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The Oil Market is dead! Long live the Oil Market!

by ChrisCook Wed Oct 26th, 2011 at 06:17:27 PM EST

Just by way of a follow on to my more general post, here's a more specific post in respect of my home turf, the oil market.

Which in my view is approximately here

The Oil Market is Dead! Long Live the Oil Market!

It is said that history never repeats itself, but it does rhyme, and there are disturbing signs that 2011 is about to echo 2008.

In order to understand what has been going on in the oil markets it is necessary to understand how the market works, and the changes that have taken place in recent years.  

The oil market has come to be dominated by intermediaries ie middlemen who put their capital at risk in search of a profit in dollars, which is the global price reference currency for oil trading.  Unlike the 'end user' producers and consumers, intermediaries have a vested interested in moving prices - for them, market price stability is death, whereas for end users price stability is necessary in order for them to budget and to invest.

A Marriage is Arranged
What changed in the early 90s was the entry of a new type of fund which enabled investors to take and hold medium and long term positions in the oil market.  The first of these was the Goldman Sachs Commodity Index (GSCI) fund.

The stroke of marketing brilliance which accompanied the GSCI was to call this investment a 'hedge against inflation' and to market it to risk averse investors.  ie to investors wishing to preserve their wealth against a  decline in value of the dollar relative to commodities.

The GSCI took a long term position across organised markets of which the largest was in crude oil and it did so through buying, and rolling over from month to month, crude oil futures contracts.  The smartest kids on the block soon came to appreciate exactly how much this gave them tactical/micro and strategic/macro advantages.

The tactical advantage was that their discretion over exactly when and how this position was to be rolled over gave them an edge over the other players. The strategic advantage arose out of their realisation that the GSCI was taking a long term position in the market which was precisely opposite to that of oil producers who wish to protect themselves by 'hedging' against a fall in crude oil prices through selling crude oil futures contracts, and rolling over that hedge from month to month.

In the jargon, GSCI was structurally short while a producer like BP was structurally long.

So in the mid nineties, BP and Goldman Sachs got married.  For 12 happy years they were joined at the head, by the same chairman, Peter Sutherland, while BP's Lord Brown sat on the Goldman Sachs board for much of this highly successful period.  During this Happy Time (the phrase used by U-boat captains when sinking  huge numbers of ships before convoys were implemented) both BP and Goldman Sachs made massive profits - no-one will ever know exactly how much - from this relationship.  

BP was essentially monetising their stocks, and even reserves, of crude oil and this gave both Goldman Sachs and BP a monumental trading advantage over other players through what is essentially ownership of stocks which is invisible to the market.

This has been termed Dark Inventory

Bubble 1.0
The GSCI fund grew relatively slowly over the years, but eventually other market players caught on, and in 2005 Shell entered into a relationship with an issuer of this new breed of Exchange Traded Funds (ETFs) called ETF Securities.  This perfectly transparent relationship enabled investors to invest directly in Shell's stocks, which provided cheap funding for Shell, and enabled investors to avoid being pillaged in the futures market casino as they rolled positions over month to month.

Other funds sponsored by banks preferred to form Dark Inventory, and set up trading operations in order to manage the process, and this enabled them to make easy profits through what is euphemistically called  'information asymmetry'. Accompanied by increasing tightness of supply in the physical crude oil market the price gradually rose from 2005 as money moved into the market and Dark Inventory built.  This rise was ramped by hype from market players, who interpreted virtually any news as being positive for the crude oil price.

The classic example was the way that restrictions on supply of crude oil products - which increased their market price - were used, through faulty economic logic, to justify a rise in the price of crude oil prices.  The truth is of course that restrictions on products reduces the demand for crude oil to refine, and logically it should have led to the fall in crude oil prices which would have occurred without the presence of purely financial buyers in the market who swallowed the faulty economics.

As a market observer who agrees with my analysis points out, the crisis in refining is indicative of the fact that something is artificially supporting input costs... and it's not end demand. In any other industry, people would conclude that the situation is not sustainable.

This macro strategy became a victim of its own success, since it turned out that there was in fact a limit to how much inventory was available to be darkened, and crude oil prices rose to levels at which the demand for products became affected.  At this point, several market players who took a view that market prices must fall made big bets by selling futures contracts.  Unfortunately for them, they were unaware of the Dark Inventory and they were 'squeezed' by those who knew where the treasure was buried, which caused a spike' in the oil price to $147/barrel.

The market then collapsed, and when frightened investors pulled money out of the funds in late 2008, the market price fell as low as $30 per barrel.

Hubris - Bubble 2.0
Bubble 1.0 had been hugely profitable for producers generally, of course, and the collapse in prices caused them all enormous financial problems.

