An instructive approach to energy trading tenets

In the challenging world of energy trading, fortune favours the prepared. Whether one is brave enough (or not) comes second and not having a clear strategy would be borderline foolishness.

Given such a backdrop, almost inevitably, there are resources aplenty targeting those who feel the need to be better informed and equipped. Among the latest reference sources, industry veteran and academic Dr Iris Marie Mack’s book Energy Trading and Risk Management published by Wiley is a pretty compelling one.

The Oilholic instantly warmed up to the book barely a chapter in, struck by its practical approach, balanced tone, contextualised narrative and a genuine desire on the author’s part to define terms and methodologies for the benefit of those with a mid-tier investment knowledge base.

Furthermore, the instructive narrative seeks to bring about a holistic understanding of how energy markets work to begin with, leading on to an adequate treatment of risk, speculation and portfolio diversity tenets. The format in which Energy Trading and Risk Management is minutely sub-sectioned point to point is simply splendid. So should you wish to salami slice and pick up bits of the subject, it would serve you just as well as a cover to cover read through.

Conversely, if you are confident enough to skip the basics and go straight through to concepts and formulas, the sequential flow of text in each chapter helps you breeze through basic definitions usually quoted in boxed text on to what you are after.

Accompanying the text are charts, case studies, background briefs, notes on macro drivers and definitions at various points split into ten weighty sub-sectioned chapters in a book of around 270 pages. From contango to the modern portfolio theory, from risk management in the renewables business to mitigation in an ever changing market climate – it’s all there and duly referenced.

While the Oilholic appreciated Dr Mack's work in its entirety, a chapter on exotic energy derivatives (which follows a passage on the plain vanilla variety) stood out for this blogger. One would be happy to recommend this title to energy professionals, fellow energy analysts and those with a desire to pursue energy trading as a career pathway.

It would most definitely appeal to entrants finding their feet in the market as well as established participants wanting to refresh their thinking and methodologies. Ultimately, for every reader this title is bound to morph from being an informative and educational book at the point of first reading, to an invaluable reference source as and when subsequently needed. That makes it worthy of any energy sector professional’s bookshelf.

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© Gaurav Sharma, October, 2014. Photo: Front Cover – Energy Trading and Risk Management © Wiley Publishers, May, 2014.

Oil, Tip TV & a ‘timely’ Bloomberg report

Brent continues to slip and WTI is along for the slide-ride too. Over the last two weeks, we’ve seen price floors getting lowered only to be breached again sooner than most expect. The Oilholic’s latest 5-day assessment saw both benchmarks as well as the OPEC basket of crudes end the week below US$90 per barrel on Friday.

One has been putting forward a short position argument on Brent since the summer to the readers of this blog and in columns for Forbes. As the tale goes, yours truly has pretty much got the call right, except for a few weeks over one month. Speculators, including but not limited to hedge funds, triumphed in June using the initial flare-up in Iraq as pretence for driving the futures price up. Market fundamentals were never going to support a price spike to $115, as was the case back then.

Those banking on backwardation were bound to get left holding barrels of paper crude on their books that they never needed in the first place for anything other than trading for profit. As the date of the paper contract got desperately close to where you might have to turn up with a tanker at the end of a pipeline, hedge funds that went long in June ended up collectively holding just shy of 600 million paper barrels on their books.

Smart, strategic buying by physical traders eyeing cargoes without firm buyers made contango set in hitting the hedge funds with massive losses. The week to July 15 then saw hedge funds and other speculators cut their long bets by around 25%, reducing their net long futures and options positions in Brent to 151,981 from 201,568 according to ICE.

Physical traders, had finally taught paper traders a long overdue lesson that you can’t cheat market fundamentals for very long. So it was a pleasure expanding upon the chain of thought and discuss other ‘crude’ matters with Nick 'the Moose' Batsford and his jolly colleagues at Tip TV, on October 6. Here’s a link to the conversation for good measure. 

Overall dynamic hasn’t altered from May. To begin with, of the five major global oil importers – China, India, Japan, US and South Korea – importation by four of the aforementioned is relatively down, with India being the odd one out going the other way. Secondly, if an ongoing war in the Middle East is unable to perk-up the price, you know the macroeconomic climate remains dicey with the less said about OECD oil demand the better.

