Naked Oil

This is a guest post by Chris Cook, former compliance and market supervision director of the International Petroleum Exchange.

All is not as it appears in the global oil markets, which have become entirely dysfunctional and no longer fit for its purpose, in my view. I believe that the market price is about to collapse as it did in 2008, and that this will mark the end of an era in which the market has been run by and on behalf of trading and financial intermediaries.

In this post I forecast the imminent death of the crude oil market and I identify the killers; the re-birth of the global market in crude oil in new form will be the subject of another post.

Global Oil Pricing

The “Brent Complex” is aptly named, being an increasingly baroque collection of contracts relating to North Sea crude oil, originally based upon the Shell “Brent” quality crude oil contract that originated in the 1980s.

It now consists of physical and forward BFOE (the Brent, Forties, Oseberg and Ekofisk fields) contracts in North Sea crude oil; and the key ICE Europe BFOE futures contract, which is not a deliverable contract and is purely a financial bet based upon the price in the BFOE forward market.

There is also a whole plethora of other ‘over the counter’ (OTC) contracts involving not only BFOE, but also a huge transatlantic “arbitrage” market between the BFOE contract and the US West Texas Intermediate (WTI) contract originated by NYMEX, but cloned by ICE Europe.

North Sea crude oil production has been in secular decline for many years, and even though the North Sea crude oil benchmark contract was extended from the Brent quality to become BFOE, there are now only about 60 cargoes each of 600,000 barrels of BFOE quality crude oil (and as low as 50 when maintenance is under way) delivered out of the North Sea each month, worth at current prices about $4 billion.

It is the ‘Dated’ or spot price of these cargoes – as reported by the oil price reporting service Platts in the ‘Platts Window’– that is the benchmark for global oil prices either directly (about 60%) or indirectly, through BFOE/WTI arbitrage for most of the rest.

It will be seen that traders of the scale of the oil majors and sovereign oil companies do not really have to put much money at risk by their standards in order to acquire enough cargoes to move or support the global market price via the BFOE market.

Indeed, the evolution of the BFOE market has been a response to declining production and the fact that traders could not resist manipulating the market by buying up contracts and “squeezing” those who had sold forward oil they did not have, causing them very substantial losses. The fewer cargoes produced, the easier the underlying market is to manipulate.

As a very knowledgeable insider puts it….

The Platts window is the most abused market mechanism in the world.

But since all of this short term ‘micro’ manipulation or trading (choose your language) has been going on among consenting adults in a wholesale market inaccessible to the man in the street, it is pretty much a zero sum game, and for many years the UK regulators responsible for it – ie the Financial Services Authority and its predecessor - have essentially ignored it, with a “light touch” wholesale market regime.

If the history of commodity markets shows us anything, it is that if producers can manipulate or support prices then they will, and there are many examples of which the classic cases are the 1985 tin crisis, and Yasuo Hamanaka’s 10-year manipulation of the copper market on behalf of Sumitomo Corporation.

When I gave evidence to the UK Parliament’s Treasury Select Committee three years ago at the time of the last crude oil bubble, I recommended a major transatlantic regulatory investigation into the operation of the Brent Complex and in particular in respect of the relationship between financial investors and producers, and the role of intermediaries in that relationship.

I also proposed root and branch reform of global energy market architecture, which in my view can only come from producer nations and consumer nations collectively, because intermediary turkeys will not vote for Christmas.

A Meme is Born

In the early 1990s, Goldman Sachs created a new way of investing in commodities. The Goldman Sachs Commodity Index (GSCI) enabled investment in a basket of commodities – of which oil and oil products was the greatest component – and the new GSCI fund invested by buying futures contracts in the relevant commodity markets which were 'rolled over' from month to month.

The genius dash of marketing fairy dust that was sprinkled on this concept was to call investment in the fund a ‘hedge against inflation’. Investors in the fund were able to offload the perceived risk of holding dollars and instead take on the risk of holding commodities.

The smartest kids on the block were not slow to realise that the GSCI – which was structurally ‘long’ of commodity markets – was taking a long term position which was precisely the opposite of a commodity producer who is structurally ‘short’ of commodities because they routinely sell futures contracts in order to insure themselves against a fall in the dollar price; ie commodity producers are offloading the risk of owning commodities, and taking on the risk of holding dollars.

So, in 1995 a marriage was arranged.

BP and Goldman Sachs get Married

From 1995 to 2007 BP and Goldman Sachs were joined at the head, having the same chairman – the Irish former head of the World Trade Organisation, Peter Sutherland. From 1999 until he fell from grace in 2007 through revelations about his private life, BP’s CEO Lord Browne was also on the Goldman Sachs board.

The outcome of the relationship was that BP were in a position, if they were so minded, to obtain interest-free funding via Goldman Sachs, from GSCI investors through the simple expedient of a sale and repurchase agreement - ie BP could sell title to oil with an agreement to buy back the oil later at an agreed price.

The outcome would be a financial ‘lease’ of oil by BP to GSCI investors and the monetisation of part of BP’s oil inventory. Such agreements in relation to bilateral physical oil transactions are typically concluded privately, and are invisible to the organised markets. However, any risk management contracts which an intermediary such as Goldman Sachs may enter into as a counter-party to both a fund and a producer are visible on the futures exchanges.

Due to the invisibility of the change of ownership of inventory ‘information asymmetry’ is created where some market participants are in possession of key market information which others do not have. This ownership by investors of inventory in the custody of a producer has been termed ‘Dark Inventory’

I must make quite clear at this point that only BP and Goldman Sachs know whether they actually did create Dark Inventory by leasing oil in this way, and readers must make up their own minds on that. But I do know that in their shoes, what I would have done, particularly bearing in mind that such commodity leasing is a perfectly legitimate financing stratagem that has been in routine use in the precious metals and base metal markets for a very long time indeed.

Planet Hype

The ‘inflation hedging’ meme gradually gained traction and a new breed of Exchange Traded Funds (ETFs) and structured investment products were created to invest in commodities. In 2005, Shell entered quite transparently into a relationship with ETF Securities which enabled them to cut out as middlemen both investment banks and the futures market casinos, and with them the substantial rent both collect.

Other investment banks also started to offer similar products and a bandwagon began to roll. From 2005 to 2008, we therefore saw an increasing flood of dollars into the oil market, and this was accompanied by the most shameless and often completely misleading hype, and led to a bubble in the price.

There was (and still is) no piece of news which cannot be interpreted as a reason to buy crude oil. The classic case was US environmental restrictions on oil products, which led to restricted supply, and to price increases in oil products. Now, anyone would think that reduced refinery throughput will reduce the demand for crude oil and should logically lead to a fall in crude oil prices.

But on Planet Hype faulty economic logic – the view that higher product prices are necessarily associated with higher crude oil prices – was instead used as justification for the higher crude oil prices which resulted from the financial buying of crude oil attracted by the hype.

You couldn’t make it up: but unfortunately, they could, and they did.

More worrying than mere hype was that a very significant amount of oil inventory had actually changed hands from producers to investors. Only those directly involved were aware that below the visible part of the oil market iceberg lurked massive unseen ‘Dark Inventory’.

Greedy Speculators and Hoarding

The pervasive narrative among people and politicians, and which is spread by a campaigning press, is of ‘greedy speculators’ who are ‘hoarding’ commodities and ‘gouging’ consumers in search of a transaction profit.

There is no better example of this meme than the UK’s Daily Mail scoop on 20th November 2009.

Here we saw pictures of shoals of some 54 shark-like tankers loaded with oil and lurking off the UK coast with millions of barrels of ‘hoarded’ crude oil, some of them having been there since April 2009. The Mail’s story was that these tankers were full of hoarded oil whose greedy owners were waiting for prices to rise before gouging the public.

The reality was rather different.

The motivation of the investors involved was not greed but fear. The Fed had been busily printing another trillion in QE dollars to buy securities and the sellers, and other investors aimed not to make a dollar profit but rather to avoid a dollar loss.

So they poured $ billions into oil index funds and similar products and the oil leases/loans which accommodated these funds’ financial purchases of oil had the effect of raising forward prices and of depressing the spot price, thereby creating what is known as a market ‘in contango’.

When the forward price is high enough in a contango market, what happens is that traders will borrow money to buy crude oil now, and sell the oil at the higher price in the future. Provided the contango is high enough, they will cover interest costs and the cost of chartering and insuring the vessel and its cargo, and lock in a profit for the trader at the end.

This is exactly what traders did through the summer of 2009, until the winter demand by refineries for crude oil and a reduction in the flow of QE dollars into the market combined to see the stored oil gradually delivered to refineries and the sharks depart the UK shores.

The point is that the widely held perception of high oil prices being the fault of hoarders and greedy speculators is – apart from very short term ‘spikes’ in the price - entirely misconceived. And even when speculators do dabble in oil markets, they are almost always pillaged by traders and investment banks with much better market information, which is probably what is happening right now.

The Bubble Bursts

In 2008 there was an influx of genuine speculators in search of short term transaction profit. The motivation of inflation hedgers, on the other hand, is the avoidance of loss, which leads to different market behaviour and the perverse outcome that they have been responsible for causing the very inflation they sought to avoid.

The price eventually reached levels at which demand for products began to be affected and shrewd market observers began to position themselves for the inevitable bursting of the obvious bubble. But those market traders and speculators who correctly diagnosed that the price would collapse were unaware of the existence of the Dark Inventory of pre-sold oil sitting invisibly like an iceberg under the water.

