By Chris Cook, former compliance and market supervision director of the International Petroleum Exchange
I outlined in a recent post my view that the oil market price has been inflated twice by passive (inflation hedgers) investors, albeit with short term speculative spikes from active (speculators) investors: once from 2005 to June 2008; and again from early 2009 to date. In attempting to ‘hedge inflation’ passive investors perversely ended up actually causing it, and allowed oil producers to manipulate and support the oil market price with fund money to the detriment of oil consumers.
But there has always been a missing link – precisely how has this manipulation been achieved?
While Izabella Kaminska’s Alphaville post was as interesting as usual, the real nugget on this occasion lay in the extremely well informed discussion which followed.
The protagonists were firstly, Patrick McGavock – a very clued up former banker whose blog rejoices in the name of the “Complete Banker”. The second commenter – whose nom de plume is “Free Again” – not only had technical mastery of a subject that has me reaching for an icepack for my head, but also displayed a comprehensive knowledge of Enron’s modus operandi.
Volumetric Production Payment (VPP) versus Prepay
The very name is enough to make the eyes glaze over, but in essence a VPP is a loan secured against a flow of production which remains in the ownership of the producer.
Prepay, on the other hand, is a forward sale of a commodity where the ownership rights to production pass to the financier.
The Alphaville dialogue is instructive as to the difference.
Free Again (to McGavock): Enron did two types of related transactions: Sales of Volumetric Production Payments (described below), which are being done today in much the same way, and Prepay transactions, which were round-trip trades (three parties involved) meant to create the appearance of Funds Flow From Operations, when it was actually funds flow from financing.
McGavock (to Free Again): Absolutely right. Although VPPs and prepays are essentially the same thing except for the ownership of mineral rights.
A day later came a response which I did not see until recently (my bold).
Free Again (replying to McGavock) Yes, I think we agree, but the most interesting distinction, and what may be relevant to the BP discussion, is the reason a company would choose a particular structure.
A VPP is a form of (acceptable) off-balance sheet financing. In most cases, reserve risk is transferred to the buyer (though the seller usually retains the operating risk).
A Prepay transaction is a little more insidious. It is a form of financing, but if structured as a commodity trade, can be made to look as if it is cash flow from operations.
This is particularly important to companies that use mark-to-market accounting, as there usually exists a huge gap between earnings and cash recognition. In order to maintain credit metrics when using MTM, the companies will structure misleading FFFO transactions, as a key rating agencies focus is FFFO/Interest Expense.
Prepay does not move the oil, which stays where it is in the ground or in tank. What prepay does is to create an ownership claim over oil which may be sold either temporarily (Enron-style) as an ‘oil loan’ to investors, or to refiners, who take delivery in due course of oil for which they have fixed the price by ‘paying forward’.
Investors prepay for physical oil which goes nowhere and stays in the custody of the producer, who has an agreement to buy the oil back from the investor, typically a month later in a forward contract that looks just like a futures contract. The outcome is that – facilitated by an investment bank intermediary – the producer lends oil to the investor, and the investor lends dollars to the producer.
The temporary ownership rights created and sold to investors via intermediaries such as Goldman Sachs essentially enable a producer to act as a private oil bank ‘printing oil’.
How does printing oil affect the market? First we’ll look at the printing process as dollars flow in to the market, and the Dark Inventory which it funds. Secondly, we’ll look at what happens when funds flow out and this paper oil is redeemed by the issuer.
In early 2009, risk averse money poured into the commodity markets, and a large portion of it flowed in to passive funds such as Index Funds and Exchange Traded Funds investing wholly or partly in oil. Units in these funds are created, and some unit issuers then entered, via investment banks, into prepay agreements with producers.
Producers obtain dollars interest-free in exchange for transferring title to oil inventory to the investment bank, and what this means is that the producers do not need to sell as much physical oil to refiners, who must therefore raise their bid price to secure supply from producers, and this is why the price rose rapidly in early 2009 even though the market was not under-supplied.
