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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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Nonsense. On the contrary, this EconMatters post was the most irrefutable article of the past month.
LOL! Economics and economic models are not ground in reality and still rely on infinite growth on a finite planet. Worst comment I have read in a long time. Crash the system, crash it now. The sooner we do, the sooner compensation returns to people who are actually worth a shit. Fuck these paper-pushing fucktards.
"speculators are the front line of the price-finding mechanism."
Sure. If you think that market price discovery is primarily about the speculators trying to find an equilibrium between themselves, and not about some poor sod in the supermarket trying to feed his family.
Of course price discovery is about speculators finding an equilibrium between themselves. What else would it be about? In the short term, speculators are the only ones who can discover prices because only speculators add or remove physical product from the market. Real consumers and producers have very sticky consumption levels. Airlines do not decide not to fly tomorrow because oil is expensive. Oil companies do not stop the pumps because oil prices dropped the day before. Only speculators or those acting as speculators buy inventory they don't need, and then hold inventory waiting to sell. Actual producers and consumers only make decisions based on long term trends and outlooks, which don't matter whatsoever in short term price discovery.
The WTI manipulation just shows that Oil is Oligarchy play of immense magnitude in the biggest consumer market of the world. The USA cannot continue down this road much longer. Its another signal that the ponzi is now creapingly affecting the real market of goods, in a way that distorts price discovery hugely. This increasing spread trend says it all. Of course the quality of WTI crude has to be clearly assessed to compensate for comparative energy yields. But that does not justify this trend.
Futures markets are not cash markets. There are no barrels in the backroom. Get a life.
Other Factors Worth Considering
There's a corporation now selling a set-up for $5,500 that will allow you to run your car,truck,SUV on water. So why not.
The system turns H2 O into Hydrogen and Oxegen and then powers the engine on the combined gas (called Brown Gas). Two electrodes in a tank of water, a bigger generator and some additional equipment. The company has sold over 20.000 units, many to fleets, and it works.
This is surpressed technology, that is now seeing the light of day, that could and is changing the dynamics of the supply and demand picture (in a very small way so far). He has had several attempts of his life (8, I believe), but is still working and filling orders, check out Angel Labs at PESWiki.com
There are other innovative generators for electric generation already out there, much more efficient that offer nuge savings.
The idea that these inventions can make a difference and that these guys are being threatened should be our concern, not that the price manipulation doesn't matter.
First law of thermodynamic -Energy is neither created nor destroyed.
In order to split that water into Hydrogen and oxygen gas (to burn in the car) you still need to input ENERGY. Where does that energy come from? The answer is a nuclear or coal fired power plant retard.
Burning wood to generate steam to drive the car would be more efficient. This is way this "technology" keeps getting ignored.
Clearly, you and Flak are unaware of the recent advances in unicorn piss and troll wish technology. Get with the program fellas.
Ummm.... are you familiar with the Second law of thermodynamics??
science can be so inconvenient
I'm sure there is an answer to this, but have never heard it mentioned. If you run an engine on hydrogen and oxygen, how do you make it sufficiently safe for general use? They are quite explosive and literally are rocket fuel.
You're confused. Brown gas is that stuff that makes a funny sound when it comes out your brother's ass. But you're right, you sure as hell could run a car on that shit.
instead of letting the terrorists into our country thru yours.. next time keep the towel heads on your side of the border.. "A"?
If you have no intention of ever taking delivery why should you be allowed to participate in the oil market. Or for that matter any commodity.
The only purpose as a speculator would be to drive the base cost up because without the actual product you could never make money. Sure you could short the market but there really is no incentive in shorting oil if demand models are followed.
The entire reason the market is broken is because the vast majority of trades are based on the transfer of paper without knowing where or how much of the actual commodity is attached. Look at the gold market. How much of the price is distorted by the insane amount of paper gold. ZH readers are all about physical ownership and not paper gold, so why woul you support paper oil.
The worst part is that over the past 10 years the oil business has been bought up by the large players and the majority of the independant producers have been forced out. When the tentacles of the squid invaded the commodity market after the CFMA was passed the landscape was forever changed. Just like the main street takeover of the vampire multinationals traded in the equity market, the takeover of the commodity market is complete. Just like all the P/E Nasdaq stocks in the 90s and above the vapires say why can't commodities trade at 10 times thier book value.