But then the 2008 credit crash came to the rescue.  The Federal Reserve Bank's monetary policies of zero dollar interest rates and massive printing of dollars drove a massive wave of inflation hedging demand into all organised commodity markets and particularly crude oil.  The fund industry urgently needed to find much greater pools of crude oil stocks and reserves to create the necessary scale of Dark Inventory.

My thesis is that a geo-political deal was struck between the US and Saudi Arabia, no doubt facilitated by the smartest brains that money can rent.  A maximum price level (a cap) was set to prevent politically unacceptable US gasoline prices, and a minimum (collar) price was set to provide the Saudis with a politically acceptable budget.  This strategy worked, as the price rose and became pegged to the dollar; OPEC meetings became incredibly boring; and the Saudis essentially acted as a global oil bank, who were printing oil, rather than dollars.

But this strategy was always an unstable equilibrium, like a Roll on Roll off ferry steaming along through calm seas, but with the bow doors open, and water swilling about on the car decks.  In March 2011 two big waves hit - one literally.  Firstly, there was a supply shock as large amounts of best quality Libyan crude oil supply was cut off, and secondly, there was a demand shock as Japan shut down nuclear power and replaced it with increased demand for carbon fuels.

These shocks saw genuinely speculative money pour into the oil market which drove the US gasoline price to politically dangerous levels, and led to expedients such as the release of strategic stocks by the IEA.

Then the Federal Reserve Bank turned off the money tap, as it ended its quantitative easing programme, and I agree with those who say that Bernanke is reluctant to implement another QE3 round because he fears negative rates, and debt deflation above all else.

What this meant for the oil market was that new Dark Inventory stopped being created.  Meanwhile, as producers continue to sell their own production and inventory at inflated prices, they take windfall dollar profits out of the markets.  So the funds which actually own this Dark Inventory now have massive unrealised losses which they can avoid only if physical demand picks up; QE3 and financial demand restarts; or they can find a greater fool to buy their Units.

This means that the new buyers necessary to keep the market price inflated in future have withdrawn  This led to future prices sagging below current prices, a state of affairs known as a Backwardation.  Moreover, recent market turmoil has seen a stampede back to the dollar. In September, $9 billion was withdrawn from commodity markets by index funds. The collapse of commodity prices in late 2008 was associated with just such an outflow of commodity market fund money.

A collapse in oil market price is actually under way, and in the Bizarro world of Dark Inventory, market participants working on conventional market assumptions mistake apparent demand for real demand.

So if a market participant buys Brent/BFOE forward contracts, physical market traders may be blithely unaware that the buyer is ending a lease agreement and repurchasing oil they have already sold.  Traders are suckered by illusory market demand into a forward sale, and then find themselves 'squeezed' and having to buy back their contracts at a loss, which 'pops' the price briefly upwards, which is precisely what happened in 2008.

Investment banks are like submarines: they are a beautiful piece of engineering, but they sink ships.  They have had two successive Happy Times, and it's time to end the war.  If the oil market collapses, as I confidently predict, it will have far-reaching effects, not least a regulatory disaster as the risk averse investors in these 'inflation hedging' funds claim that they were never informed of the true risks they were running and the extent to which they were being pillaged by the casino.

They did not realise that they had inadvertently caused the very inflation they sought to avoid: an example of Soros's reflexivity in action.

This oil price collapse is a necessary step on the path to a next generation of networked and resilient oil market where middlemen transition to a role as 'capital lite' market service providers.

The Oil Market is Dead: Long Live the Oil Market!

Back in the spring of 2008, when I saw columns in Barron's touting commodity funds, especially in oil, as "investments in real products" to investors concerned with inflation, and when I saw some indication of  the volume of retirement fund $$ going into these funds it seemed obvious to me that these dollars were the "air" inflating a big bubble that had to pop. But I did not understand the mechanism. I recall asking you if the producers were, in effect, taking the money and storing the oil in the ground and you responded that it seemed likely. One would think that the burns that CALPERS and other pension funds took in 2008 would have taught people a lesson. Obviously not.

The mechanism for the producers to profit from the whole process is that they can use it to keep the price at the demand destruction upper boundary of the trading range for a much greater portion of the time while their superior knowledge of market dynamics enables them to also profit on the down swing through superior timing. It seems like this involves what is effectively a short on futures contracts when they know price is due to decline. But the exact mechanism eludes my tiny brain. (There is a reason I stay out of this stuff.)

