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Oil Market: Rectifying The Broken Paper Pricing Model
By EconMatters
It has become quite apparent that major changes are necessary in the oil futures market after the latest year of volatility which had little relation to the actual fundamentals of supply and demand in the marketplace.
Oil is too an important commodity to have such a large dislocation from the actual physical market of supply and demand. It is used by people all over the world as a necessary commodity for daily transportation, businesses rely on the commodity to produce goods, and economies need a stable price reflective of fundamentals to flourish in an efficient matter.
In short, speculators have no business in the oil market, they distort prices, and sure helped slow global growth during the past year by running up prices well beyond the fundamentals based upon actual inventory levels of the commodity.
WTI & Cushing Inventory - A Curious Correlation
Let us look at WTI, it was trading at $115 a barrel while US inventory levels at Cushing were at record levels of over 40 million barrels in storage, in contrast WTI was trading at $76 a barrel when Cushing inventories were actually only 36 million barrels. (Back in May, when WTI was at $100/bbl, we wrote this piece predicitng oil would drop to $80 a barrel by Sept....We probably were too conservative.)
In addition, Libyan oil was offline the entire time, often cited by bullish speculators as a thesis to push up price regardless of the actual market effects of the offline oil which was more than made up for by Saudi Arabia. So now we can empirically validate that oil should never have been $115 a barrel, the market was actually over-supplied based upon inventory levels in relation to their 5-year averages.
Global GDP & Consumers Pay The Price
The run-up in the oil market is probably the single most destructive factor that is responsible for the deterioration in GDP growth the last two quarters, and signs of a potential recession.
Why? Because it is one thing if the economy is booming and oil prices were high reflective of true dynamic demand in the economy, but it is an entirely different matter when prices are artificially high by a substantial amount and not reflective of demand in the market. That translates to a humungous tax being placed on the entire global economy which in the end is deflationary, and detrimental to economic prosperity.
Debunking The Brent & Libyan Oil Connection
Let us now examine the Brent Futures contract, which traded as high as $127 a barrel, and was trading as low as $97 a barrel just recently. Again, the fact that Libyan oil being offline was commonly used as the reason for it trading at such high prices, but notice there was no actual correlation between Libyan oil offline and $97 or $127 a barrel, and that alone is a $30 per barrel price discrepancy.
The world needs a better pricing method for dictating price of such an important commodity.
Brent/WTI Record Spread Explained
The real problem with the Brent Futures market is that there is no transparency whatsoever, there are no inventories tied to the futures market to judge historical inventory versus current levels, and the market doesn`t have a physical delivery mechanism in place.
It literally can be any price, just pull a number out of a hat, because it is completely divorced from a fundamental marketplace where price would be set by producers and consumers. There are no producers and consumers setting the prices in either of these markets though as even WTI contracts that take delivery each year is so minuscule, i.e., so far less than 1% to be essentially a no delivery market as well.
The high premium for Brent oil compared to WTI (as much as $25 a barrel at times) is often rationalized as being based upon fundamental demand for Brent versus WTI, but that is just a smokescreen for the actual reasons which are that all the big players love the Brent market because it lacks any transparency, no inventories or delivery metrics, and the fact that it is such any easier market to obscure position limits.
These are the primary reasons for the hefty Brent premium, and not fundamental supply issues.
From Jackson Hole to MENA Conflict
Another point worth noting is the QE2 affect on Oil prices, Bernanke steadfastly denied this but as we can examine in retrospect, it was absolutely a major factor in the rise of the commodity right after the Jackson Hole speech straight through to the MENA (Middle East & North Africa) conflict. It is just too tempting for Wall Street when $50 Billion is being created out of thin air each month to move some of this newfound capital electronically into the Oil markets.
After all, it was Bernanke`s stated goal to inflate asset prices, and the oil markets are assets the last time I checked, and commodity assets to boot, which get more love with loose monetary policy initiatives.
Oil Price Needs To Be Insulated from Monetary Policies
But the Fed at times will need to stimulate the economy with various policy initiatives, and the changes I am suggesting will help insulate the oil markets from such fed policy measures so that we can have the best parts of the stimulus, i.e., the wealth affects and business optimism, and leave out the worst parts of the stimulus in higher oil and gasoline prices which slow down the economy.
