Is Oil in a Bubble? Notes from Expert Call

On Monday 11/12, we hosted an Expert Call with Chris Cook, former Compliance and Market Supervision Director at the International Petroleum Exchange, [now the InterContinental Exchange (ICE)].  We summarize the key points from the call below.  Note that these bullets reflect Chris Cook’s views, and not necessarily ours.  To listen to call replay, use this link: Expert Call With Chris Cook (email us if you have log-in issues).

 

Thesis

  • Global oil markets are dysfunctional, manipulated by financial intermediaries to the point where prices do not reflect the fundamentals of physical supply and demand. 
  • Currently, oil is in a bubble, inflated by colluding banks and producers, with passive investors shouldering the risk via oil-indexed funds and structured products. 
  • Eventually the bubble will burst and Brent crude will fall below $60/bbl; it is not a matter of if it happens, it is only a matter of when.

The Run-Up to the 2008 Bubble and Collapse

 

“The genius of the Goldman Sachs approach was to invent the marketing phrase ‘hedging inflation’ . . .  We have had billions of “inflation-hedging” dollars actually causing the very inflation that they aimed to avoid.” 

  • Over the long-term, the price for any finite resource is up.  There are boundaries between which the price will fluctuate – the level at which demand is destroyed and the level at which supply is locked in.
  • Producers want a high, stable price (near the level at which demand is destroyed); consumers want a low, stable price (near the level at which supply is locked in); the intermediaries want instability.
  • Seminal moment in the oil market: in 1992 Goldman Sachs invents the Goldman Sachs Commodity Index (GSCI).  This first introduced a new dynamic into the oil market: passive investors “hedging inflation.”  A long-only strategy, these investors are not seeking to make a profit, but to avoid a loss, a loss of purchasing power.  The banks offload their market risk onto these passive investors via such long-only products.
  • In the late ‘90s/early ‘00s, the banks (via these new passive investors), who are structurally long oil futures via long-only products like the GSCI, and producers, who are a routinely short oil futures to protect against a fall in the price, begin colluding.  For instance, BP begins leasing oil to GSCI investors, creating “dark inventory” as such transactions are held off-balance sheet.
  • The 2008 oil spike had nothing to do with “speculators,” it was a private sector bubble.  CFTC futures and options data shows no evidence of a “speculative bubble.” 

A New Bubble Builds (and is Bound to Burst)

 

“If producers can, they always will, keep the prices up.  The only question is who provides the leverage.  In tin it was the sovereigns moving the forward market in the 80’s and literally the price collapsed when the funds were no longer available.  The price collapsed in 1985 from $8,000/ton to $4,000/ton literally overnight.”

  • Beginning in late ’08, loads of passive investment dollars again flood into commodity and equity markets due to interest rates at 0% and massive money printing.  Financial purchasers of oil (passive investors via banks) begin looking for producers that will sell/lease oil to them. 
  • Saudi Arabia begins entering into large-scale pre-pay agreements with banks, likely JP Morgan (Saudi Arabia’s banker since the 1930s).  The market moves into a super-contango on this pre-pay activity (increased demand for forward contracts).
  • Oil prices move beyond the point at which demand is destroyed; physical demand for crude oil begins to fall at the same time as new, more expensive supplies (like US shale) are brought on due to the high price.
  • By Sept 2011, index fund money (aka the “inflation hedges”) has begun to come out of the oil markets, prices begin to decline, and the market moves into backwardation.  This backwardation is misinterpreted/misconstrued by speculators/banks as a bullish demand signal.  But in this false market, it signifies only the collapse of forward demand (no more pre-paid activity).
  • “Shocks” of Libya, Fukushima, and Iran keep bubble propped up, but are temporary events.
  • Bubbles, like this one, burst; it is only a matter of time.  The supply-demand dynamics in the physical market will overwhelm market manipulators.
  • We are seeing signs that the bubble is now faltering – waves of Saudi tankers arriving to the US is a sign that they can no longer roll over pre-paid contracts profitably.
  • When the bubble bursts, fundamental support is around the $60/bbl level, but could fall below that depending on how precipitous the correction is.

The Illusion of the Iran Risk Premium

 

“I think there is zero chance of any violence between the two nations [of Iran and Israel].”

  • Two types of sanctions on Iran: physical sanctions are “dumb,” while financial sanctions are “smart.”
  • Dumb sanctions are the ones restricting physical crude exports.  In the short-run, these sanctions increase the commodity price, and hence, Iran’s revenues.  BUT, over the long-term, the sanctions should be bearish for oil prices, as it lowers the overall bid in the market.  Chinese and Indian buyers are happy to low-ball Iran below market prices.
  • Financial sanctions are “smart” sanctions.  The elite there with Swiss bank accounts are hurting.  The rial is clearly under pressure, making life difficult for all.
  • Very little risk of conflict between Iran and Israel.  Energy security is too important to the US and China to ever permit Israel to attack Iran.  It is a very useful bit of “noise.”  Iran actually wants to cut the subsidies on domestic gasoline, and can now do so and blame the US. 
  • It's likely that we see a settlement between Iran, Israel, and the US in the coming months.

Saudi Arabia - Watch What they Do

 

“I don’t believe a word the Saudis say on anything.”

  • Believes that Saudi has agreed to an acceptable trading range for crude oil with the US.
  • Saudi wants +$100/bbl prices.
  • Saudi is trying to maintain an oil price peg to the USD by entering into pre-pay agreements with JP Morgan.  That is the grand plan, but it is not sustainable.
  • Saudi sending increased shipments of oil to the US is a sign that the bubble is faltering.

A Natural Gas Solution

 

“When the price collapses, we will have a regulatory disaster on our hands, as passive investors were not told that their “inflation hedge” could collapse."

  • It is possible to come up with a global benchmark natural gas price, and crude oil could be priced as a function of natural gas (as opposed to the other way around today).  All oil benchmarks today are completely manipulated.  A new natural gas-based benchmark would not have financial intermediaries, but only service providers. 
  • Disintermediation is actually in the interest of the financial intermediaries, and that is why they are actually doing it via selling ETFs and structured products to passive investors.

Common Misconceptions and Other Tidbits

 

“Low stockpiles are not necessarily a bullish factor at all.”

  • Demand destruction sets in first on the product side – the independent refiners are the ones that have gotten hit hardest (Petroplus).  Refinery closures are never a bullish signal for oil prices.
  • Low product stocks are not a bullish factor.  There’s no incentive to store oil and products when the market is backwardated, as it is today.
  • The Qataris were hedging crude as low as $50/bbl in 2011.
  • The Brent price in euro terms has never been higher.
  • You would have to be mad to own oil ETFs and structure products as an inflation hedge because of the roll yield – “it is like playing a roulette wheel with 6 zeros.”
  • The Brent market is so illiquid than it only takes one or two players to manipulate it.
  • Land-locked oil prices (like WTI) are a better indication of actual fundamentals than the global Brent price.  That is where buyers and sellers of physical crude are actually coming together.

 

Kevin Kaiser

Analyst


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