Is "assetization" of Black Gold out of control?

Crude oil price should reflect a simple supply-demand equation, but it rarely does in the world of oil index funds, ETFs and loose foresight. Add to the mix an uncertain geopolitical climate and what you get is extreme market volatility. Especially since 2005, there have been record highs, followed by record lows and then yet another spike. Even at times of ample surpluses at Cushing (Oklahoma) - the US hub of criss-crossing pipelines - sometimes the WTI ticker is still seen trading at a premium defying conventional trading wisdom. The cause, according to Dan Dicker, author of the book Oil’s Endless Bid, is the rampant "assetization" of oil.

The author, a man with more than 20 years of experience on the NYMEX floor, attributes this to an influx of "dumb money" in to the oil markets. Apart from introducing and taking oil price volatility straight to the consumers' wallets, this influx has triggered a global endless bid for energy security. Via a book of just under 340 pages split by three parts containing 11 chapters, their epilogue and two useful appendices, Dicker offers his take on the state of crude affairs.

While largely authored from an American standpoint, Dicker throws up some unassailable truths of global relevance. Principal among them is the fact that visible changes that have taken place in the oil markets over the past 20 years. Go back a few decades, and everyone can recollect the connection between price volatility and its association with a major economic or geopolitical crisis (economic woes, Gulf War I, OPEC embargo, etc.)

Presently, there is near perennial volatility as the trading climate and instruments of trade available place an incessant upward pressure on black gold. Reading Dicker's thoughts one is inclined to believe that at no point in history was the phrase "black gold" more appropriate to describe the crude stuff than it is now; particularly in the last six years, as investment banks, energy hedge funds and managed futures funds have come to dominate energy trading and wreak havoc on prices.

In his introduction to the book, Dicker makes a bold claim - that we've lost control of our oil markets and it has become the biggest financial story of the decade. When the Oilholic began reading it, he was sceptical of the author's claim, but by the time he reached the ninth chapter the overriding sentiment was that Dicker has a point - a huge one, articulated well and discussed in the right spirit.

Ask anyone, even a lay man, a non-technical question about why the price of oil is so high - the answer is bound be China and India's hunger for oil. A more technical person might attribute it to the US Dollar's weakening and perhaps investors playing with the commodities market as the equities markets take a hit.

But are these reasons enough to explain what caused prices to soar 600% from 2003 to 2008, only to take a massive dip and soar again over the next couple of years? Something is fundamentally wrong here according to the author and the latter half of his book is dedicated to discussing what it might mean and where are we heading.

Whether you agree or disagree is a matter of personal opinion, but the author's take on what broke the oil markets, and how can they be fixed before they drag us all down into an economic black hole, strikes a chord. He also uses part of the narrative to reflect on his life as a trader before and after passage of the US Commodities Futures Modernization Act opened up the oil markets to a flood of "dumb money."

Sadly, as Dicker notes, the biggest victim of oil markets frenzy is the average consumer, who pays the price at the pump, and in the inflated costs of everything - from food and clothing to electric power and even lifesaving medications. The Oilholic is happy to recommend this book to those interested in crude oil markets, the energy business, US crude trading dynamic, petroleum economics or are just plainly intrigued about why getting a full tank of petrol has suddenly lost the element of predictability in the last half decade or so.

© Gaurav Sharma 2011. Photo: Cover of ‘Oil’s Endless Bid’ © Wiley Publishers, USA 2011.

Col Gaddafi, crude euphoria & last 7 days

The moment Libyan rebels or the National Transitional Council (NTC) as the media loosely describes them, were seen getting a sniff around the Libyan capital Tripoli and Col. Gaddafi’s last bastion, some crude commentators went into euphoric overdrive. Not only did they commit the cardinal sin of discarding cautious optimism, they also belied the fact that they don’t know the Colonel and his cahoots at all. Well, neither does the Oilholic for that matter – at least not personally. However, history tells us that this belligerent, rambling dictator neither has nor will give up that easily. In fact at the moment, everyone is guessing where he is?

