Posted by: cjenscook | 08/04/2009

Last Chance Saloon

On the face of it, the investment proposition of ETFs invested in energy is as simple as it gets – a 50/50 choice – do you think energy prices are going to get more expensive, yes or no?

The problem with ETFs is how they work. This 50/50 bet may take place on exchanges – NYMEX and ICE – which are essentially casinos. If ETFs are unable to participate on exchange traded derivatives, then their only option is to enter into “Over the Counter” swap contracts with trading intermediaries. The price upon which these contracts are based or “derived” comes from the wildest game of all – the Brent/BFOE Complex of contracts in North Sea crude oil.

The BFOE Last Chance Saloon
The actual global benchmark price for crude oil has nothing to do with exchanges: they are the visible tail of an invisible dog.

The price is based upon prices reported by Platts in respect of “Dated” cargoes of 600,000 barrels of BFOE quality (oil from the Brent, Forties, Oseberg and Ekofisk fields in the North Sea) available for “spot” delivery. Over 60% of world prices are set directly against this benchmark, while most of the rest is priced indirectly through an “arbitrage” taking place on the ICE Europe platform between their BFOE contract and their “clone” of NYMEX’s WTI (West Texas Intermediate) contract.

Neither the ICE Europe BFOE futures contract nor their WTI contract are physically deliverable but are both essentially financial bets in respect of underlying market prices. The BFOE contract is based upon the price of the BFOE forward contract – known as the “21 Day” contract due to its delivery cycle – which allows BFOE producers to sell their production forward, and this in due course gives rise to “Dated” deliveries of cargoes.

North Sea production is in secular decline, and there are now only about 70 BFOE cargoes per month produced worth, at current prices, around $3 billion. It will be seen that it is well within the financial capability of major traders such as BP, Goldman Sachs, Shell, Vitol, Phibro, to secure enough cargoes – via purchasing 21 day BFOE forward contracts – to jerk the short term market price around at will.

It is even possible that with a self-fulfilling campaign of manipulative price forecasts, judicious intervention, and leverage based upon hundred of billions of dollars in ETF investment in the market, it would be possible to engage in medium term price manipulation. In the long term, of course, supply and demand for physical oil will set the price, but in the short and medium terms, volatility is caused not by ETFs but by speculative activity by trading intermediaries.

What are the Odds?
The first thing energy ETF investors need to know is, what are the odds they face?

Well, the first factor – entirely negative – is the cost of trading, which has three components: firstly management costs, which are reasonable compared to actively managed funds; secondly, commissions, which may be pretty minimal, but add up, since positions “roll over” once a month; and finally the “dealing spread” paid when the ETF sells (say) January crude oil futures at a counter-party’s bid price, and buys February futures at the counter-party’s offer price.

The second factor is the wild card of the market price structure. If the market price is in contango – ie nearby months cost less than later months, then the ETF loses money when it rolls over month to month. Conversely, if the market is in backwardation then the ETF makes money.

The final factor is the return ETF investors receive in respect of their cash balances.

So the return from an energy ETF isn’t as simple as it looks.

What’s happening in the Casino?
In casino parlance, an ETF is a “whale” – a big player. Unfortunately, it’s looking like the casino regulators – the CFTC – are about to limit the maximum bet by imposing position limits and obliging ETFs to go to a private OTC swap game if they want to play.

Energy ETFs are – as marketing literature makes clear – actually an “inflation hedge”. ETFs offload the price risk of money, and take on the price risk of energy. ETFs are prepared to buy futures every month when producers hedging price risk of production wish to sell. Better still, they may do so at levels which are advantageous for both compared to those available from the trading intermediaries who own and control the casinos.

The only market participants capable of manipulating the physical market price of oil in the real world are those capable of making or taking delivery, and ETFs are categorically unable to do so.

Does anyone seriously think that if exchange position limits were good for ETF investors that investment banks would go along with them? They know that limits will drive ETFs straight into the BFOE Last Chance Saloon.

The “London Loophole” gleefully jumped upon by uninformed US politicians simply does not exist. The real problem is the global “Physical Loophole” in the actual market in real, not paper, oil. Why is GLG – noted as one of the smarter hedge funds around – setting up a physical energy operation? Because that’s where the money is.


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