Traders who had sold off-exchange Brent/BFOE contracts or deliverable WTI contracts found themselves ‘squeezed’ because title to the crude oil which they thought would be available at a cheaper price to fulfil their contractual commitment had been ‘pre-sold’ to financial investors. This meant that they had to scramble to buy oil at a higher price than they had expected.

The price spiked to $147 per barrel, and then declined over several months all the way to $35 per barrel or so, as many of the index fund investors pulled their money out of the market in late 2008 and joined a stampede to the safety of US Treasury Bills. What was happening here was that the Dark Inventory which had been created flooded back into the market, and overwhelmed the market’s capacity to absorb it.

Convergence and Futures Pricing

The oil market price is – by definition – the price at which title to dollars is exchanged for title to crude oil.

But there is very considerable debate among economists about the effect of derivative contracts on this spot market price, and whether it is the case that the futures market converges on the physical market price or vice versa.

Now, in the case of a deliverable exchange futures contract, a price is set for delivery of a standardised quantity of a particular specification of a commodity at a particular location within a specified period of time. If that contract is held open until the expiry date and time then there will indeed be a spot delivery and payment against documents at the original price. in accordance with the exchange’s contractual terms.

But the key point is that this futures contract will not be held open to the expiry date at the original price unless the physical market price – which is set by physical supply and demand – is actually at that price at that specific point in time. If the physical price is lower or higher, then the futures contract will be closed out through a matching purchase or sale and a profit or loss will be taken.

I managed the International Petroleum Exchange’s Gas Oil contract for six years, which was deliverable in North West Europe, and the final minutes of trading before contract expiry were Europe’s greatest game of ‘chicken’.

Moreover, no IPE broker in his right mind would dream (because the broker was responsible to the London Clearing House for defaults) of letting a financial investor with no capability of making or taking delivery hold a position into the last month before delivery. And if a broker was not in his right mind, it was my job to act under the exchange rules to ensure such positions were liquidated.

In other markets, the ability to own physical commodities – eg through ownership of warehouse warrants – is much more straightforward for investors. But the logistics of oil and oil products are such that financial investors are simply incapable of participating in the physical market. In my view, the use of position limits for financial investors in crude oil and oil products is of little or no use if the clearing house, exchange, and brokers are doing their job.

Finally, now that the US WTI contract is just the tail on the Brent/BFOE physical market dog, this discussion has moved on, since the ICE Brent/BFOE futures contract is in fact settled in cash against an index based on trading in the BFOE forward market, with no physical delivery. It is simply a straightforward financial bet in relation to the routinely manipulated underlying BFOE physical market price - ie, the question of convergence does not arise.

Anything but Dollars

With interest rates at zero per cent, and with the Federal Reserve Bank printing dollars through QE, a tidal wave of money flowed into equity and commodity markets purely as an alternative to the dollar, and they did so through a proliferation of funds set up by banks.

Note here that the beauty of such funds for the banks is that it is the investors who take the market risk, not the banks, and the marketing and operation of funds has become a very profitable use of scarce bank capital.

So a flood of financial purchasers of oil were looking for producers willing and able to sell or lease oil to them.

Producers in Pain

Producing nations who had massively expanded their spending in line with a perceived ‘sellers’ market’ paradigm where they had the whip hand, were badly hurt by the 2008 price collapse and OPEC took action to restrict production.

But might some OPEC members or other producing nations have gone further than this?

What is clear is that the price rose swiftly in 2009 and then remained roughly in a range between $70 and $90 per barrel until early 2011 when twin shocks hit the oil market. Firstly, there was the supply shock in Libya which saw 1.5m bbl per day of top quality crude oil leave the market, and secondly, the demand shock of Fukushima, which saw a dramatic switch from nuclear to carbon-fuelled energy.

My thesis is that Shell directly, and others indirectly, were not the only ones leasing oil to funds. I believe that it is probable that the US and Saudis/GCC reached – with the help of the best financial brains money can rent – a geo-political understanding with the aim that the oil price is firstly capped at an upper level which does not lead to politically embarrassing high US gasoline prices; and secondly, collared at a level which provides a satisfactory level of Saudi/GCC oil revenues.

The QE Pump Stops

In June 2011, the QE pump which had been keeping commodity and equity markets inflated and correlated stopped, and price levels began to decline. Consumer demand – as opposed to financial demand – for commodities had also been affected not only by high prices, but by reduced demand from developed nations for finished goods. In September 2011, more than $9bn of index fund money pulled out of the markets for the safe haven of T-bills.

What happened as a result was that the regular rolling over of oil leases, and the free dollar funding for producers of their oil inventory ceased. So the leased oil returned to the ownership of the producers, while the dollars returned to the ownership of the funds.

Since the ‘repurchases’ were no longer occurring, the forward oil price fell below the current price, and this ‘backwardation’ was misinterpreted by market traders and speculators. They believed that the backwardation was – as it usually is - a sign that current demand was high and increasing relative to forward demand, whereas in this false market the current demand is unchanged but the forward demand is decreasing.

As in 2008, speculators and traders were again suckered too soon into the market, and this led to profits at their expense to those with asymmetric information, and a ‘pop’ upwards in the price as they were forced to close speculative short positions. My information is that a major oil market trader was successfully able to ‘squeeze’ the Brent/BFOE market on at least two occasions in late 2011 precisely because they were aware of the true situation of inventory ownership, and the rest of the market was not.

As an insider puts it……

You can’t have proper price discovery when half of the inventory is being sold elsewhere at a different price. On exchange physical doesn’t even exist. Futures are converging to physical, but only the physical which is visible for Platts assessment.

….pointing out that transactions in respect of physical ownership of oil do not take place on an exchange, and that there is effectively a ‘two tier’ market. Only a proportion of spot or physical Brent/BFOE transactions therefore actually form the basis of the Platts assessment of the global benchmark oil price.

Enter Iran

In my view, there is little or no chance of military action against Iran, and having been to Iran five times in recent years, and as recently as two months ago, there is much I could write on this subject.

While financial sanctions have been pretty smart, and increasingly effective so far, the medium and long term effect of the proposed EU oil embargo – which will in fact affect only a pretty minimal and easily accommodated amount of demand which is evaporating anyway – is more apparent than real.

While there would undoubtedly be a short term price rise – cheered on by the usual suspects – in the medium and long term the embargo will act to reduce oil prices. This is because Iran will necessarily have to sell oil at below market price to China and others, and since the market is over-supplied, particularly in Europe, this will undercut market prices generally.

Mexico has routinely hedged oil production for years, and Qatar – who are very shrewd operators – began to do the same in November 2011 since they expect the price to fall this year. In the short term the Iran ‘crisis’ is in my view being hyped for all it is worth to entice yet more unwary speculators into the oil market so that other producers may sell their production forward at high prices while they last before the inevitable and imminent collapse.

Current Position

If you believe the investment banks – who all have oil funds to sell to the credulous – Far Eastern demand is holding up, supplies are tight, and stocks are low, so prices are set to rise to maybe $120 or above in 2012, even in the absence of fisticuffs involving Iran.

I take a different view. I see real demand – as opposed to financial demand and stock-piling, such as in the copper market – declining in 2012 as the financial crisis continues at best, and deepens at worst, particularly in the EU. Stocks are low because bank financing of stock is disappearing as banks retrench, and it makes no sense for traders to hold stocks if forward prices are lower than today’s price.

As for supplies, US crude oil production is probably higher, and consumption lower, than widely appreciated. Elsewhere, there is plenty of oil available now that much of the Dark Inventory has been liquidated, and this liquidation was probably why in November 2011 we saw the highest Saudi monthly deliveries in 30 years.

Finally, we see North Sea oil being shipped – for the first time since 2008 – half way around the world to find Far East buyers. We also see Petroplus, a major independent Swiss refiner, crippled by inflated crude oil prices, and shutting down three refineries because demand for its products has disappeared, and it can no longer finance crude oil purchases now that banks have pulled its credit lines.

In my world, refineries closed due to reduced demand for their products imply a reduction in demand for crude oil: but not, apparently, on the Planet Hype of investment banks with funds to sell.

History does not repeat itself, but it does rhyme, and my forecast is that the crude oil price will fall dramatically during the first half of 2012, possibly as low as $45 to $55 per barrel.

Then What?

As the price collapses we will see producer nations generally and OPEC in particular once again going into panic mode, and genuinely cutting production. We will also see the next great regulatory scandal where a legion of risk-averse retail investors who have lost most or all of their investment will not be pleased to hear that they were warned on Page 5, paragraph (b); clause (iv) of their customer agreement that markets could go down as well as up.

At this point, I hope and expect that consumer and producer nations might finally get their heads together and agree that whereas the former seeks a stable low price, and the latter a stable high price, they actually have an interest – even if intermediaries do not – in agreeing a formula for a stable fair price.

We can’t solve 21st century problems with 20th century solutions and I shall address the subject of a resilient global energy market architecture in my next post.

History does not repeat itself, but it does rhyme, and my forecast is that the crude oil price will fall dramatically during the first half of 2012, possibly as low as $45 to $55 per barrel.

And what does Goldman Sachs say?

