Beware Of The Muppets In The Oil Market
17 May 2012 34 Comments
Obviously, there was a speculative bubble from early 2007 to mid 2008 which then collapsed during the second half of 2008. In a series of articles, Chris Cook claims that the crude oil price has been in another bubble since the end of 2009 and that this bubble is just beginning to pop. The present article is an attempt at understanding the mechanics underlying Chris Cook’s ideas.
The Mechanics of Oil Swaps
In order to understand the mechanics of the oil market, I translate all positions into the language of swaps of oil for US$. Such a swap involves borrowing US$ and at the same time lending oil, both for a fixed term and with the same counterparty. This can be realized, for example, by selling oil for US$ in the spot market (i.e. for immediate delivery) and at the same time purchasing an Over The Counter (OTC) oil forward contract for delivery at some point in the future. Alternatively, one can sell oil for US$ in the spot market and purchase a WTI futures contract at the New York Mercantile Exchange (NYMEX).
If the forward price of oil is higher than the spot price, the oil market is said to be in contango. The opposite condition is called backwardation. More precisely, the contango is the difference of the forward price of oil minus the spot price. The term structure of the oil market at any given time is the function that describes how the contango depends on the time until maturity of the swap.
The article Profiting from a contango, not so easy (8 December 2008) by Izabella Kaminska contains the following diagram of the term structure between spot and 60 months of the NYMEX WTI futures contract for 3 October 2008 (black curve, left scale) and for 28 November 2008 (red curve, right scale).
The contango, i.e. the forward price minus the spot price, is precisely the interest payable when swapping oil for US$. If the oil market is efficient and arbitrage is possible, the term structure is determined by the no-arbitrage condition:
+ nominal risk-free yield of US$
+ risk-premium because you might not return the borrowed US$
+ storage expenses for the oil
– risk-premium because your counterparty might not return the oil
The reasoning is precisely the same as described for gold and silver in Backwardation in the Case of a Monetary Metal.
Why would somebody swap his oil for US$ and pay the contango as the interest on this swap? One answer is that this is a way of obtaining a cheap US$ loan because the oil effectively serves as the collateral for that loan and the risk-premium on the oil loan offsets the risk premium on the US$ loan. So in an efficient market and in a situation in which both parties have comparable default risk, the contango basically equals the risk-free return on US$ plus the storage expenses for the oil.
Term Structure Arbitrage
In the case of gold and silver, it is plausible to assume that the market is efficient and that the term structure is always determined by the no-arbitrage condition. Firstly, for both metals, there is a large investment stock available and ready to trade. Secondly, there exists ample storage space and both storage expenses and transportation costs are small compared to the price of gold and silver.
In the oil market, however, the situation is more difficult. If, for example, the contango is higher than the risk-free rate plus storage expenses, the following arbitrage becomes profitable. The well-capitalized arbitrageur can purchase oil in the spot market and at the same time sell it forward, storing the oil for the duration of this swap. But this can be done only by those market participants who have access to the infrastructure for handling physical oil, and only if enough free storage capacity is available. In addition, the transactions costs are no longer negligible as soon as the oil has to be moved.
Towards the end of 2008, i.e. after the first oil bubble mentioned at the beginning of this article had popped and the spot price had collapsed, the market had a huge contango as can be seen in the above diagram (red curve). We refer to the article Is it a bird? No, it’s a super-contango (11 November 2008) by Izabella Kaminska. In fact, since the end of 2008 and during 2009, the contango was so high that the arbitrageurs had already used all the available storage capacity onshore, and in addition they chartered oil tankers in order to be able to store even more. These tankers just remained anchored close to the major ports. Already on 30 January 2009, the Houston Chronicle wrote:
Frontline LTD, which runs one of the largest crude supertanker fleets, estimates 80 million barrels of oil are drifting slowly on the high seas—roughly equal to a day’s oil consumption for the entire world.
On 23 December 2009, the website Oil-Price.Net wrote
We have recently had a large contango in the oil market. In January, we saw an all-time high contango in oil – an incredible $23.70 a barrel [VtC: for a 1-year term].
That was quite an incentive to just keep any oil you had and sell it at a later date, even after paying to have the oil stored in massive oil tankers. In April, there was a record amount of oil in floating storage – 100-120 million barrels! And a record number of supertankers being used for that purpose – 56.