Even though Exxon knows it could still make billions with $30 oil why would they ever let it drop below $80. The world will still use the same that it does now becuase we have no choice. $80 oil is also a great hedge even if we do use less oil. We would need to reduce consuption by over 50% at that price to really make a dent. Paper profits would still be just as high as a few years ago.
We will never see true price discovery of anything again in our lifetimes unless the system is completely dismantled. Problem is that will bring about a revolution many people will not want because it will be very hard to make it through unscathed.
duplicate
"dictating price of such an important commodity"
Really? Because I don't want to take delivery of an oil tanker I can't invest in OIL? I love when people so much smarter than me decide that it's much better that they "dictate" things like prices because if a retard like me was to actually try to make a dollar by investing my money in something that can't be printed away by ChairSatan, I could upset the precious social balance of the world.
Your idea of insulating oil from monetary policy is the most inane thing in the whole article.
"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"
In-fucking-sane. This is a price control. Have price controls ever worked? So if the fed prints 5 jillion dollars and dumps in on the market in your fantasy world you will just "dictate" oil to be at $100 a barrel and there will still be plenty of supply because a dolt commoner like me can't take delivery? Talk about setting the stage for the big boys to rig the market, holy shit.
Are there distortions in the market? of Course, should big banks and HFT schemes be investigated? Probably. Fix that and supply and demand will take care of itself, if the true demand isn't there, speculators will take a bath, and if there is collusion throw somebody in jail, but please don't tell me that "Econ Matters" and then dump this article telling me that essentially Economics do not matter and that supply and demand can be just ignored and regulated around by super smart people like you.
This guy is essentially arguing for unregulated regulation by economists. What a contradictory idiot. Must have graduated recently with a degree in economics and wants to instantly find a job where he is "in charge" of something.
Sorry idiot, you have to earn it like everybody else.
When I read this article, I immediately thought of Wiemar, 1970s, Zimbabwe, Russia, etc.
It's people like this that are going to bring us the gas lines, odd/even days, and empty shelves in the grocery stores - AGAIN.
I suppose those damn speculators losing their shirts when they're wrong is of no consequence, since it certainly doesn't further the price controls cause.
Anyway, we should get used to it all. We're going to see the mother of all witch hunts when this shit blows up, and those evil speculators will be at the top of the list. Of course, the monetary and political causes will be ignored until the very end, when there is nobody else left to blame and the politicos who got us there are long gone.
If the author had any sense he would study history, not theory. 'Wage-Price Control - Myth and Reality' would be a good start.
But alas, catering to populist whinery is clearly more desirable for those looking to profit on stupidity.
This has to be one of the worst articles I've ever read on ZH.
The reason the WTI/Brent spread is distorted is due to all the oil coming out of Canadian tar sands and the Bakken shale in North Dakota. This oil heads to Cushing, OK which is the delivery point for WTI. The increased production coming from Bakken has made a glut in Cushing, causing the price of WTI to fall relative to Brent. They need a pipeline to carry oil from Cushing to the Gulf of Mexico to get the Bakken oil to the world market, but this is at least 2 years away. Until then you have to use trucks to carry the oil down there which is very expensive - hence the price distortions. Until the pipeline is in service Bakken oil will be "stranded" and somewhat disconnected in price from WTI. This is exactly the same reason why the price of natural gas varies so much from one geographic area to another. There aren't always pipelines available to move the gas from where it's cheap to where it's expensive.
"WTI & Brent futures contracts opened for each month must be 100% deliverable." This is a stupid idea. If you force a speculator to take delivery they will just move the oil from the storage at Cushing to a private storage facility that would probably be built right next door. The speculation would continue, but at a higher cost and with less efficiency than it is today.
Speculation is a critical function of a proper market is a provides the necessary price signals to producers to raise or lower their production. No one can perform this function more efficiently than speculators. If they could, they would be wealthy speculators themselves. Poor speculators are quickly run out of business. Producers aren't as good at forecasting as they are at producing. If their forecasting ability was better the opportunity for speculators wouldn't be there in the first place would it?