"It is not necessary to have hope in order to persevere."

by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Wed Oct 26th, 2011 at 09:43:52 PM EST
Petrol here in Australia is still bloody expensive as it is priced at Singapore. Why so much difference between brent/WTI and Singapore prices ?
by fredouil (fredouil@gmailgmailgmail.com) on Thu Oct 27th, 2011 at 01:27:12 AM EST
Perhaps it has something to do with this:
FTA Turns Indonesia's Trade Surplus With China Into Deficit

JAKARTA, July 30 (Bernama) -- The implementation of its Free Trade Agreement (FTA) with China has turned Indonesia's trade surplus with the former into a deficit of US$3.61 billion, a chamber of commerce and industry official said.

There are winners and losers with free trade agreements. China has obviously won WRT Indonesia, so China gets better terms of trade with Indonesia and that drives up the cost of oil from Indonesia for Australia. Same for oil from all other ASEAN countries. Cheap consumer goods from China = expensive oil for other ASEAN oil importers.

Oil from Alaska goes to Japan by long habit and short transport distances. Oil from Saudi Arabia to the USA by long habit and in exchange for security considerations.  to China might not be able to get a very good price for its goods from the USA but, as the old joke goes, it makes up for it in volume. But, in this case, this enables China to accumulate huge reserves of US$ which gives it an advantage with other Western Hemisphere oil exporters via its ability to provide investment funds in the (still) world reserve currency, which buys China preference as an oil export destination. With others getting the good deals on oil, Australia gets bad deals, especially as it imports about two thirds of its oil.

Australia is a net exporter of LNG and is developing new fields offshore. Perhaps an LNG-hybrid power plant for trucks and automobiles would work for Australia. And, of course, renewables would help, especially with plug-in hybrid vehicles.  

"It is not necessary to have hope in order to persevere."

by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Thu Oct 27th, 2011 at 11:44:29 AM EST
[ Parent ]
A collapse in oil market price is actually under way

On what time scale? What I see is a noisy retreat from the Libya/Tsunami spike. Plausibly, this would bring us back to the Saudi target price band of $80 to $100.

If you posit that the collapse is under way, what metric do you base this on?

BLOCKQUOTE>So the funds which actually own this Dark Inventory now have massive unrealised losses/BLOCKQUOTE>

Is this a mechanical effect of the decline in prices since the spike? Are they holding overpriced oil futures? Sorry if these are naive questions, but they are important to the understanding of the narrative.

Izabella Kaminsky at Alphaville seems to be on your wavelength. Here she describes strategies of dark-inventory holders :

FT Alphaville » The power of the dark inventory

Overall, your profit-taking strategy will see you dumping stock in rising markets, and buying in falling ones. Risk on, risk off. Your accumulation and dispensation of assets will be counter-intuitive to market sentiment.

But since not everyone is a believer in the rally, shorts will also be accumulating. These shorts will serve you well when you want to give the market a pop. Every time there is even a whiff of a fall, you will try to overcome the shorts with large buy orders, shaking them out, or ideally causing some genuine squeezes.

The danger comes in over-estimating the size of the shorts and having your dump-and-buy strategy overwhelm the market. With no shorts for support, and no other buying interest present in the hugely thin public market, the proverbial floor will be lifted. The result, of course, is a flash crash-esque price crash, which won't recover until the second leg of your strategy -- the continued buying bit -- kicks back in.

But the strategy does have one major vulnerability -- it only works for as long as you have access to cheap financing for the accumulation and maintenance of your dark inventory in downside markets. If you run out of financing, you will be restricted on how much more stock you can buy to support the market. This is especially the case if you can no longer find appetite for your off-balance sheet vehicles.

... I think I'm starting to get it... I don't see how the end of QE mechanically creates unrealized losses, but I can see where decline in demand will create a snowball effect.

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

by eurogreen on Thu Oct 27th, 2011 at 12:51:41 PM EST
The actions of dark inventory holders described by Kaminsky in the Alphaville post seem pretty consistent with what has been happening in the Precious Metals markets, but, presumably, without the dark inventory. That is why a fail in PM markets would be harder. Allegedly, certain players are using naked shorts, with the aid of Central Banks in the form of ZIRP money, to hold down the price. They may be paying for their losses on the down side through calls on upside moves in paper markets.  

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Thu Oct 27th, 2011 at 05:06:42 PM EST
[ Parent ]
She's commenting a Reuters column, which discusses various possible causes for the downtrend in oil prices over the past few months, while most of the "serious money" expects the price to rise :

FT Alphaville » "Something structural has changed in current fundamentals"

But if there is one indicator of "another" story to be told, we would say it's this one:

The ratio of long to short position of managed money is still a very bullish 3:1 in light sweet crude, but it's nowhere near the 10:1 ratio we saw in April/May just before the US debt ceiling debacle shenanigans began in earnest, and before QE came to a chortling end in July.