Paul Tossetti, Dallas-based director of oil markets at consultant PFC Energy, estimated that it costs 50 cents to 60 cents each month – $6-$7.20 per year – to store each barrel on a supertanker. So as long as the contango stayed above $7 per barrel [VtC: for a 1-year term], it made economic sense to just let the oil sit.
Muppets Make the Market Inefficient
Before we discuss the role of the muppets, let us stress that the oil market is infamous for being extremely opaque. The price benchmarks such as WTI or Brent refer to specific contracts with rather narrow markets, but are used as a reference for a much larger volume of oil trade, and so it is comparably easy and profitable for large market participants to influence these benchmarks. In addition, the number of market participants with access to the actual physical oil infrastructure is small, and so even if term structure arbitrage is possible, it may not be executed for strategic reasons. Finally, during times of a liquidity shortage such as in 2008 and early 2009, arbitrage may not happen simply because the required liquidity is not available.
A significant additional market inefficiency is introduced by passive investors such as ETFs and other retail products as well as by pension funds and insurance companies who use the oil market in order to hedge against inflation. All these investors, let us call them muppets (again following Chris Cook), operate solely in the financial markets, but do not have and do not want access to the physical oil infrastructure.
In an efficient market, the following two positions are essentially equivalent:
- Purchase a futures contract for delivery of oil in 3 months.
- Purchase oil in the spot market and immediately swap this oil for US$ for a term of 3 months.
The muppets, however, have access only to method (1) because (2) involves the handling of physical oil. As a variation of (1), a pension fund can, for example, purchase an OTC oil forward contract that is settled in cash rather than oil.
During a period of strong muppet buying, we therefore expect the contango to increase beyond the value that would be enforced by term structure arbitrage, simply because the muppets bid up the futures price, but not the spot price. This apparently happened between November 2008 and the end of 2009 when investors were betting that the risk of deflation was exaggerated and when they purchased oil futures. The arbitrageurs responded by buying physical oil in the spot market, by selling it forward and in the meantime storing it. But the arbitrage was still incomplete, the contango remained high and the market inefficient for almost a year.
Since the muppets cannot take delivery of their oil, but rather have to keep rolling their futures position, i.e. to sell the near month and purchase a futures contract with a longer maturity, they keep bidding up and paying the contango as long as they hold their paper only position. The arbitrageurs, in turn, can pocket the excessive contango as long as they can store physical oil on behalf of the muppets.
Although some hedge funds got involved in the ‘oil tanker trade’, i.e. in storing physical oil and capturing the arbitrage, the prime candidates for this arbitrage are the oil producers.
During normal operation, they keep shipping a certain flow of oil to the consumers and keep selling it in the spot market or through similar contracts. A producer can thus perform the term structure arbitrage simply by selling less oil in the spot market and more oil in the futures or forward market. On the one hand, they give up the immediate cash flow, but on the other hand, they can earn the artificially high interest rate embedded in the contango.
In order to see whether this idea is consistent with the published data, let us take a look at the Commitment of Traders (COT) data for WTI at the NYMEX and at the ICE. In Where have all the oil hedgers gone? (30 April 2012), Izabella Kaminska shows the following diagram by John Kemp.
The green area below the x-axis is the short position held by the commercial traders, i.e. oil producers and consumers. This class of investors is typically net short because the producers tend to hedge a greater share of their production in the futures market than the consumers hedge their purchases.
The yellow area above the x-axis shows the long position held by those classified as ‘managed money’. Indeed, both of these positions increase between fall 2008 and spring 2010, indicating that investors purchased the future and kept rolling their contracts while the producers entered the market as arbitrageurs and took the opposite position.
If the muppets purchase and keep rolling the future, thereby driving up the contango, and the producers respond by maximizing their profits, i.e. by arbitrage in order to earn the excess contango, this results in a shift of producer sales from immediate delivery to forward delivery. Supply is shifted from the present to the future which contributes to a rising oil price.
The previous considerations for the producer, i.e. selling less oil immediately and more oil forward, refers to the ownership of the oil. It is a different question of where the oil is located physically.
Since transportation of crude oil overseas is technically demanding, the producers might prefer to ship a continuous flow of physical oil to the consumers. Although the sales are shifted from immediate to future delivery, the physical oil is shipped at the usual rate, corresponding to the long term average demand, in order to optimally utilize the existing shipping capacity.