Thirdly, odd as it may seem, while Iraqi statehood is facing an existential threat, there has been limited (some say negligible) impact on the loading and shipment of Basra Light. This was the situation early on in July and pretty much remains the case early October. There is plenty of crude oil out there while buyers are holding back.

Now if anything else, hedge funds either side of the pond have wised up considerably since the July episode. Many of the biggest names in the industry are net-short and not net-long at present, though some unwisely betting on the ‘only way is long’ logic will never learn. Of course, Bloomberg thinks the story is going. One has always had a suspicion that the merry team of that most esteemed data and newswire service secretly love this blog. Contacts at SocGen, Interactive Brokers and a good few readers of ADVFN have suggested so too.

Ever since the Oilholic quipped that hedge funds had been contangoed and went on to substantiate it on more than one occasion via broadcast or print, this humble blog has proved rather popular with ‘Bloomberg-ers’ (see right, a visit earlier this week). Now take this coincidental October 6 story, where Bloomberg claims "Tumbling Oil Prices Punish Hedge Funds Betting on Gains."

Behind the bold headline, the story doesn’t tell us how many hedge funds took a hit or the aggregate number of paper barrels thought to be on their books. Without that key information, the story and its slant are actually a meaningless regurgitation of an old idea. Let’s face it – ideas are not copyrighted. Some hedge fund somewhere will always lose money on a trading call that went wrong, but what’s the big deal, what’s new and where’s the news in the Bloomberg story? Now what happened in July was a big deal.

The 4.1% jump in net-long positions as stated in the Bloomberg report, only for the Saudis to adjust their selling price and cause a further oil price decline, does not signify massive blanket losses for the wider hedge funds industry. Certainly, nothing on July’s loss scale has taken place over the last four weeks either for the WTI or Brent, whether we use ICE or CFTC data.

So here’s some advice Bloomberg if you really feel like probing the matter meaningfully. In the style of Mr. Wolf from Pulp Fiction, if the Oilholic “is curt here, it’s because time is a factor” when putting these things together, “so pretty please with sugar on top” - 

(a) Try picking up the phone to some physical traders of the crude stuff, as price aggregators do, in order to get anecdotal evidence and thoughts based on their internal solver models, not just those who pay way too much for expensive data terminals and have never felt or known what a barrel of crude oil looks like. It'll help you get some physical market context. 

(b) Reconcile at least two months of CFTC or ICE data either side of the pond to get a sense of who is electronically holding what. 

(c) Take the aggregated figure of barrels held at a loss/profit to previous month as applicable, be bold and put a round figure estimate on what hedge funds might well be holding to back up loss/profit slant.

Or (d) if you don’t have the tenacity to do any of the above, email the Oilholic, who doesn’t fix problems like Mr. Wolf, but doesn’t bite either. In the meantime of course, we can keep ourselves fully informed with news about Celine Dion’s whereabouts (see above left, click to enlarge), as Will Hedden of IG Group noted in a recent tweet – the kind of important market moving news that reminds us all how good an investment a Bloomberg terminal is! That’s all for the moment folks! Keep reading, keep it ‘crude’!

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To email: gaurav.sharma@oilholicssynonymous.com

© Gaurav Sharma 2014. Photo 1: Shell Oil Rig, USA © Shell. Photo 2: Bloomberg's visit to the Oilholic, Oct 6, 2014 © Gaurav Sharma. Photo 3: Bloomberg Terminal with Celine Dion flashes © Will Hedden, IG Group, August 2014.

Hedge Funds have been ‘contangoed’

Recent events may have pushed the Brent front month futures contract back towards US$108 per barrel; but there's no denying some have been 'contangoed'! Ukrainian tensions and lower Libyan production are hard to ignore, even if the latter is a bit of a given.

Nonetheless, for a change, the direction of both benchmark prices this month indicates that July did belong to the physical traders with papers traders, most notably Hedge Funds, taking a beating.

