Big Long - Reprise
My thesis of the Big Long is that Saudi/GCC producers used sovereign reserve assets (Petrodollars/Petroeuros) as capital to fund crude oil being stored off-market by commercial market participants.
This had the effect of inflating and supporting oil market prices, and was achieved - via investment bank "swap dealers" - through exchanging firstly (until mid-2014) US Treasuries and then (from early 2015) euro-denominated sovereign debt (probably Bunds) for a "Dark Inventory" of crude oil which was subject to Purchase & Resale (Prepay) agreements. In effect, this was a value swap of currency over time for oil over time.
The liquidity necessary for oil market cash flow came from Quantitative Easing (QE), which, until October 2014, came in dollars from the Federal Reserve Bank, and from January 2015 in euros from the European Central Bank.
Since the Big Long was published on February 27th, the crude oil market price has - contrary to my expectations - increased further to trade in a range above $40/barrel.
So does that disprove the Big Long thesis? Or have I simply been - not for the first time - right too soon, misjudging the speed with which the physical oil market juggernaut can turn?
Big Long Queues
Beginning with the much-hyped upcoming meeting in Doha, I find it difficult to understand how OPEC and Russia freezing production at record levels will address structural oversupply.
A picture is worth a thousand blog posts, and these images of oil tanker traffic and congestion tell you everything you need to know about the state of the oil market's physical production and consumption. Moreover, while there has been much discussion of availability of static storage of oil as a factor in oil market pricing, the much more important subject of the flow of oil receives less attention outside the industry.
The problem is that physical oil market production, distribution and consumption now has very little to do with oil market prices in what has become a terminally dysfunctional and sociopathic global market platform run by middlemen for the benefit of middlemen. The oil market price moved from $80 to $147 to $35 and back to $80 per barrel within a two-year period, during which physical supply and demand varied by no more than 3%.
In my analysis, the fall from $147/bbl in July 2008 to $35/bbl in December 2008 had little to do with physical demand - which was high, with producers struggling to accommodate it - and almost everything to do with the drying up of trade finance, particularly Letters of Credit, for the flow of oil.
However, five years of prices over $80/barrel saw the market evolve, both through mega-barrels of increased production and nega-barrels of reduced consumption, to structural oversupply. I believe we have now seen a global market inflection point of peak demand for oil, proving Yamani's point that the Stone Age did not end for lack of stones and the Oil Age will not end for lack of oil.
But whether or not this peak demand thesis is correct does not address the question of how and why the oil market price - which is set by a relatively few cargoes of physical crude oil in the UK North Sea - should have spiked back over $40/barrel in the face of physical market oversupply.
Finally, and hot off the press, we now see "BRENT structure surges into backwardation between June and July futures contracts."
This move to backwardation - which is consistent with my February prediction - is not caused by physical demand for spot oil for consumption, but rather by financial demand for spot oil combined with forward sales.
US Commodity Futures Trading Commission (CFTC) Commitments of Traders (COT) reports breakdown market positions on organised futures markets regulated by CFTC into the following categories:
"Managed Money," and
'A "money manager," for the purpose of this report, is a registered commodity trading advisor (CTA), a registered commodity pool operator (CPO), or an unregistered fund identified by CFTC. These traders are engaged in managing and conducting organized futures trading on behalf of clients.
Hedge Funds and other Animals
The CFTC itself notes that unregistered funds include hedge funds, for whom a useful definition might be - for the oil market at least - that it is an "active" fund which risks investors' capital in pursuit of trading profit.
Hedge funds therefore buy and sell oil, not necessarily in that order, and their typically short-term speculative positions represent an important source of liquidity in the market for producers who wish to hedge their production.
It is now over two decades since Goldman Sachs first dreamt up the Goldman Sachs Commodities Index (Pending:GSCI) fund and the concept/meme of "inflation hedging". This was the first of new breeds of index funds and exchange-traded funds whose motivation is not to actively risk capital in pursuit of profit, but rather the complete opposite - to avoid loss.