Goldman sees massive upside risk in oil prices

Price increases in Brent crude already in the first weeks of the year mean Goldman's end-year target is only 13 percent away, but it is the commodity with the greatest potential to break above its target, Head of Commodities Research Jeff Currie said.

"Oil we like the most from a fundamental basis but at $113 a barrel in the current environment is pretty rich," he told a strategy conference in London.

Goldman expects Brent oil to end the year at $127.50 per barrel and trade at an average of $120 in 2012.

They have a history of hyping the price then liquidating their position. Superspike and all that.

EDIT: I wouldn't discount this thesis out of hand


I rest my case. :-)

If the squid is hyping something you can bet they are reducing their exposure to it.

It's always helpful to look at the global supply data, but let's take a quick look at Saudi data. Note that at Saudi Arabia's 2002 to 2005 rate of increase in net oil exports (BP), they would have (net) exported about 13 mbpd in 2010, versus the actual 2010 net export level of 7.2 mbpd (versus 9.1 mbpd in 2005). While it appears that Saudi Arabia, for only the second time since 2005, has shown a year over year increase in net oil exports in 2011, I estimate that their 2011 net exports will be between 1.0 and 1.6 mbpd below their 2005 rate.

As noted below, we saw a doubling in global crude oil prices from 2002 to 2005, corresponding to a massive increase in Saudi net oil exports.

But then in response to the doubling in global crude oil prices from 2005 to 2011, we have seen a substantial decline in Saudi net oil exports, relative to 2005.

Could the post-2005 decline in Saudi net oil exports be completely voluntary? Possibly, but there is always the simplest explanation, to-wit, that Saudi Arabia, like the prior swing producer, Texas, is not immune from the laws of physics.

A Review of Annual Brent Crude Oil Prices Versus Global Production & Net Export Data

Here is a link to EIA data showing annual Brent prices, which is a good indicator of global crude oil prices:

Here are the annual Brent crude oil prices from 2005 on, along with the rates of change relative to 2005:

2005: $55,
2006: $65, +17%/year
2007: $72, +13%/year
2008: $97, +19%/year
2009: $62, + 3%/year
2010: $80, + 8%/year
2011: $111, +12%/year

The 2011 annual Brent price is about twice the 2005 annual price, and it is the highest annual crude oil price ever, up 26% over the annual 2010 price, and up 14% from the annual 2008 price.

Note that we have had two price doublings since 2002, from $25 in 2002 to $55 in 2005, and then from $55 in 2005 to $111 in 2011.

In response to the first price doubling, we did of course see a substantial increase across the board in total liquids production (inclusive of biofuels), in total petroleum liquids, in crude + condensate, and in Global Net Exports (GNE) and in Available Net Exports (ANE). Note that the rates of increase in GNE and in ANE exceeded the rates of increase in the production numbers (which is what our model predicted would happen).

In response to the second price doubling, we have seen a very slow rate of increase in total liquids production (up 0.5%/year from 2005 to 2010), virtually flat total petroleum liquids and and virtually flat C+C production (through 2010), and a 1.3%/year and 2.8%/year respective decline rate in GNE & ANE (through 2010). Note that we saw declines in the GNE & ANE numbers , versus flat to very slowly increasing production numbers (which is what our model predicted would happen).

I estimate that the ANE decline rate will accelerate to between 5%/year and 8%/year from 2010 to 2020. Note that at China & India's (Chindia's) combined rate of increase in their in their net oil imports as a percentage of Global Net Exports from 2005 to 2010, the Chindia region alone would consume 100% of Global Net Exports in about 19 years.

I estimate that the current CANE (Cumulative Available Net Exports, post-2005) depletion rate could be on the order of about 8%/year (versus a 2005 to 2010 2.8%/year rate of decline in the volume of ANE). The CANE depletion rate would be the rate that we are consuming the cumulative post-2005 supply of global net exports available to importers other than China & India. Based on a simple model and based on actual case histories, note that it is common for the initial depletion rate to exceed the initial annual rate of decline in net exports.

In round numbers, I estimate that the remaining cumulative supply of (net) exported oil available to importers other than China & India is falling at an annual rate that is about three times the rate that the annual volume of (net) exported oil available to importers other than China & India is falling.

Think of it this way. Let's assume you have $100,000 in the bank and you withdraw $10,000 the first year, $9,000 the second year, $8,000 the third year and $7,000 the fourth year. The rate of decline in annual withdrawals is 12%/year, but the cash balance in the account is falling at 27%/year.

Here are the observed rates of change for key liquids measurements for 2002 to 2005 and for 2005 to 2010 respectively (respectively corresponding to first Brent crude price doubling and to most of second Brent crude price doubling):

Production/Export Measurement: 2002 to 2005 rate of change, 2005 to 2010 rate of change (change between the two)

Total Liquids (EIA, Including Biofuels): +3.1%/year, +0.5%/year (84% reduction in rate of increase)

Total Petroleum Liquids (BP): +2.9%/year, +0.15%/year (95% reduction in rate of increase)

Crude + Condensate (EIA): +3.1%/year, +0.08%/year (97% reduction in rate of increase)

GNE (BP + Minor EIA data, top 33 net oil exporters): +5.2%/year, -1.3%/year (shifted from increasing GNE to declining GNE)

ANE (GNE less Chindia's combined net oil imports): +4.2%/year, -2.8%/year (shifted from increasing ANE to declining ANE)

Five annual "Gap" charts follow, showing the gaps between where we would have been at the 2002 to 2005 rates of increase, versus the actual data in 2010 (common vertical scale):

EIA Total Liquids (including biofuels):

BP Total Petroleum Liquids:

EIA Crude + Condensate:

Global Net Oil Exports (GNE, BP & Minor EIA data, Total Petroleum Liquids):

Available Net Exports (GNE less Chindia’s net imports):

I would particularly note the difference between the first chart, total liquids, and the last chart, Available Net Exports (ANE).

Two GNE & ANE scenarios:

0.1%/year Production Decline (2010 to 2020), Top 33 Net Oil Exporters:

1.0%/year Production Decline (2010 to 2020), Top 33 Net Oil Exporters:

CERA, et al tend to focus on the total liquids data while ignoring the GNE & ANE data. Since Yergin is now calling for less than a one percent per year rate of increase in total liquids productive "capacity," which is similar to what we saw from 2005 to 2010 in the EIA total liquids data (+0.5%year), it seems to me that Yergin is, almost certainly without realizing it, in effect predicting a continued decline in GNE & ANE:

What about countries which have floating prices for their oil now? For instance would you consider Nigeria to be a net exporter or net importer when they export all their oil and import refined product at a floating international price? I think the idea of net exporter vs importer is too simplistic because I think it doesn't take into account the countries which have a floating price and can experience the same demand destruction as net importers and I see sales of oil in those countries as being sales of convenience with many of the oil producers willing and able to sell on the international market if the producers themselves are privately held or publicly held companies. Maybe net exports better represents those countries where the state has both a fixed price locally and ownership of oil production than say a country like Canada which exports crude produced by independent companies.

Well. thats as clear as mud.

Isn't this the oil accordion explanation on steroids?

I am looking forward to your second post

thesis is that Shell, directly, and others indirectly were not the only ones leasing oil to funds. I believe that it is probable that the US and Saudis/GCC reached – with the help of the best financial brains money can rent – a geo-political understanding with the aim that the oil price is firstly, capped at an upper level which does not lead to politically embarrassing high US gasoline prices ; and secondly, collared at a level which provides a satisfactory level of Saudi/GCC oil

I take it the GCC is ?

midi - I'm with you. There's a reason no one should ever listen to a geologist talk about oil trading. We may good at finding the grease but that's about it. I sent the post to an engineer who does understand the market and also works for a international financial company. Asked for his bottom line thoughts about the proposition presented here. I'll let you know what he thinks.

I don't discount it and I wish to understand the operation of these financial instruments more...

I suspect the poster is right in that they are not fit for purpose.

Since a crash is almost guaranteed shortly, you don't need insider knowledge to see that oil will fall again in price. $55 is a good enough guess I suppose.

What i do want to know is what that crash will reveal about the true state of world oil supplies (for instance whether $80ish is really a minimum now for getting oil out of the ground).

You people still do not understand the difference between money and energy. Who cares what the price is, what you should be worried about is availability.

You see, you all have done a fantastic job at achieving one hundred percent dependance on a mission critical resource. Now you all TRADE it in a "free market" using debt-based money, all while giving the keys to the mine safe to the economists. If it weren't so tragic it would be hilarious in its obvious greed. The "price fluctuations" are going to kill millions if not start a war. And , really, it's not the price its the availability. Much like starving or wounding an animal you will find out the difference between money and energy.

I think we all get that...

You may get it, but I don't think "we all get that". Behaviour needs to change as an example and it has not.

For instance, you all are looking at energy availability in terms of "markets" or "money". That's bad and you better figger out why soon.

well even the OP suggests something must be done

Lets see what he has to say......

For me a reason why this is important is when talking to folks re: Peak Oil, and export limitations, how many times do we hear "it's just the speculators manipulating prices". I would like to know how much truth is in that response? I always assumed speculation played a very minor role, and I believe that is true. However, it would be awesome to be able to know how much of price spiking is based on speculation or actual demand.


"Behaviour needs to change as an example and it has not."