"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." Oil is a critical commodity with inelastic pricing and should therefore often be priced at a premium to what fundamentals suggest. A good price premium makes it possible to build storage facilities, take delivery at spot and deliver in the future and make a profit. This means that we will have oil in storage to help smooth out supply disruptions on a critical commodity. If no speculation were permitted there would be almost no storage of oil and supply disruptions would be devastating. The premium paid in prices should be viewed as an insurance premium against running out of oil at various times.
"Oil Price Needs To Be Insulated from Monetary Policies" - Price controls? What a terrible idea. Price controls have failed so many times I feel guilty for wasting any pixels on them here. Go to Venezuela to see how price controls work. Eggs, meat, and sugar are all priced very reasonably. There just isn't any on the shelf at the store for one to buy. Price caps ALWAYS lead to higher prices in the end as producers stop producing due to the price controls.
All the arguments about oil being too important for speculators to mess with are false. Speculators are more important than ever for oil exactly because oil is so important and because a disruption in or shortage of supply would be so devastating. If you think specuators ran the price of oil up too high in 2008 how high do you think oil would go if the demand had acutally exceeded the supply? Oil would have gone a lot higher. Speculators running up the price of oil early served to stimulate production and curtail consumption which ensured that the demand never exceeded the supply.
If the author really thinks that the paper markets are worthless and completely disconnected with reality and overprice oil then why doesn't he just short the paper, buy at spot and deliver the physical to cover his short? If the problem is so big and so obvious how come he's not a billionaire arbing the paper against the physical?
Well said. Unfortunately, and honest or otherwise, that thinking will build the path to goverment capture. They will add safety, military, and other bullshit to the mix but the bottomline will be the same, more distortion.
Prepare to be junked a million times for disagreeing with the cult.
Very well put nevertheless. Much more eloquent than my rant.
Dude I've decided the junking is a badge of honor. There are a lot of big goverment will save us types on zero hedge, but I can promise you there are people that receive a paycheck to troll this place. For now it is probably dirty hippies paid by some Soros outfit, but soon it will be a cyber agent. You can't make this stuff up. Google "anonymous operation metal gear".
To avoid the spin that is spun from all sides, you have to educate yourself about the real fundaments of oil supply and demand....
Once you start to see production profiles, net exports, the increasingly difficult oil fields to develop, learn the difference between kerogen, bitumen and light sweet, decline rates in horizontal fracked wells, sulfur content as a function of time then you are in a position to read through the bull shit...
Try reading Twilight in the Desert, not for its conclusions, but why Simmons reached those conclusions.
Edit: For example, you never heard on the MSM that Libya represented ~8% of the net exports of light sweet crude on the market. Puts it in a different perspective, eh?
you mean it's not cause Muammar is democracy's boogeyman?
Twilight is a great book. I'm not sure I fully agree with his conclusions, but you're right. How he got there is definitely something good to take home from it.
Re: Libya, there's a lot about Libya the MSM didn't say. And to me, what they don't say is often far more important than what they do say.
Unless it is "play money" or you are paid to play futures, the single best way to play oil is buy the cashflows from an oil field...
Check out the 15 year performance of PBT or SBR...
Yes thanks, I'll check out SBR. I've looked into PBT at times in the past, but now with that endangered lizard debacle going on I'll hold off until that is settled or the Enivrostormtroopers aren't in power any longer.
HGT is a pure conventional NG play... All of my clients own all three.
Don't sweat the lizards... PBT is all but stripper wells that will produce for a long time. They produce ~1000 bpd from 20 or so wells... and FWIW, it is real WTI oil, the very definition
I've never done much with the stripper plays. Are they still profitable at this price level? What about tax rate risk?
The pure strippers are a cash cow. I can't say anything about punitive changes to the tax structure.
Imagine having two wells producing a net of 2 bpd (98% water cut) that is powered by wind.
The tough decision is when and if the well needs a workover.
Interesting. I remember reading an article a few years ago about strippers being tested with wind power. I think there was a project in Abilene or Amarillo or somewhere around there that they were trying it out. I'll have a look into that. Do you know of any good sources for info on them?
There was a good article at theoildrum a month or so ago....
this whole article is pointing out the obvious, oil is hoarded like gold ( primarily via paper hoarding), because like gold, there is certainty that it will retain value ( the physical) over time due it being a traditional store of wealth preservation or, as with gold, a source of btu's.
