Date: 08/02/2021
Author: Kent Moors, Ph.D.
I find myself more frequently returning to what used to be a personal area of expertise – global oil and energy – as we move into the next cycle of volatility. Despite the rise of more recent additions to the investment landscape (e.g., cryptocurrency, ESG, electric vehicles, next generation batteries and storage, meme stocks, and others) the position of energy in general and crude oil in particular is once again telegraphing how markets are increasingly subject to manipulation.
The focus remains on how oil is priced and traded. Here, my prior experience has been useful in an early detection of new moves by those intent on distorting the connection between price and physical trade.
With the rise of futures contracts four decades ago, the pricing of oil products was supposed to be taken from field postings dictated by the major producers (the so-called “Seven Sisters”) and given to a much broader range of investors.
As far as it went over the initial several decades, that process achieved its purpose, largely providing a new level of pricing predictability by wrestling control from dominant producers. This occurred despite the introduction of a new consideration – arbitraging the difference between “paper barrels” (the futures contracts) and “wet barrels” (the underlying actual consignment of oil in physical trade).
As a futures contract nears expiration, traders and end users need the futures contract price to reflect the market price for the actual oil contained in an equivalent delivery contract. It is not unusual to experience a slight divergence between the two. In that case, paper is cut on one side or the other to make the contract/consignment prices the same.
Such an approach –known as arbitrage – is often used to flatten out differences between forward contracts and deliveries in a wide array of commodities. However, with oil there are added wrinkles that become more pronounced when the pricing trajectory is in one direction – as it has been over the past several years, first primarily down and then (as a balance appears to form and global production caps have emerged) up more recently.
The futures will have a series of options associated with them as hedges against pricing fluctuation. However, a new generation of derivatives have arisen because of more vexing arbitrage problems at expiration. This paper has simply increased the likelihood of volatility induced by the attempt to generate artificial value in the spread between the futures and the underlying oil itself.
In addition, as market prices advance, there is an accelerating and additional distortion resulting from the withholding of physical volume from the market. We had witnessed this previously in mid-2014. Then, crude prices were pushing above $100 a barrel and considerable anecdotal evidence existed that trading companies were running paper barrels while acquiring physical oil consignments and then keeping that volume from market to provide a distorted pricing bump.
A few of these machinations surfaced in the US, with at least one resulting in regulatory action. But I had been running into these plays frequently in international trade. Here, the ability to estimate genuine impact, as well as the portion of the wet barrel aggregate consignment totals involved remained hampered by the cross-border and multi-jurisdictional paths of the activities.
It is not unusual for operating companies to withhold production from market (i.e., leave oil in the ground) to mitigate price declines. On the other hand, this is not a preferable course of action in most situations like the one emerging today – where companies need to move volume to generate short-term revenue flows in a pricing situation that once again show signs of plateauing.
Rather, the distortions are coming from the trading, rather than the extracting, side. And that brings to mind an intriguing conversation I had in Paris a while back. Then, I wrote about it elsewhere this way:
Jacques Donat is in his mid-thirties and used to be a trader in physical consignments of oil. Now he works for a medium-sized oil tanker firm. The Dutch-based company still has tankers and is still in the oil business. Except the fleet no longer hauls crude anywhere. These days, the tankers are used as floating storage units.
The approach became popular when global oil prices collapsed but production continued unabated. The flow of volume was ongoing. Yet injecting what was coming out of the ground directly into the market would merely increase supply and further depress prices.
Producers resorted to using tankers as a way of keeping burgeoning oil surpluses away from influencing price. The consignments would usually be sold to a large oil trading entity with that company holding the oil off market until prices improved, thereby improving profitability.
Of course, two factors intervened impacting this strategy. First, the profits only came if the oil trading curve was in contango – that is, as you move further out into the future, the expected price would be higher than it is today. Second, the overall aggregate stationary storage capacity would obviously limit to what extent the approach could be utilized.