This is possible, however, only if the producer can indeed accumulate inventory in the country of the consumer. This inventory is still owned by the producer and will therefore not show up in the usual inventory statistics. It is so-called dark inventory.
In fact, people speculate that Saudi Arabia owns a substantial amount of inventory overseas. For example, in the Financial Times of 28 March 2012, the Saudi oil minister, Ali Naimi, writes
For the record, as things stand today, our inventories in Saudi Arabia and around the world are full. Our Rotterdam inventory is full, our Sidi Kerir facility is full, our Okinawa facility is full – 100 per cent full.
In More On Crude (30 March 2012), Marshall Auerback speculates that Saudi Arabia can even utilize unused capacity inside the Strategic Petroleum Reserve of the United States, and cites
The SPR DOES have legal authority to store foreign oil. According to the Petroleum Reserve Annual Report for Calendar Year 2010 (Page 34)
“The Strategic Petroleum Reserve promotes the concept of storing foreign oil in its unused storage space as a strategy to increase world oil stockpiling, generate revenues for the United States Treasury, and/or add oil to the Strategic Petroleum Reserve (in lieu of a fee). The Balanced Budget Act of 1997 (Pub L. 105‐33) provides specific authority to store petroleum products of another country, or its representatives, in the facilities of the Strategic Petroleum Reserve, provided that the United States is fully compensated for all related costs, and that the ability to draw down Strategic Petroleum Reserve oil is not impaired. To enhance the Strategic Petroleum Reserve’s offer to store oil for foreign governments or their representatives, the Big Hill storage site was activated as a special purpose Foreign Trade Zone subzone on September 28, 1998. This designation permits customers to store oil without paying customs fees and certain taxes. The Big Hill storage site is the only storage site to receive this designation.”
What are the costs for a producer to enter the arbitrage and play the counterpart of the muppet? We recall that effectively the muppet swaps oil for US$ with the producer. The producer effectively sells less oil immediately and more forward, i.e. he loses cash flow. The arbitrage is profitable only as long as the (excessive) interest embedded in the contango that the producer earns through the arbitrage, exceeds his average financing costs.
As soon as this is no longer the case, the producer will again prefer to sell immediately and leave the muppet-induced arbitrage opportunity on the table for somebody else to take.
Who other than the producer can take the position opposite to the muppets? Firstly, other companies that typically handle physical oil, can perform the same arbitrage as the producer. They will probably have similar financing costs though. Secondly, some speculator who seeks an explicit short price exposure can sell the futures contracts directly to the muppets.
But arbitrage, i.e. a risk-free position, at the short end of the term structure can be performed only by those with access to the physical oil infrastructure. As soon as their financing costs exceed the (excessive) interest rate embedded in the contango, they can no longer profitably perform the arbitrage.
Until they realize that they can borrow against their excess (dark) inventory. In fact, rather than stopping the arbitrage, the producer can try to find a financial intermediary and swap his oil for US$, in effect borrowing US$ and using the oil as the collateral. Any financial intermediary who is willing to receive title to the oil for the period of the swap, can take the other side of this swap. This is profitable as soon as the financing costs of the financial intermediary are lower than those of the producer. This is where the large U.S. banks come in.
Let us summarize the position of the producers.
- When they enter the arbitrage with the muppets, they buy spot and sell the future. (Well, they sold less immediately and more forward).
- When they borrow US$ against their inventory, they sell spot and buy the future.
These two positions compensate each other. This means that effectively, the producers are now out of the arbitrage business.
But still, rather than selling to the consumer in the spot market, they now sell to the bank. The bank buys spot oil, owns the dark inventory, and sells the future to the muppet. So in effect, the aggregate muppet long position now corresponds to dark inventory held by the bank on behalf of the muppet.
If the producers indeed start to finance their inventory in this way, one should see the short position be transferred from the producers to the swap dealers (financial intermediaries). This is clearly shown in the chart of the COT data above. Since fall 2010, the commercial short position (green area below the x-axis) has been gradually replaced by the swap dealer short position (blue area below the x-axis).
Chris Cook writes in the comments to Izabella Kaminska’s Saudi Arabia Resorts to Jedi Mindtricks (29 March 2012):
Furthermore, my take is that the Saudis and J P Morgan Chase have for three years been using Enron-style Prepay contracts to maintain what was essentially an oil peg against the dollar using distinctly un-open market operations via oil repos.
