Wednesday, January 11, 2012

The Coming Collapse in Crude Oil Prices (GS)

Probably up first to set the trap, then down.
We last visited the writer, Chris Cook, in 2009's "Oil: the Market is the Manipulation" which is still worth a read.
Here's his most recent via naked capitalism:
Naked Oil
By Chris Cook, former compliance and market supervision director of the International Petroleum Exchange

All is not as it appears in the global oil markets, which in my view have become entirely dysfunctional and no longer fit for its purpose. I believe that the market price is about to collapse as it did in 2008 and that this will mark the end of an era in which the market has been run by and on behalf of trading and financial intermediaries.

In this post I forecast the imminent death of the crude oil market, and I identify the killers; the re-birth of the global market in crude oil in new form will be the subject of another post.

Global Oil Pricing

The “Brent Complex” is aptly named, being an increasingly baroque collection of contracts relating to North Sea crude oil, originally based upon the Shell “Brent” quality crude oil contract which originated in the 1980s.

It now consists of physical and forward BFOE (the Brent, Forties, Oseberg and Ekofisk fields) contracts in North Sea crude oil; and the key ICE Europe BFOE futures contract which is not a deliverable contract and is purely a financial bet based upon the price in the BFOE forward market.

There is also a whole plethora of other ‘over the counter’ (OTC) contracts involving not only BFOE, but also a huge transatlantic “arbitrage” market between the BFOE contract and the US West Texas Intermediate (WTI) contract originated by NYMEX, but cloned by ICE Europe.

North Sea crude oil production has been in secular decline for many years, and even though the North Sea crude oil benchmark contract was extended from the Brent quality to become BFOE, there are now only about 60 cargoes of BFOE quality crude oil (and as low as 50 when maintenance is under way), each of 600,000 barrels, delivered out of the North Sea each month, worth at current prices about $4 billion.
It is the ‘Dated’ or spot price of these cargoes – as reported by the oil price reporting service Platts in the ‘Platts Window’– which is the benchmark for global oil prices either directly (about 60%) or indirectly, through BFOE/WTI arbitrage for most of the rest.

It will be seen that traders of the scale of the oil majors and sovereign oil companies do not really have to put much money at risk by their standards in order to acquire enough cargoes to move or support the global market price via the BFOE market.

Indeed, the evolution of the BFOE market has been a response to declining production and the fact that traders could not resist manipulating the market by buying up contracts and “squeezing” those who had sold forward oil they did not have and causing them very substantial losses. The fewer cargoes produced; the easier the underlying market is to manipulate.
As a very knowledgeable insider puts it….
The Platts window is the most abused market mechanism in the world.
But since all of this short term ‘micro’ manipulation or trading (choose your language) has been going on among consenting adults in a wholesale market inaccessible to the man in the street. It is pretty much a zero sum game, and for many years the UK regulators responsible for it – ie the Financial Services Authority and its predecessor – have essentially ignored it, with a “light touch” wholesale market regime.

If the history of commodity markets shows us anything it is that if producers can manipulate or support prices then they will, and there are many examples of which the classic cases are the 1985 tin crisis, and Yasuo Hamanaka’s 10 year manipulation of the copper market on behalf of Sumitomo Corporation.

When I gave evidence to the UK Parliament’s Treasury Select Committee three years ago at the time of the last crude oil bubble I recommended a major transatlantic regulatory investigation into the operation of the Brent Complex and in particular in respect of the relationship between financial investors and producers, and the role of intermediaries in that relationship.

I also proposed root and branch reform of global energy market architecture, which in my view can only come from producer nations and consumer nations collectively, because intermediary turkeys will not vote for Christmas.

A Meme is Born
In the early 1990′s Goldman Sachs created a new way of investing in commodities. The Goldman Sachs Commodity Index (GSCI) enabled investment in a basket of commodities – of which oil and oil products was the greatest component – and the new GSCI fund invested by buying futures contracts in the relevant commodity markets which were ‘rolled over’ from month to month.

The genius dash of marketing fairy dust which was sprinkled on this concept was to call investment in the fund a ‘hedge against inflation’. Investors in the fund were able to offload the perceived risk of holding dollars and instead take on the risk of holding commodities.

The smartest kids on the block were not slow to realise that the GSCI – which was structurally ‘long’ of commodity markets – was taking a long term position which was precisely the opposite of a commodity producer who is structurally ‘short’ of commodities because they routinely sell futures contracts in order to insure themselves against a fall in the dollar price. ie commodity producers are offloading the risk of owning commodities, and taking on the risk of holding dollars.
So in 1995 a marriage was arranged.

BP and Goldman Sachs get Married
From 1995 to 2007 BP and Goldman Sachs were joined at the head, having the same chairman – the Irish former head of the World Trade Organisation, Peter Sutherland. From 1999, until he fell from grace in 2007 through revelations about his private life, BP’s CEO Lord Browne was also on the Goldman Sachs board....MORE
Throughout the spike in 2008 and the crash into 2009 we were posting on the distortions introduced by the GSCI and the long-only index "investors", CalPERS in particular.
From July 2010's ""Bread and Derivatives: Goldman’s control of market structure might just starve us, strand us, and leave us in the dark. Literally." (GS)":
Oh My Goodness.
For three years I was writing about Goldman's use of their designation as a "Commercial" trader to avoid and help their clients avoid the position limits that the CFTC applies to "Speculators".

I felt like the proverbial [it's Matthew 3:2, not Proverbs -ed] voice crying in the wilderness,

A quick note on nomenclature. In commodity markets speculators provide a societal good.
Where things got interesting was GS being a "commercial" allowed them to take positions that they would put into index form and then swap with the true speculators. Or sometimes just straight swap the position.
These speculators included giants such as CalPERS and other public employee pension funds and University endowments. I'll have more after the jump.
From New Deal 2.0:
In 2008, before the financial system almost melted down and threatened an economic collapse of biblical proportions, some very odd events occurred in the market for commodities derivatives.  It is now clear that financial institutions and investors already understood that the mortgage market was teetering and that severe problems for the financial firms were on the horizon.  Stress was building, but how did this relate to the commodities markets?  We still do not know for certain, but we do know that it coincided with peak investment levels of $317 billion in several investment vehicles known as commodity index funds.

In 1991, Goldman Sachs invented the commodity index fund.  While several other firms have replicated the fund, Goldman has maintained a 60-75% market share....
That New Deal 2.0 piece was written by Wallace C. Turbeville, former CEO of VMAC LLC and a former Vice President of Goldman, Sachs & Co.

All the while the academics were saying the spike was not caused by speculation while market participants said it was.

Both Paul Tudor Jones and Wilbur Ross said oil was a bubble i.e. price increases caused by speculators, with Ross repeating the claim three days before the $147.47 top-tick.
Wilbur went out and bought SpiceJet figuring a decrepit Indian airline was the most leveraged way he could play the price collapse he he expected.

"Bread and Derivatives" and "REVISITING SPECULATIVE COMMODITY BUBBLES" (GS) have links to earlier posts that pretty much tell the whole story. My closing paragraph from "Bread and Derivatives":
...We're no blogger come lately, no sirree.

If I were a betting man my money would say that one of the big reasons that gold has moved out of proportion to oil is that GS realized that continuing the same old game in consumables would result in such a hue and cry among the citizens that the politicians would be forced to shut down the game permanently.

Rather than risk that they went to something that people didn't get price quotes on every time they gassed up, or bought a loaf of bread