Posted by: cjenscook | 10/26/2011

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 by 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 every 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!


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