Sure, whatever. Another oar put in concerning behavior changes. Usually such musings reflect pre-existing religious, philosophical, or esthetic preferences having at best very limited relationship to the subject matter. So frog-march people out to farmettes. No, frog-march them in to jampacked towns. Run the economy with interminable "meetings" of starry-eyed local committees who feel that everything comes from fairy dust and unicorn horns. No, have state bureaucrats micromanage everyone and everything from hundreds or thousands of km away. No, go back to "simpler" tribal times. And so on upon tiresome and-so-on.

So with respect to the subjects at hand, what specific behavior changes do you feel would bring about your favored hypothetical Utopia?

The only meaningful policy remains volume based taxes (which is much more in line with the free market than subsidies things)
And this to push products towards better efficiency (not necessarily through breaking new technology, more like lighter, smaller, less powerful vehicles)
Of course could only work with a clear associated message.
Much probably way too late anyway, also true ..
Even though it is still the most meaningful policy

Aloha PaulS,

There is quite a delicious irony in your sarcasm, since any of the options you mention will likely work better than the way things are going now. I'd rather trust in "fairy dust and unicorn horns" than Goldman Sachs.

...achieving one hundred percent dependance on a mission critical resource.

Isn't that a redundant statement?

Kinda, but heres the subtle difference:

Air is a "mission critical resource" because it is your genetic mission to take another breath, but really you are one hundred percent dependent on it to survive.

Petroleum, on the other hand, is only a "mission critical resource" for the very reason that we ALLOWED ourselves to become "one hundred percent dependent" on it. In reality, we could do one hundred percent without as has been proven countless times.

Clear as mud? which could be argued as being a "mission critical resource" that we are "one hundred percent dependent on"

Clear as mud? Yes. Minor point? Maybe, maybe not.

Oxygen is mission critical because of how our metabolism evolved. The lack of options is what makes it a mission critical resource. (Stating we're 100% dependent on it adds nothing.)

Applying this thinking to civilization gets muddy. Since, as you imply, we have options proven countless times. Of course, what options remain depend on how our fling with oil affected the top soil, etc.

It might be clearer to say that petroleum is mission critical for modernity, a recent and specific version of industrial civilization. Industrial civilization itself existed pre-petroleum, as did other forms of civil society. Modernity (e.g., a consumerist version of industrial society) flourished on cheap and abundant crude oil. We'll descent out of that version soon. We, here, seem to disagree mainly about the rate of descent (and what landings are possible short of demise).

doesn't "Stoneleigh" from the AutomaticEarth blog predict deflation as well?

Several comentators on TAE predict it, and they can make a good economic case for it, particularly given that QE1 & 2 have NOT been as inflationary as they should, under ordinary modeling.

I suppose we will see, won't we?


Thanks Chris for a fascinating article. It's almost too much information for those who don't live in a the world of finance but the perspective from your catbird seat is highly valuable.

I do have some questions, though.

1) You wrote:

The price spiked to $147 per barrel and then declined over several months all the way to $35 per barrel or so as many of the index fund investors pulled their money out of the market in late 2008 and joined a stampede to the safety of US Treasury Bills. What was happening here was that the Dark Inventory which had been created flooded back into the market, and overwhelmed the market’s capacity to absorb it.

As I understand it, the phrase "dark inventory ... flooded back into the market" refers to financial inventory, not any inventory of physical oil. From my simple minded supply/demand perspective this seems unnecessarily convoluted. I would describe the situation as "economic dislocation resulted in decreased demand which caused prices to drop". Yes, financial shenanigans exacerbated the short term price swings but on a yearly averaged basis it seems that normal supply/demand considerations would account for what happened.

The determination of cause and effect often depends on what time scale one is asking a question. On a minute-by-minute basis the price of oil is determined by traders. On a decade-by-decade basis, however, it is undoubtedly determined by global supply and demand. On what time scale do you think your "dark inventory" thesis is important? It looks like month-to-month to me.

2) Related to the above, you suggest that prices could drop as low as "$45 to $55" per barrel, presumably an intra-session low. Would you care to wager a guess as to what the annual average price might be in 2012? Although daily prices are important for markets and politicians, anyone making long term plans (5-10 years) for family, business or government policy needs to be more concerned with the annual average prices.

Thanks for your input.


PS__ Readers can check out current and historical oil futures chains at the Market Futures databrowser. We also created a movie of these plots that goes from July, 2009 until March, 2011. We could extend it to the present if there were sufficient interest.

I am struggling here too on this "flood of oil"

there must be some physical oil in storage that was transformed into these financial instruments? I can see how "in effect" the speculators in these products can cheat and be on both sides of the deal at expiration but I can't see why they need to expire at all

Unless the oil is physically released?

Jonathan Callahan

We are indeed talking about financial inventory here.

The economic interest in the oil has become detached from the oil itself, so that the oil has literally been monetised.

Dark Inventory is very much a factor on a short to medium time horizon which may keep commodity prices and even equity prices (not just oil prices) financialised and inflated wherever it deployed.

As I have written on the Oil Drum before I see two trend lines in oil prices - both of them rising (because I subscribe to the peak oil thesis).

The upper boundary trend price is the 'seller's market' at which demand is destroyed: the lower boundary trend price is a buyer's market, at which production is locked in/destroyed.

In a perfect world, sellers, who desire a stable (ideally increasing) high price and buyers, who desire a stable (ideally decreasing) low price, would aim to agree a formula for a stable and equitable (inevitably increasing) 'fair' price.

But for the middlemen who intermediate buyers and sellers, Stability is Death, and so they will always tend to cause volatility. Financial middlemen also enable buyers and sellers to finance or fund stocks, and to manage price risks from price volatility through using debt and derivatives.

Note also that if producers CAN hold prices at the 'upper bound' - because financing and funding of inventory is available - then they WILL.

I think we will see the price collapse within Q1 and Q2, and attempts will then be made to resuscitate the price as before.

Now, in the long term the oil price can, and for the sake of the planet IMHO should, be at the level which destroys demand.

But for the next year or two at least - absent a new settlement and market architecture - I see desperate producers pumping as much as they can. I also see a world in pretty deep recession if not depression which will keep 'real' demand low, and I see no appetite for the sort of financial demand necessary to fund the maintenance of the price above the 'lower bound' trend line.

"Monetization" of energy or any other mission critical resource seals your fate. You need to learn the difference between money and energy, they are not interchangeable.

Perhaps some one could discuss hypothecation in the crude markets?

if you open a line of credit on these GSCI things or even a standard contract(s) I guess you are on your way....

Sorry I am a bit stupid.... Still not getting this

Q1 Dark inventory=real physical oil in storage somewhere?

yes or no?


And mainly where producers store it for free - in the ground.

that infers to me dark inventory release is dark spare production capacity... which represents a massive global conspiracy.

ie to control the price there needs to be hidden production capacity [of significance] that can control the price

the mystery swing producer... if the contracts expire without the oil actually be released onto the market then the investment vehicle/bank fails

or if production capacity has to diverted from other consumer streams the price goes up on the spot market.

that strikes me as unlikely.


The price is affected because market players mistake financial demand for real demand.

There are no games going on with production. What we are seeing is games with different types of financial claims over production.

And not just in the oil market. every organised market has been financialised in this way, as I wrote here.

It's just that the oil market is the one I know best.

they are massive idiots then.... how can they conflate the two?

why would they go down to the floor and buy oil they don't need?

moreover if the financial futures are just casino bets WGsAF? ATEOTD its a bubble that is open to attack by someone taking a bet going short.... is this your insight into Goldman Sachs position..hype and dump

what if they took out insurance on the contracts failing if the oil is called in for real and/or start a sell off? that would be armageddon if the capacity doesn't exist!

why would they go down to the floor and buy oil they don't need?

That is what speculators do. They buy stuff on the come, hoping they can sell the promise of delivery for a greater price than they promised to pay. It is claimed that Goldman acts as an enabler of fraud.

yeah but not on the expiration date day... and since this happens once per month its hard to believe speculators have hiked the price up by the amounts claimed.

the only way for them to speculate long term is to hoard

as for these financial GSCI derivatives and such I.... as a hypothetical oil trader should just ignore AFAICS

That is what speculators do.

Of course that's what speculators do. They also sell stuff they don't need. Every contract has two sides, a long side and a short side. And just as many speculators are on the short side as there are speculators on the long side. They watch the fundamentals and try to guess which way the price of oil will move. If they guess wrong they lose.

I find it truly amazing that some people believe speculators can drive up prices and keep them there when the demand is not there? That is absolutely impossible! Speculators can cause swings in the futures market, both up and down but the price always follows the line of supply and demand.

Picture a water skier being towed by a boat. The skier can swing way to the left of the boat then way to the right but the general direction of the skier must be the same as the general direction of the boat. The skier is like the speculators and the boat is the fundamentals. The price of oil must follow the fundamentals, supply and demand, but the speculators can cause short term swings but they can never cause long term price changes.

It is just ludicrous to think that speculators can cause the price to rise and stay high when the demand to keep prices up is just not there. High prices cause demand destruction. The US uses almost three million barrels per day less than we used in 2005. High prices have knocked over 10 percent off the consumption of oil in the US. Speculators had not one damn thing to do with it.

Ron P.

Ron P

Correct. Speculators had nothing to do with it.

That is my point.

It is ludicrous to say that speculators (let's call them active investors in search of transaction profit) can do any more than spike the price temporarily.

This is why I - and, I now see, also Mike Masters in June 2009 - are saying that it is not speculators (who are being pillaged by the casino in a less than zero sum game) but passive and risk averse investors avoiding loss who are the problem.

