Executive Summary: The run-up in oil prices despite a glut in physical market (for "wet barrels"), is due to too much money ("investors", "speculators") flowing into the derivatives markets of NYMEX and ICE to buy "paper barrels" and the concurrent lack of meaningful arbitrage to balance supply and demand between the two markets (spot and derivatives).
Oil to $386.57 per barrel!
Yes, you read correctly, price oil at USD $386.57 per barrel. Why? Because that's the price of GOOG (Google Inc) stock. "But... what does Google's stock price have to do with oil price? There is no connection." you'll ask. Correct.
But then again, the way oil price is set today, we might as well randomly pick some financial instrument like Google stock to use for pricing oil! Afterall, for several years (since 1988), the price of oil is set by "paper barrel" trading in the derivatives markets, but these markets increasingly have NO connection whatsoever with the supply/demand picture in the market of physical oil market
of real "wet barrels".
Since the late 1980s, there are two distinct markets for oil: an illiquid spot market (for real "wet barrels
") and 2 liquid derivatives markets
(for so-called "paper barrels
" of oil) at NYMEX and ICE (more
). Theoretically, "wet barrel" and "paper barrel" prices should all be tied together by arbitrage
, as it happens in most commodity and stock index futures markets, but apparently not in the oil market. This probably happens due to the fact that the types of crude oil traded in derivatives (West Texas Intermediate and UK Brent) represent a very small % of world's daily oil production, which prevents meaningful arbitrage. Leading to broken price discovery mechanism, as oil price keeps going up and at the same time oil producers can't find buyers for all their oil
(including light sweet crude, not sour). The run-up in oil prices is NOT an indication of shortages in the physical market, but a financial phenomenon
Background: For the past few years, untold billions are flowing into active and passive (long-only) commodity funds, which invest in them in contracts ("paper barrels") of oil in the derivatives markets. Commodity indices -used by passive funds- are heavily weighted towards energy (e.g. in Goldman's GSCI commodity index the weight of energy is ~75% - source
(Note that the chart above doesn't even include the assets of hedge funds or proprietary trading of major investment banks)
The reasons for money flowing into commodities (as an asset class) are pretty obvious:
Let's look at the facts
- to front-run developing countries' (China/India/etc) needs, i.e. "buy today what China will want to buy tomorrow"
- to escape ongoing fiat currency (USD, EUR, Yen etc) depreciation (the same reason why gold/silver etc went sky high). Oil and metals like copper can be better alternatives than gold and silver, because of the almost price insensitive, inelastic demand (you *will* find someone to buy it from you), let alone better tax treatment.
- "liquidity" (due to cheap borrowing rates and money printing) sloshing in the system
- and to follow the trend, herd behaviour after a mature 4yr old bull market.
Despite media propaganda, let's look once more at the FACTS:
The physical ("wet barrel") market is awash in oil. Saudi Arabia, the world's top exporter, had to cut production from 9.5Mbpd level of the past 2 years down to 9.1Mbpd (-400,000 barrels per day) since April-06, because it can find no buyers for it, The Wall Street Journal quoted Oil Minister Ali Al Naimi as saying on 5-Jun-2006.
In an interview after a meeting here of the Organization of Petroleum Exporting Countries, Ali Naimi said other cartel members are having trouble finding buyers for all the crude they are producing, at a time when global stores are near full and many refiners have closed facilities for routine maintenance. One Saudi official said an estimated three million barrels a day of refining capacity is out of action and unable to process crude, at a time when the world is using some 84 million barrels a day of oil products like gasoline and jet fuel.
"It's not just heavy oil. Even light oil is having problems" finding buyers, Mr. Naimi said, referring to premium grades of crude known as light crude that are highly prized by refiners because they have high gasoline yields.
Asked if the kingdom was easing up on supply because of concern about the buildup of inventories in the U.S. and other importing countries, Mr. Naimi rejected such a motive, replying: "At $70 a barrel?" Mr. Naimi suggested that producers will sell all the oil they can at such high prices.
The implication of Mr. Naimi's remarks is that Saudi Arabia would again open its oil spigots when buyers ask for more oil. For the past two years, the Saudis say, their policy has been to sell as much oil as buyers want, to the limit of the kingdom's production capacity.
