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Keith Schaefer writes on oil and natural gas markets in a simple, easy to read manner. His new newsletter will outline which TSX-listed energy companies have the ability to grow, and bring shareholders prosperity even in these tough times. He has a degree in journalism and has worked for several... More
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  • One of the Most Important Interviews You'll Read on Oil Trading 5 comments
    Oct 7, 2011 2:36 PM
    Retail consumers of oil – and retail investors of oil – are the big losers now that oil has become a financial product, says Dan Dicker, author of Oil's Endless Bid.

    But the irony is they're doing it to themselves—by buying oil ETFs (Exchange Traded Funds) and ETNs (Exchange Traded Notes) and other financial derivative products based on oil.

    I only came up for three gulps of air while reading the book, and I emailed Dan immediately afterwards asking for an interview.  He writes in a simple, earthy and honest way—that I wouldn't have expected from an oil trader on the floor of the New York Mercantile Exchange.

    One point he explained so well to me was that the investment banks that now dominate trading have created a massive new market of buyers, and only buyers – no sellers – with their financial products like ETFs.  And that has inflated the price of oil for consumers.  The oil price nowadays is not just based on fundamental supply and demand.

    "In 1980 oil demand was about 60 million barrels a day.  In 1990 it was 70 million and in 2010 it was about 90 million.  What’s interesting is that demand has been fairly steady in how it’s increased; about 10 million barrels a day each decade.

    "But the oil price has been entirely flat for 20 of those 30 years.  What that says to me is that something clearly changed in how we’re pricing the stuff in the last 10 years."

    And that something is the involvement of the financial industry, he says.  "It's all about the pricing mechanism, who’s involved and the money being thrown at it."

    That money comes in the form of ETFs and index funds all geared around the price of oil, and are obviously set up by the big investment banks.

    But Dicker says that is ALL "long" interest, meaning they are all BUYERS and not SELLERS.  And we all know what happens to the price of something when are more buyers than sellers.  The price goes up.

    "What has happened in last 10 years, those who have been setting price based on fundamentals in the market have been swamped out by the financial sector, who have very little engagement with the physical product.  Yet their input is equally important to the price of oil as those physically involved in the sector.

    "The market is democratic, but it wasn’t designed to be democratic."

    And there is the irony!  Oil becomes a democratic market—where institutional and retail investors get to help set the price by all of their buying in these indexes, ETFs and ETNs to gain exposure to the oil price (which isn't possible, Dicker writes) but in effect drive the price up.  So they pay more at the pump.  Democracy at work!

    And sadly, the other side of the coin is that the investment banks make a nice share of the coin in the oil trade.

    "The stock market can theoretically have a whole group of winners as the stock market goes up—forever.  With oil that's not true.  When someone buys oil, someone has to sell it to them.  At the end of the day or month or year when trades settle the amount of money won equals the amount of money lost.  When institutions make money trading oil, that eventually comes out of the pockets of people filling their tanks, refrigerating their meats— it’s a zero sum game."

    Well, wait a minute Dan—you just said everybody in oil is long, i.e. they're buyers, but then you just said there has to be a buyer for every seller.

    “Yes, almost everyone who is investing and even hedging oil is long, so the market has to somehow generate sellers, something the stock market for example doesn’t need to do.  So how do you generate sellers where there aren’t any to begin with?

    "Well, first, you must make the price pretty high:  Imagine you own a $100,000 house in a neighbourhood of $100,000 houses and all of a sudden, a new group of home buyers wants to have your house, for whatever reason.

    What will get you to sell?  Well, someone knocking on your door with a $200,000 check might get you to think about it.  So, price is driven artificially higher, that’s the first thing.”

    “But sellers in an oil market also don’t have physical assets.  Even when enticed by a high price, they need a hedge for those sales, because they don’t have oil to deliver, any more than buyers want to actually accept deliveries of oil.”

    “So, in generating sellers,  you also generate trade correlations. Like, the corn chart and oil chart look almost exactly the same. And the correlation between oil and oil stocks become uncannily close.”