To begin, while the end is nigh for the Gaddafi regime, a return to normalcy of oil production outflows will take months if not years as strategic energy infrastructure was damaged, changed hands several times or in some cases both. As a consequence production, which has fallen from 1.5 million barrels per day (bpd) in February to just under 60,000 bpd according to OPEC, cannot be pumped-up with the flick of a switch or some sort of an industrial adrenaline shot.

In a note to clients, analysts at Goldman Sachs maintain their forecast that Libya's oil production will average 250,000 bpd over 2012 if hostilities end as "it will be challenging to bring the shut-in production back online."

These sentiments are being echoed in Italy according to the Oilholic's, a country whose refineries stand to gain the most in the EU if (and when) Libyan production returns to pre-conflict levels. All Italy’s foreign ministry has said so far is that it expects contracts held by Italian companies in Libya to be respected by “whoever” takes over from Gaddafi.

Now, compound this with the fact that a post-Gaddafi Libya is uncharted geopolitical territory and you are likely to get a short term muddle and a medium term riddle. Saudi (sour) crude has indirectly helped offset the Libyan (sweet) shortfall. The Saudis are likely to respond to an uptick in Libyan production when we arrive at that juncture. As such the risk premium in a Libyan context is to the upside for at least another six months, unless there is more clarity and an abrupt end to hostilities.

Moving away from Libya, in a key deal announced last week, Russia’s Lukoil and USA’s Baker Hughes inked a contract on Aug 16th for joint works on 23 new wells at Iraq's promising West Qurna Phase 2 oil field. In a statement, Lukoil noted that drilling will begin in the fourth quarter of this year and that the projected scope of work will be completed “within two years.”

While tech-specs jargon regarding the five rigs Baker Hughes will use to drill the wells at a depth exceeding 4,000 meters was made available, the statement was conspicuously low on the cost of the contract. The key objective is to bring the production in the range of 145,000 to 150,000 bpd by 2013.

Switching tack to commodity ETFs, according to early data for August (until 11th) compiled by Bloomberg and as reported by SGCIB, energy ETPs have attracted their first net inflows in five months with US$9.5 billion under management. This represents a net inflow of US$0.7 billion in August versus an outflow of US$1.5 billion recorded in January. Interest in precious metals continues, even after a very strong July, but base metal ETPs have returned to net outflows. (See adjoining table, click to enlarge)

Meanwhile, Moody’s has raised the Baseline Credit Assessment (BCA) of Russian state behemoth Gazprom to 10 (on a scale of 1 to 21 and equivalent to its Baa3 rating) from 11. Concurrently, the ratings agency affirmed the company's issuer rating at Baa1 with a stable outlook on Aug 17th. The rating announcement does not affect Gazprom's assigned senior unsecured issuer and debt ratings given the already assumed high level of support it receives from the Kremlin.

Moody's de facto regards Gazprom as a government-related issuer (GRI). Thus, the company's ratings incorporate uplift from its BCA of 10 and take into account the agency's assessment of a high level of implied state support and dependence. In fact raising Gazprom's BCA primarily reflects the company's strengthened fundamental credit profile as well as proven resilience to the challenging global economic environment and negative developments on the European gas market in 2009-10.

"Gazprom has a consistent track record of strong operational and financial performance, which was particularly tested in 2009 - a year characterised by lower demand for gas globally and domestically, as well as a generally less favourable pricing environment for hydrocarbons," says Victoria Maisuradze, Senior Credit Officer and lead analyst for Gazprom at Moody's.

Rounding-off closer to home, UK Customs – the HMRC – raided a farm on Aug 17th in Banbridge, County Down in Northern Ireland, where some idiots had set-up a laundering plant with the capacity to produce more than two million litres of illicit diesel per year and evade around £1.5 million in excise duty. Nearly 6,000 litres of fuel was seized and arrests made; but with distillate prices where they are no wonder some take risks both with their lives, that of others and the environment. And finally, Brent and WTI are maintaining US$100 and US$80 plus levels respectively for the last seven days.

