Tuesday, March 20, 2012

A perfect storm approaches in the toxic oil market architecture....

A perfect storm approaches in the toxic oil market architecture....and a catastrophically dysfunctional and inequitable market system....

On the evening of Friday, March 16, Reuters broke the news that Saudi Arabia was chartering 11 Very Large Crude Carrier (VLCC) tankers to deliver some 22 million barrels of crude oil in the last few days of March and early April.

The initial reaction to this fleet is that these cargoes could perhaps slake the insatiable thirst for crude oil of refiners in the east, which according to conventional wisdom has driven the global benchmark price - North Sea Brent quality crude oil - to US$126 per barrel.

But this Saudi fleet is not eastbound: it will in fact make a right turn and head for the US Gulf. This means that the price received by the Saudis will be based on US WTI quality crude oil, at a price of $107 a barrel.

More mysteriously still, the report revealed that these VLCCs are far from being the first to recently carry Saudi oil to the US at a WTI price that was often at even greater discounts to the global Brent benchmark.
Provisional weekly data from the US Energy Information Administration (EIA) shows that the rise in supplies began several months ago, and outpaced gains to other consumers such as China.

US imports of Saudi oil hit 1.5 million barrels per day (bpd) in the first 10 weeks of 2012, up 300,000 bpd from the fourth quarter of 2011 and marking the largest rise in shipments since the second quarter of 2003. Saudi shipments to China in January rose only 14% from the year before.

Total US crude imports are up only 165,000 bpd in the first 10 weeks of the year versus the fourth quarter. The EIA was not immediately able to respond to requests for an explanation of the data.
What on earth is going on? Why does Saudi charity to the US extend to $400 million for these VLCCs alone?

The myths
Reuters quotes various explanations from the creme de la creme of oil market commentators.

One said:
"... there has been a major public shift by the Saudis since the Iran tensions started to raise the price of oil. Saudi Arabia and the United States are trying to show the Iranians they (the Iranians) will have little flexibility, and they shouldn't count on the world needing all the oil that Iran produces."
This aim could have been better achieved if the Saudis were simply to profitably deliver crude oil to those countries whom the US wish to wean off Iranian oil. So we may safely ignore this nebulous explanation.

Another felt that the Saudis were making efforts to build up global inventories:
"I think that if you look over a longer term, the Saudis are increasing their exports to the whole world right now and not just the US. The Saudis are getting oil onto the market to encourage inventory building, and to show their customers they can deliver whatever is needed."
Now, the first point to make here is that neither the Saudis nor traders and refineries are charities. Trader inventories are low because the market pricing structure and the lack of availability of bank finance makes it unprofitable or impossible for them to be maintained. Some refineries were prepared to buy and hold inventories as a hedge, ie because they feared prices would rise. By sending the tankers eastbound to them, rather than to the better supplied and lower priced US market, the Saudis would pocket a cool extra $400 million.

Finally, there were some half-hearted explanations based upon new US Gulf refining capacity. These ignore the fact that oil which has been locked away in the WTI delivery hub of Cushing, Oklahoma, will begin from June 1 to be piped to the Gulf. Furthermore, some 2 million barrels per day of US East Coast refining capacity has recently been shut down, and this is reflected by reduced demand for crude oil. Market expectations were in fact for less Saudi oil to flow to the US, not more.

So these accounts are completely unconvincing.

The reality
As I have explained previously to readers of Asia Times Online, if there is one thing that the history of commodity markets tells us, it is that if producers can support or manipulate prices in their favor, then they will. [1]

We have in fact seen two bubbles in the oil market price, the first being from 2005 to July 2008, and the second being from early 2009 to date. Both of these bubbles have been inflated by the presence in the market not of active risk-taking speculators but rather of passive, risk averse investors who aim to hedge inflation through buying anything but dollars.

The precise mechanism by which these bubbles were inflated was murky, and it has only recently come to light that the original author was (who else?) the "Smartest Kid In The Room", ie Enron.

Enron concealed the true state of their indebtedness by entering into misleading "off balance sheet" three way commodity transactions involving Prepay deals. Essentially Enron would sell commodities forward to a bank via a third party and later repurchase them at a loss. The overall effect was to disguise a loan at interest as a commodity transaction at a loss to Enron and a profit - equating to interest - to the financier.

Whereas Enron was skillfully scamming shareholders and creditors, the perpetrators of the oil bubbles have been misleading the market at large. Prepay and repurchase transactions have been used to create "paper barrels" and a "Dark Inventory" of oil which was no longer beneficially owned by producers and which creates a false two-tier market with only one or two participants "in the know". Prepay deals enable the inflation and maintenance of oil price bubbles until for one reason or another the bubble deflates or is burst by a spike.

Bubbles and spikes
This Commodity Futures Trading Commission (CFTC) chart (below) is essential to understanding what is going on. It shows the participation of investors - "Managed Money" - in the WTI market in terms of the proportion who are "long"of the market (betting it will go up) against those who are "short" (betting it will go down).

It will be seen that there there was a massive influx of (speculative) investment between March and June 2011 and that there is an even greater influx now, which is why the respected Reuters journalist, John Kemp, recently wrote that there is a danger of a similar "flash crash" today to that which took place in May 2011.

