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phirang

09-20-08, 04:41 PM

http://www.atimes.com/atimes/Global_Economy/JI19Dj02.html

SPEAKING FREELY
Oil market collapse waiting to happen
By Chris Cook

Speaking Freely is an Asia Times Online feature that allows guest writers to have their say. Please click here (http://www.atimes.com/mediakit/write-for-atol.html) if you are interested in contributing.

After a phenomenal "spike" in oil prices to US$147 per barrel, the price has declined to just over $90. In the US this led to a "spike" to $4 per gallon of gasoline and placed energy prices right at the top of the US political agenda. Moreover, this political interest rapidly crossed the Atlantic since British trading of US contracts was believed to be instrumental in a speculative oil market price "bubble".

In view of my background in energy markets - I was for several years director of compliance and market supervision at the

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International Petroleum Exchange (which is now ICE Futures Europe) - I was asked recently by the British parliament's Treasury Select Committee to give evidence to them in relation to regulation of oil markets. Such an inquiry is a new direction for the committee, and following this initial hearing they decided to commence a full-blown Inquiry - in the finest US tradition - in October.

I told the committee - and their subsequent initial questioning that day of British regulators implied that my message was understood - that to follow the US approach to regulation of oil futures markets would be to try and solve today's problems with yesterday's tools.

The New York Mercantile Exchange (NYMEX) West Texas Intermediate (WTI) crude oil market price has become almost entirely irrelevant in the real world of physical and forward oil trading, which largely takes place, believe it or not, in Yahoo chat rooms. While NYMEX members still provide a massive pool of trading capital or "liquidity", the inconvenient truth is that oil market pricing power has moved across the Atlantic to the price of North Sea crude oil.

Brent benchmark
The price of North Sea (Brent) crude oil is now the direct benchmark for over 60% of global crude oil pricing, and, through the mechanism of massive "arbitrage" trading between Brent and WTI, it also constitutes an indirect benchmark for most of the other 40%.

Most people - including virtually all mainstream press reporters - believe that it is the price of futures contracts that is used as a benchmark. In fact, it is the reported "spot" market price of "dated" Brent/BFOE (see below) cargo transactions that constitutes the direct and indirect benchmark for most global oil transactions. The massively traded ICE Futures Europe Brent/BFOE Crude Oil contract is merely a financial bet on these underlying prices, and these financial contracts are settled in cash, not oil.

For many years, the production of the Brent oil field has been in decline, and the production of other North Sea oil fields has therefore been amalgamated with it to ensure a sufficient number of transactions to give a credible benchmark price.

We now see four fields - Brent, Forties, Oseberg and Ekofisk ("BFOE") - together supplying the BFOE "Brent" contract whereby 600,000 barrel "cargoes" of these qualities of oil may be bought and sold forward for eventual physical delivery.

The problem is that even this extended North Sea BFOE production is still only running at less than 70 cargoes per month, which is a total monthly production of little more than 40 million barrels. Even at $150 per barrel that represents a value of only $6 billion, and at current prices less than $4 billion.

Sitting on this base of physical trading is an off-exchange complex of price risk consisting of the simple forward BFOE contracts themselves, a host of derivative contracts, and an increasing number of "structured finance" transactions. It is estimated that in total, some $260 billion was recently invested in oil markets one way and another, and this pool of funds was superimposed as an inverted pyramid of risk on this relatively tiny base of physical crude oil.

Could these transactions have been instrumental in causing an oil market speculative bubble?

The answer is obvious: of course they could, and in all likelihood, they did. Unfortunately, because the transactions directly affecting the BFOE price took place off-exchange, not only does no regulator know, but none is in a position to know. Worse than that, even if regulators did know, there are no agreed market regulatory standards to enforce, and any offenders are for the most part smugly immune from enforcement action in offshore jurisdictions in any case.

Don't shoot the piano player
As I pointed out to the Treasury select committee, to blame national regulators, such as the FSA in Britain and CFTC in the US, for problems of a global marketplace does not help, other than in providing a useful scapegoat. This is because the problem lies both in the global scope of the market and in its conflicted structure, where the interests of trading intermediaries or middlemen are diametrically opposed to those of end-user producers and consumers of oil and oil products.

In the absence of a new approach to market structure we will inevitably see repeats of the recent spike in oil prices as waves of hot money swill in and out of the market. In my opinion, that will inevitably lead, sooner rather than later, to a market meltdown - similar to the literally overnight collapse of the tin market in 1985 from $800 to $400 per tonne.

The conventional wisdom is that the "central counterparty" clearing houses of futures exchanges, which guarantee the performance of transactions, backed by a pool of capital and margin, are a strength of these markets.

In my view, they also constitute a single point of failure, where oil price risk is concentrated in exactly the same way that Fannie Mae and Freddie Mac were massively exposed to house price risk.

I made a presentation a couple of years ago in Lausanne to an audience of high-level security experts at a seminar covering the subject of economic terrorism. This fascinating seminar covered the subject of the susceptibility of global markets and commerce to acts aimed at causing economic destruction, rather than physical destruction and death.

I pointed out that current levels of gearing and risk, and the concentration of risk in single points of failure, together mean that the only difference between "economic terrorists" and proprietary traders such as hedge funds is motive. The former would destroy a market deliberately: the latter by accident.

While the oil market survived the recent storm surge of money, the inevitability of future waves of speculative money sweeping into the market, mean that an oil market meltdown is an accident waiting to happen.