Then again, Iran had been utilizing tankers to store its own production during the Western sanctions. I have suggested that initial rises in their exports would come more from storage than from increasing production given the pronounced field problems Iran has been experiencing.
Well, I had a long and very interesting discussion with Jacques over how “floating” excess supply influenced the trading in oil. Given the current assumptions about a worldwide oil glut acting as a ceiling on price increases, one would think his tankers would comprise an ingredient in that restraint.
What I found out, on the other hand, was very interesting.
It seems the profits of both his company and the traders who come to own the stored volume have been increasing. That’s because the actual volume held in these floating storage units has been dramatically cut.
He estimates the overall amount of oil in floating storage had been anywhere between 30 and 50 million barrels, depending on whose figures you accept. Currently, however, the estimate is about 10 million even factoring in the Iranian situation.
In other words, at least from the European perspective, that elusive oil balance may be coming much quicker than anticipated. Almost right on cue, Saudi Energy Minister Abdulaziz bin Salman Al Saud announced the same conclusion.
Once Jacques had filled me in from his end, I added information about a strange situation we are experiencing back in the States. Once again, figures are not telling us what we assumed they would.
There has been a rising disparity between the apparently “simple” calculation of what ought to be in US storage and what is reported.
There are essentially three ways crude is stored: underground; tank farms and terminals; and refinery intake. The first two are very predictable and can be calculated directly. Therefore, the Energy Information Administration (EIA, the government data assembler) usually determines surplus storage as follows:
Stock Change = Domestic Production + Net Imports – Crude Oil Input to Refineries
When differences arise, the EIA would apply an “adjustment” to its weekly totals. If minimal, they could be ignored. But more recently this has not been the case. The disparities have often represented as much as 60 percent!
There are no explanations for this aberration other than to conclude that manipulation is taking place. The glut expected apparently is not actually there in the storage itself. Several years ago, Art Berman and Matt Mushalik provided a very interesting analysis of this unusual development (http://peakoil.com/consumption/us-storage-filling-up-with-unaccounted-for-oil).
Art and Matt remind that some of the statistics have tax implications for both the producers/refiners and the state agencies. The former has an active interest in moving volume about their books to decrease oil for which they have tax liability. In contrast, the government agencies are clearly interested in maximizing tax revenues.
The authors conclude that, given all the variables concerned, the glut probably exists more on paper than in real oil.
This also may explain some rather extraordinary EIA weekly drawdowns, some historically high and significantly beyond anything that was anticipated by market analysts.
All these gyrations become more difficult to hide when the market presumption is for rising oil prices. Despite the allowance last month of increasing production hitting the market in August, with OPEC+ (OPEC plus Russia) striking an accord providing for additional volume moving into global trade, the price floor has been showing signs of levelling off. In this environment, the advantage of carrying an apparent oil surplus on the books declines.
I have on several occasions suggested that those who bridge paper and wet barrels have profited from manipulating the difference. Given the phantom surplus we seem to be experiencing on both sides of the Atlantic, I asked Jacques whether he thought this was true.
He simply smiled and said, “Why do you think a guy like me who used to trade oil now pursues profit spreads by leaving oil offshore?”
Point taken.
An additional concern has now emerged. Here’s what I want to add today. There is movement among parties using derivative swings between futures and consignments to expand the ability to profit from merely manipulating figures as the underlying balance in the oil market generally takes hold.
More of my conversations with non-American financing sources (those increasingly cutting the paper in question) now involve setting up investment vehicles to acquire either US production or control over the disposition of the oil resulting (or both). The intermediary paper will continue and will probably multiply. But the non-market forced manipulation will move further up the production sequence.
The next stage is traveling upstream to the fields themselves.
Dr. Kent Moors
This is an installment of Classified Intelligence Brief, your guide to what’s really happening behind the headlines… and how to profit from it. Dr. Kent Moors served the United States for 30 years as one of the most highly decorated intelligence operatives alive today (including THREE Presidential commendations).
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