These investors are funding producers ability to support prices, and are killing every market in which they participate by distorting the pricing mechanism through taking medium and long term positions, which can be - and are - maintained for years.

Best Regards

Chris Cook

but how can these medium and long term positions effect the pit price on the day .. especially if they are rolled over and no oil appears?

I still do not understand how the paper oil effects the spot price

I just do not understand

I go and buy up a whole bunch of long term positions and push those positions up in've been contangoed... at expiration if the demand isn't there I lose my shirt


if I roll over in some cash contract off the floor because the original seller buys it back no one knows and its as thou the oil never existed ...... the money is just kept in stasis hovering on the edge of a cliff...

or am I wrong?

Midi, on average over half of all contracts traded are for the near term contract, especially early in the life of that contract as "near term". When that contract has only a few days to run, then contracts will begin to move to the next month. Check it out at: Light Crude Oil. That contract (February) has less than 10 days to run but volume is still over four times higher than the next contract (March), though March open interest is now higher.

But look down at the far out months, the ones some folks claim pushes the price higher. They have very little volume. These contracts have virtually no effect on near term prices. Only the nearest term contract, and near expiration the second to near term contract, has any effect on the price of oil. The near term contract is the only one ever quoted and the only one used as any kind of benchmark.

The far out contract prices are simply ignored, except by some paper traders of course. Some traders specialize in arbitrage and try to hedge one contract against another. And of course hedgers constantly watch the far out contracts because these are the only contracts they buy or sell. They are hedging themselves to guarantee a fair price in the future. But true hedgers make up only a very tiny fraction of all trades.

Note: So called "Hedge Funds" have nothing to do with actually hedging the future price of oil. They call themselves "Hedge Funds" because they buy and sell several different commodities. If they lose money in one they may hope to make it up in another. That is their "hedge". True hedgers are actually producers or consumers of oil like refineries or dealers in the physical product.

Ron P.

thats roughly my understanding as well

This sounds correct to me and always seems to put someone on bottom and someone on top. So hope your the guy on top.


I think the Hunt brothers' speculative gambit back in the 70's, trying to corner the market in silver, is illustrative of this point. NO matter what they do to price on a temporary basis, if production continues the price will drop to what it costs to produce and make a profit. Temporarily higher, maybe, but long term it won't work with active commodities.

What will, and does, drive price is cost of production, coupled with demand. If COP exceeds demand price, production ceases. There can come a point where price is so high that there is no demand whatever. No oil will be produced beyond that point.

For those who wonder, the pharmaceutical and lubrication uses will enable a bit of production to continue, at a very high price. Only the 1% of the 1% will be able to burn petrol in an ICE, or for heating purposes at that time. And that, strictly speaking, is what peak oil is really about. Not that we run out, for there will be oil remaining. It will simple be far too expensive to continue to use it as we do today.


"... where producers store it for free - in the ground."

So the idea is that firms or countries that have credible oil wells simply claim that they are pumping oil at a flow rate that is greater than the engineering measurement true flow rate and claim that this extra oil is in storage in a secure undisclosed location. Then it leases this 'oil in storage' to Goldman and Goldman uses this lease as its working capital for its index fund.

The next step is to do the same thing with the gold that is dissolved in sea water. Claim that one has developed a method to extracting from seawater* and that one is busy working the process and putting the resulting bullion in an undisclosed vault. If this is believed, we really could return to the gold standard, for as long as the belief in this magic spell lasts.

*Of course the process for extraction is being kept secret because it is a 'proprietary' innovation.

Another idea: Perhaps the numbers for internal oil consumption in export land countries are inflated as well as the production numbers, and the truth is that both are smaller than reported by the same amount. This offers cover for claiming that they have oil in storage somewhere when, in fact, they do not.

Who is auditing the internal consumption numbers? Maybe the populace in these countries is not using as much oil as the rulers claim. Maybe the numbers are being invented to support a story. If so, I can't see how this will end well.

I see desperate producers pumping as much as they can. I also see a world in pretty deep recession if not depression which will keep 'real' demand low, and I see no appetite for the sort of financial demand necessary to fund the maintenance of the price above the 'lower bound' trend line.

The Thirties case history is interesting. It appears that global demand fell only one year, in 1930, rising thereafter. Annual US crude oil prices fell to $1.80 in 1931 (down from $3.70 in 1929), and generally rose until 1937, hitting $2.60 in 1937, before declining to $1.90 in 1938.

There were reportedly three million more cars on the road in the US in 1937, versus 1929. And of course, China is to our current predicament as the US was to the Thirties, with the difference being that hundreds of millions of consumers in developing countries want to buy, and in many cases can buy, cars now--and of course we are now looking at declining Global Net Exports of oil, versus rising exports in the Thirties.

Oil Price Data Source: Global Financial Data


Thank you for that clarification. The idea that there is an overall price trend and that middlemen profit from swings between the upper and lower bounds makes perfect sense.

I think your vision of desperate producers and a world in deep recession is a very likely outcome. There is no doubt that a deep recession will reduce 'real' demand in OECD nations but I am also open to the possibility that the economic return per barrel consumed in developing nations will limit the reduction in demand globally. I think it is quite plausible that growth in non-OECD demand will outpace any declines in OECD demand thus keeping upward pressure on oil prices on an annual averaged basis.

Volatility is the new normal.


Chris, in compiling weather forecasts these days, I'm quite sure that UK MET office forecasters sit in a darkened room with their supercomputers and forget that it would be a good idea to look out the window before issuing their forecast. I wonder if you may also be guilty of being too absorbed by your model and have overlooked a very obvious fact in your analysis - demand for liquid fuel is at a record high (chart from Stuart Staniford at Early Warn)

I spent most of last year expecting the bottom to fall out of the markets - as happened in 2008, but have been overwhelmingly impressed by the determination of OECD governments to keep the system afloat - first sign of trouble and we will have QE3. And so without a market crash, and for so long as global economy continues to grow in aggregate, I don't see oil prices crashing as a result of a speculative bubble in oil prices bursting.

Volatility has virtually abandoned the oil price, and we have stability arguably in the pink spot that will keep producers very happy without crippling OECD economies - though high energy prices are a major drag. The inflationary impact will shortly fall out of the equation since most of the price rise was over by March 2011.

Of course, some of us round these parts think that an observed 2005 to 2010 average volumetric decline of one mbpd per year in the volume of Global Net Exports available to importers other than China & India might be a contributing factor to the doubling in annual Brent crude prices that we saw from 2005 to 2011.

If we assume basically flat production by the top 33 net oil exporters, and if we extrapolate the China, India & Top 33 Net Oil Exporters' 2005 to 2010 rates of change in consumption, then for every two barrels of oil that non-Chindia importers (net) imported in 2005, they would have to make do with one barrel in 2020.

I think the emphasis on demand vs consumption need to be set against the point the OP makes about the market being "pressurised" and at the margins to start with

fewer cargoes produced; the easier the underlying market is to manipulate.

this manipulation of price and extreme price volatility in the medium term interrupted by the present short term "price stability" are in a way symptoms of systemic failure in the market to address peak production...

IE these games in the markets are only possible because the price moves massively at the margins irrespective of the geological fundamentals..even if the price plummets to $20 a barrel it matters not.

hence unfit for purpose

thats if I understand the argument correctly

Think of it this way

The markets don't work

because the short term price is never correctly translated into a realistic long term price. In no small part because the feedback into the short term price by the longs is being manipulated by a so many words.

Or annual Brent crude oil prices doubled from 2005 to 2011 because of an ongoing decline in GNE & ANE, in contrast to the rapid increase in same from 2002 to 2005, i.e., rising oil prices in response to declining volumes of (net) exported oil. But maybe I tend to simplify things too much.

maybe I tend to simplify things too much.

I think in essence this is what he is saying

the price is not simply an analog of daily oil production vs demand and its easier to manipulate at the margin

when its really tight everyone is swing producer including ragtag guerrillas in the Niger delta....

what has occurred since 2000 perception wise is a redefining of tight production where a million barrels per day more or less sends the price all over the shop

I'm confused. From this graph we see Crude + Condensate well about "The Peak(s)" of 2005 and 2008. Will somebody enlighten us to why we see C+C approaching 90 MB/day instead of going into the "Post Peak" decline? Is this just more hype to hide the "Dark Inventory" to wipe naive investors out from a rigged financial shorting game?

You are looking at monthly total liquids data (subject to revision), inclusive of low net energy biofuels. Here is the annual EIA total liquids chart through 2010:

Here is the annual EIA C+C chart:

But as noted up the thread, we have seen multimillion barrel per day declines in GNE & ANE, which are measured in terms of total petroleum liquids.


In my view, and for the reasons given, the collapse is already under way. Irrespective of physical demand for yer actual black stuff the VALUE of the oil - the economic interest, if you like - has ALREADY been dumped and if I am correct, then nothing other than a significant and sustained supply shock can now temporarily stop the collapse in price.

My take on the high November Saudi deliveries is that they were merely delivering Dark Inventory of pre-sold crude into the market and they will have since been selling futures as fast as they can to unwary speculators to lock in the price during what they probably expect to be a temporary collapse, like the last one.