OPEC monotonously insists that supply is plentiful at every meeting since 2004:
05-28-06 05:05 PM ESTAfter Katrina, in Oct-2005, in a so-called "symbolic move" to calm market "psychology" rather than actual supply shock, OPEC said they would offer additional 2 million barrels/day, IF THERE IS A BUYER:
CARACAS -(Dow Jones)- OPEC's acting secretary general, Mohammed Barkindo, said Sunday that the global oil market is well supplied.
"This market is very well supplied both in terms of crude and products," Barkindo said upon arriving in Venezuela for an OPEC ministerial meeting. Ministers of the Organization of Petroleum Exporting Countries will hold a formal meeting in Caracas on Thursday.
"You have to look elsewhere (than market fundamentals) at what is driving the prices," he said.
OPEC Offers an Extra 2M Barrels of Oil
2005-09-21 11:18:40 AP
Ministers of the OPEC agreed here on Tuesday to provide an extra two million barrels of crude oil a day in a bid to calm down the world oil market.
VIENNA, Austria-OPEC offered world markets an extra 2 million barrels of oil a day — its entire spare capacity — on Tuesday in an attempt to show that supply fears were unfounded even with traders eyeing another hurricane approaching the Gulf of Mexico.
The cartel, which has come under international pressure over the near-record prices that followed Hurricane Katrina, said its output ceiling would remain at 28 million barrels a day and stressed that the main obstacle is refining capability, not a shortage of crude.
"If you have a buyer, bring him, we'll give him the 2 million. We have the availability to provide it," said OPEC President Sheik Ahmed Fahd Al Ahmed Al Sabah, who is also Kuwait's oil minister.
He said the 2 million barrels, representing all the spare capacity of the Organization of Petroleum Exporting Countries, would be available for three months beginning Oct. 1.
"We hope that this will reflect positively on prices," Sheik Ahmed said. "We are very keen to help the market. We know there are geopolitical and weather crises."
There was no buyer for the extra 2Mbpd, confirming OPEC's constant comments that the REAL physical oil market is very well supplied and has been for a long time. Actually since 2005 OPEC claims that market is oversupplied by 2 million barrels per day "OPEC President Edmund Daukoru said on Friday that the global oil market is “oversupplied” by about 2 million barrels per day." 3-Mar-2006.
- Demand:According to the recent (4-May-06) testimony by D.Yergin before US Congress world oil demand was up only 1% in 2005 (source). Physical world oil demand (oil shipments) has been flat or down since 2005.
China/Asia is often getting blamed for the high oil prices, yet China said that since 2004 it was going to rely on domestic supplies for most of its energy needs. And delivered on that promise, as according to recent data China's oil demand in 2005 was actually LOWER than 2004: "The National Development and Reform Commission said recently that China's dependence on oil imports was 42.9 per cent in 2005, 2.2 percentage points lower than in 2004. It also said China consumed 318 million tons of oil last year, 1.08 million tons less than in 2004." source
Commercial (oil company) crude oil stockpiles in US (excluding oil stored in the Strategic Petroleum Reserve) stand are at the highest levels in years, of ~350Million barrels:
Also, US SPR (Strategic petroleum reserve) has been filled up in a hurry to 100% capacity, highest level ever, between 2002 and Aug-2005, for another ~700 million barrels, (a questionable move, which many think contributed to oil price spike. Before, the SPR was being slowly filled by the US govs since the 1980s).
So we know that the market is well supplied, private and government oil inventory at all-time highs, OPEC insists it has ample untapped spare capacity, recently even scaled back on production due to lack of buyers (for real "wet barrels"), delivery capabilities were not strained (as evidenced by the drop in oil supertanker shipping rates). The only bottleneck would be refining capability (and only in USA), which logically would push oil prices down and only affect refined products (gasoline etc).
All "demand" keeping prices at these absurd levels of $70+/bar is happening in the futures derivatives markets, off which real physical oil is priced. Derivatives is what OPEC calls "paper barrels", with open contracts just in NY futures market being ~1.6 BILLION "paper barrels". Nearby month futures contracts in NYMEX and ICE trading about ~250 million "paper barrels" per day (vs ~80 million barrels per day world production).
Speculation in futures, on its own, is NOT wrong or damaging etc (although authorities have been known to curtail such activities under extreme situations, like 1987 stock crash or 1980 silver spike up). But the problem of the past several years is an issue of too much money flowing into oil futures and inability to do arbitrage between futures and physical
. For some background on oil markets and the influence of futures and how oil price is set, read Oil Markets and Prices
OPEC has been stating the effect of "paper barrels" since year 2000
Friday, 22 September, 2000, 09:13 GMT 10:13 UK BBC
Oil: New rules of the trading game
Market speculators using sophisticated financial instruments are having an increasing influence on oil prices.