The second effect was that the demand for forward contracts for the producer to buy the oil back again drove the forward price higher, and this created what is defined as a ‘contango’ market. In fact, it was so pronounced it was called a ‘super-contango’.
What happened as a result was that traders began to buy oil, and to sell it forward, since the contango difference in price enabled them to pay to insure and finance the oil; to lease tank storage, and even to charter the fleets of tankers which sat as floating storage off the UK coast through spring and summer 2009.
Passive investors, for their part, lose money in such a contango market, because the oil lease contracts are rolled over from month to month at a loss to them, since they would (say) sell June delivery oil contracts which they are in no position to perform, and have to buy July delivery oil contracts at a higher price.
It is this continuing loss to long term fund investors which funds the ‘contango trade’ of the arbitrageur traders who charter the tankers.
“De-Pay” – Fund liquidation
When risk-averse investors ask for their money back, what happens is that the oil leasing agreement comes to an end, the fund units are liquidated, and the dollars are returned to the fund investors.
So when the oil is repurchased by the producer from the investment bank, the position is no longer ‘rolled over’ and no further contract purchase is entered into in the next delivery month. This depresses the forward contract price relative to today’s price, a state of affairs which is known as a ‘backwardation’.
Moreover, the producer now has fewer dollars and more oil, and is exposed to a fall in the price of the inventory which he now owns once again. Of course, the producer could sell to refiners on a prepay basis, which a refiner would be happy to do at a suitably discounted price. Or alternatively, the producer could sell futures contracts to speculators who for some reason expect that prices will increase.
There have been two outflows of passive investment from the market, firstly in September 2011 when sentiment turned in favour of T-Bills as safe haven. The second was in December 2011, following the MF Global problem, which demonstrated that unit issuers come with a counter-party risk, since though the issuer may not be taking market risk themselves, they may nevertheless be playing games with the asset.
In each case we have seen the physical market go into backwardation, and in my view the record deliveries by the Saudis may be explained by an urgent desire to sell inventory returned to their ownership at high prices before the collapse they know is on the way.
But the exit of passive investors from the market has yet to have the effect it did in late 2008 when the price collapsed to $35/barrel from the high of $147/barrel. The reason is that the current noise and rhetoric re Iran has firstly attracted refiners, who have purchased oil forward, and possibly even prepaid, because they fear prices will rise.
This forced up the physical price of oil in the current ‘spike’ which will further kill off demand, while speculators have poured into the market to buy futures contracts, which producers have been only too happy to sell, in order to lock in high prices and insure against a collapse.
It is only a matter of time before this spike ends as the market turns, and at this point there is literally nothing holding the market up.
Private inventories are at record lows, and this is mistakenly taken by commentators as a sign of demand. The reality is that traders will only store oil if they are able to afford to store it and sell it at a profit. The problem is firstly that many traders are being starved of credit by the banks, which will make it difficult for them to act as a ‘buffer’ through buying surplus oil
Secondly, the market is in fact in backwardation, which means that holding oil costs traders money, and if producers have cash flow problems, they too have an incentive to sell at a discount.
Refiners’ Demand for Oil
No investment bank with oil funds to sell you will ever come up with any reason why oil prices will ever go down, but their faulty economic logic can reach laughable proportions.
For instance, falling demand for products in the US and EU has seen massive closures of refineries, to the extent that some 2m barrels per day of US East Coast refining capacity has closed. This is of course good for the refineries left standing since it can create local shortages and opportunities for high margins and profits.
A very well respected investment bank analyst recently suggested in the FT that the resulting higher US gasoline prices would increase the demand for crude oil and hence – surprise, surprise – was bullish for oil prices. What he was ignoring was that all of the crude oil which used to go to the refineries which had shut will be looking for another home.
