Oil to $386.57 per barrel! (Very Long Article)

Posts: 707

Quote:

Executive Summary: The run-up in oil prices despite a glut in physical market (for "wet barrels"), is due to too much money ("investors", "speculators") flowing into the derivatives markets of NYMEX and ICE to buy "paper barrels" and the concurrent lack of meaningful arbitrage to balance supply and demand between the two markets (spot and derivatives).

Oil to $386.57 per barrel!

Yes, you read correctly, price oil at USD $386.57 per barrel. Why? Because that's the price of GOOG (Google Inc) stock. "But... what does Google's stock price have to do with oil price? There is no connection." you'll ask. Correct.

But then again, the way oil price is set today, we might as well randomly pick some financial instrument like Google stock to use for pricing oil! Afterall, for several years, the price of oil is set by "paper barrel" trading in the derivatives markets, which increasingly have NO connection whatsoever with the physical oil market of real "wet barrels".

Since the late 1980s, there are two distinct markets for oil: an illiquid spot market (for real "wet barrels") and 2 liquid derivatives markets (for so-called "paper barrels" of oil) at NYMEX and ICE (source). Theoretically, "wet barrel" and "paper barrel" prices should all be tied together by arbitrage, as it happens in most commodity and stock markets, but apparently not in the oil market. This happens due to the fact that the types of crude oil traded in derivatives (West Texas Intermediate and UK Brent) represent a very small % of world oil daily production, which prevents meaningful arbitrage. Leading to broken price discovery mechanism. As a result, the run-up in oil prices is NOT an indication of shortages in the physical market, but a financial phenomenon.

Record inflows

Background: For the past few years, untold billions are flowing into long-only commodity funds, which invest in them in contracts ("paper barrels") of oil in the derivatives markets. Most commodity indices are heavily weighted towards energy (e.g. in Goldman's GSCI commodity index the weight of energy is ~75% - source)

(Note that the chart above doesn't even include the assets of hedge funds or proprietary trading of major investment banks)

The reasons for money flowing into commodities (as an asset class) are pretty obvious:

1. to front-run developing countries' (China/India/etc) needs, i.e. "buy today what China will want to buy tomorrow"
2. to escape ongoing fiat currency (USD, EUR, Yen etc) depreciation (the same reason why gold/silver etc went sky high). Oil and metals like copper can be better alternatives than gold and silver, because of the almost price insensitive, inelastic demand (you *will* find someone to buy it from you), let alone better tax treatment.
3. "liquidity" (due to cheap borrowing rates and money printing) sloshing in the system
4. and to follow the trend, herd behaviour after a mature 4yr old bull market.

Let's look at the facts

Despite media propaganda, let's look once more at the FACTS:

1. Supply.
The physical ("wet barrel") market is awash in oil. Saudi Arabia, the world's top exporter, had to cut production from 9.5Mbpd of the past year down to 9.1Mbpd in April-06, due to a drop in refinery demand (i.e. no buyers), The Wall Street Journal quoted Oil Minister Ali Al Naimi as saying on 5-Jun-2006.

In an interview after a meeting here of the Organization of Petroleum Exporting Countries, Ali Naimi said other cartel members are having trouble finding buyers for all the crude they are producing, at a time when global stores are near full and many refiners have closed facilities for routine maintenance. One Saudi official said an estimated three million barrels a day of refining capacity is out of action and unable to process crude, at a time when the world is using some 84 million barrels a day of oil products like gasoline and jet fuel.

"It's not just heavy oil. Even light oil is having problems" finding buyers, Mr. Naimi said, referring to premium grades of crude known as light crude that are highly prized by refiners because they have high gasoline yields.

Asked if the kingdom was easing up on supply because of concern about the buildup of inventories in the U.S. and other importing countries, Mr. Naimi rejected such a motive, replying: "At $70 a barrel?" Mr. Naimi suggested that producers will sell all the oil they can at such high prices.

The implication of Mr. Naimi's remarks is that Saudi Arabia would again open its oil spigots when buyers ask for more oil. For the past two years, the Saudis say, their policy has been to sell as much oil as buyers want, to the limit of the kingdom's production capacity.

OPEC monotonously re-iterates that supply is plentiful at every meeting:

05-28-06 05:05 PM EST
CARACAS -(Dow Jones)- OPEC's acting secretary general, Mohammed Barkindo, said Sunday that the global oil market is well supplied.
"This market is very well supplied both in terms of crude and products," Barkindo said upon arriving in Venezuela for an OPEC ministerial meeting. Ministers of the Organization of Petroleum Exporting Countries will hold a formal meeting in Caracas on Thursday.
"You have to look elsewhere (than market fundamentals) at what is driving the prices," he said.

After Katrina, in Oct-2005, in a so-called "symbolic move" to calm market "psychology" rather than actual supply shock, OPEC said they would offer additional 2 million barrels/day, IF THERE IS A BUYER:

OPEC Offers an Extra 2M Barrels of Oil
2005-09-21 11:18:40 AP
Ministers of the OPEC agreed here on Tuesday to provide an extra two million barrels of crude oil a day in a bid to calm down the world oil market.