These were christened passive funds, since their purpose is to preserve investor capital by avoiding loss. These funds offload the risk of holding dollars in favour of the risk of holding oil and thereby "hedge inflation".
Their consistent long-term long-only presence in the oil market has meant that the true extent of oil market speculative buying by risk-taking hedge funds has been obscured by risk-averse investors whose motivation is to avoid loss, rather than make profit.
If my thesis of macro market manipulation by producers is correct, then they must have been participating in financial oil markets, either directly or indirectly - using swaps and other OTC oil market positions with investment banks - through intermediary vehicles (i.e., funds).
As with tracking a tiger, it is possible to track these market animals only through the kills and spoor they leave as they pass through the market jungle.
Open Interest Data
The first set of tracks is visible in this useful chart produced by the excellent John Kemp of Reuters, which shows the overall - across Brent and WTI - net long open interest.
Firstly, it will be observed that money managers have been structurally net long throughout, which illustrates the preponderance of passive over-active fund investors.
Secondly, there is the fall of some 400,000 contracts in the net long position in Q3/Q4 of 2014, which was accompanied by a dramatic fall in oil prices.
We then saw the open interest rise in Q1/Q2 2015 accompanied by a price rise to $60/bbl, and fall again in Q3/Q4 2015 accompanied by a price fall into the $20s.
Finally, we saw open interest rise to record levels in Q1 2016 accompanied by a resurgence of the price to almost $45/bbl.
Through a Glass Darkly
By filtering this open interest data between Brent and WTI, a different picture emerges. Back on February 22nd - before my Big Long article was published - John Kemp was observing a "GREAT ROTATION: hedge funds increasingly bearish on WTI but bullish on Brent," and he recently updated that chart here.
Firstly, it will be observed that until February 2015 WTI net long fund open interest was always greater - sometimes as much as 250,000 contracts greater - than that for Brent.
Secondly, this changed sharply in February 2015, and WTI and Brent open interest tracked each other until around November 2015.
Finally, we saw Brent open interest take off in January 2016, followed a month later by WTI.
So how does this data support the Big Long thesis?
The Big Long
In essence, the Big Long trade is simple: Saudi/GCC borrowed oil via investment banks in exchange for their Treasury Bills - first US, and later (say) German. In doing so, the borrowed Dark Inventory is no longer available on the market, and this acts to support the price, which producers will always do wherever they can.
In practice this trade is not so simple. Global crude oil prices are set via the UK North Sea Brent, Forties Oseberg, Ekofisk (BFOE) Complex, which is a bewildering mix of forward, futures and swap contracts. The BFOE forward crude oil contract (on which the ICE Brent Crude oil futures contract is based) is the tail that wags the global oil market dog.
In order to control or support the price, it is necessary to support the price of Dated (spot) Brent/BFOE cargoes, which is achievable in turn through purchasing the forward Brent/BFOE oil contracts which give rise to these Dated Brent/BFOE cargoes upon expiry. Since the number of qualifying cargoes is dwindling as North Sea production is in secular decline, such price support is becoming more and more straightforward to achieve for those with the capital and the motive.
In order to borrow oil and create the Big Long, spot oil must be bought and then resold (or replaced in kind with other oil) at a later date to an investment bank swap dealer. The swap dealer manages the market price risk by taking back-to-back positions on the market. Historical COT reports show clearly how, for years during the manufactured Big Long oil bubble, the short positions of swap dealers mirrored a large proportion of the Managed Money long positions.
In my analysis, the swap dealers firstly conducted a rolling programme of forward physical BFOE purchases which underpinned the market price. Secondly, oil futures contracts would be sold by swap dealers for the duration of this "oil loan," and the oil producers would take matching "long" futures position via participation - in the US - through Managed Money funds.
The swap dealers would exchange US Treasury bills held by the producers (Petrodollars) for dollars available via the QE programme, and these dollars would be lent to or swapped with North Sea players - BP Plc (NYSE:BP) and Statoil (NYSE:STO) come to mind - in exchange for the purchase and resale (borrowing) of oil in tanks or even in reservoirs.
