The Underlying European Oil Contagion

Includes: OIL
by: Kent Moors

As we await another down day on Wall Street, attention once again turns to weakness on European banks as the culprit. Actually, that seems to be only half the situation.

Crude oil in New York was poised to move down again this morning, following an almost 6% drop yesterday. Brent in London, however, dropped only half that and, despite the bank problems and the ever-present continental debt worries, was going back up again today.

At close yesterday, the spread between the Brent benchmark crude price and WTI (West Texas Intermediate, the benchmark used in Nymex trading) stood at over 29% of the WTI price. Remember, as I have mentioned many times before, WTI is a better grade of oil than Brent. That should mean, if normal market conditions actually dictated trade, WTI prices would be at a premium to Brent. And they were consistently… until last year at this time. For the past twelve months, the reverse has been the case.

I have also noted before some of the reasons for this, with the primary cause being the fact that Brent is now used as the standard for discounting more actual crude physically traded worldwide than WTI. The vast majority of daily global transactions are in oil having more sulfur content than either of the primary benchmarks. Neither Brent nor WTI, therefore, really represents the world's stock of crude.

However, of late my curiosity has been poking around elsewhere. How can the effective pricing of Brent remain at such levels, given the fiscal malaise that is Europe?

My initial take on this was presented to the Greek Finance Ministry in late June, during an eventful stay in Athens marked by high humidity and higher tempers in the streets. My preliminary analysis had concluded that as much as 28% of the Greek debt problem had effectively been discounted and transferred into Brent oil futures.

After I gave my briefing, the ministry released a truncated press release holding the rest of Europe responsible for a quarter of the country's debt mess! That was hardly my intention, but it did give me some reason to consider this further.

Later events have simply reinforced the following observation: The European price for oil is supported by its debt problem. We have spent so much time treating European debt in isolation – regarding it as a sovereign fiscal problem or a result of undercapitalized banks – that the analysts as a whole have been missing something important. As the concern over European debt contagion increases, the oil contagion is taking place almost unnoticed.

It happens this way: Crude oil is a financial asset as well as a commodity. That means the contract has a collateral (and a fungible, for that matter) application. It can be exchanged, leveraged or used to buy and sell other assets. Anything that has this flexibility and has an underlying market value to boot has a larger market presence than simply the contract itself. Any financial asset has this utility. Some, such as agricultural commodities (which have a striking parallel to oil contracts in market dynamics), are so well known for doing this that their trade is heavily regulated on exchanges.

There are also the matters of ease of transfer and ready liquidity to purchase. I may have considerable asset value in my house, for example, but it is released only if I can sell it. That is a big unknown in the current market. So what do I do? If I need the cash, I will take out a home equity line of credit. And that gets us back to the European oil situation.

Oil, however, while often traded on the Nymex or the ICE (Brent trade moves internationally this way) has been finding its exchange progressively moved off the market (OTM). Rather than appearing as a straight oil transaction, these deals are structured more as credit default swaps.

I will save you the trouble of sitting through a course lecture at this point. It is enough to say that such swaps are designed to meet the individual needs of counter parties and, as such, are quite varied in structure. They also are unregulated.

Two things have happened at this point in the European oil situation. First, derivatives have been cut on the European debt load, allowing its trade at a discount, with that discount becoming more severe as the debt problem in, say, Greece (sovereign) or Credit Suisse (banking) worsens. Options are cut in an attempt to lessen overall risk exposure. That paper representing discounted debt is now available for use, and more of it is being swapped, or in other ways employed, to under-gird Brent futures contracts.

Those oil contracts are already using similar synthetic paper, often disguised as quite exotic option spreads. What initially appeared as an apples and oranges situation, now allows for the easy exchange of derivatives.

The options themselves are disproportionately European in type. This does not refer to the region in which they are cut but to the provision that they cannot be sold until expiration (unlike American options that allow selling at any time up to expiration). It is now the effective exchange of the derivatives that govern the price of both the debt and the oil, not the nominal (or actual market) price for either.

You make more moneyas the usage of these intermediary artificial (or synthetic) exchange devices increases. However, they bear less relationship to the actual underlying value of the assets they represent. Sound familiar? Just think "subprime mortgage debt obligations" here.

Second, the Brent price has been based on a blend of oil from as many as 15 offshore fields in the North Sea. Today, however, only four of those fields essentially determine the price. With overall Brent production declining, on any given day there is less crude volume represented than in the calculations of WTI in New York City. That is why the excess storage problem in Cushing, OK (the primary pipeline crossroads location in the U.S. and the place Nymex prices are struck) has a greater impact in New York than volume considerations have with Brent in London.

This allows fewer traders to have a greater control over Brent availability. Combine the wider usage of derivatives with more oligopolistic control over the underlying wet barrel consignments, and a major opportunity emerges to profit from the volatility in both oil and debt.

This is already happening. Production from the fields that feed into the Brent mix fell 13% from 2008 to 2010. The less oil output there is, the easier it becomes for a single trader to exert a heavy influence on prices by buying up a large amount of North Sea crude.

Earlier this year, Hetco, the trading arm of Hess Corp. (NYSE:HES), provoked fears of a Brent squeeze when the company bought one-third of the February supply of Forties, the largest component of the benchmark blend. Ultimately, Hetco sold its cargoes without triggering any major price moves. Some observers (me included) believe this was a trial run for what is now taking place regularly in the world of paper exchanges.

The recent moves to ban short sales on some European exchanges in an attempt to shore up bank stocks, therefore, miss the point. Why short a market when you can play the debt-to-oil futures derivative swap OTM and accomplish the same thing?

Disclosure: None

Original post