The secretary general of the Organisation of Petroleum Exporting Countries (Opec), Rilwanu Lukman, says the world oil market is held captive by the derivatives markets. The old rules of supply and demand have been distorted, he says, by the creation of what he calls "paper barrels" of oil.
Opec president Ali Rodriguez says that at least $8 of the oil price is due to speculation.
They are both articulating the anxiety at the loss of control felt by the Opec oil producers. They can no longer manipulate the market mechanisms that have made them lots of money recently, but which no longer respond to the old fashioned rules they prefer.
Thus, says Mr Lukman - and he should know - the time has long gone when the complex trading systems that are responsible for moving oil around the world from producer to consumer were only governed by the rules of supply and demand.
Mr Lukman was for many years Nigeria's oil minister and representative at Opec, and as one of the organisation's oldest hands, has watched the oil market closely for almost three decades.
I guess nowadays, OPEC just sits back and enjoys windfall profits, courtesy of the derivatives markets in NY and London. And OPEC simply re-iterates on every occasion that "current prices don't reflect supply/demand fundamentals", that "market is oversupplied and overpriced" and that speculation is affecting prices.Follow the money - Who benefits?Oil producing nations
, the oil companies
and the finacial industry, big trading houses
(e.g. investment banks, funds) are enjoying huge profits from commodity trading (look at where most of the their revenues come from). Even "investors
" in oil make money, but only as long as oil price rises, because they're charged huge "carrying costs". BUT, almost everyone else is getting scr*wed
.Why no arbitrage?
If arbitrage in oil would work as in almost every other market, then I could e.g. buy those extra 400,000 barrels/day from Saudis (which recently cut, citing lack of buyers) at prevailing price $70 and immediately sell short 400 contracts at $70.
If I held my shorts as we approach delivery date (of physical), then the "investors" in oil would either bail out of their longs (driving the price down), or build storage tanks to accumulate ("hoard") the extra 400Kbpd, i.e. 12 million barrels per month. If I kept doing it for a few months, investors would have to keep building tanks to accept new oil or at some point choke on the supply of new oil and stop initiating new longs (buying new paper barrels of oil). Yet I would still be buying 400Kbpd from Saudis and selling short 400 contracts per day, which -in absence of "investor" buyers- would pressure the price down.
And when that happens, the "oil investors" would incur a big loss, because they'd have accumulated their hundreds of millions barrels inventory held in their tanks, at higher prices.
The abovementioned scenario ofcourse assumes REAL "wet barrel" oil demand is stable (e.g. China's oil imports were down -2.2% in 2005).
But, apparently it works differently for oil, because unless those 400Kbpd from Saudis are the exact type specified in the futures contract (as e.g. Brent is 0.4% of world's oil production, but is used to price 60% of world's oil), I can't do this kind of arbitrage at a scale that it would PROMPTLY affect price.
So right now it's enough for "investors" to control/hoard only the few barrels of types (WTI and Brent) which are "eligible" for physical delivery in the futures markets, to control the whole pricing system for oil.
That's probably why oil price is going up while producers claim they can't find buyers for their real "wet barrels" of oil.Contango and buildup of inventories
To get technical, effectively a large buying pressure for oil futures by investors and futures in "contango", result in a buildup of inventories, as it is inducing refiners to buy more crude oil than they can currently process and sit on it, because the carrying cost of the inventory is lower than the expected spot price in the future.My opinion
The current oil price discovery mechanism is broken. Given relatively small spare production capacity for the types of oil used in futures markets (WTI light sweet crude or UK Brent, where e.g. Brent represents 0.4% of world's total oil production but is used as benchmark to price 60% of world's oil) results in lack of meaningful arbitrage ability between physical and derivatives.
Consequently, "investors" ("speculators") aided by other factors (e.g. price insensitive filling of SPR in 3yr if you believe in coincidences) were able to drive oil to $70+/barrel on sheer buying power of billions $$$, as price is set at the margin.
The reason (excuse) was perceived fears of supply disruptions. Despite those "fears" persisting for the past 3yr, the physical market always remained very well supplied and inventories -to be used as buffer in case of a supply disruption- are at all time highs.