So here are the changes that need to be made to the oil markets, I actually feel that agricultural and some other key commodity groups may also need to addressed in the same fashion as these are too important commodities not to be based upon the fundamental supply and demands dynamics of a true marketplace and not a bunch of artificially created electronic/paper infused speculation but that is for another time.
Could This Be Rectified?
So these are the recommended changes to the oil markets:
1) WTI & Brent futures contracts opened for each month must be 100% deliverable, so you either provide delivery or take delivery each month or time frame in the future, and positions can be as large as any participant needs.
This will bring back some market fundamentals of true price discovery as all participants will actually utilize the commodity, no more paper market mechanism in place. So in short, a trader can speculate all they want, they just have to take delivery or provide delivery – this will cut out a bunch of the nonsense that currently goes on in these markets.
2) The Brent contract needs to be connected with some European storage facilities so that there can be a weekly transparent update which has historical benchmark capabilities so that inventory levels can be tracked and analyzed similarly to the EIA`s reporting on US inventory levels and statistics.
This is long overdue, and for such an important commodity the fact that this has taken this long to occur in the era of modern technology is just ridiculous.
Paper Trading Benefits No One But Few "Elite Groups"
This isn`t the dark age. Isn`t knowledge and actual real data important for efficient economic resource planning and forecasting purposes? The Brent contract shouldn`t be clouded in mystery, we shouldn`t have to take some anecdotal thoughts on Brent inventory levels, we should just be able to access the numbers in a weekly report that show the supply levels either well above or below their historical five-year levels just like the WTI contract and the total US Inventory Regions.
Yes, traders are going to have to find other markets to make their living, but frankly the oil market is too important to the vital health of the global economy to not return to price discovery based upon fundamental supply and demand, and not paper trading by large speculators for the sake of making money for a small elite group at the expense of the entire world population of consumers who are currently being artificially taxed by said speculators.
If these changes are made we will never again have to question the legitimacy of the price of oil for all practical purposes.
Yes I know big speculators can do the contango trade by taking delivery and store oil off the market, but there are costs to doing this-- capacity restraints, and at some point the oil will come back to the market.
Nevertheless, compared to what the current dynamics in place of 100% paper markets that exist in both the WTI and Brent Futures contracts, this will seem like a trivial “market price dislocation” and could be addressed if speculators seem to be purposely abusing the system on a case by case basis in the future.
In reality this will be a major step forward in the right direction, if we have to make some minor tweaks along the way, then so be it.
As the 2007 run-up to $143 and then back down to $33, and this last year`s move from the mid $70`s up to $115 and then back down to $76 illustrate these markets are broken, and no true price discovery mechanism exists other than what the speculators say the price of oil is via capital inflows and outflows.
This current model leads to inefficient pricing and increased volatility which hurts economic growth and needs to be replaced by actual true price discovery of supply and demand fundamentals dictating the market price. Price needs to be dictated by producers and consumers who actually either create or consume the commodity, and not the large speculators who neither produce nor consume the commodity but paper trade it. This leads to continual distorted and mispriced markets which in itself indicates that we have a problem in how these oil markets are being priced.
Further Reading: Is Speculation The Reason For High Oil and Gasoline Prices?
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The worst thing about the oil industry is that it's subsidized by the taxpayers.
This is written by a "chartered economist"...no wonder it is such a pile of shit that it makes little sense to anyone with experience in oil
gee, sure would like to see your credentials (if any) and your "pile of shit" (again, if any) that got published anywhere
How about you work on your reading comprehension Global
That's why, with a team of analysts, we at EconMatters focus on identifying the fundamental theories of cause and effect in the financial markets that matters to your portfolio.
Are you the same guys who advised Ford and Carter?
There are several analysts who work for that site, CFA`s included FYI.
How about just position limits like they do for grains and livestock unless your hedging, with real teeth and real fines if you're caught fucking with the allocation. Did you ever think of that?
this is the stupidest crap i have read all day. go ask schiff why oil wont stay down.
you dude, how about food. I think eating may be more impt. why do speculators belong in food!!
So why did a bank, JPM, buy 30 million barrels of the 60 mil Barry released? What is a bank doing with physical oil? Why didn't Barry let it go into the market?
yes, they are not banks anymore, they are government agents and paid handsomely I might add.