The problem with this central oil bank strategy is that it requires a continuing flow of funds from muppets into the market as the producers take excess profits out.
There we go. In fact, as long as the aggregate muppet long position grows, this is in effect financial oil demand that drives the spot price up and that disappears into the dark inventory. If the aggregate muppet long position shrinks, this creates financial oil supply, additional oil on the market that seems to appear out of nowhere, being released from the dark inventory.
When the Muppets Start Selling
Finally, when the muppets start liquidating their longs, they will disproportionately affect the futures price, but not spot, reducing the contango or even causing backwardation. Inded, Zero-Hedge shows the following term structures for WTI (black: 7 October 2011; green: 2 November 2011; organe: 9 November 2011).
The WTI term structure started inverting at the short end between 7 October and 2 November 2011. Note that the onset of backwardation at the short end (end of October 2011) coincides with the peak in the open interest in the COT data (end of February 2012) only up to a time lag of four months which may be due to the majority of muppets holding longer term futures or forwards. In any case, the muppets have started selling.
The last time the muppets started selling en masse, was in 2008 (please take a look at the chart at the very top of this article). Saudi Arabia’s oil minister Ali Naimi just wrote in the Financial Times Saudi Arabia will act to lower soaring oil prices (28 March 2012). Note that Saudi Arabia has a track record of taking on the speculators. Marshall Auerback writes in The Oil Conundrum (21 March 2012):
Well, let’s look at history to get a clue: in 1990-1991: the oil price went up from $20 to $40 when Saddam invaded Kuwait. The Kuwaiti fields went down and we embargoed the Iraqi oil.
But then Saudi went full throttle. The oil produced went into hidden stockpiles. For five months. Then when the air war began in Jan of 1991 the oil price fell from 40 to 20, most of it in one day. The Saudis and the allies dumped the oil and killed the specs.
Should Saudi Arabia stop both the term structure arbitrage and the inventory financing, they would no longer sell a part of their spot oil to J.P. Morgan, but rather to the consumers, causing the oil price to fall.
J.P. Morgan has no price exposure, and so it is a different question whether they want to unwind their remaining swaps whose counterparty are in effect the muppets. Since oil is now in backwardation, they can simply close these swaps at the same time as the muppets sell their futures. J.P. Morgan would therefore sell their dark inventory in the spot market and buy back the futures at a discount thanks to backwardation.
If there is not enough backwardation for a decent profit, they can just take their short futures positions into the delivery period, causing another headache for the muppets. Since the muppets cannot handle physical oil, they need to sell their futures well before the delivery month, if necessary at a loss, causing precisely the backwardation that is now profitable for J.P. Morgan.
There are finally independent indications that the producers expect the oil price to decline in the medium term. The Financial Times reports in Qatar joins Mexico with oil hedge (26 October 2011) that
Qatar, a member of the Opec oil cartel, has joined Mexico in taking out an insurance policy against falling oil prices next year, hedging some of its oil for 2012
bankers said that Qatar has taken out insurance only rarely over the last two decades.
(There was a rumour that Qatar purchased put options around $45/bbl for a part of their production whereas Mexico is known to hedge most of their production at $75/bbl.)
Where are all the Tankers Going?
There is finally one further observation that is perhaps not quite consistent with this picture. On 16 March 2012, Reuters reported:
Saudi Arabia is preparing to extend this year’s unexpected surge in oil sales to the United States, according to tanker industry sources and government data
Contrary to expectations that the modest recent rise in the kingdom’s output was bound for fast-growing Asian markets, preliminary data shows that shipments to the United States have quietly risen 25 percent to the highest level since mid-2008, when the OPEC kingpin was driving up production to knock oil prices off record highs near $150 a barrel.
The surge appears set to continue. Vela, Saudi Arabia’s state oil tanker company, has booked at least nine very large crude carriers (VLCCs) capable of carrying 2 million barrels of crude each from the Middle East Gulf to the U.S. Gulf since the start of March, the biggest such wave of fixtures in years, analysts say.
While the rise in Saudi output has been well charted, the fact that the lion’s share of it appears destined for U.S. refiners will come as a surprise to many. Overall U.S. demand for foreign crude has ebbed this year as a boom in domestic and Canadian production reduces the need for imports.
