Oil: The Big Long

by: Chris Cook

Forward commodity price curves are based on fear, not hope and greed.

The Big Long is in the oil market and is the greatest market manipulation the world has ever seen and ever will see.

Superbackwardation? In the absence of coordinated oil production cuts, we will see oil prices drop to or even below $20, likely accompanied by a superbackwardation.

Capex Drought: $1.6 trillion pa in petrodollars has evaporated. A capex drought combined with energy-related insolvencies will lead to global recession at best, depression at worst.

Market Expectations

In oil markets, the forward price curve has a minimal basis on price expectations because forward prices of oil and oil products are driven by fear, rather than hope or greed.

Oil producers generally have a budgetary interest in locking in oil prices by hedging, either through options or forward sale of their production - particularly producers with oil-related development debt. Unfortunately for these oil producers, while refiners will invariably insure against the risk of rising oil prices through buying forward, they have much shorter time horizons. I well recall that in 1990, when I became a director of the International Petroleum Exchange (IPE, now ICE Futures Europe), the third contract month (Month 3) of IPE's flagship Brent Crude Oil futures contract rarely traded.

All that changed from 1995 when the Goldman Sachs Commodity Index (GSCI) fund began to 'hedge inflation' by taking long commodity market positions, and moreover, to do so as far in the future as they could. Essentially, what was happening was that oil producers were offloading oil market risk in favor of dollar risk, while the risk-averse 'passive' investors to whom Goldman had sold inflation hedging were offloading dollar risk in favor of oil market risk.

In this way, the forward price curves in oil and other commodities became detached from any basis on fundamental supply and demand of the underlying commodities for consumption.

The Big Long

I have been published widely in relation to the two oil market bubbles which took place in the decade since 2005. The first bubble, culminating in July 2008, was a private sector affair driven by new forms of long-only 'passive' commodity funds and fueled by leverage from bank credit and derivatives. The second bubble, from 2009 onwards, was in my view the greatest market support/manipulation and transfer of wealth the world has ever seen: The Big Long.

That the oil market price completely parted company from the reality of production and consumption is strikingly illustrated by the fact that within two years, the oil market price gyrated from $80 to $147 to $35 and back to $80 while physical consumption changed by less than 3%.

While the first bubble to July 2008 was a private sector affair fueled by derivatives and bank credit, this leverage largely disappeared with the banking system's capital base in October 2008. The advent of zero interest rates and quantitative easing saw a rush of risk averse money into stock index funds and commodity funds. Passive funds bought oil as far forward as producers hedging would sell to them and a forward oil price curve thereby took shape.

The outcome was essentially a swap of dollars over time for oil over time, while oil price curves become correlated with commodities and stocks. Oil prices, apart from front months, became financialized, losing touch with supply and demand in the physical market, and movements in the dollar yield curve closely tracked moves in oil price curves.

Enter the Saudis

Commodity producers throughout history, from tin to copper, cocoa to coffee and from diamonds to oil have shown that if they can support the price of their commodity through creating cartels or otherwise then they will. Saudi Arabia and Persian Gulf states in their desperate position in early 2009 were a classic case. Despite OPEC cuts in production of 3 million bpd by December 2008, the price had declined to $35/barrel with no apparent end in sight.

In order to support prices, two elements are required: capital and liquidity. The Saudis/GCC had plenty of petrodollars after the first oil bubble and much of this capital was in the form of US Treasury bills, which are essentially a sale and repurchase of dollars. Moreover, infinite interest-free liquidity was available in the form of Quantitative Easing by the Federal Reserve Bank.

In my analysis, what then occurred is that in addition to the influx of 'muppet' inflation hedgers to the market, Saudi/GCC acted to remove excess inventory from the market by swapping reserves of T-Bills for Enron-style prepay purchase and re-sale of crude oil.

In the first half of 2009, the market was in what became known as a 'Supercontango' (when the forward price was massively in excess of the spot price) which enabled traders to buy and store cargoes of crude oil. Such a market structure is of course typical of oversupply. But at the same time, the market price rose dramatically to regain $80/barrel (which was a level below which it did not again fall until 2014) which can only have been because the market was under-supplied.

This conventionally inexplicable market paradox could only be explained if there were an actor in the market with the motive and the means to take opaque positions affecting the physical market price. My case is that Saudi Arabia and GCC nations had both the motive and the means to support the market price. In my analysis, they did so with the assistance of US investment banks and probably one or two key North Sea oil market participants who were in a position to control the Brent complex of contracts which set the global oil market price.

During the next five years, excess profits in excess of cost flowed to oil producers in unprecedented amounts - between $5 and $10 trillion as a rough estimate - and the resulting flood of petrodollars enabled the global banking system to fund both commodity inventory and capital expenditure on new commodity production.