But the key to understanding the Big Long is to realise that it is possible - where market conditions make it the least dollar cost option - to repay such oil loans in kind. So, a producer like Saudi/GCC could deliver their own oil rather than buying oil to return it to North Sea producers.
This is where the Saudi's Motiva joint US refining venture with Shell - where Shell has recently been bought out by the Saudis - came in. Oil could be, and often was, delivered into the US by the Saudis to be refined there, and the occasional waves of deliveries may be accounted for by flows within the context of the Big Long.
Similarly, many of the strange moves in US oil inventories which routinely confound market observers can, in my view, be accounted for by opaque transfers of title of oil held in US storage. This is not dissimilar to the way that London Metal Exchange base metals move on- and off-warrant "across the line" in LME warehouses.
The outcome of financialising the oil market in this way has been that the forward oil price curve came to mirror the forward dollar yield curve through this time swap between the dollar and oil, made possible by QE liquidity.
Reading the Signs
In my view, what happened - and is reflected by the falling open interest - was that the QE taper in 2014, which ended in October 2014, saw US Treasuries returned to Saudi/GCC on the one hand, and oil inventory released onto the market on the other hand. This thereby deflated the oil bubble, which, as I had predicted in 2011/12, was inevitable once QE ended.
Then, from January 2015, once the ECB brought forward euro QE (probably specifically for the purpose of backing the euro with oil), it appears that Saudi/GCC re-inflated the oil bubble using reserves which were being switched from Petrodollars to Petroeuros, probably to German Bunds.
In my analysis, US shale oil production capacity was intended to be, and now operates as, a (high-cost) second-tier Strategic Petroleum Reserve. This has enabled the US to loosen an increasingly troublesome relationship, of which Petrodollars were one element.
The rise in price from $35 to $65 per barrel within six weeks in Q3 2015 had little or no fundamental justification. However, it was accompanied by an increase in open interest, which saw WTI and Brent open interest roughly track each other instead of Brent open interest being consistently less than that of WTI as it had been.
The problem with the Big Long strategy was that while Saudi/GCC had sufficient capital to fund further inventory, sufficient commercial storage did not exist to accommodate it, and this euro-funded support operation came to an end.
What we are now seeing is the return of commercial inventory to the market, since, in the absence of sufficient contango (not to mention bank funding), it is no longer economic to commercial producers and traders to hold inventory once existing cash and carry positions come due.
So, are the Money Market fund positions in the COT reports those of hedge funds?
Firstly, the idea that hedge funds - i.e., active risk takers - should, as a class, be short of WTI and long of Brent or vice versa is misconceived. Maybe one or two hedge funds might take a punt on this arbitrage on a relatively small scale, but not as a class, and certainly not on this scale.
Secondly, risk-averse passive fund investors would, by definition, never knowingly take the risk involved in such a transatlantic arbitrage. It follows that only a fund with some kind of off-exchange position invisible to the market is involved.
The result of this market position taken by Managed Money funds is a "short squeeze to end all short squeezes". A great deal of oil now being delivered into the market is - unbeknown to 99% of participants (and so, in what as a UK oil market regulator I used to call a "false market") - prepaid oil in which the economic interest is not where futures sellers shorting the market believe.
The current spike in prices means drastic production cuts are even less likely than before to be agreed in Doha, and that excess supply will continue to flow into the market.
When combined with the maturation of cash and carry positions, recently documented by John Dizard in the FT, and the virtual absence of contango, there is every reason to believe inventory will increasingly be dumped on the market in a global game of "pass the parcel," which will have the effect of lowering forward prices and possibly creating a superbackwardation.
Add to this prospect the existing oil market transport congestion documented above, and I suggest that the market can only, as I previously forecast, test new lows in the absence of significant coordinated production cuts.
However, what has been for a decade now a regulatory disaster zone of a two-tier global "false market" in crude oil is not for the faint of heart, and the spot oil price may yet spike further as massive Managed Money fund positions are liquidated or run to expiry.
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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.