'Non-Profit' Is Back With A Bang: 'Beggar Thy Neighbor' Complicates The Oil Industry

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Includes: BNO, DBO, DNO, DTO, DWTI, OIL, OLEM, OLO, SCO, SZO, UCO, USL, USO, UWTI
by: Procyon Mukherjee

Summary

Financial development in Oil futures market increased risks for the industry as well as for other commercial constituencies involved in oil.

Only 0.1% global capacity taken out in oil so far; ‘beggar thy neighbor’ policy could take months for this game to be played out.

All four commercial constituencies in oil losing money as hedge effectiveness is low.

Price recovery in oil would depend on how quickly fundamentals return; however commercial participants in the futures market could play the role of a deterrent.

Those who had a penchant for 'non-profit', take note that the global oil industry would be the biggest non-profit institution in the world, with a host of partners in queue, at least for now.

The historical lows in oil prices mirror some events of the past, but it could be a new phenomenon that protracted low prices are forcing the bulk of global capacity to lose money. What is striking is that only 0.1% of global capacity has been stopped or moth-balled so far as per this Bloomberg report . In fact the world has seen for the first time the longest stretch of decoupling of prices with supply and demand, aided by financialization; the long spell of high prices triggered by speculation and hedging aided the capacity addition which was somewhat delinked from the fundamentals. Now when the prices have crashed, it has not sparked off closure of capacities at a speed that the situation demands.

The lukewarm response to capacity reductions is somewhat typical of 'beggar thy neighbor' strategy, which means every player expects the other to take the brunt of the price reduction by cutting production. This time the OPEC & Saudi Arabia, in particular, did not play ball to be the first to announce capacity reductions. The axe fell on the swing outfits that operate at the edges of the last quartile of costs, which happens to be the much touted shale oil and gas in U.S. The reductions so far have been very minimal.

But we must first understand how the financial hedges allowed a protracted run in Oil and commodities, much to the mixed fortunes of a range of constituencies as one would see this in details in Damir Tokic's treatise "Rational de-stabilizing speculation, positive feedback trading, and the oil bubble of 2008". There are four constituencies, for example in Oil, whose positions determine where the prices would be headed.

1. Long term institutional investors, example retirement funds, university endowments or large Financial Institutions. They view crude oil as a financial asset, an integral part of their investment portfolio. Crude Oil is viewed as an effective hedge against inflation, particularly during periods of currency devaluation.

2. Crude Oil Producers: The oil producing countries and energy companies, who engage in short hedging-sell longer term futures contracts to lock in their profit margins.

3. Speculators: Short term traders in the crude oil futures markets , for example ,traders on NYMEX floor, trend-following Commodity Trading Advisors and hedge funds; also known as 'noise' traders.

4. Crude Oil Consumers: The refiners and the large scale consumers, who engage in long hedging-buy longer term futures contracts to lock in their profit margins. The airlines companies or the downstream value chain in oil are the key proponents of this.

The net long positions must balance the net short positions eventually, but the game is hardly even in short periods and that is what makes the choppy periods look so volatile. Let us look at how the interplay happened that led to the rise in prices and how that finally crashed. This can be explained in eight levels:

Level 1: Noise traders push oil prices to the upper level of the fundamental value range, as viewed by oil producers and oil consumers, who use fundamental analysis of supply and demand to determine the value range for the price of crude oil.

Level 2: Oil producers short more futures to benefit from temporarily rising prices. Oil consumers consume more oil from their inventories to avoid buying crude oil at higher than justified prices.

The combined actions of oil producers and oil consumers ensure that oil price returns to its fundamental value range.

Level 3: Institutional investors allocate funds to the crude oil futures because (A) they possibly expect a sharp longer term stock market downturn and accordingly diversify their portfolios to crude oil futures, and/or (B) they hedge inflation due to an upward revision to future inflationary expectations.

Level 4: Huge increase in prices due to the investor interest despite shorting from producers; producers remove their short hedges to limit the losses on their hedge positions. Therefore, oil producers become positive feedback traders.

Level 5: Consumers face depleting inventories; consequently commercial crude oil consumers start to aggressively long hedge. Therefore, oil consumers also become positive feedback traders.

Level 6: Negative feedback traders sell short crude oil futures as the price of crude oil rises expecting trend reversal.

Level 7: Positive feedback traders or trend followers keep buying the crude oil futures as the price of crude oil rises expecting the trend to continue.

Level 8: The bubble bursts as all positive feedback trading exhausts and the crude oil investors sell their holdings as they realize that the price of crude oil went beyond any fundamental value range, including the adjustment for potential higher inflation expectations and a potential stock market crash.

Price recovery in this market would have to follow the same underlying principles and would take several rounds of 'positioning'. The good news is that the hedges are due for expiration for most of the participants and consumers are refraining from entering into new hedges, while speculators remain coy. That leaves the floor open for long term funds and producers to get their act together.

But there is way too much capacity still out in the open that has to be taken out. But that is a painful process that must be played like a 'beggar thy neighbor' strategy. As long as the price of oil remains above the marginal cost of production for those producers (currently that would mean those who operate in the first and second decile of the cost curve) we can expect production to continue. With interest rates, wherever they are, it could mean that the party might last longer for some. The long term buyers on the other hand who had hedged oil at a much higher level are losing money, the producers and long term funds have been insulated so far, but the hedges are about to expire and the new windows are yet to give a clear view of things.

Raghuram Rajan in his seminal paper (2005), "Has Financial development left the world riskier," had actually looked at the effect of speculation and hedging in a number of areas. Current floor in oil, that leaves all the constituents in a precarious situation, reminds one of his foreboding more than a decade ago.

In sum, the uncertainty with respect to inflation and economic growth notwithstanding, the forthcoming moves by the Fed combined with the situation in the Middle East would probably determine the movement of oil prices if one goes by the fundamental analysis. However commercial participants in the futures market do not have superior inflation forecasting models and are unable to arbitrage any crude oil pricing inefficiencies due to strictly financial variables. This apparent limit to arbitrage, which led to the speculative bubble in crude oil could be a deterrent to price recovery in the near term as well.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.