It's astonishing (or perhaps not) that many paper traders went long on Brent banking on the premise of "the only way is up" as the Iraqi insurgency escalated last month. The only problem was that Iraqi oil was still getting dispatched from its southern oil hub of Basra despite internal chaos. Furthermore, areas under ISIS control hardly included any major Iraqi oil production zone.

After spiking above $115, the Brent price soon plummeted to under $105 as the reality of the physical market began to bite. It seems European refiners were holding back from buying the expensive crude stuff faced with declining margins. In fact, North Sea shipments, which Brent is largely synced with, were at monthly lows. Let alone bothering to pull out a map of Iraqi oilfields, many paper traders didn't even bother with the ancillary warning signs.

As Fitch Ratings noted earlier this month, the European refining margins are likely to remain weak for at least the next one to two years due to overcapacity, demand and supply imbalances, and competition from overseas. Over the first half of 2014, the northwest European refining margin averaged $3.3 per barrel, down from $4 per barrel in 2013 and $6.8 barrel in 2012.

Many European refineries have been loss-making or only slightly profitable, depending on their complexity, location and efficiency. They are hardly the sort of buyers to purchase consignments by the tanker-load during a mini bull run. The weaker margin scenario itself is nothing new, resulting from factors including a stagnating economy and the bias of domestic consumption towards diesel due to EU energy regulations

"This means that surplus gasoline is exported and the diesel fuel deficit is filled by imports, prompting competition with Middle Eastern, Russian and US refineries, which have access to cheaper feedstock and lower energy costs on average. Mediterranean refiners are additionally hurt by the interruption of oil supplies from Libya, but this situation may improve with the resumption of eastern port exports," explains Fitch analyst Dmitry Marinchenko.

Of course tell that to Hedge Funds managers who still went long in June collectively holding just short of 600 million paper barrels on their books banking on backwardation. But thanks to smart, strategic buying by physical traders eyeing cargoes without firm buyers, contango set in hitting the hedge funds with massive losses.

When supply remains adequate (or shall we say perceived to be adequate) and key buyers are not in a mood to buy in the volumes they normally do down to operational constraints, you know you've been 'contangoed' as forward month delivery will come at a sharp discount to later contracts!

Now the retreat is clear as ICE's latest Commitments of Traders report for the week to July 15 saw Hedge Funds and other speculators cut their long bets by around 25%, reducing their net long futures and options positions in Brent to 151,981 from 201,568. If the window of scrutiny is extended to the last week of June, the Oilholic would say that's a reduction of nearly 40%.

As for the European refiners, competition from overseas is likely to remain high, although Fitch reckons margins may start to recover in the medium term as economic growth gradually improves and overall refining capacity in Europe decreases. For instance, a recent Bloomberg survey indicated that of the 104 refining facilities region wide, 10 will shut permanently by 2020 from France to Italy to the Czech Republic. No surprises there as both OPEC and the IEA see European fuel demand as being largely flat.

Speaking of the IEA, the Oilholic got a chance earlier this month to chat with its Chief Economist Dr Fatih Birol. Despite the latest tension, he sees Russian oil & gas as a key component of the global energy mix (Read all about it in The Oilholic's Forbes post.)

Meanwhile, Moody's sees new US sanctions on Russia as credit negative for Rosneft and Novatek. The latest round of curbs will effectively prohibit Rosneft, Novatek, and other sanctioned entities, including several Russian banks and defence companies, from procuring financing and new debt from US investors, companies and banks.

Rosneft and Novatek will in effect be barred from obtaining future loans with a maturity of more than 90 days or new equity, cutting them off from long-term US capital markets. As both companies' trade activities currently remain unaffected, Moody's is not taking ratings action yet. However, the agency says the sanctions will significantly limit both companies' financing options and could put pressure on development projects, such as Novatek's Yamal LNG.

No one is sure what the aftermath of the MH17 tragedy would be, how the Ukrainian crisis would be resolved, and what implications it has for Russian energy companies and their Western partners. All we can do is wait and see. That's all for the moment folks. Keep reading, keep it 'crude'!

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To email: gaurav.sharma@oilholicssynonymous.com

© Gaurav Sharma 2014. Photo: Oil pipeline © Cairn Energy