That peak in the ratio happens to in coincide with when the down trend in crude prices began.Which is not surprising since it ties with a swift reduction in the length controlled by `managed-money'. If that length was the flip side to commercial shorts... and if their view didn't change quite as quickly, it's unsurprising that it translated to the choppy volatility we have seen since March and April. Physical wants to sell futures at a higher price than there is demand to supply futures, from managed money. That's naturally either going to translate into a choppy ride lower on the flat price as futures converge with the physical (if the curve is to remain intact) or see the curve backwardate until the excess supply built up to support that managed money is flushed out.

So, there's lots of managed-fund money with long positions, in an unsteadily falling market. Chris tells us that QE was instrumental in inflating prices; is the absence of QE enough to drive them down, while physical supply is still tight? So it would seem.

But for a true collapse, there has to be a tipping point where the managed money seeks to cut its losses. Probably triggered by something else entirely?

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

by eurogreen on Fri Oct 28th, 2011 at 11:24:53 AM EST
[ Parent ]
Chris, i assume you didn't miss this, but in case, FT Alpha I thought I saw a backwardation

If the rolls had diminished in size, it's fairly possible that not all shorts usually positioned to take advantage of the "elephants in the room" would have been able to cover their positions profitably. That being the case, outstanding shorts may have been accumulated. Many might even have been left outstanding until the moment the second-month contract became the first month, on the hope that the usual convergence with the physical reality (still oversupplied) would have allowed one last chance to avoid a loss.

If that failed, there would naturally be a rush to cover any remaining shorts (which would now be situated in the front month contract) -- a move which may then have squeezed genuine "bearish economy" positions leading to the backwardation flip we experienced on Monday.

It's beyond me.

"Life shrinks or expands in proportion to one's courage." - Ana´s Nin

by Crazy Horse on Thu Oct 27th, 2011 at 04:16:18 PM EST
If you've never sat in your shorts in a room full of elephants, there's no way you can understand.
by afew (afew(a in a circle)eurotrib_dot_com) on Thu Oct 27th, 2011 at 04:31:51 PM EST
[ Parent ]
well, I've accumulated some outstanding shorts in my time, but I've never had occasion to position them in order to take advantage of elephants. Nor am I adventurous enough to squeeze genuine bears, or perform backwardation flips.

It is rightly acknowledged that people of faith have no monopoly of virtue - Queen Elizabeth II
by eurogreen on Thu Oct 27th, 2011 at 05:43:43 PM EST
[ Parent ]
Analysis - BP, rivals signal rising oil prices over long term | Reuters

(Reuters) - An increasing number of oil companies are likely to see $100-a-barrel oil as the new norm, a sign the price floor is moving up over the long run and a trend that could give a boost to stagnant merger activity in the industry.

The long-term price view of oil giants such as Royal Dutch Shell (RDSa.L) tends to be conservative because it underpins the planning of projects whose life can exceed half a century. Only a decade ago, the industry made its plans based on an oil price assumption of around $25 a barrel.

Since then, the likes of BP Plc (BP.L) have more than tripled their estimates and are now signalling that oil at $100 a barrel might be a new long-term reality.

"I think you'll find more and more people in the industry using numbers of $90 to $100 a barrel going forward," BP Chief Executive Bob Dudley said this week, replying to a question on the price BP needs to turn a profit from new projects.

Corporate propaganda?

by afew (afew(a in a circle)eurotrib_dot_com) on Thu Oct 27th, 2011 at 04:29:29 PM EST
Wishful thinking. Have you seen the profits the oil companies posted today?

It is rightly acknowledged that people of faith have no monopoly of virtue - Queen Elizabeth II
by eurogreen on Thu Oct 27th, 2011 at 05:45:02 PM EST
[ Parent ]
Correct that the long term price is up.

Of course, profit from new projects, which may take ten years to come on stream, is one thing. Profits on existing production at those price levels is quite another.

If producers can support prices, they will. That is undoubtedly why BP and Goldman Sachs started their inflation hedging/dark inventory partnership, and in addition to knowing where a lot of treasure is buried, there's barely a barrel moves, or scheduled to move, that they don't know about.

I believe between them they have probably benefited from the most profitable 'macro' market manipulation ever seen. And I hasten to add that I am sure they have taken care to do so entirely within the law.

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

by ChrisCook (cojockathotmaildotcom) on Thu Oct 27th, 2011 at 05:53:45 PM EST
[ Parent ]
Despite all the economic data pointing in the same direction (downwards), oil prices surged overnight... on a rumour that the US monetary authorities are planning more quantitative easing to combat unemployment.

Which would seem to indicate that QE favours higher oil prices more than it favours employment, the two being in contradiction.

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

by eurogreen on Wed Nov 2nd, 2011 at 06:56:53 AM EST

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