    "So you get these trade correlations, but not a fundamental correlation.  So we now have a very different correlation between the oil market and the stock market than what we had before.

    "The oil market-stock market trade looks like a correlation, it's perceived as one, but it doesn’t make sense, because high oil prices are intuitively not good for the stock market.  So they call it a measure of growth.

    "Now we’re looking at a double dip recession and EU going down and oil prices more than $110—how does that fundamentally make sense.  It doesn't because the marketplace designed for producers and consumers is overrun by people who are financially engaged."

    OK, now I am a believer that there is big premium in oil because it has become a financial product.  How big is that premium and how does... can it ever go away... can we ever end The Endless Bid on Oil?

    "You’ll never know what the premium is until you remove this financial mechanism.

    "The chances of ending it IMHO are pretty slim.  The path to fixing this is simple to see—but making it happen is nearly impossible in practice.

    "You would need to restore the market to close to the way it was before these financial influences took control of it, and let commodity markets operate the way they were intended.  The financial industry will say that’s a destructive rollback of investment trading.  The banks and the entire financial industry have big stake in this."

    In his book, Dan tells some great and funny stories about how he won and lost lots of money (for him) on the old NYMEX floor, despite being a very small independent oil trader. In between the wry smiles, you will get his core message:

    "Treating what was a commodity as if it was a stock, is inherently a bad path toward a pricing model that will be volatile, unreliable and unfairly high.

    "This is a commodity that people rely on (in their daily lives), and they're treating it like it’s investable—and the outcomes are fairly obvious to see."

    You can buy Dan's book — again, it's very simple English — at Amazon. Here is the link:
    Oil's Endless Bid: Taming the Unreliable Price of Oil to Secure Our Economy

    - Keith

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Comments (5)
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  • Dan Dicker
    , contributor
    Comments (4) | Send Message
    Thanks, Keith, for the fabulous review of my book -- I'm so pleased you found it informative as well as fun...... Best regards -


    7 Oct 2011, 04:33 PM Reply Like
  • captiankirkoptions
    , contributor
    Comments (241) | Send Message
    Good article - oil is a wild complex animal. I still can't figure out a good reason for the WTI - Brent difference. Only thing I can think of is wild buying and selling going on in WTI that is not happening in Brent.
    10 Oct 2011, 02:55 PM Reply Like
  • bbarberayr
    , contributor
    Comments (218) | Send Message
    It makes sense that as Oil ETF's grow, they will pull supply out of the market to support these. Correspondingly, once these ETF's stop growing, they will be buying and selling the same $ value of futures, so will have no effect on the price of oil. Finally, when these ETF's start to shrink (once buyers realize they are not a good proxy for oil or oil prices start down on their own accord), the ETF's will be net sellers and supply will be added to the market.


    It is really the creation of these products which is creating a 1 time price increase, but this cannot, mathematically, be a perpetual price increase. An easier way to think about this is to look at the Gold ETF, GLD. As long as the market cap of GLD is growing, they are buying gold on the open market and driving up the price. When the market cap begins to shrink, they will be forced to sell. Because of this, they are magnifying the moves in both directions, but again, once the GLD product has reached its "full size", regular supply demand fundamentals will apply.
    13 Oct 2011, 08:05 AM Reply Like
  • RM13
    , contributor
    Comments (1264) | Send Message
    That is my way of seeing this as well - it's a one time increase in oil value with volatility that comes from flows in and out of the market. The problem with this is that oil (or other commodity) volatility affects the economy and all of us on daily basis, and it's increasingly difficult to plan for small/medium sized business when the fluctuation in its raw products are +/-30% on yearly basis. So my conclusion is that large well run companies benefit in long run - they can hedge correctly and have size to resist downturns.
    20 Oct 2011, 09:14 AM Reply Like
  • Patrick 1948
    , contributor
    Comments (178) | Send Message
    Think about how much 90 million barrels of oil is. This will fill 250,000 million car gas tanks. Every day .
    Every day this disappears forever. And how can we expect the price of such a commodity to go down ? Every day this lake of oil has to be replaced.
    29 May 2013, 10:42 AM Reply Like
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