST
Not bad. Bloomberg and Reuters are normally quite good.

But these WTI contracts are almost entirely bets.

It is forward physical supply contracts - particularly those entered into in respect of the rapidly declining number of cargoes of Brent/BFOE quality North Sea crude oil - which are driving up the global oil price. The WTI price level is related to that Brent/BFOE price by arbitrage.

These futures contracts allow producers to lock in the price - the supply contracts with buyers are almost invariably made separately, and indeed the Brent/BFOE futures contract is not deliverable at all. Note also that alongside the speculators there will also be refiners hedging themselves against a rise in prices.

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

by ChrisCook (cojockathotmaildotcom) on Fri Mar 9th, 2012 at 05:00:33 AM EST
[ Parent ]
More content in one discussion than a month of WSJ...

Align culture with our nature.
by ormondotvos (ormond no spam lmi net no spam) on Sun Mar 11th, 2012 at 04:08:53 AM EST
Izabella Kaminska ties this theme up rather nicely :

FT Alphaville

Why, oh why is Saudi sending so much oil to the United States? Everyone, as Reuters notes, was expecting imports destined to US refiners to fall. [snip]
 One man has a theory. Chris Cook, a senior research fellow at the Institute for Security and Resilience Studies at University College London, in a series of posts on Naked Capitalism, has discussed the idea that some of these "sales" may in fact be deliveries satisfying pre-paid transactions.

Neatly summed up, the idea is that these may be deliveries that were already sold to the market by intermediary banks in bilateral deals on behalf of producers back in the days of contango madness, completely off radar and off balance sheet. That the likes of Saudi received $$$ (or, interest-free loans) for the barrels long ago.

And she links a Saudi production graph from the Oil Drum :

FT Alphaville

A huge cut in Saudi production post-2008 would have translated into an equally huge cut in sovereign revenues. If a country like Saudi wanted to keep its revenues steady, pre-pay deals -- effectively borrowing from your future oil sales -- would have have made a lot of sense.  At the very least, it would have helped Saudi stomach the financial burden associated with cutting production to stabilise the oil-price crash.

It's also worth pointing out that these sorts of pre-pay, sale and repurchase "repo" deals would have been in line with Islamic financing models  -- where interest is replaced by the profit that can be earned from the ownership of the commodity instead.

It all makes sense to me. And the timing fits in nicely with Obama's need to bring down the gas price in time for the elections.

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

by eurogreen on Mon Mar 19th, 2012 at 07:13:31 AM EST
It's also worth pointing out that these sorts of pre-pay, sale and repurchase "repo" deals would have been in line with Islamic financing models  -- where interest is replaced by the profit that can be earned from the ownership of the commodity instead.

Traditionally, one way to get around religious regulations against lending at interest was to quote different prices for immediate and deferred payment. Pay cash, enjoy a discount is the same as charging interest for paying later, but passes religious muster.

There are three stories about the euro crisis: the Republican story, the German story, and the truth. -- Paul Krugman

by Migeru (migeru at eurotrib dot com) on Mon Mar 19th, 2012 at 08:04:01 AM EST
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