...Officially since 1913.
and like the Mafia, as things get tough so do their rates.
How do you expect them to make their quarterly profits.
My take is this:
JPM et al was shorting the shit out of oil at the behest of the Treasury/Fed so as to drive the price down to pave the way for whatever form QE3 comes in... The oil allows them to cover their shorts.
As for requiring physical delivery makes perfect sense as an aid to actual price discovery and sounds good to me. The howl will come that this is insufficient liquidity and speculators add to liquidity of the markets, but you pay a price/tax for that.
Saudi Arabia yesterday decided to drop the widely used West Texas Intermediate oil [futures] contract as the benchmark for pricing its oil. The decision by the world's biggest oil exporter could encourage other producers to abandon the benchmark and threatens the dominance of the world's most heavily traded oil futures contract. The move reveals the growing discontent of Riyadh and its US refinery customers with WTI after the price of the benchmark became separated from the global oil market this year.
From January 2010, Saudi Arabia will base the price of oil for its US customers on a new index developed by Argus, the London-based oil pricing company. The Argus Sour Crude Index will track the price in the physical market of a basket of US Gulf Coast crudes, including Mars, Poseidon and Southern Green Canyon.
Saudi`s are a bunch of slimeballs, I caanot blame them it is in their best self interest. However, instead of saying straight out that they want the Brent price, they hide behind the index, which by the way is based upon what the Brent price is, it sets the price for california to louisiana, but that would be too obvious so they do an end around to get the same end result.....they want $25 dollars more for their oil per barrel---just another part of the many scams that is the oil market:)
The Saudis don't want to sell at WTI prices because WTI no longer reflects the world market price. There is so much oil coming from the Bakken to Cushing, OK where WTI is priced that there is a glut in Cushing. Until there is a pipeline large enough to carry the Bakken oil from Cushing down to the Gulf of Mexico where it can be loaded onto tankers and sold to the world market the WTI price will be somewhat disconnected from the world price of oil. Bakken oil is effectively "stranded" at the moment unless you want to load up tanker trucks and drive it to the Gulf. One can hardly criticize the Saudis for not wanting to sell their oil for the same low price as stranded Bakken oil. If the Bakken folks want a better price for their oil they need to pony up and build the pipeline to carry it to the world market.
"Saudi`s are a bunch of slimeballs, I cannot blame them it is in their best self interest"
say that three times, record it, then play it backwards
Exactly. Just like the gold and silver markets, WTI can be pushed around at will by paper contracts.
The volume of paper traded in these markets totally swamps the actual volume of physical commodity traded.
As long as there are millions of hedge funds out there trying to "make a killing" on the Peak Oil myth, paper can always be used to flush these guys out and push prices lower.
the are more myths about truths than truths about myths
What market isn't manipulated and designed to skim money from chumps (ie average consumers and investors)? This is why the paper markets were created and made legal in the first place.
I agree wholeheartedly with the proposed changes in this post. I also wish all commodities markets could not be manipulated with "paper futures" or other means. But these kind of changes would be met with all the threats and all the power that the elites can muster, up to and including physical violence IMHO. Who is powerful enough to tell Goldman or JPM to "go make their money somewhere else?" Congress? The President? Give me a fucking break. These people are in on the scam.
Correct me if I'm wrong, but isn't this a consequence of "hot money" ? The Bernanke prints and the Wallstreet guys borrow cheap. They sure as hell don't want to put it into equities, that's the playground of Robots. Even they don't understand how the Algos work, only the Quants know how. So it goes into commodities. So because of the "printing press" you get misallocation and inflation. I know it's simplistic, but I'm a simple man
Algos are trading commodities and FX just like they are equities...
Come on! Wallstreet owns the robots.
Another hater of "free market" economy. Let the market decide what to do....mind your own business. Oil is another hedge against the weak...and weakening dollar.
So be it. Go to the back of the room and sit down.
demand for crude a largely inelastic commodity changed that much to merit a drop from 143 a barrel to 33, and back again to 75 rather quickly with a higher unemployment rate than when it fell to 33 a barrel at over 10% when it was back up to $75. What changed...... fund inflows pure and simple....the crude oil market is the most manipulated market in finance today other than the pink sheets!