But what about the spike in prices in 2008 which burst that year's bubble and which everyone "knew" was caused by greedy speculators, hoarders and price gougers?

Inspector Gregory: "Is there any point to which you would wish to draw my attention?"
Sherlock Holmes: "To the curious incident of the dog in the night-time."
Gregory: "The dog did nothing in the night-time."
Holmes: "That was the curious incident."
- The Curious Incident of the Dog in the Night-time

The WTI price spiked to $146 a barrel in July 2008 and then collapsed to over $30 a barrel in December 2008. It then more than doubled (at a time of over-supply) to over $70 a barrel in July 2009. But the above chart records no bark in this time from the speculator dog. If greedy price-gouging hoarders and speculators weren't responsible for the bubble and spike, then who was?

I have written previously of the way that BP and Goldman were joined at the head for more than 15 years and the probability that a combination of astute marketing; hype and their mutual use of pre-pay contracts was instrumental in the first bubble in oil prices.

In relation to the 2008 spike which burst that bubble, some sore losers at Semgroup blamed Goldman Sachs for a market coup of which they were the principal casualty. As Forbes reported:
"What transpired at Semgroup was no less than a $500 billion fraud on the people of the world," says John Catsimatidis, the billionaire grocer turned oil refiner who is attempting to reorganize Semgroup in bankruptcy court.

The $500 billion is how much the world would have overpaid for crude had a successful scam pushed up oil prices by $50 a barrel for 100 days. [2]

While the 2008 bubble was a private sector affair, it was just practice for the current public/private partnership bubble created by the US and the Saudis.

Smoking funnels
What we have seen since early 2009 in the oil market may be the single greatest act of market manipulation in history. Through entering into Enron-style pre-pay agreements, the Saudis and JPMorgan Chase - whose Morgan Guaranty arm has had a relationship with the Saudis since 1933 at least - have been able to fund the manipulation and support of the oil price through creating what are essentially "paper barrels" and lending them to passive investors in return for dollars loaned interest-free.

The actual support of the global oil market price was achieved through suitably manipulative transactions in the aptly-named Brent Complex of oil contracts which sets the global oil price benchmark price, and which is linked to the US WTI price by a web of cross-Atlantic "arbitrage" trading on a massive scale.

But from September 2011, the inflation hedging dollars which flowed into Saudi oil have been leaving for the safe haven of Treasury Bills. This outflow led, through the unwinding of the pre-pay deals between the Saudis and JPMorgan Chase, to the fleets of Saudi tankers. The forthcoming voyages to the US - for which Chavez-like charity to and pity for US consumers is a charming but not credible reason - stands as unmistakable evidence of what has been market manipulation on a breathtaking and indeed cosmic scale.

The tankers represent not so much a "smoking gun" as "smoking funnels".

Stand and deliver
As dollars flow out of the oil markets the first thing that happens is that the "repurchase" element of the Enron scam strategy no longer takes place. So instead of JPMorgan Chase continuing to roll over temporary sales to investors, they must - if demand for this oil elsewhere has dried up, which, despite all the hype, it finally has - actually take physical delivery of the oil. Hence the recently chartered Saudi fleet of tankers.

Since the April 2012 WTI contract actually expires this Tuesday, March 20, it will be interesting in the next couple of days to see what the other WTI market participants make of what may be an unexpected 22 million barrels of oil being delivered into the US market. Now, my view is that this macro manipulation - massive though it is - is only a part of a wider geopolitical and economic strategy being played out by the US.

A perfect storm
Global energy producers and consumers gathered in Kuwait last week at the International Energy Forum and Saudi Arabia's oil minister Ali Al Naimi had this to say:
Volatility is bad for the consumer, bad for producers and bad for the sort of long-term planning required in the energy business. Market volatility is not in the interest of anyone present here today.

But, ultimately, volatility is caused by speculation in the marketplace, based on conjecture over tighter supply-demand balances in the future, and increased interest in energy commodities as an asset class for financial investors. It is this emphasis on "paper barrels", rather than actual cargoes, which creates problems.
The cosmic irony is that the very purpose of the Saudi relationship with JPMorgan Chase has been to opaquely create the very paper barrels Mr Naimi deplores, and to use them for the purpose of enabling the US and Saudi Arabia to maintain a mutually acceptable relationship between oil and the dollar.

As we have seen, paper barrels are a double-edged sword, and investors in Saudi paper barrels are not in fact the speculators in search of transaction profit whom Mr Naimi detests but their complete opposite. Speculators do not buy paper barrels, but rather use derivatives to bet on the price of paper and real barrels which to them - and indeed almost everyone else in the market - are indistinguishable.

The moribund deficit-based dollar financial system; the completely toxic oil market architecture; and the staggering greed of middlemen like JPMorgan Chase, BP and Goldman Sachs have combined in a perfect storm to bring an end to the carefully constructed mechanism by which the US and Saudi Arabia have been macro manipulating the oil market since 2009.

Hopefully Mr Naimi's fleet of tankers will sail into the West through this perfect storm and will shortly deliver us from our catastrophically dysfunctional and inequitable market system.

1. See for example
The end game, Asia Times Online, February 28, 2012, and Back to the future, Asia Times Online, December 22, 2011.
2. See

Chris Cook is a former director of the International Petroleum Exchange.

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