In particular, banks funded investment in US shale oil, and in my view, this was as a result of a US political decision - for energy security reasons - rather than for economic reasons. The result of this lending was that US shale oil production increased by 5 million barrels per day, while US oil product consumption shrank by 2 million bpd over the same period.

The outcome has therefore been the creation by the US of what is essentially a second tier high cost strategic petroleum reserve and freedom from reliance on the Saudis who had increasingly become an embarrassment. In my view, the US has now ended their 1945 guarantee of the Saudi regime, which has responded by switching out of petrodollars, in particular to euros.

End of the Big Long

As I forecast four years ago when the oil price was over $100/barrel, the price collapsed following the end of QE to $45 to $50/barrel, and fell even further. Then within six weeks in early 2015, the price dramatically reflated to $60/barrel with no physical market justification whatever. In my analysis, Saudi/GCC reserve assets in euro denominated debt such as German government bunds were acquired and then swapped for oil inventory. Meanwhile, the European Central Bank brought forward their program of QE which created the euros necessary to be exchanged for the dollars which were being sold.

The problem was that at this re-inflated price level the oversupply persisted and possibly even increased as underlying demand for consumption (Chinese oil purchase have increasingly been as reserves) began to fall. Since storage is finite there could only be one outcome, and this price support operation - the Big Long - is now being liquidated.

There are many data points which tend to support the liquidation of a Big Long. There are complaints - such as by BP's (NYSE:BP) Robert Dudley - that liquidity from buyers is no longer available in forward months. We have also seen the forward curve decline significantly at the same time as a major long position has been built in the early contract months.

I believe that movements in US inventories which routinely confound analysts' expectations may be accounted for by opaque transfers of title of oil in tank storage.

In my view, we have also been seeing a 'short squeeze' in the physical market to end all short squeezes. I believe this to be the reason for recent wild swings in the Brent/WTI spread and the dramatic volatility in oil prices. There now exists a two tier 'false market' in crude oil, based upon a Dark Inventory of prepaid oil. This is akin to an iceberg under the market ocean upon which many traders and hedge funds unaware of its existence have been wrecked. So for instance, traders expecting funds to roll over positions may have been caught out when the funds did not do what they expected.

John Kemp of Reuters recently suggested that funds are currently in two minds being both short and long of the market. In my analysis, a large proportion of fund positions are not actually hedge funds taking speculative positions, but actually represent the liquidation of the prepaid inventory accumulated earlier in the year.

Add to this John Dizard's recent observation in FTfm that last year's wave of 'cash and carry' commercial arbitrage plays is now coming to an end. In my view, in the absence of commodity dollars generally and petrodollars specifically, bank funding will no longer be available for these positions to be rolled over.

As Dizard points out, we could well see this oil coming onto the market in a wave as commercial players rush for the exit. But I disagree with his conclusion that dumping inventory onto the market can be positive for the market price. In my view, we are more likely to see the opposite of what happened in early 2009.

Whereas we then saw the paradox of a Supercontango combined with a rising market, it is possible that this time - in the absence of coordinated production cuts - that we will see the paradox of a Superbackwardation in a falling market.

Whether or not that is the case, I suspect that the approaching expiry on Monday, 29th February of the April 2016 ICE Europe Brent BFOE contract - which is the first of contract month to move away from the historic mid-month Brent/BFOE settlement cycle - could well see dramatic price action in the oil market in its aftermath.

Finally, and away from the oil market, it is always useful to follow the guiding principle of all fraud investigators - 'Follow the Money'. There have been unusual moves in Saudi monetary reserves since at least late 2014 for market observers have dreamt up all kinds of strange explanations in relation to Saudi expenditure.

I think the month to month swings in Saudi monetary flows are such that they are probably related less to swings in expenditure than to switches from reported reserve assets to other assets which are not currently being reported.

Long Gone

There is a difference of view as to the effect of lower oil and commodity prices. Many economists consider that the effect will be stimulative through reducing costs, and this is in my view self evident.

But the problem is not so much the stimulative effect of cost reduction, but rather the depressing effect of the loss of the surplus value or economic rent which flowed - in the form of a colossal five year windfall - to commodity and oil producers.

This is actually removing purchasing power from the global economy on a cosmic, multi trillion dollar scale. Several observers, including Warren Mosler, believe that this reduction in global purchasing power is leading to a significant and increasing reduction in capital expenditure.

I believe that the global markets have reached an inflection point, and that new global institutional frameworks will be necessary as a response. But that response - possibly in the form of an Energy Clearing Union - is another story, requiring a new settlement akin to Bretton Woods.

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.