It has been clear since President Trump was elected to office in November 2016 that major changes in financial and commodity markets have been taking place since then, but it has taken until now for any indication to emerge as to any organising principle for the new administration's foreign policy doctrine.
To an outsider, the foreign policy of the Trump administration appears to be based in no particular order firstly on a desire to erase all vestiges of President Obama's policies, whatever they may be, and secondly, on an America First doctrine of primacy of U.S. interests in the global economy.
Finally, on 29th June, President Trump announced at an Energy Department event “Unleashing American Energy” a new doctrine for energy policy which he termed Energy Dominance, without specifying what this actually means.
In the four months since then, sufficient data points have emerged to make an educated guess.
The ICE Age
Towards the tail end of the Clinton administration and the Dot Com boom in 2000, Gary Cohn of Goldman Sachs (NYSE:GS) had dinner with his counterpart at Morgan Stanley (NYSE:MS), John Shapiro. From this dinner was hatched an audacious plan to take control of the global oil market through a new electronic global market platform.
The first step was to acquire a moribund mid-American electronic trading system (Intercontinental Exchange – ICE) and its dynamic founder. Secondly, key oil market intermediary companies (including BP (NYSE:BP), Shell (NYSE:RDS.A) & Total (NYSE:TOT)) agreed to provide liquidity in exchange for a share of ICE equity ownership followed by a second tier of market participants who then joined on less attractive terms.
Having secured physical and financial oil market liquidity, ICE still needed participation by end-user producers and consumers. After an abortive effort to acquire the New York Mercantile Exchange (NYMEX), ICE made the membership of London's International Petroleum Exchange an offer they could not refuse: either sell IPE to us, or our members take their hedging elsewhere.
Meanwhile in the North Sea, the new BP owned flow of crude oil from the Forties field was coming on stream and boosted Shell's declining flow of Brent crude oil to the extent that BP were now in a position to control the market. The new Brent/Forties contract rapidly became the preferred global oil price benchmark in preference to land-locked WTI, and the benchmark was later augmented by Statoil's (STO) Oseberg and Ekofisk fields.
Enron really were the smartest guys in the room. With the complicity of investment banks they were able to defraud investors and creditors alike for over a decade through the use of tripartite 'Prepay' funding contracts and accounting chicanery which concealed these liabilities off-balance sheet. The extraordinary fact is that over the period of Enron's existence some 70% of their income was entirely illusory.
There is nothing new about such macro (long term) fraud or manipulation: a producer cartel manipulated the tin market for decades until the price crashed in the 1985 Tin Crisis. Similarly, Sumitomo's Yasuo Hamanaka manipulated the copper market for ten years, five years of which was after David Threlkeld had rumbled what they were doing and blown the whistle, only to be ignored.
From 2001 onwards, the passive investment phenomenon of index fund and ETFs began to make inroads into the oil market via the inspired marketing narrative of 'inflation hedging' – ie off-loading dollar risk in favour of oil risk. These long-only passive investors enabled oil producers such as BP and Shell (who wished to offload oil risk in favour of dollar risk) not only to hedge production, but also to monetise inventory and even reserves.
There's nothing wrong with the use of prepay financing provided it is done transparently, but if it is opaque, then as Enron demonstrates, the results can be devastating.
It is my case that several oil market players, particularly BP and Goldman Sachs, and probably extending to Norway's Statoil and at least one other U.S. investment bank, began to quietly facilitate and use prepay funding on a big scale. The result was to withhold physical crude from the market and as the global market tightened this led to the inflation of a bubble in price which those involved always knew was unsustainable.
This bubble was spiked at $147/barrel in July 2008 (some say deliberately) and while global physical demand remained buoyant the reason for the oil price collapse to $35/barrel was that buyers were unable to actually pay for the oil. This was because international trade finance clearing through instruments such as letters of credit became unavailable when trust temporarily evaporated from the dollar system of global trade clearing and settlement.
Transition through Gas
The organizing principle of U.S. foreign policy has for over 100 years been energy security, and the means to achieve this has oscillated between (dumb) military and (smart) financial action.
President Obama's smart financial energy policy doctrine had two key objectives. The first aim was to reduce reliance on Saudi oil, and this required (as after the 1973/4 Oil Shock) prices high enough to make viable new U.S. and global production, funded by petrodollars reinvested by beneficiaries of inflated oil prices.
So, as I documented in a series of Seeking Alpha articles beginning with Oil: The Big Long the oil price was rapidly re-inflated and supported for 5 years over $80/barrel through Enron-style prepay funding. This created an opaque Dark Inventory of oil reserves held by a custodian (the U.S. Big Hill SPR) but where the economic interest is held by fund investors via prepay contracts with investment banks.
A highly lucrative two tier false market in oil was also created where most market participants were (and remain) unaware of the true beneficial ownership of oil. This led to periodic unaccountable moves in inventory and to trading coups (short term micro manipulation) via 'short squeezes' and otherwise. While this Dark Inventory was funded by investors of petrodollars, the liquidity needed for oil market cash-flows was provided by the Federal Reserve Bank via Quantitative Easing.
At these inflated price levels, substitution by renewable energy and investment in energy efficiency acted to reduce demand, while massive investment in shale oil increased U.S. production by 5m bpd in 3 years.
The second objective was a switch from oil to natural gas, and when the U.S. was obliged to leave Saudi Arabia, they thereupon established their biggest regional base in Qatar, who co-own with Iran the greatest single natural gas reserve on the planet – South Pars.