Do not mistake the trading of paper oil (and futures are NOT paper oil but claims over mainly paper oil) for physical supply and demand, which changes relatively slowly, but with the odd de-stabilising shock like Libya's crude falling out of the market - and of course flooding back in as fast as the engineers and the Vitols and Trafiguras of this world can facilitate it.

I believe the Chinese oil demand - as it is for copper and for almost everything else - is as a stockpile against future use, and of course a hedge against dollar inflation. They will quite happily hoover up all the Iranian oil they can lay their hands on but they will be looking for the cheapest price going.

As For QE3 it will not IMHO happen, since Bernanke knows (or at least believes, because his thesis was on the subject) that further US QE will see T-Bill rates go negative, money market funds will 'break the buck' and all hell will break loose.

Chris, it is a fascinating article, as much because I understand so little of it, and don't really understand your reply here;-) Its like we are from different worlds speaking a different language. For example, when you say:

for the reasons given, the collapse is already under way. Irrespective of physical demand for yer actual black stuff the VALUE of the oil - the economic interest, if you like - has ALREADY been dumped

Where is the evidence for this? Do you have charts or tables? ICE Brent front month is currently $112.5 - around the mean of the narrow trading range of the past 10 months. I just don't see any evidence of NET dumping. The futures market is originally constructed to allow producers to hedge price and currency fluctuations, and for every winner in the game there is an equal and opposite loser.

And when you say:

further US QE will see T-Bill rates go negative, money market funds will 'break the buck' and all hell will break loose

Bunds went negative this week - investors happy to pay Bundesbank to look after their money - but for opposite reasons to those you cite for the FED. Why will excessive demand for Bucks break them?

I live in a world of declining N Sea, Mexican, N Slope production, rampant Chindia demand and static supply since 2005.

In your main article you say:

Now, anyone would think that reduced refinery throughput will reduce the demand for crude oil and should logically lead to a fall in crude oil prices.

EH?! surely it is high price that reduces demand leading to lower refinery throughput? and I think you say this...

In my world, refineries closed due to reduced demand for their products imply a reduction in demand for crude oil: but not, apparently, on the Planet Hype of investment banks with funds to sell.

Demand for oil is in decline in the OECD who are losing mkt share to Chindia where, I imagine refineries are working flat out. As pointed out in my lead comment, demand for liquid fuel IS at an all time high (by volume).

Concerning refinery throughput and demand, think about the interaction between oil price and the economy. With no peak oil, when consumer demand for oil exceeds supply, suppliers make more oil, everyone is happy.

With peak oil, when consumers demand more oil, supply can't keep up, price rises, this causes an economic recession. Demand goes down, prices plummet. With prices low, the economy starts to recover, demand goes back up, eventually demand exceeds supply and the cycle repeats.

Peak oil produces what Eric Janszen calls the "peak-cheap-oil" cycle (something he forecast in his 2010 book and perhaps earlier on his website The current price spike would be the second period of the cycle which will continue indefinitely unless, as the author of this article suggests, steps are taken to smooth things out. The overall trend of price will be up whether the cycle continues or steps are taken to stabilize price (and the overall economic trend will be cyclical recessions amounting to a deepening depression).


By the way, I know that's not exactly what this author is saying, but that's what I'm hearing! (although I wouldn't say when the price spike will end and suddenly decline, it could very well be later than this article is predicting).

Euan Mearns

I am talking about the exit from the market of index funds and ETFs, and possibly one of the factors in this exit was the realisation by investors - thanks to the MF Global insolvency - that even though they had managed to offload dollar risk in favour of commodity risk, they still had the counter-party risk of the fund issuer.

So they have decided they prefer to have the Fed and/or Treasury as a counter-party instead.

$9 billion exited the markets in September and undoubtedly a lot more since. These were exactly the players who exited the market in Q2 2008.

As I said, when this 'inflation hedging' money exits the market it leads to false signals which lure in unwary speculators and traders. Coupled with the Iran noise, the market is in my view currently at an Oil-e-Coyote point.

Further QE would mean further demand for T-Bills, and in the same way that demand for Bunds has seen rates go negative, so T-Bill rates would go negative.

Have a read of FT Alphaville on the subject - they've convinced me.

Finally, let's think of what's going on as rather like the opaque creation by producers of oil vouchers redeemable in payment for oil.

It doesn't matter what the physical supply and demand for oil is: if a batch of oil vouchers finds its way to refiners then they don't need dollars to pay for oil supplied by the issuer.

The price of oil in dollars will fall until new dollar buyers emerge and this equalises selling in dollars with buying in dollars and stops the fall.

Conversely, when a producer is creating and selling vouchers (lending his oil and creating dark inventory) then he does not need to sell as much oil for dollars, and the 'real' dollar demand for oil will increase the dollar oil price - as it did.

I am talking about the exit from the market of index funds and ETFs, and possibly one of the factors in this exit was the realisation by investors - thanks to the MF Global insolvency - that even though they had managed to offload dollar risk in favour of commodity risk, they still had the counter-party risk of the fund issuer.

Well I bought some Brent ETFs back in The Fall of 2010 and became extremely pissed off when their rise did in no way reflect the rise in Brent in the following months. These were underwritten by Shell physical. Now I was told the reason for this was market in contango and every month when the contract rolled there was attrition! WTF? Now i do believe that markets can be and are being rigged in a disgraceful way to line the pockets of the market makers. But I don't believe this activity is influencing the direction of the market.

$9 billion exited the markets in September and undoubtedly a lot more since. These were exactly the players who exited the market in Q2 2008.

And the oil price did not flinch in September - look out the window and see if folks are still driving their cars! And when these players exited the market in 2Q 2008 the oil price continued to soar. Now this may have been a leading indicator of trouble to come with banks raising liquidity. But the oil price crashed in 2008 as a result of a banking crisis, a freezing over of global trade and a fall in demand for oil of 2 mmbpd. It didn't crash as the result of institutions liquidating balanced positions in paper oil 3 months before.

If the European banking crisis is not resolved, then sure we may see a rerun of 2008. But if it is resolved then I and many other observers see oil prices stabalising in current range - $100 to 130 - which is high enough to underpin plateau oil production for a while at least.

The flight to T Bills and Bunds at present has more to do with failing confidence in banks and the €. If the FED prints again, then this is designed to keep the party going on FIAT vapor and funds will flow back to oil and gold that will both rise relative to $US.

But to be clear, no doubt oil price and industrial civilisation will crash if there is a major financial dislocation. Back in 2008 no one saw it coming. Today everyone sees it coming - including Mervyn King - and are doing all they humanly can to prevent this calamity from happening.

Euan Mearns

Your experience of ETFs demonstrates the reflexivity at work.

The very presence of yours and other passive/inflation hedging funds in the market created the very contango which gradually ate away your investment.

Re 2008 ...ooops....I meant second half, not Q2 - no-one was liquidating no, the price didn't crash because of index fund liquidations.

The bubble was one of several across markets and prices generally collapsed in the meltdown after the oil price was 'spiked' by manipulation/speculation (depends on if you believe Semgroup were goosed by Goldman)

But the depth of the fall was undoubtedly exacerbated by the exit of index fund money in the second half of 2008, mainly in September and October as I recall.

Mike Masters' CFTC testimony is interesting bearing in mind when he made it (June 2009).

Not only did Masters say that 2008 represented a classic bubble and crash, he also warned presciently that another bubble was on the way (pages 2 & 3), and was particularly scathing (pages 25 onwards) about the effect of 'passive' (ie index funds and ETFs) long term investors on markets.

Re the situation now, the effect of 'passive' index money pulling out is not an immediate crash, because of the structure of the market and the delivery cycle of forward contracts involved in oil leasing.

The effect is - as described in my article - to 'pop' the market price as speculators sell forward without knowledge of 'Dark Inventory' and are then forced to cover their positions. We have just finished mopping up after that, and speculators/traders are licking their wounds and pretty much staying on the sidelines.

Re the economic situation, I think that the € will struggle on for a little while yet.

But if it does, I disagree with you and other observers re oil market prices, which - as I wrote - will, absent a large supply shock, head down sooner rather than later.

More QE might boost physical gold - but I think that the ETF era is pretty much on its last legs, and shows all the signs of being the next great regulatory disaster. I don't see QE3 money boosting oil prices again.

Hi Chris, thanks for the email and link to FT Alphaville that is pasted below. The oil price in Euros is interesting but note the following: 1) if you deflate the numbers they are probably still below the 2008 peak; 2) the € is very strong in the periphery and very weak in Germany causing a boom in that country (that has come to a halt now) 3) Germany is rapidly expanding use of renewables and energy efficiency gains - it is a dynamic system.

I have been waiting for oil price to crash for 12 months but instead it has plateaued - up today on Iran sanctions. I've run a series of posts following this (2 links below) and would reiterate that the negative impact of oil price is two fold 1) inflation and 2) erosion of disposable income and as already noted the inflationary part is about to fallout of equation. Inflation falling in China will now lead to easing of monetary policy.

Euan... according to the Bank Participation Report, the U.S. Bank Commercials are not betting that the EURO is going to die anytime soon. Not only have they increased their EURO FX long contracts almost 50,000 since October, they have liquidated 675,000 of the Short 3 Month Euro-Dollar contracts:

what if its all nonsense.

what if the money can not be used as a measure of where money is going because its a burst bubble. What if we are just watching the money flow from one part of a broken engine into another part as thou that was a safe haven... but in reality its just because there is nowhere left to go.

