State of the Oil Market
So another OPEC meeting has come and gone and once again the OPEC meme machine is in full flow to talk up the price. However, the market share rhetoric appears to have been dialed down, as market participants have come to realize that market share is what you get when you pump as much oil as you can. The reason Saudi Arabia is pumping oil pretty much as fast as it can (and merits an Olympic medal for cheating) is also the reason for an Aramco IPO which would never be taking place if the Saudis thought oil prices would rise in even the medium term.
The Saudi aim has always been to maximize dollar profit and there appears to be a new realization that Zaki Yamani was right - the Stone Age did not end for lack of stones and the Oil Age will not end for lack of oil. Rising energy intensity of oil production has run up against the capacity of consumers to pay for oil products, and against increasing investment in the Fifth Fuel (energy efficiency) and substitution of oil with renewable energy.
So now what we hear from Saudi/OPEC is that they are focusing on commercial inventory as a rationale for their strategy. Investment banks and traders whose lifeblood is volatility have therefore jumped on this narrative to jerk the market around with every twitch in commercial inventory levels.
But the commercial inventories narrative is if anything an even more threadbare story than market share. Traders and oil companies are not charities, and if it is uneconomic for them to maintain inventory, then they will dump it on the market, having covered price risk through hedging with futures or options. This is precisely what is happening now, because the continuing presence of $3bn of financial support - the Big Long - combined with producers hedging as far forward as they can means that the contango price structure necessary to fund oil storage is not there beyond the first few months.
It is not a question of if OPEC members cheat, but how they cheat, and some are more successful at hiding cheating than others. Meanwhile if traders and oil companies are emptying their commercial inventory, it has to go somewhere. So who is the Buyer of Last Resort in the market?
If there's one thing that can't be hidden, it's oil tankers, and it is here that new tools are opening up and democratizing the physical oil market and helping to create a level playing field for traders of any size.
The brilliant work of Samir Madani and Lisa Ward at Tanker Trackers sheds light in the murky places of the oil market. According to Sam, China has not only been building new oil storage facilities at a phenomenal rate but they have been overstocking by 10% throughout the year to date. As Sam put it, China is "averaging at more per month than the U.S. has added so far this year." For instance, some 40m barrels of oil went into China's inventory in March this year, and 49m barrels in April.
One explanation for this influx is that China is planning to cut import licenses in the second half of 2017: another is that oil-backed financing (commodity swaps) entered into to bypass domestic credit restrictions are being unwound leading to a financial shortage of oil. Then there is the inflation hedging argument that China prefers holding oil reserves to dollar reserves, while adding strategic reserves for resilience reasons.
Finally, there is the possibility that China simply can't resist a bargain and is busy hoovering up - as the buyer of last resort - whatever distressed oil is available on the fringes of the market. In that context I have heard directly from an OPEC member source that the bid from Chinese "teapot' independent refinery bottom feeders is currently between $24 and $28/barrel and that they have not been lacking sellers.
As a former oil market regulator with a continuing interest in market risk and resilience, I believe that market and credit risk has never been so concentrated as it is now, with much of the risk having shifted since the 2008 financial crash from clearing banks to clearing houses.
I have been saying for some time that the principal risk in the market is of a slowdown in Chinese buying and Sam Madani shares that perspective. As he put it: "If they even slow down by 10%, the show's over ... the biggest threat now is if China turns away a single VLCC every day."
I believe the combination of a demand shock gap down - exacerbated by or due to automated trading - when combined with the need of traders to liquidate inventory as collateral value falls, could lead rapidly to a doom loop in which the market price falls very rapidly indeed to and through the lower bound market clearing level before it bounces back again.
Such a China Syndrome market meltdown could lead to the need to bail out "too big to fail" market clearing houses, which would be challenging for U.S. and UK administrations which are both ideologically opposed to doing so, and suffering from a shortage of financial market expertise.
So what does all this mean in trading terms? My take is that out of the money options represent useful protection on the one hand and an interesting punt on the other.
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.