VIENNA, Austria-OPEC offered world markets an extra 2 million barrels of oil a day — its entire spare capacity — on Tuesday in an attempt to show that supply fears were unfounded even with traders eyeing another hurricane approaching the Gulf of Mexico.

The cartel, which has come under international pressure over the near-record prices that followed Hurricane Katrina, said its output ceiling would remain at 28 million barrels a day and stressed that the main obstacle is refining capability, not a shortage of crude.

"If you have a buyer, bring him, we'll give him the 2 million. We have the availability to provide it," said OPEC President Sheik Ahmed Fahd Al Ahmed Al Sabah, who is also Kuwait's oil minister.

He said the 2 million barrels, representing all the spare capacity of the Organization of Petroleum Exporting Countries, would be available for three months beginning Oct. 1.

"We hope that this will reflect positively on prices," Sheik Ahmed said. "We are very keen to help the market. We know there are geopolitical and weather crises."

There was no buyer for the extra 2Mbpd, confirming OPEC's constant comments that the REAL oil market is very well supplied and has been for a long time.

So, why wouldn't someone buy the extra 2M barrel/day offered by OPEC and bring the oil price down for the front-month contract? (the far away futures contracts might still be trading higher or lower, based on real of fictional supply/demand issues).The problem is that due to how the oil contracts are defined, it's practically impossible to do any MEANINGFUL arbitrage, which would bring the two markets (derivatives and physical) back in sync for the current contracts.

2. Demand:
According to the recent (4-May-06) testimony by D.Yergin in US Congress world oil demand was up only 1% in 2005 (source). Physical world oil demand (oil shipments) has been flat or down since 2005.
China/Asia is often getting blamed for the high oil prices, yet China said that since 2004 it was going to rely on domestic supplies for most of its energy needs. And delivered on that promise, as according to recent data China's oil demand in 2005 was actually LOWER than 2004: "The National Development and Reform Commission said recently that China's dependence on oil imports was 42.9 per cent in 2005, 2.2 percentage points lower than in 2004. It also said China consumed 318 million tons of oil last year, 1.08 million tons less than in 2004." source

3. Stockpiles:
Commercial (oil company) crude oil stockpiles in US (excluding oil stored in the Strategic Petroleum Reserve) stand are at the highest levels ever, of ~350Million barrels:

Also, US SPR (Strategic petroleum reserve) has been filled up 100% between 2002 and Aug-2005, for another >700 million barrels, (a questionable move, which many think contributed to oil price spike. Before, the SPR was being slowly filled by the US govs since the 1980s).

Conclusion:

So we know that the market is well supplied, private and government oil inventory at all-time highs, OPEC has ample untapped spare capacity, recently even scaled back on production due to declining demand (for real "wet barrels") from refineries, delivery capabilities were not strained (as evidenced by the drop in oil supertanker shipping rates). The only bottleneck would be refining capability (and only in USA), which logically would push oil prices down and only affect refined products (gasoline etc).

All "demand" keeping prices at these absurd levels of over $70/bar is happening in the futures derivatives markets. It is what OPEC calls "paper barrels", with open contracts just in NY futures market being over 1.6 BILLION "paper" barrels (vs 80 million barrels daily world consumption).

Speculation in futures is, on its own, is NOT wrong or damaging etc (although authorities have been known to curtail such activities under extreme situations, like 1987 stock crash or 1980 silver short squeeze spike). But the problem of the past several years is an issue of too much money flowing into oil futures and inability to do arbitrage between futures and physical. For some background on oil markets and the influence of futures and how oil price is set, read Oil Markets and Prices

OPEC has been stating the effect of "paper barrels" since year 2000

Friday, 22 September, 2000, 09:13 GMT 10:13 UK
Oil: New rules of the trading game
Market speculators using sophisticated financial instruments are having an increasing influence on oil prices.

The secretary general of the Organisation of Petroleum Exporting Countries (Opec), Rilwanu Lukman, says the world oil market is held captive by the derivatives markets. The old rules of supply and demand have been distorted, he says, by the creation of what he calls "paper barrels" of oil.

Opec president Ali Rodriguez says that at least $8 of the oil price is due to speculation.

They are both articulating the anxiety at the loss of control felt by the Opec oil producers. They can no longer manipulate the market mechanisms that have made them lots of money recently, but which no longer respond to the old fashioned rules they prefer.

Thus, says Mr Lukman - and he should know - the time has long gone when the complex trading systems that are responsible for moving oil around the world from producer to consumer were only governed by the rules of supply and demand.

Mr Lukman was for many years Nigeria's oil minister and representative at Opec, and as one of the organisation's oldest hands, has watched the oil market closely for almost three decades.

I guess nowadays, OPEC just sits back and enjoys windfall profits, courtesy of the derivatives markets in NY and London. And OPEC simply re-iterates on every occasion that "current prices don't reflect supply/demand fundamentals".

Follow the money - Who benefits?