How exactly do they "manipulate" a 5% depletion rate?.... These guys are more talented than I thought.
Expect everything but lower lows. As Flak flaks, its symbiotic - the shortage raises the price, the price stalls the economy, the price falls to a higher low and on we go...
The fall to 33 was the result of overlevered players having a puke moment... Any real oil analyst saw this as almost the buy of a lifetime...
As I said, PO will result in huge volatility...
Given peak, we're in for a ton of bulimics.
From FT.com October 29 2009
Saudis drop WTI oil contract
Saudi Arabia yesterday decided to drop the widely used West Texas Intermediate oil [futures] contract as the benchmark for pricing its oil. The decision by the world's biggest oil exporter could encourage other producers to abandon the benchmark and threatens the dominance of the world's most heavily traded oil futures contract. The move reveals the growing discontent of Riyadh and its US refinery customers with WTI after the price of the benchmark became separated from the global oil market this year.
From January 2010, Saudi Arabia will base the price of oil for its US customers on a new index developed by Argus, the London-based oil pricing company. The Argus Sour Crude Index will track the price in the physical market of a basket of US Gulf Coast crudes, including Mars, Poseidon and Southern Green Canyon.
Paul Horsnell, head of commodities research at Barclays Capital in London, said Saudi Arabia's decision was likely to reflect a "wider discontent" from its customers in the US about WTI performance. Edward Morse, chief economist at LCM Commodities in New York, said: "It is a recognition by large players that WTI sometimes does not reflect the true value of crude oil in the waterborne market." Saudi Arabia has priced its oil using WTI since 1994.
So I ask you, if WTI futures are no longer serving the physical oil industry as a benchmark oil index (supposedly their primary purpose), and if experts in the financial industry are confirming this fact, then who is this paper market serving, and how and why? And by the way, what is it that all you bozos who bought the USO ETF think you really own?
Here’s a link to the full article:
http://www.ft.com/cms/s/0/2034dd70-c42c-11de-8de6-00144feab49a.html#axzz1Vww9bcvJ
It is serving political entities that don't want to admit that oil is a finite resource. It is also a way to fool the unedgumicated masses that the price of oil is actually below $100 a barrel.
WTi is a barbarous relic.....
Yeah oil is so much in demand all during this time that nobody ever wants to take delivery and store on a barge......make them take delivery.....and then you will see the real price of crude oil around $45 to $50 a barrel, consumers have been getting ripped off paying probably on average $1-2 per gallon above real market prices.
I heard these same peak oil arguments when Oil was 143...what happened four months later when it was $33........the PermaBulls are right up there with the tin-hat wearing crowd. I know demand dropped over 150% in 4 months......the fact remains that if you make everyone take delivery then you will see who really wants the oil versus the Goldman Sachs paper trading market pumpers that have been manipulating this market for the past 7 years!
you're not living up to your name.
Nail, I would like you to meet Hammer...
Why don't you check out CERA/IHS on the marginal cost of a new barrel in the Bakken, DW GOM etc...FWIW, CERA is a thinktank that vehemently denies PO (at least in the sense that we are currently witnessing)...
PO causes extreme volatility... not necessarily monotonically increasing prices. When oil overshoots to the upside it stifles the economy and prices overshoot to the downside... I have called it the sawtooth economy. Any significant uptick in global economic activity removes the spare oil production capacity....
Take a look at the production profile for whale oil and the price... Whale oil is a good example because we have reliable data and production figures....
For oil, like gold BTFD, you won't be disappointed.
Speculating and manipulating are too very different concepts......you can speculate all you want, just put your money where your mouth is and take delivery.
But the Russia argument is invalid, nobody said you cannot "speculate" just actually take delivery!
We are not even talking about a 30% taking delivery market, it is less than .0000001%, it is a pure day trading instrument, watch it trade for 24 hours straight and you can see the constant games being played with the market (even in this time frame).
Without proper regulation you get abuses, see Enron and the California Electricity market: Having a physical deliverable market cuts out the blatant manipulation because their are consequences involved, it self regulates if you will.
But again proper regulation has nothing to do with speculation, speculate all you want, just be prepared to use the commodity or pay to store it.
Moreover, the author is right the current system is broken, and needs to be fixed.
Supply and demand.
Fundamentals.
