Oil - The Big Long And The Great Unwind

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

Summary

The Big Long is the thesis that Saudi/Gulf Producers supported oil prices by swapping use of Petrodollars/Petroeuros for 'Dark Inventory' of producer oil in storage or reservoir.

Current record Money Market fund positions in crude oil represent the final stage of liquidation of the Big Long.

Following expiry of Brent June 2016 contract the contango has almost disappeared discouraging commercial storage & leading to tanker congestion of unsold cargoes.

The North Sea Forties field crude oil borrowed by Saudi/GCC which has been instrumental in supporting the global oil price is now being returned to producers.

Treasury Bills are being returned to the Saudis in exchange for the return of borrowed crude oil and this reduces the apparent Saudi deficit.

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.

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.

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 and Resale (Prepay) agreements.

In effect, this was a value swap of currency over time for oil, and we are now seeing this value swap unwound as Forties crude oil - which is the "F" in the BFOE (Brent, Forties Oseberg, Ekofisk) benchmark price - is returned to producers while Treasury Bills are returned to Saudi monetary reserves.

The Great Unwind

In the run up to today's expiry of the June 2016 Brent/BFOE futures contract the contract price rose rapidly to peak over $48/barrel.

In the meantime, the June 2016 price rose more rapidly than the price of later contact months, which has the effect of reducing the Contango, and this in turn reduces the incentive for traders to buy and store crude oil.

Meanwhile the reality of the physical crude oil market has increasingly been parting company with financial demand from Managed Money funds which have built a record long position in the market.

I found this Reuters market update, titled "Unsold crude at sea raises warning flag to oil price bounce," to contain useful information.

Dozens of tankers with unsold crude have been amassing at sea in the past few weeks, vividly reminiscent of 2015 when a recovery in oil prices was scuppered by rising physical supply.

In 2015 we saw Saudi financial reserves poured into the market - re-inflating the price. This inflow also created a sufficient Contango for commercial 'cash & carry' storage to be viable.

However, by mid 2015 it became clear that while the financial capital to continue market support by funding inventory was available, the global capacity to store oil inventory was no longer sufficient.

'We ... see worrying parallels to 2015, when oil prices rose sharply well into May before collapsing in the second half of the year,' Commerzbank analysts said in a note.

This note is perceptive, but the difference this time around is that Saudi Petrodollar capital will not remain in the market through funding inventory, but is instead draining out to help stem the hemorrhage of Saudi reserves.

Vessels holding 7 million barrels of Forties - one of the grades that determines the level of the global dated Brent benchmark - have built in the North Sea this month. The volume equates to half of the entire Forties loading program for next month, and Reuters shipping data shows no supertanker bookings yet to sail to Asia in April, an absence of a crucial arbitrage flow that has not happened since last August.

In my analysis, it is through purchase and resale (oil leases) of Forties production that the Saudis have been able - through the Brent complex of contracts - to support the Brent/BFOE pricing tail which wags the global oil market dog. The economic interest in these Forties cargoes has now reverted to whoever lent Forties (via swap dealers) to the Saudis in exchange for an interest-free loan.

Market Now

The view of the Reuters authors is as follows:

Idle cargoes could well be the growing pains of a market that is rebalancing, where barrels find homes more slowly, but are being processed into products, rather than squirreled away in tanks in the hopes of a rebound later.

The only possibility for the market to rebalance and to "clear" is if there is a drastic and coordinated cut in production. Whatever impetus there was behind a production freeze with oil at $40/barrel is hardly likely to be increased by oil nearer $50/barrel.

Producers have good strategic reasons to stockpile oil firstly, to smooth production and secondly to optimize price. Consumers will also stockpile for both strategic energy security reasons and because they perceive oil reserves to be more desirable economically than dollar reserves.

But traders - who are commercial animals - will not squirrel away stocks in the "hope" of a rebound, but rather for the reason that they have locked in an arbitrage - risk-free - profit through buying and forward sale. The authors also miss the point that barrels of oil which are processed into products do not magically disappear from the market, but simply transform a surplus of crude oil into a surplus of oil products.

Finally, these new data points - and the flattening of the oil price curve towards the backwardation I predicted - confirm my view that the only thing which is holding the market price up is the record long position held by Money Market funds. Some market commentators believe this represents an active (speculative) position held by hedge funds; others that it is a passive position in Index Funds and Exchange Traded funds held by inflation hedgers (and likely to cause the very inflation being hedged).

A Global 'False Market'

In my view, in the course of winding down the Big Long, Saudi/GCC have bought Brent Crude oil futures contracts while at the same time having an inventory of oil for which they have prepaid and which may - directly or indirectly (via Exchange for Physicals) - be delivered into the contract.

Many in the market have observed what one oil trader calls a "Big Boy Squeeze". Anyone who sells futures without holding physical barrels, is essentially giving away free money to the funds who simply absorb the sales bid up the market price again.

During my time as a UK market regulator such a two tier physical market situation - where 1% of the market is aware of the existence of market information not possessed by the other 99% - was known as a 'false market' to be rectified immediately, where possible or with the market shut down in the public interest if not.

Trading the Big Long

Anyone who agrees with my "Big Long" thesis and wishes to trade upon it, might consider deep out of the money crude oil put options: August or later for Brent options and July or later for WTI options.

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.