© Gaurav Sharma 2011. Photo: Veneco Oil Pumps © National Geographic. Table: Global commodities ETPs © Société Générale CIB/Bloomberg Aug 2011. 

Crude mood swings, contagion & plenty of chatter

There is a lot going on at the moment for commentators to easily and conveniently adopt a bearish short term stance on the price of crude. Take the dismal US jobs data, Greek crisis, Irish ratings downgrade and fears of contagion to begin with. Combine this with a relatively stronger dollar, end of QE2 liquidity injections, the finances of Chinese local authorities and then some 50-odd Chinese corporates being questioned and finally the US political standoff with all eyes on the Aug 2 deal deadline or the unthinkable.

Additionally, everyone is second guessing what crude price the Saudis would be comfortable with and MENA supply fears are easing. Quite frankly, all of these factors may collectively do more for the cause of those wishing for bearish trends than the IEA’s announcement last month – no not the one about the Golden Age of gas, but the one about it being imperative to raid strategic petroleum reserves in order to ‘curb’ rising prices! The Oilholic remains bullish and is even more convinced that IEA’s move was unwarranted and so are his friends at JP Morgan.

In an investment note, they opined that the effectiveness of IEA’s coordinated release is a matter of some debate and crude prices have rebounded quickly. “But while the US especially has demonstrated a willingness to use oil reserves as a stimulus tool in what has become a rather limited toolbox, a second release will require higher prices and a far more arduous task to achieve unity,” they concluded.

Now, going beyond the short to medium term conjecture, the era of cheap oil, or shall we say cheap energy is fading and fast. An interesting report titled – A new world order: When demand overtakes supply – recently published by Société Générale analysts Véronique Riches-Flores and Loïc de Galzain confirms a chain of thought which is in the mind of many but few seldom talk of. Both analysts in question feel that the last long cycle, which extended from the middle of the 1980s to the middle of the 2000s, was shaped by an environment that strongly favoured the development of supply; the next era will in all likelihood be dictated by demand issues.

Furthermore, they note and the Oilholic quotes: “According to our estimates, energy demand will at least double if not triple over the next two decades. This is significantly more than the IEA is currently projecting, with the difference being mainly attributable to our projections for emerging world energy consumption per capita, which we estimate will considerably rise as these countries develop. Applied to the oil market, these projections mean that today’s proven oil reserves, which are currently expected to meet 45 years of global demand based on the present rate of production, would be exhausted within 15-22 years.”

IEA itself estimates that demand will grow by an average of 1.47 million barrels a day (bpd) in 2012, up from the current 2011 average of 1.2 million bpd. Moving away from crystal ball gazing, Bloomberg’s latest figures confirm that record outflows from commodity ETPs (ETF, ETC and ETN) observed in May slowed abruptly. According to SG Cross Asset Research apart from net inflows into precious metals – the biggest sub-segment measured by assets under management – other categories such as Energy and base metals saw limited net outflows (see table on the left, click to enlarge).

Meanwhile, the London Stock Exchange (LSE) was busy welcoming another new issuer of ETFs – Ossiam – on to its UK markets on Monday. It is already the largest ETF venue in Europe by number of issuers; 20 to be exact. According to a spokesperson there are 481 ETFs listed on the LSE. In H1 2010 there were 369,600 ETF trades worth a combined £19 billion on the Exchange's order book, a 40.3% and 33.5% increase respectively on the same period last year.

Switching to corporates and continuing with the LSE, today Ophir Energy plc was admitted to the Main Market. The company listed on the Premium segment of the Main Market and raised US$375 million at admission and has a market capitalisation of US$1.28 billion.