But, why wouldn't someone buy e.g. the extra 2 million barrels/day offered by OPEC or (if the 2Mbpd are thought to be mostly heavier crudes) the 400,000 barrels per day more recently cut by Saudi Arabia due to lack of buyers and then keep force-feeding them down the market (selling the futures and holding to delivery)? The problem, as explained above, is that due to how the oil contracts are defined, it's practically impossible to do arbitrage in sufficient volume, which would PROMPTLY bring the supply/demand picture of the two markets (derivatives and physical) back in sync for the current contracts.
And so we are experiencing the paradox where oil price goes up and up and during the same time oil producers can't find buyers for all their oil
(even light sweet crudes, just in case one wonders) and even CUT production e.g. Saudi's -400,000 barrels/day since Apr06. Oil producers insist that the market is oversupplied by over 1 million barrels/day since early 2005.
People who claim "but the market, i.e. sky high prices, suggests otherwise", need to remember that markets are far from perfect in determining fair valuations (one just has to think of the dotcom bubble of year 2000 in stocks, not to mention Enron's manipulation of electricity and nat.gas markets).
Politically speaking, I think "investors" (mostly westerners) in oil are shooting themselves in the foot. An unprecedented wealth transfer to oil producing nations has been taking place during the past years. In this process, the BigOil and the financial industry have realized enormous profits at the expense of the gullible public.
Overall, IMO, the lack of action by Western leadership against this kind of massive wealth transfer is nothing short of criminal. Of course I would hardly expect any better from people who are having their countries mortgage its future (borrowing from the future) to fund its overconsumption today. What Warren Buffett called "sharecropper society" a year ago.
Ordinary people have faith that their government is doing the best for them and that the media is actually informing them. If all you hear from the media (many of which IMO are just shills for those making $$$ from this) is that oil is going up because the supply/demand is marginal, the world is running out of oil, because China etc is using so much, because of refinery bottlenecks (which is the same as saying "the price of wheat is up because of bakery problems/bottlenecks" whereas in fact a refinery bottleneck would increase the price of one type of e.g. light sweet crude and create a glut of another type e.g. heavy sour crude oil) then you might accept $70+/bar oil like a "natural disaster".
So, from the lack of real action for 3+ years now, e.g. no additions of refinery capacity for the heavier types of oil, or expanding the types of futures contracts traded, or adding risk to holding speculative longs by randomly selling e.g. 30Mb from SPR (instead of letting momentum funds front-run mindless price-insensitive buying for filling of US SPR during 2002-2005), or even suggesting that we go back to nation-to-nation contracts, I can only conclude there is some hidden agenda behind accepting the broken price discovery mechanism in oil market today
and that despite what they claim in public, the people in charge are happy with the rigged oil price and its consequences. In addition, the orwelian Ministries of Truth and media of mass deception, keep repeating that these absurd oil prices of $60-70/bar are here to stay for a few more years, managing people's expectations.
References for further reading:Andy Xie, MorganStanley economist for Asia, thinks oil is financial bubble (16-Jun-2005)Andy Xie, MorganStanley: Asian oil demand is declining (Jul-05)The real problems with $50 oil
By Henry C K LiuThe Danger of Speculation in oil
by Mike Norman for FOX Fan CentralLaRouche: Bankrupt Speculators With $25 Per Barrel OilCan natural gas fall this far without oil prices moving more (21-May-2006)Speculators hijack oil market
The Times, 12-Sep-2004Explanation of price discovery in oil marketsOPEC: World awash in oil (6-Mar-2006)Opec boss rounds on oil speculators (25-Jan-03)Saudi Arabia: Oil market 'oversupplied, over-priced' (1-Jun-2006)How hedge funds, traders, and Big Oil are really driving gas prices
Fortune, 18-May-2006State of the Oil and Gas Industry
by Saudi Aramco CEO Abdallah Jum'ah: "At Saudi Aramco's present production levels, that means we will have well over a century's worth of oil to produce."Leo Drollas, the deputy director and chief economist of London's Center for Global Energy Studies
: "So we've got a huge influx of money into commodity-tracking indices, and a large part of those indices of course refer to oil. ... investors coming into oil, thinking they're on a roll now and that oil prices will forever increase. And in a sense, this tends to fulfill the prophecy, as long as the money keeps coming in."