Oil: The Big Long... Going, Going, But Not Yet Gone

by: Chris Cook


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.

Money Market funds have prepaid for oil and any speculative futures seller is giving free money to the funds - a classic False Market.

Commercial storage is being emptied because it is no longer profitable to hold stocks, but tanker availability is congested.

Absent coordinated production cuts oil price will fall once fund liquidation is complete, accompanied by a backwardation.

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 and Resale (Prepay) agreements. In effect, this was a value swap of currency over time for oil.

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.

Setting the Scene

My recent article outlined how major Managed Money oil futures positions attributed to hedge funds, in fact, represent the unwinding of the Saudi/GCC Big Long position.

John Kemp of Reuters published an interesting article today, which is rich in data, but upon which - since the lens through which I view the market is very different - I come to very different conclusions, beginning with a few market observations.

Firstly, as I wrote in The Big Long , forward oil prices have virtually nothing to do with expectations of oil prices, and everything to do with producer fears, and the dollar yield curve. This is because forward buying - beyond the first few months - is almost entirely by financial buyers.

Secondly, hedge funds - as a class of active speculative investors - tend to trade outright futures contracts, usually in the most liquid Month 1 and Month 2 contracts. They don't tend to trade spreads other than to roll a position over from Month 1 to Month 2, and you will NEVER find hedge funds with far forward positions, which tend to be illiquid and relatively stable.

Passive investors, such as Exchange-traded funds and Index funds, on the other hand, maintain a medium/long-term position in the market which is routinely rolled over from month to month, when they become the object of a feeding frenzy by locals and market makers. These passive and risk averse funds certainly do not take the arbitrage risk of transatlantic Brent/WTI spreads and neither do hedge funds, at least not as a class of investor.

In other words, far forward positions held by Managed Money funds are neither active hedge funds nor passive inflation hedgers, but something else, and my thesis is that these positions are held by producers (Saudi/GCC) who have swapped Petrodollar/Petroeuro financial assets (T Bills/Bunds) for a Dark Inventory of physical oil assets held by oil producers, particularly in the North Sea.

Kemp observes that the Brent June (Month 1)/July (Month 2) spread has now risen to 17c and attributes this to:

"short-term output disruptions, tanker loading delays and now the oil workers' strike in Kuwait, which have combined to cut near-term crude availability"

The Big Long Queue

Putting to one side the Kuwait oil workers' strike, the key - and market-wide - issue is that of tanker congestion - the Big Long Queue.

Now that the contango is, as Kemp observes, rapidly disappearing - which is in my analysis because the Saudi/GCC capital supporting it is in the process of being returned to them - commercial storage is no longer economic.

This means, that as John Dizard perceptively wrote that an enormous amount of global oil inventory is going to re-enter the market. However, I think - and this is where Dizard and I may differ - that both buyers for the oil and the tankers to lift it will be in short supply.

Short Squeeze to End All Short Squeezes

Many in the market have written about the current ramp in prices being due to a short squeeze, but I don't think the mechanics of this one are like the plain vanilla futures squeezes we know and love/hate depending which side we're on.

In my analysis, the current massive Managed Money long position - the highest (see below) since July 2014 - is for the most part neither active hedge funds nor passive inflation hedgers, but rather Saudi/GCC funds liquidating the Big Long. Since they will, in my analysis, be taking delivery of prepaid physical oil - probably through Exchange for Physical (EFP) on Brent/BFOE expiry - they have locked in a price for that oil.

This means that any speculative (naked) short position in Month 1 Brent/BOE represents free money, and when anyone attempts to march the market down the hill, the BWAVE algorithms will march it straight back up again.

This explanation is consistent with why the expected post-Doha collapse in prices was a temporary spike down, and also with the increasing M1/M2 backwardation and sagging yield curve.

Market Prognosis

I repeat my previous view that - absent serious production cuts - the market will fall, and possibly dramatically, while entering into an increasing backwardation. But exactly when this will be is impossible to say.

However, as Howard Simons, of Rosewood Trading said in Dizard's article:

"Historically, when contangos in oil unwind, they move very fast, because you get a huge reward for being the first mover. I would say this will happen within a six-month period."

My sense is that this contango - having a basis in financial rather than physical demand - could unwind much faster than that.

How to Play the Market?

Having been asked this question in discussion, I am unable to draw upon any trading skill or experience, but I shall make three observations.

Firstly, I would not touch oil futures with a barge pole.

Secondly, the Oil Vix represents investor expectations of volatility which in my view bear no relationship whatever to the true risk, and options are cheaper than they probably should be.

Finally, the $30 WTI July Puts I saw trading post-Doha at 17 cents looked like a bargain to me.

And before anyone asks, I'm fully invested in my work, so I will not be putting any money where my mouth is.

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.