Ophir is an independent firm with assets in a number of African countries particularly Tanzania and Equatorial Guinea. Since its foundation in 2004, the company has acquired an extensive portfolio of exploration interests consisting of 17 projects in nine jurisdictions in Africa.

The company is one of the top five holders of deepwater exploration acreage in Africa in terms of net area and could be one to watch. So far it has made five discoveries of natural gas off Tanzania and Equatorial Guinea and has recently started drilling in the offshore Kora Prospect in the Senegal Guinea Bissau Common Zone. For the LSE itself, Ophir brings the number of companies with major operations in sub-Saharan Africa listed on its books to 79.

Across the pond, Vanguard Natural Resources (VNR) announced on Monday that it will buy the rest of Encore Energy Partners LP it does not already own for US$545 million, gaining full access to the latter’s oil-heavy reserves. While its shares fell 8% on the news, the Oilholic believes it is a positive statement of intent by VNR in line with moves made by other E&P companies to secure reserves with an eye on bullish demand forecasts over the medium term.

Meanwhile, a horror story with wider implications is unfolding in the US, as ExxonMobil’s Silvertip pipeline leaked oil into the Montana stretch of the Yellowstone River on July 1. The company estimates that almost 42,000 gallons may have leaked and invariably questions were again asked by environmentalists about the wisdom of giving the Keystone XL project the go-ahead. This is not what the US needed when President Obama was making all the right noises – crudely speaking that is.

In March, he expressed a desire to include Canadian and Mexican oil in the US energy mix, in May he said new leases would be sold each year in Alaska's National Petroleum Reserve, and oil and gas fields in the Atlantic Ocean would be evaluated as a high priority. To cap it all, last month, the President reaffirmed that despite the BP oil spill in the Gulf of Mexico in 2010, drilling there remained a core part of the country's future energy supply and new incentives would be offered for on and offshore development. Leases already held but affected by the President's drilling moratorium, imposed in wake of the BP spill, would be eligible for extensions, he added. The ExxonMobil leak may not impact the wider picture but will certainly darken the mood on Capitol Hill.

Russians and Norwegians have no hang-ups about crude prospection in inhospitable climates – i.e. the Arctic. Details are now emerging about an agreement signed by the two countries in June which came into effect on July 7. Under the terms, both countries’ state oil firms – i.e. Russia’s Gazprom and Norway’s Statoil – will divide up their shares of the Barents Sea. USGS estimates from 2008 suggest the Arctic was likely to hold 30% of the world's undiscovered gas and 13% of its oil.

Finally, Sugar Land, Texas-based Industrial Info Resources (IIR) came-up with some interesting findings on the Canadian oil sands. In a report last week, the research firm noted that Canada's Top 10 metals and minerals industry projects are large scale oil sands and metal mining endeavours, with the No. 1 being in Alberta's oil sands.

IIR observed that what was once considered a “large project” was now being dwarfed by “megaprojects”. Not long ago a project valued at CAD$1 billion was considered a mega project; now the norm is more in the region of CAD$5 billion (and above) for a project to earn that accolade. Not to mention the fact that the Canadian dollar has been stronger in relative terms in recent years and not necessarily suffering from a mild case of the Dutch disease like its Australian counterpart. IIR’s findings take the Oilholic nicely back to his visit to Calgary in March, a report he authored for Infrastructure Journal and a conversation he had with veteran legal expert Scott Rusty Miller based in Canada's oil capital. We concurred that while the oil sands developments face myriad challenges they are certainly on the way up. The Canadians are developers with scruples and permit healthy levels of outside scrutiny more than many (or perhaps any) other jurisdictions.

IIR recorded US$176 billion worth of oil sands projects and all of the projected investment capital, except for one project in Utah, is in Alberta. It is becoming more likely than ever that Prime Minister Stephen Harper’s dream of Canada becoming an energy super power will be realised sooner rather than later.