Lukester

09-20-08, 10:01 PM

Phirang - oil is very likely not done correcting. It could see a 50% retracement of it's $145+ high and even that retracement would in no way "prove" that the preceding high of the bull run was a "bubble". Of course you agree with this, right? I'm reasoning this is so because A) all commodity markets overshoot horribly both up and down, as is their long standing behavior, and B) because (few of us are left disagreeing) that oil can and will continue right on to $450 a barrel by mid 2020's. So if it has yet another 400% upside even beyond it's recent "wildly speculative bubble" top at $145+, then the recent top could by no means have been described as wildly speculative in the first place.

What's to ponder about that? Further, I'm spending several thousand dollars at this time to go far and wide and buy a half dozen sources of intelligence on where the CRB and oil and the PM's may go, because that is dirt cheap insurance for what I have at risk. And in the course of soaking up all this new analyst advice, it is becoming abundantly clear to me that ALL assertions (not your assertions, those of others ) that oil's rise to date has consisted primarily of USD inflation are hogwash. The real price has risen massively. Fussing over what percentage that might be net of USD decay is missing the point - why do we need to fuss over "portions" of a 900%?

The complexities of whether the CRB leads fiat monetary abuse, or the fiat monetary abuse leads the CRB are a red herring. They are bound up tightly together. But a 600%-900% net real rise in the oil price to date in this bull market constitutes one of the six largest commodity bull markets of the past two hundred years, and is right now in the process of not just correcting, but collapsing. Yes, it's agreed, it will come down hard yet further. What's my point? Anyone who concludes from this that it's been a bubble, or will be a bubble is being illogical by not regarding this assertion in the context of it's full (future) trajectory. Meantime, all the endless ink spilled on these pages as to whether it's been a bubble due to the quite large and quite evident traces of speculative activity might try to broaden their thesis further out towards the implications in the 2020's.

Within it's full context all the talk of "bubble" is myopic and merely hostage to a much narrower thesis than the full event that is playing out. If the price of petroleum scoots up to $450 in another 6-8 years, all this talk abut how speculators have been driving would then appear short sighted. Massive speculation may be real, but the critical thing to grasp in larger terms is that it is not "leading" this bull market in oil one bit. That would be a very large misapprehension, which I am sure you agree, right? The above analyst has "myopic analyst's disorder", because in hot pursuit of the speculators (it's a very vogue subject right now apparently) he loses sight of the macro story. I find no reference to oil's future price likely dwarfing all of these numbers in his article. Therefore quite obviously what he is dissecting is the froth at the end of one of the biggest oil bull runs in centuries, while conflating it as one of the drivers of the main event.

And the thing to note here in terms of drawing a larger insight, is that we will have another such event in short succession in just another couple of years ( back to back colossal oil "bubbles" - who could imagine that - that one "bubble" in oil could after a really harsh correction be immediately succeeded by yet another "bubble" in oil - which would be unheard of in commodities history, no? ), due to the large anomaly of resource depletion and population explosion, which is reputedly a "hopelessly naive and untutored idea" that many technical or financial analysts by instinct will regard with blank incomprehension. This is why the bubble oil topic is so out of focus. Whatever we wish to "debunk" here about oil's price run-up, it is important to distinguish the locomotive of the train from the caboose. Real world factors together with a commodities supercyle are the "locomotive" and the speculation is the "caboose".

Shakespear

09-21-08, 01:09 AM

Strange. If we agree that production in the North Sea is long past peak, then imagining that the price will come down to where it was about 3-4 years would imply that in the mean time sufficient reserves have been found to offset these declines else where.

Unless this can be shown to be true I can not imagine that we have an oil price bubble.

Some percentage of the price is due to speculation, but IMO the price is being driven by supply/demand which is amply discussed with real data on other boards. :-)

Every day/month/year oil/gas fields are declining. The rate of finding new fields is anything but spectacular. At least the available numbers are showing this. Also you have an oil giant like BP begging to be allowed to stay in Russia as elsewhere the pickings are slim.

Lukester

09-21-08, 03:56 AM

Shakespear - As you know, I am fully in agreement with practically your entire position. Maybe I miswrote it, or you misread it - the (potential) oil price downside here was only to the lows of last summer (August 2007). Not 3-4 years ago, by any means. I've just come across a great interview / update with David Bensimon of POLAR PACIFIC and he's got some sunny news for the commodity bulls among us - somewhere in around the spring of 2009 is his projection of the end of this nastiness, and the kickoff for more (long lasting) upside, and this is also what I've read in two or three other places.

I think the world will get hit across the side of the head with a two by four by the spring that will be coiling up in the petroleum market in the next six to eighteen months. None of us should be in any hurry to get where this thing is rapidly heading.

I'll post a link on the news page to his latest interview.

Lukester

Strange. If we agree that production in the North Sea is long past peak, then imagining that the price will come down to where it was about 3-4 years would imply that in the mean time sufficient reserves have been found to offset these declines else where.

Unless this can be shown to be true I can not imagine that we have an oil price bubble.

Some percentage of the price is due to speculation, but IMO the price is being driven by supply/demand which is amply discussed with real data on other boards. :-)

Every day/month/year oil/gas fields are declining. The rate of finding new fields is anything but spectacular. At least the available numbers are showing this. Also you have an oil giant like BP begging to be allowed to stay in Russia as elsewhere the pickings are slim.

Jay

09-21-08, 10:04 PM

I would imagine that part of the price spike was related to the possibility of war with Iran. Now that that possibility has faded somewhat, the oil price has sagged along with war sentiments. I would agree that the underpinnings for oil look strong in the mid/long term.