Middoctors... I actually agree with you. It is all nonsense in the end. Unfortunately, the monetary authorities have two alternatives here:

2) DIE

So, they will continue to print. Many analysts are forecasting future paths of the US Dollar and U.S. deficits well into 2020. I see no way for the system to continue this long without some serious changes in the monetary system.

I am completely surprised at the lack of understanding of money by those who are highly educated and who should know better. Those praying and hoping their paper wealth will make it through it all... have my deepest sympathy.

Right, because fiat money is, in the end, political. If money is not natural (gold), then it's political.

The debt is evaporating and is being replaced with fiat.

The way to play the game going forward is to get as much fiat as you can, and continuously convert it into harder assets. That's all you can do, at least that's all I see. Either taking on debt, or lending, is extremely risky in this environment. "Neither a borrower nor a lender be." In my opinion, the world's bond markets are the most dysfunctional of all (which is saying something), and that's where the final endpoint will be. The sheeple are being herded there, as they exit "risky" assets only to find themselves in the cauldron of Treasury positions as the door shuts them in.

Bonds are not cash! There is no such thing as a cash equivalent, either you have cash or you don't. An FDIC insured account is practically the same thing, as without this the entire banking and payment system fails. The bond market, on the other hand, can fail without the payment system failing. So ultimately, a bank account is safer than even government bonds. I don't understand why people argue otherwise. If the banks don't work, that's the ultimate sign of collapse, and I don't think it will quite come to that yet.

You can either survive with cash, gold, and real assets, or you can die with bonds. Your choice.

Volatility has virtually abandoned the oil price, and we have stability arguably in the pink spot that will keep producers very happy without crippling OECD economies


Another way to look at this is that a market that is working is volatile, with lots of new knowledge and tweaks in underlying market drivers moving the price in a chaotic way. If you see stability in the market, then you've seen the market decouple from basic drivers (attractors), even if you don't know what they are or why.

Such behaviour tends to result in 'drift' until the market is captured by a new attractor (set of drivers).

Now that WTI graph in the top right over previous months has tended towards a step pattern, day on day, with stability during the trading day. That suggests to me that the market is being set outside the US, and that normal OECD demand drivers on price aren't really playing.

The other half of this is to realise that the entire financial market is made of fraudsters and cheats - all looking to 'do over' each other to make money. They might have paid for laws that don't make their behaviour strictly criminal - but as we would know it, they're all crooks and without a moral scruple.

The market needs volatility to make money, no matter what the producers or consumers want. Therefore any market that gets stable is a problem. In addition, they don't want to get taken to the cleaners the same way twice. If the op is correct, and fraudulent games are being played to try to make large sums - that requires there is a mug willing to play. These crooks know when they are being defrauded.

Whilst there might be a hidden decline in demand that is about to knock the bottom out of the (fraudulent) market - I'm not so sure. Recessions are built on belief and so far that belief has been positive. A shock is needed to move it.

Thus I'm much more worried that the stability you talk about is going to be upset because the hidden game is changing, the market number is decoupled, and that is exactly the moment when a new crook with a new plan can get it caught by a new attactor (one that makes them trillions).

An oil price decline can't really precede an obvious recession (no matter what the op implies) so I think a spike is on the cards first, bringing that necessary volatility that can then make someone very rich.

In short, its quiet, too quiet.

Well here's what we are looking at (chart from the FT). I guess my use of the word volatility was rather loose. The large - scale price changes, rise fall and then rise again are gone for present with almost 12 months of stability. But the small-scale fluctuations are still there. I've always taken the view that speculative variance is reflected by some of this small - scale fluctuation. I do not agree that the overall structure of the chart is controlled by the financials preferring to believe this is more linked to OPEC spare capacity, the supply - demand dynamic, the need for Chindia to out bid OECD to create flow of supplies from west to east and above all the responsiveness of Saudi Arabia to shifts in the market - where they do a fantastic job but sometimes get wrong footed and need to scurry to find rigs.

I'd tend to agree with you that with Iran being squeezed out of market, their customers are going to be looking for oil else where and that upwards pressure is currently more likely. I have given up trying to forecast the oil price. In the period 2003 to 2007 i was very good at it - previous year + 20%. But since, it has become a game of trying to guess what will happen to global banking system.

Beautiful graph!
I know nothing.
I observe that, over the interval that the left side scale covers 1/7th of the data range, 75mbpd-85mbpd, the right side scale covers a 5X data range, $25/b - $125/b, and is adjusted for inflation. This 35:1 difference in the scales is what makes the curves seem to nest so nicely. I also have not heard of any huge investment, any vast renovation having to be made to maintain this level of oil production. It seems the price represented is quite disconnected from both the value of the currency and the availability of the product.
Drop by 1/2? Rise by 2X? Sure, why not.
The system is irrational.

Capitalism is great, as long as it is not for anything you really need:

Healthcare - U.S. primary healthcare insurance industry
Electricity - Enron
A house - mortgage fraud disaster
Food - junk food
Education - student-loan industry
Information - corporate media
Culture - video games
Retirement - 401K

I am still not clear how the monetisation of part of BP’s oil inventory actually distorts the spot price..

am I right this occurs because the genuine expiration of these long investments releases a flood of oil into the spot market?

if there is spare oil to control the price then the only thing that can stop the ongoing creation of rolled over futures without delivery (off the exchange floor so to speak) is above ground storage?

this takes me back to santelli pointing out that the distortions are in the future price.. not the spot price

What will happen is that market players sell BFOE/Brent forward physical contracts, and OilCo buys them.

The market players sold because they believed the price will fall, in the expectation that they can buy back similar contracts cheaper in this 'over the counter' market and make a profit.

The problem is that OilCo already owns some or all of the inventory/rights to production available, and this means that the hapless seller finds himself 'squeezed'. He therefore has to buy the spot oil necessary to fulfil his forward sale contract from the only seller - ie Oilco.

And the spot price 'pops' upwards (and is distorted) as a result.

this can really only happen in the short term as the loser knows he will lose

ie its a one shot effect. and it only happens to the speculators going short

if I just want oil in my back yard?


A lot of traders and speculators are nursing their wounds, and keeping out of the oil market and other similarly financialised zombie markets until they see a trend they can follow.

And yet, and yet:
Financial oil has almost constantly in contango for the past few years. I buy December 2012 contracts at Price X, and by the time December 2012 rolls around, it is underwater. In my limited experience buying and selling these things, it has not worked exactly the way you say-- and that is why the ETF's are getting murdered. If buying spot oil pops the price, then the physical price moves up, allowing the financial price to clear out at a higher level. But that hasn't been happening.

My small mind is missing something here.

I do understand that GS has an interest in making people believe that oil will head much higher, so that those futures contracts stay high. GS makes money on the contango, selling options on the financial oil in December 2011, and then covering in December 2012 at a much lower price.

The rest, I do not follow.


As I said just now to Euan, the presence of passive funds in the market reflexively causes the very contango which eats away at them.

The 'pop' in spot prices, and the associated backwardation due to the absence of forward bids (which briefly rewards remaining index fund-holders) is caused by the exit of index funds from the market, which sends false signals to traders and speculators trading actively 'for profit', rather than passively to avoid loss.

The likes of GS don't make money on the other side of the contango - they don't have the capital to run that position - it's the producers who do. GS would just be the middleman, making money by trading with superior 'asymmetric' market knowledge; high frequency trading and the like.


assume for a moment I am a complete idiot and know nothing about HF trading and all that jazz

draw a flow chart or somefink graphic

On the Edge with Max Keiser-World oil markets & their structure-02-04-2011-(Part1)

On the Edge with Max Keiser-World oil markets & their structure-02-04-2011-(Part2)

On the Edge with Max Keiser-World oil markets & their structure-02-04-2011-(Part3)

He is right about incentives being perverse. He is right about the mal distribution of wealth. But his prognosis for 2011 was wrong.

Of course if interest rates were not near zero, prices would be lower. But they are near zero and likely to stay there until we see come economic recovery. When and if that comes demand will tend to raise oil prices.

Peer to peer in oil will not work. Oil is not like music.

He commits the original sin of energy analysts: comparing things that are different.

That futures markets determine the physical cash price has been going on for hundreds of years. This is also true in the grains. I doubt minipulation of prices is anything more than a short term phenomenon if it exists.

There are other bench mark prices for crude than WTI and Brent. They all more or less confirm each other.

His prediction that oil prices will fall to $45-55 in the first half of 2012 may fit with his distorted view of the oil market, but it is contrary to the seasonal tendency of oil prices to rise in anticipation of spring demand.

Chris Cook's oil price forecast is wrong and so is his analysis of Brent pricing IMO.

Hi x,

Usually a comparison looks at things that are different and comments on the similarities and differences. If one only compared things that were the same, it wouldn't amount to much, after concluding they are the same we would be finished.


There is a way to do this, research "Odum" or "biophysical econometrics", "Charles Hall", or "Nate Hagens".


As I said, forward prices - and futures are a standardised version - will eventually become the spot price upon delivery.

But they will not go to delivery unless the physical market price - which is determined by supply and demand in the physical market - is at that price.

The Brent/BFOE price is the tail that wags the global market dog, and all other qualities are related to it by arbitrages in one way or another.

Peer to Peer in oil - in the sense of an ownership claim over oil - is precisely what is going on today, and also in every other market in which ETFs and similar funds have been investing.