Oil producing nations, the oil companies and the big trading houses (e.g. investment banks, funds) are enjoying huge profits from commodity trading (look at where most of the their revenues come from). Even "investors" in oil make money, but only as long as oil price rises, because they're charged huge "carrying costs". BUT, almost everyone else is getting scr*wed.

My opinion

Politically speaking, I think "investors" (mostly westerners) in oil are shooting themselves in the foot. An unprecedented wealth transfer to oil producing nations has been taking place during the past years.

Overall, IMO, the lack of action by Western leadership against this kind of massive wealth transfer is nothing short of criminal. Of course I would hardly expect any better from people who are having their countries mortgage its future (borrowing from the future) to fund its overconsumption today. What Warren Buffett called "sharecropper society" a year ago.

Ordinary people have faith that their government is doing the best for them and that the media is actually informing them. If all you hear from the media (which IMO are just shills for those making $$$ from this) is that oil is going up because the supply/demand is marginal, the world is running out of oil, because China etc is using so much, because of refinery bottlenecks (which in fact would increase the price of refined products and actually create a glut of crude oil) then you might accept $70+/bar oil like a "natural disaster".

So, from the lack of real action for 3+ years now, I can only conclude there is some hidden agenda behind accepting the broken price discovery mechanism in oil market today and that despite what they claim in public, the people in charge are happy with the rigged oil price and its consequences.

References for further reading:
Andy Xie, MorganStanley economist for Asia, thinks oil is financial bubble (16-Jun-2005)
Andy Xie, MorganStanley: Asian oil demand is declining (Jul-05)
The real problems with $50 oil By Henry C K Liu
Explanation of price discovery in oil markets
OPEC: World awash in oil (6-Mar-2006)

http://dhatz.blogspot.com/2006/06/oil-to-38657-per-barrel.html

Posts: 100

Boy was this article ever accurate.

Rolling Eyes

Posts: 146

437. Manipulate oil price (9/20/2006)

After Bush took the presidency, he created a huge budget deficit, and a huge trade deficit as well. The deficit will cause a big inflation. So Federal Reserve has to raise the interest rate to deal with it. In June 2006, the overnight interest rate was raised to 5.25%. The Federal 10 years treasury bill was 5.25% too. The 30 years fix mortgage rate reached its recent high: 6.93%. Although this rate is still low viewed from history, it touches off a down turn of the real estate market. Because the price of house is stretched too tight that a tiny increase of the mortgage rate will cause a big change.

Feds hold a large quantity of houses in my case, they tried their best to keep the property value. What we saw are: Federal Reserve stops its step to raise the interest rate. Oil price declined. The rate of bonds goes down. So does the mortgage rate. From June to September, the bench mark rate of Federal funds stays at 5.25%. The rate of 10 year treasury bill drops to 4.73% from 5.25%. The 30 years mortgage rate is 6.44% now.

Today you only pay 4.73% interest rate for a ten years long term loan but have to pay 5.25% rate for an overnight loan. Does that mean there will be no inflation within ten years? Or even mean there is a deflation? With common sense you know it's impossible as long as the oil price doubled in one year. All these were done by Feds to protect their property value so you saw these strange phenomenon.

1. Oil price.
The result of a big trade deficit is that foreign countries hold a large amount of US dollar. When US has not enough goods or assets to exchange these dollars back, it has to think of a way to make these countries to keep the dollar instead of dumping it. One way is to push up the oil price.

A country which consumes one million barrel of oil a year has to keep 30 million dollars in bank (when oil price is at 30 dollars/ barrel) Then how much should it reserve if the oil price jumped from 30/barrel to 60/barrel? It has to double its dollar reserve to 60 millions. So large amount of dollars were locked up in bank as oil payment (Dollar is the appointed currency in oil trading.)

Now you know why the oil price jumped so high. It is used to solve the deficit problem of US. To delay the US financial crisis. Who benefit from it?
(1) Oil export country.(Though much of them are Islamic countries which US dislike. There is no choice.)
(2) Speculator (mostly oil groups). They bought in large quantity of future contracts in a short period. Say, from 30/bar to 60/bar, the average price paid was 45/bar. Then when the market was steady at 60/bar to 75/bar, they sold it at average of 67.5/bar. Their profit is 22.5/bar.
(3) Federal Reserve and US economy. Federal Reserve can avoid to pay a high interest rate in order to lure the dollar in. US can avoid a financial crises.

The loser is always the average people. They have to take the final cost - a higher gas price.

But it's a double side sword. High oil price will also cause inflation to force the rising of interest rate. When it endangers real estate market, then we saw a dramatic decline of oil price. (from 75/bar/Aug 3 to 60/bar/Sept 19, a 20% decline in 6 weeks.) After all, the interest of Feds, is above everything else.

To keep in mind that when the oil price went up this year, it's not that oil supply was in shortage. And when the oil price drops recently, it's not that there is less demand. It's not a market economy any more. It's an artificial manipulating market.

Greenspan knew it. But he could only say what he was allowed to say.
Quote, "The former Fed chief also detailed how investors, rather than users of oil, have come to set the price of oil through purchasing futures contracts."

Posts: 707

Thank you very much, kathaksung. It was a great leap at debunking peak oil.