© Gaurav Sharma 2011. Photo 1: Pump Jacks Perryton, Texas © Joel Sartore, National Geographic. Photo 2: Shell Athabasca Oil Sands site work © Royal Dutch Shell. Table: Global Commodity ETPs: Inflows analysis by category © Société Générale July 2011.

ETFs, Brent's Strength & ExxonMobil's Russian Deal

There seem to be more backers of the theory that Brent is winning the crude battle of the indices. I certainly believe Brent provides a much better picture of the global oil markets over WTI. Back in May 2010, I blogged that David Peniket, President and COO of Intercontinental Exchange (ICE) Futures Europe, gave Brent his backing. SocGen joined the ever-growing chorus last week. In a note to clients, the French banking major noted that Brent is a much better barometer of the global oil markets, where both crude and product demand have been strong.

Regarding premium between Brent and WTI, SocGen analysts note: “First, preliminary Euroilstock data showed a 4.2 Mb crude stockdraw in December. When this month-on-month per cent change is applied to the end-November OECD Europe crude stock figures from the IEA, the result in end-December European crude stocks that are below average; this is in sharp contrast to the near-record high stocks at Cushing.”

Additionally, oil field technical problems have caused some supply losses in the North Sea and planned pipeline maintenance at the Gullfaks field, in Norway, was also announced last weekend. Moving away from the North Sea, news has emerged that Roseneft and ExxonMobil have penned a deal for oil and gas exploration in the Black Sea, though intricacies and value of the deal is as yet unknown.

Finally, SocGen’s Mutual Fund & ETF report published last week makes for interesting reading; a sort of a continuation of trends noted by the wider market in general. It notes that the commodity rally was supported by US$23 billion inflows in 2010 (click on graphics to enlarge). Over the past 6 months, the rally in commodity prices has been significant (CRB index +27%) and directly associated with the expected pick-up in demand, but reallocation to protect against inflation has clearly played a role as well.

However, SocGen observed that Precious metals, and not energy, dominated commodity inflows. Precious metals were by far the largest category in commodity ETPs (including ETFs, ETCs and ETNs) accounting for 76% of US$157 billion assets under management and they continue to attract most of the inflows.

© Gaurav Sharma 2011. Graphics © SGCIB Cross Asset Research, Jan 19, 2011

Is Brent Winning Battle of the Indices?

Is London’s Brent Crude winning the battle of the indices? David Peniket, President and Chief Operating Officer of Intercontinental Exchange (ICE) Futures Europe, certainly seems to think so.

Speaking at the Reuters Global World Energy Summit on May 27th, Peniket said, “Brent is the global oil benchmark. Brent is used as the price benchmark for around two-thirds of the world's traded oil. It reflects the fundamentals of the oil market on a global basis and we're seeing Brent used as part of the pricing for oil throughout the world.”

Looking ahead, he added that based on “ongoing” growth in Asia, ICE currently expects Asian market participants to use Brent to hedge their risk rather than other benchmarks.

WTI Volumes traded on the NYMEX are far higher than those of Brent on ICE but Peniket said that from 2008 to 2009 Brent grew by 8% in volume terms while WTI grew 2%. Over Q1 2010, Brent grew by 34% while NYMEX WTI grew by 8%.

He declined comment on when he thought ICE Brent volumes may exceed WTI on NYMEX but said that, “Brent is a seaborne crude; it's at a point of the world where crude oil can move around and it can act as a point of arbitrage between different crude grades. Clearly WTI is an important US benchmark but I don't think it reflects the fundamentals of the global oil market in the way that Brent reflects them.”

Elsewhere in the summit, Reuters reported that top bosses of several leading commodities exchange, including Peniket, expressed their common view that speculation has not caused extreme volatility in oil prices and the efforts by state regulators in various markets are unwise to say the least. That will hardly convince politicians seeking capital and a largely sceptical wider public opinion, most notably in the US.