There is some rationality in this article...
WTI is the fucked metric... play games with Brent and somebody will say, here's my tanker fill it..
Net Exports are down ~10% since 2005.... A simple model based on the DXY and the IMF oil inelasticity says Brent should be trading in the range 103-118..
It's called Peak Oil....
I thumbs down this article. It worships at the altar of futures trading as if such a thing is somehow sacrosanct and even remotely meaningful to society.
If you want to have an oil index, legislate public disclosure of what refineries pay for crude. It can be 30 days late to protect business secrets, but make it public because THAT, not any futures contract, REGARDLESS OF DELIVERABILITY, is all that matters. These oil analysts who have no degree in petroleum engineering or geology or even field management experience and want to talk only about the futures markets KNOW NOTHING.
Everyone and his brother knows full well that US refineries on the coasts are paying Brent prices. And everyone also knows that the midwest refineries are charging the same amount for gasoline output as those coastal refineries. They are pocketing the crack spread. THIS HAS NOTHING TO DO WITH FUTURES TRADING. They pocket the big spread they get from a lower input price than the coasts get, and they care NOTHING about what NYMEX says.
I worked at XOM's baytown plant back when I was a kid. It never ceased to amaze me what their markups were like for their products. And while I think we all know that plastics and other non-fuel products are always high on the profit scale for refiners, I was absolutely stunned at their margins at the time. I don't know what they're like today but I'd imagine they're not too shabby still.
"some" There are indeed a lot of fucked metrics but the biggest one, like you said, is avoiding the main issue. Like the budget, if you drew percentages of all the factors affecting the black magic, peak would look like defense, interest, and entitlements.
No doubt PO is playing a major role here. Also no doubt there are some serious shenannigans going on at NYMEX, Cushing, and the pipelines as you and I have talked about in the past, but this guy's premise ignores all the major factors. Further, it ignores the historical precedence that has existed for thousands of years of people forgetting the past and trying price controls again. Specs get burned just like everyone else. I seem to recall several IBs getting their greasy hands on a bunch of SPR crude for >$100 not but two months ago. I wonder if they were able to flip it all before this little tumble? I'd imagine so, but perhaps not?
Flakmeister and Malikai- both correct and thanks for posting.
Your "solution" is not a solution! It would just create a smaller market which is easier to manipulate by the large producers and consumers. The "evil speculator" boogey man theory of the markets is BS trotted out to deny the unpleasant and uncomfortable truth that there is no "fair price" or "constant price" for anything in this world.
Futures markets no question have big players pushing the price around, oil in particular. When the price was $127 for Brent don't forget there was tremendous instability in the Middle East. My guess if something had gone boom at Ras Tanura (Saudi port) every airline in the world would have wished they were hedged at $127.
Which producers and which consumers are going to choose what the price is suppose to be? If one wants to bring some normalcy to the market then ban HFT trading. Since the electronic are co-located next to the NYMEX servers volatility has gone through the roof.
As far as the Brent WTI spread you made no mention of the land locked nature of WTI. Between the increased production in the Bakkann and from the Canadian oilsands and flat demand in the mid continent WTI has no where to go, that is why the spread is where it is not because of Brent being manipulated up.
When the Keystone and Enterprise pipelines come on line in a couple years that will allow mid con crude to reach the Gulf Coast the brent WTI will go back to flat and not until then.
100% deliverable!?! You want the same thing for corn, how about gold, in fact lets go back to using chalkboards to mark down the last trade. I understand being upset at the volatility and the high price's effect on economic activity. If the world was a mundane place then many 5% vol would make sense, if you have looked out your window recently you will see a bunch of crazy people driving around with big guns blowing up stuff all across the Middle East.
Oh by the way the country across from Saudi has threatened to close the Persian Gulf if anyone ever attacks their centrifuges. From my window that is worth a few dollars of risk premium.
Please enough of the calls for oil being left to only the producers and consumers you sound very silly when you say that.
The problem is not oil speculators- they have always been there. The problem is Bernanke. ZIRP and QE forever has begat hot and unstable liquidity. End of story.
The entire US lifestyle is manipulated.
Every other market is rigged or manipulated, why not the oil market.