In the four months since President Trump's announcement, the market strategy developed by Gary Cohn is now being implemented and its elements are emerging into view.
Firstly, there has been a massive inflow of Managed Money into the oil market, particularly the Brent contract, which has seen the Brent oil price increase by 35% since the starting point, which I believe can be dated to the August Brent/BFOE Crude Oil option expiry on June 27th 2017.
Secondly, on 1st July 2017 the Saudis ceased to price oil against the BWAVE weighted average of Brent/BFOE futures contract (perfectly suited for HFT algorithmic trading) and began to price oil against the ICE Brent settlement price.
This image shows the striking change in market price activity which took place at that point
Thirdly, now that the spot Brent/BFOE price has been inflated through $60 per barrel, internationally accessible U.S. oil deliveries are now available to the market which form a necessary precondition for a successful U.S. based futures contract.
The direct effect of this flow of funds into the market has been to:
- Drive the spot Brent futures contract over $60 per barrel;
- Encourage oil producers to hedge, particularly U.S. shale oil producers selling future production in order to lock in finance;
- Create a significant Brent backwardation, which has now, via Brent/WTI arbitrage, had the effect of dragging WTI out of contango.
Finally, and perhaps the most intriguing data point of all, is this chart from Olivier Jakob of Petromatrix titled crude oil in time and space
Here it will be seen that even while the December 2017 Brent futures contract soared over $60 per barrel as fund money poured in, the U.S. WTI December 2019 futures contract was pretty stable around $50 per barrel.
Physical or Financial Demand?
A cynic once said that there are always two reasons for an action: the reason given, and the real reason.
The dominant market narrative is that the backwardation in Brent is evidence of surging global oil demand which has emptied inventories and is leading the price to new sunlit uplands. However, I see the market rather differently.
Firstly, whether the Brent spot month is supported by financial, rather than physical demand, the result will still be a backwardation, and because few oil producers expect a price over $60 to be sustainable they therefore hedge and depress the forward price. In support of this view, I am far from the only market observer who believes that Aramco, and Rosneft would not be selling equity if either Saudi Arabia or Russia believed the oil price trajectory will be positive even in the medium term.
Secondly, it is not a matter of if OPEC members cheat, but how and here Tanker Trackers combination of tanker geolocation with Planet Labs microsatellite imagery is shining new light on the dark world of physical flows of oil.
So for instance, Russia has been overstating production on a grand scale while China is continuing to act as buyer of last resort and had accumulated over 300 million more barrels of inventory at an average rate rate of over 1m bpd in Q1, Q2 & Q3 of 2017.
Third, while the U.S. is now exporting oil to Europe and elsewhere, October 2017 saw Gunvor landing themselves with an extraordinary 14 out of 21 cargoes of Forties crude oil and a 'record-breaking' fleet of six VLCC tankers then took 12 million barrels of crude oil half way around the world to Asia to buyers of last resort.
The $64 Billion Question
I have yet to find anyone in the market who is either willing or able to answer the simple question of who exactly is buying down the Brent curve?
Someone has bought Brent futures contracts to the tune of some 200,000 December 2018, 100,000 December 2019, and 45,000 December 2020. In addition there are 250,000 further contracts from January 2019 onwards in other contract months.
Could this be refiners hedging crude oil supplies? I think not, because refiners do not tend to hedge oil purchases far forward, and market consensus seems that $55/bbl is an expensive hedge.
So then it must be investors? But if so, then these investors participate on the ICE market via funds who take futures market risk either directly (Managed Money) or indirectly via investment banks (Swap Dealers).
But the problem with this is that Managed Money investors, whether actively speculating for transaction profit (hedge funds), or passively holding and rolling over long-only positions (ETFs & Index funds) participate only in the liquid ICE front month contracts.
So what exactly is going on down the curve?
Firstly, one part of the explanation is that financing of shale oil development has evolved through the entry into the market of DrillCo financing structures where oil market risk is taken by fund investors (eg Carlyle) in future shale oil production. But as the article author said: "Drillcos are not risk free. If oil prices tumble, investors’ ability to grab high returns within a few years fade"
Since shale oil production decline rates are high the necessary hedging by investment banks of some £2bn market risk could account for a great deal of 2018 long open interest.
This still leaves open the $64 billion question of which market participant is motivated and able to support the ICE Brent term structure for years into the future by swapping dollar risk (T-Bills) for long term oil risk (oil reserves leased via prepay purchase/resale contracts).
My conclusion by a process of elimination is that this Big Long can only be Saudi Arabia and regional allies, with Saudi Arabia now under the management of the thrusting young Mohammad bin Salman.
So what are the intended outcomes of the U.S. Energy Dominance strategy as outlined above?
Firstly, the re-establishment of WTI as global oil market pricing benchmark after some 15 years domination by the Brent/BFOE benchmark.
Secondly, to stabilise the global oil price between $50 and $60 per barrel, as forecast by S & P Global Platts and BP.
Thirdly, preferential America First U.S. and Saudi oil market access, with U.S. antagonists such as Iran or Russia being able to access the market on inferior terms, if at all.
Finally, the emergence of an Oil Standard for the U.S. dollar through basing the dollar directly on monetized U.S. and Saudi oil reserves.
What is meant by the oil standard, and why the Energy Dominance strategy is doomed to fail, will be the subject of a second article.
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.