© Gaurav Sharma 2010. Photo Courtesy © Royal Dutch Shell

The Crude Month of May!

The month of May was an extraordinary one for those following crude price fluctuations. Cumulatively speaking, both the major oil futures markets saw the oil price tumble by nearly a fifth since April 30. Over the last fortnight, the price of oil closed below US$70 a barrel for the first time in 2010 driven down by the Greek debt crisis as well as US inventory build-up.

However, between May 26 and 28, the market witnessed a spectacular rebound when the NYMEX contract for July spiked nearly $7 a barrel. Hence, the weekly rise on the back of a healthy 48 hours came in at 5.6% or $3.93 a barrel. Impressive as it may appear, several market commentators I spoke to on the day seemed reluctant to rule out fresh lows over the course of next week (and well into June).

There’s plenty to spook the markets – Greece debt crisis, the Euro’s woes as a result of it, Spain’s recent debt ratings downgrade and US consumer spending. Brent’s premium to NYMEX, which was markedly visible mid-May, also disappeared by Friday.

Predictably, near-term futures contracts are trading at a discount to more-distant contracts. Prices for the most actively traded NYMEX futures contract fell 14.1% or $12.18 in May, the worst month on record since December 2008. Concurrently, over the same period, the front-month Brent crude contract fell 15.4% or $13.42 a barrel, the highest monthly decline since November 2008.

Overall, May was a tough old month for energy futures in general, with perhaps the notable exception of Natural Gas. Expect more of the same in June.

© Gaurav Sharma 2010. Chart Courtesy © Digital Look/BBC

Adios Cheap Oil, Says Shell's CEO

As the crude oil price lurks around its 52-week high of $83.25 a barrel, one cannot but help thinking about what CEO of Royal Dutch Shell Peter Voser said earlier this month. Speaking at the Wall Street Journal’s ECO:nomics conference in California on March 4, Voser told delegates, "I think what is dead is cheap oil. There is sufficient oil around but producers will have to spend more to get it. And I think you'll see that in the end price for consumers."

Debunking the “Peak Oil” hypothesis, Voser said that by 2050 around 40% of cars worldwide will be electric leaving some two-thirds still running on oil. “We will need conventional oil for the foreseeable future,” he added.

Oil futures gained over 2% last week, on the back of positive U.S. jobs data and healthy market feedback on Chinese and Indian economic growth. According to an investors note sent out to clients, analysts at Commerzbank AG believe the price of oil could exceed the current trading circa of $70 to $82 a barrel.

Earlier today, the crude contract for April delivery rose to an intraday high of $82.47 a barrel on the NYMEX before being tempered by a rising U.S. dollar, with the ongoing Greek debt tragedy continuing to weigh on the Euro. At 17:15 GMT, NYMEX crude contract for April delivery was up 10 cents or 0.12% at $81.51 a barrel. Concurrently, London Brent crude contract was trading at $80.35 up 11 cents or 0.14%.

Classic problem for forecasters is that direction of the economy and currency fluctuation aside, ETFs have more or less converted investing in commodities into a pseudo asset class. Hence, retail investors could de facto bet on commodities consumption patterns of emerging economies by investing (or divesting) in commodities, especially oil, via ETFs.

Oil has always been the vanguard of the commodities bubble. Excluding, London and Singapore markets, in 2003, ratio of paper barrels traded to physical barrels traded on NYMEX stood at 6:1. By 2008, the figure had risen to 19:1 and continues to rise, according to industry sources. Now imagine adding London and Singapore markets to the ratios?

It is a no-brainer that anyone who holds a paper barrel hopes to profit from it and few have any intention whatsoever of ever taking an actual delivery of oil. I feel it is prudent to mention that I am not joining the “Hate Speculators Club”. While supply and demand scenarios should (and in most cases do) dictate market movements, there’s more than one reason why cheap oil’s dead.

© Gaurav Sharma 2010. Photo Courtesy © Royal Dutch Shell