By way of example, Hovensa joint venture refinery at St. Croix in the US Virgin Island, which used to receive 350,000 barrels per day from the Venezuelan state oil company PDVSA which was one of the partners, has now closed. It is hardly likely that the PDVSA will now increase the price of their heavy crude oil when offering it to (say) the Chinese. The point being that oil refiners have been caught between the rock of a manipulated and inflated crude oil price and the hard place of cash-strapped consumers.
So in a nutshell, demand in the West is dropping like a stone. I do not believe for a minute that demand for consumption in the East will make up the slack. In my view much of that demand (if not wishful thinking and hand waving by analysts) is financial, being the building of strategic reserves and refinery stocks as a physical hedge.
It will be seen that the effect of Prepay on the oil market has been to create a parallel financial market in ‘paper oil’ which means that most participants are completely misled as to the true state of the market.
In summary, as I previously outlined, my analysis is that the oil market stands like an Oil-e-Coyote – running hard beyond the edge of a cliff, but not having yet looked down………
Window Dressing Enron
For those with short memories, Enron fraudulently concealed their financial position from investors and the rest of the world through a variety of sophisticated techniques. One of the most egregious was the use of prepay transactions with investment banks via a special purpose vehicle in a tripartite agreement which essentially misrepresented what was in reality a loan as a forward commodity purchase and sale.
In other words, Enron – facilitated by investment banks – was window dressing its balance sheet and fraudulently misleading investors and counter-parties alike.
Window Dressing the Oil Market
It appears to be the case that BP and Goldman Sachs have for many years been directly or indirectly enhancing BP’s balance sheet and cash flow through enabling BP to lend oil to passive inflation hedger investors and in return obtain interest free dollar funding and literally monetising oil.
Possible accounting legerdemain by BP is one thing, but the greater problem by far has been the effect of passive investors entering the market en masse via this route. As I explained, these transactions have eroded the foundations of the oil market, which have become entirely financialised and have lost touch with the reality of physical production, consumption and storage.
The fact that oil market inventory has been prepaid in this way creates a two tier physical market, where the tiny minority who have knowledge of the resulting ‘Dark Inventory’ of oil in temporary investor ownership have a massive advantage over the majority who do not and who enter into derivative contracts upon a completely false assumption as to physical supply and demand.
Whether or not this is illegal, and if so, in what country, is an interesting question. But as a former head of regulation of a global energy exchange I have no hesitation in saying that the result has been a complete perversion of the oil market, which has become, for maybe as long as ten years, in every sense a ‘False Market’.
The sheer scale of this oil market manipulation, and the staggering sums involved, make Yasuo Hamanaka’s ten year $ multi billion copper market manipulation for Sumitomo look like a car boot sale.
If my analysis of the oil market is correct, many if not all prepay transactions have been terminated in recent months as passive investors have pulled out and the market has become free again of Dark Inventory. However the oil price has been kept inflated by a massive wave of speculative buying attracted by rhetoric and noise about Iran.
With the market’s underpinnings eaten away by fulfilment of these pre-paid contracts (which will temporarily depress physical demand), a collapse in the oil price is inevitable once speculators exit. After this, perhaps steps may then be taken by producers and consumers collectively to free the oil market from the pernicious control of middlemen, and to completely reconfigure the market through a new settlement.
I’m not holding my breath, but I do live in hope.
Author’s Notes: Peak Oil
Before once again being assailed by Peak Oil proponents as a ‘denialist’, I am completely convinced of the proposition that crude oil is finite and that there is a maximum level of crude oil production, which we have either reached or approached.
The problem is that current markets are operated and manipulated by and on behalf of intermediaries with a vested interest in volatility and extraction of profit at the expense of producers and consumers.
The requirement is for a new and equitable dis-intermediated market architecture where carbon fuel prices are maintained at the level where demand destruction sets in, but where part of the surplus is reinvested in renewable energy and energy savings with a view to reducing future demand for carbon fuels)