“We were all expecting to see U.S. imports fall for Vela, so it’s a jump at a time when we are preparing for a reversal given the Seaway pipeline,” one shipping source said. “It raises the question why would they need more imports?”
Omar Nokta, managing director with investment bank Dahlman Rose & Co, said in a note on Friday that it was the first time in “several years” for Vela to book so many tankers in such a short time.
Provisional weekly data from the U.S. Energy Information Administration shows that the rise in supplies began several months ago, and outpaced gains to other consumers such as China.
If we wanted to interpret this message in the light of the arbitrage and inventory financing described above, the following would be consistent.
- Saudi Arabia still held some short futures positions directly with the muppets that had not been transferred to the banks and that they now deliver on. (And the poor muppets who cannot deal with physical oil have to sell their futures contracts to some lucky consumer who will be happy to take delivery.)
- Saudi Arabia had not only financed their dark inventory located in the U.S. with the banks, but they had also financed some inventory that was still located in Saudi Arabia. Now that the arbitrage and thereby also the inventory financing is being wound down, they have to deliver this inventory to the consumers in the U.S.
It is not clear that these possibilities can explain the large volume though. From the COT chart shown above, the muppets have perhaps purchased 100 million barrels during the six months until March 2012, i.e. half a million barrels per day. This is indeed the same order of magnitude as the excess shipments from Saudi Arabia. But we also know that U.S. demand has been declining and Canadian and U.S. supply increasing. Already without the excess shipments by Saudi Arabia, Marshall Auerback estimates that
So the US is importing a million barrels a day that America apparently doesn’t need..
Why and where is that oil going? It is not showing up in our inventory data. And what will that import level be when the new increase in Saudi bookings to the US lands on our shores?
It is also possible that Saudi Arabia ships additional crude oil to the U.S. just in order to overwhelm the muppets and to hit the speculators. But we don’t think it is plausible that Saudi Arabia would finance such a presumably loss-making enterprise with their own money if the predictable unwinding of the muppets’ positions are perfectly sufficient in order to bring the oil price down.
Finally, there remains the possibility that they are acting on behalf of the U.S. government, trying to build up inventory inside the U.S. in anticipation of a crisis in the Middle East. We do not have any inside information, but like to relay the following opinion expressed by Chris Cook:
My take – I know for a fact that Marc Rich was in Tehran a few weeks ago, and it wasn’t to take the air or go clubbing – is that Obama and Khamenei (who is now firmly back in control) have come to an understanding. Marc Rich is one of the few people trusted by Khamenei: don’t forget that he was happily flogging Iranian oil to Israel for six years under the Shah, and another 14 years for his friend Khomenei.
That could be why Iran wrote within a couple of days of the election (which gave Khamenei political legitimacy over the Ahmadinejad oligarchic faction) to the 5 + 1 meeting to get the ball rolling again; why Obama suddenly became so clear that Iran were not going to have nukes; and why Khamenei was making comprehensive condemnations of nukes as a sin.
My scenario is that we will soon see Iran backing off – with as little loss of face as possible – to the very same concessions Cheney turned down in 2003 (when Khamenei called the shots) with the difference being that Obama will not insist upon regime change.
Apart from the possibility that Chris Cook is wrong and there will be a war in the Persian Gulf with a possible closure of the Strait of Hormuz, the additional crude oil shipments from Saudi Arabia to the United States are difficult to explain.
Imagine you favour a high oil price. How do you facilitate this? We have seen that one major component is the behaviour of the inflation hedgers, aka the muppets. As long as they are willing to hold an increasing aggregate futures and forward position, we only need a producer, perhaps together with a bank, who are willing to take the opposite position. This will create financial oil demand, and this oil disappears into the dark inventory, contributing to rising prices.
Both in the spot price chart at the top of this article, and also in the open interest in the COT chart, we see two recent peaks. April/May 2011 was the civil war in Libya. January/February 2012 was the anti-Iran rhetoric. It is not just the reduction in supply that affects the price, but also the predictable behaviour of the muppets.
Finally, the excessive oil shipments from Saudi Arabia to the U.S. fit into this picture qualitatively, but the quantity seems to be out of proportion by perhaps as much as one million barrels per day over several months. No explanation for this so far.
Update (27 June 2012):
Brent oil is back in contango throughout the 12 nearest months (FT Alphaville).