Is this the fucking funnies section and the joke of the day??
The oil business may be dirty but the money is always clean. The oil market is as follows:
Racketeering
Collusion
Fraud
The average US citizen needs to decide if they want capitalism...or not. If they do, then they have to be willing to absorb a few bumps in unruly open markets. If not...then they have to be willing to absorb some bumps when central planners make mistakes. Either way...their road will have bumps.
While it seems obvious that markets need rules and boundaries to prevent the worst excesses and market manipulation....no one has yet found a way to provide open markets AND insulate every citizen from being hit with uncomfortable economic swings. Life ain't perfect......
I agree that average Americans have (in general) become mindless lazy slobs that want a guarantee on everything, including their health (even though they don't exercise and eat like shit). They should definitle realize that life makes you no promises. Everyone faces adversity, how an individual overcomes it is the important bit.
What the central planners are NOT telling everyone (and the importance of sites like this) is what we all should really be concerned with. I am hoping that friday is uneventful.
Blah, Blah, Blah. The world economy still runs on oil. There is plenty of demand. Soon enough, some countries (and people) will still have the capital to afford oil purchases and some countries (and people) won't.
It is as simple as that. Yes, food is very much attached to the price of oil. (Mainly because of nitrogen fixation for fertilizer and NOT transport). There won't be any rioting until the U.S. loses world reserve currency status and the cost of everything thriples overnight. Then you might have a riot or two. Hence, we get a long slow decline. Rather than throw you into the abyss your central planners are arranging a "soft landing".
What a total disconnect from reality traders have vs. the consuming public. Why should you make money at the expense of others on a commodity that is essential to life on this planet?
The problem is this: no one does any real work anymore. Making money by manipulating a commodity or pushing buttons on a computer is not work. Go out and get a skill and get a real job and then see how you like paying more than you should for gas or heating oil because some suit or tech dude can manipulate money and data on a screen.
The entire economic system is corrupt and there are no free markets.
The argument about price discovery or doing a good thing for the market is utter bullshit when it comes to oil.
Precisely why we need to crash he system now. The paper pushing fucknuts will actually have to do some real work to survive. Compensation (and price dicovery) will actully retunr to folks who are worth a shit and know how to deliver goods and services of REAL value.
I always laugh when I hear my accountant talk about financial "products". Total bullshit, no such thing.
Everyone take a look at the natural gas and tell me that futures cause high prices due to "speculation". What you fail to realize that people use liquid paper positions to hedge deliverable OTC agreements that are tailered to their specific needs. If you're burning 25,000 dthm in NY per month, what good does delivery sometime in the month at the HH do you? How the hell are you going to get it up there?
Lets say I have a small oil well in south east TX. I pump the output into a tank and empty it every two days. I deliver it to the coast . You're telling me I need to cart it up to cushing if i want to use a use a WTI future when I think the market has overpriced oil? Apparently you think it's better to force the entire WTI trade into OTC markets. That will surely help price discovery. I know platts would be happy at least.
And how the hell do you "force delivery"? You're not allowed to exit a position once you take it? What happens if your well drys up? What happens if your building burns down?
Christ you're out of touch here.
http://www.shtfplan.com/forecasting/complexity-theorists-predict-food-cr...
it's 'official' Complexity Theorists Predict Food Crisis, Riots and Civil Unrest By April 2013
Also, my mom was saying just last night how detrimental the futures traders have been to the viability of the family farmers. We own some family farms, and she grew up there, so she should know! Farmers are some of the most vulnerable people on earth...not only do they fall prey to the forces of the market, but to the forces of nature as well!
The government started screwing with agriculture in the 30's, and has made family farming almost impossible. I hope people here will think about that....farmers work so much harder than most!
From my humble perspective, ALL of the markets are rigged at this point. The simplest thing to do would be to NOT PRINT FIAT MONEY!!! When printing is done without the underpinning of true economic growth, then it is INFLATIONARY over time. THAT affects consumers on ALL levels. As Ron Paul says, if you would get central banks out of our monetary policy and return to sound money and policy, then the markets would take care of themselves!
Quit printing the damn money!
worst article i have read this week. speculators do not distort gas prices, and crude oil is not what you put in your car. speculators are the front line of the price-finding mechanism. economics obviously does not actually matter to you.