Your assumptions are diametrically opposed to mine, and therefore the results of our analysis differ.

Time will tell.

Virtually no futures crude futures contracts end up in physical delivery. I think last year something like 3,000 WTI contracts ended up physical (so that is 3mm bbl for an entire year). The physical market and financial markets are quite separate.
BTW, the notion that producers can meaningfully hedge their production seems to be a myth. If, for example Mexico wanted to hedge its production (which would not make sense anyway because they'd be locking in high prices for internal consumption and herefore would only try to hedge exports) they'd have to sell hedge, assuming 2.7mm bbl/day*365=985,000 contracts one year out. The actual total number of contracts one year out is a few thousand. if it were done over the counter who would be the counterparty??
Whoever that theoretical counterparty is would be out of business if the price of oil were to decline meaningfully, thereby effectively cancelling the hedge for mexico.



Quite right.

The purpose of futures markets is to manage risk, not make and take delivery, and indeed the ICE Brent/BFOE contract is just a financial bet settled in cash.

You make an extremely acute point re producers hedging like Mexico and Qatar being exposed to performance risk on their 'hedge'.

This is exactly why I say that the clearing of off-exchange oil contracts by a central counter-party clearing house - which the EU and CFTC are dead set upon - is an almost entirely misconceived policy which simply concentrates all the risk in the very same people already demonstrably too big to fail.

The only good point in favour is that a database of all market positions is created. But it is not necessary to guarantee the performance of the contracts to achieve that outcome. Mandatory transaction registration would do just as well, and that is what I have advocated for many years.

exposed to performance risk on their 'hedge'

If you measure "performance risk" in terms of payment of money, or shares, then no problemo see below re a "drop in the bucket"... If, however you measure the "performance risk" in terms of the ability to deliver product, huge difference, then there might be a problemo.

Unlike gold and silver or even base metals, if you hedge poorly you lose. If in the production of petroleum, if "you" hedge poorly, a lot of people lose, particularly as overall depletion rates in the largest fields begin to bite in. Perhaps it's time to reconsider the necessity or desirability of energy futures markets altogether?

That said, I agree that futures markets --and especially second and third order derivatives like credit default swaps-- do everything to increase price volatility, and nothing to reduce it (their supposed function if you listen to the advocates). The only people who benefit from derivatives and high frequency commodity trading are giant Wall Street firms, hedge fund managers and professional traders. The rest of us get wild price swings, frequent recessions, paltry investment returns, and pretty much screwed in the a$$.

The rest of us get wild price swings, frequent recessions, paltry investment returns, and pretty much screwed

This is where availability becomes an issue. Regardless of cost, if availability becomes an issue ie if some can get it some can not no matter what the cost, there will be serious problems.

Futures contracts and (most) OTC contracts have margin requirements from both sides of the transaction which guarantee performance - and which is why only when a broker like MF global starts to play games rather than when a counterparty fails - there is a performance issue. The system as a whole is chronically overcollateralized, which is a good thing and because margin is settled on a daily basis the damage done if somebody fails to meet his/her obligation is limited.
Large OTC transactions, at least in the US, clear through exchanges such as ICE so there is already a record of who has which positions. One would have to be extremely confident in the counterparty to do otherwise and entities who can effect large transactions want them to be secured.
What is not kept track of in a centralized fashion I believe is physical above ground crude positions, for example when Morgan Stanley charters a VLCC for 3 months. But how significant can that really be? Say they rent 10 VLCCs with 500k bbl each for a total of 5mm bbl over 3 months. That means that in effect they take 5/(72*90)= 0.077% of the production over that period off the market, only to sell it after 3 months. It is hard to see how that can have a significant influence on prices although is still may be lucerative for the party involved, or not, of course.


That means that in effect they take 5/(72*90)= 0.077% of the production over that period off the market, only to sell it after 3 months.

In regards to the "physical above ground crude positions" it is the "drop in the bucket" effect.

Not only that, the effect of buying, no matter how minor it may be, is reversed when the speculator unwinds his/her position. This is why whenever this talk about "speculators" pops up I feel compelled to jump on it. Speculation accrues to the market makers, not the buyers or the sellers because they take a (little?) slice from each transaction.


Rick Santelli oil speculation debunk

Most investment vehicles similar to GSCI invest in futures, not spot (physical) commodities. The focus of financial players on backwardation and contango (whether spot prices are below of above prices for forward delivery)
a) net out to zero (for every long position there is a short position)
b) very short-term focused - because there is virtually no liquidity in longer dated contracts.
And therefore pretty much irrelevant to prices beyond a couple of months. These types of short-term moves though can make it more difficult to distinguish between signal and noise.
Even if there were "Dark inventory" at some point that inventory was taken off the market, and at some point it is put back onto the market, again, creating noise in prices but not significantly impacting prices over a full "load the boat - unload the boat" cycle.
Undoubtedly there are entities which manipulate prices in the relatively short-term, but it is hard to see how that significantly impacts (particularly) production because the lead time on production is just so much longer than a short-term cycle of manipulation.


in effect a dark inventory is no different to a increase in production and by definition as you say it has to go to zero

I guess it may have a short term price smoothing effect? but it has to come to market at some point OR there is not dark inventory but genuine Dark spare production capacity!!!!!

This is exactly why your rate of production matters. So many people think that, like money you can just print, you can just turn up the spigot and increase your production rate, but you can't. That is due to geology, chemistry and physics. In addition this critical point, any increase in production rate means you run out faster. It's just too bad that an increasing population is mortally dependent on a certain production rate .... see above discussion re "performance risk" and "hedging"

The analysis is maybe correct from a technical point of view but fails to take two very important facts into consideration:
1.The cost to bring new oil(mostly offshore)is about USD 85 per barrel.
2.Saudi and Russia the big elephants need USD 95 to balance their budgets.Since 85-90% of the world's oil is now controlled by NOC's the chances of oil falling are way out remote.
What is possible is that governments shut down the future's market all together as a scapegoat for outlandish pricing.Expect a lot of nationalizations of the remaining private oil and refining companies as situation reaches crisis point just to please the public.

I can take away one thing from the post, with the pleasure one always feels when vindicated.

There are speculators that matter, and speculators that don't-minnows.

The ones that matter are the major players-big oil companies and the banks that finance them and work closely with them.I have maintained that this is the case all along.

Anybody who cares to read about such things must realize that there have been cartels of one sort or another in most commodities at some point, if the industry ever got big enough that only a handful of players were able control the bulk of the production, distribution, processing, and marketing.Citrus fruit, sugar , tobacco, and milk are prime agricultural commodity examples easily enough researched since all of these have been controlled by manipulating marketing and production within the recent past-or at present. These four operated or continue to operate by government sanction.

Little people may make or lose little people's fortunes making naked bets on future prices.People with good sense who are not out to gamble use the futures market to more or less guarantee their future income from selling product and or expenses incurred in buying product.

If you farm and sell wheat forward, if you make money on the contract, you lose the same approximate amount in the cash market, and vice versa.But you know about how much you will realize per bushel either way at the end of the day, whereas without the hedge, you could take in a lot more, or a lot less, when you sell your crop.

In the end, supply and demand rule-if Gold in Sacks makes a few billion by squeezing folks who sell inventory they don't own, more power to them, although I wouldn't stop and offer an investment banker a ride if he were about to be engulfed in a forest fire.

The people who get squeezed are adults who should know their business better.

"Against stupidity, the God's themselves contend in vain."

hole in head

It is true that the trend of oil prices is up, in line with increased production cost.

But the swilling of paper oil (the economic interest in oil) in and out of the market causes wild oscillations - depending on how much leverage is involved - above and below the price trend lines.

We also see over-corrections and 'spikes' above the upper boundary 'seller's market' price and below the lower boundary 'buyer's market' price.

Whereas the price spiked through the lower 2008 clearing price (maybe $45?) this time that clearing price might be $60 to $70, and the spike would then only reach (say) $45 to $50/bbl.

A new architecture for oil markets is long overdue, but unless and until the price collapses again, the producers will have little interest in acting to achieve it.

Chris,The 2008 event was a black swan,too many factors(sub prime,war costs,deficits etc etc)happened at the same time to crash the price.This is not the norm and cannot be the base argument for your thesis.Whether price collapse is overdue or not is unimportant, and anyway who decides about this?You have failed to rebut or answer my point of view to satisfaction.I deem your post as purely hypothetical and beyond the realm of the current worldwide market,political situation.

First, great post - I learned a lot. A minor correction's needed - see this paragraph:

"But I do know that in their shoes, I would have done, particularly bearing in mind that such commodity leasing is a perfectly legitimate financing stratagem which has been in routine use in the precious metals and base metal markets for a very long time indeed."

(What would you have done? - the same?)


Let us assume that Mr. Cook is correct, and the prices are bound to fall to late Clinton era prices, what does this bode for the oil boom in North Dakota and perhaps more importantly the Canadian Oil Sands and the proposed Keystone XL pipeline?

How long does Mr. Cook expect that this reduction in price last? I can imagine if such a crash were to persist a long time, anyone who's picked up and moved to North Dakota will be stuck in their trailer for some time to come - work will come to a standstill as everyone from the top to bottom goes broke.

Thought provoking post indeed.

Cheers, Matt

Indeed, if the same thought had occurred to me, I would have acted to get interest free funding if I were BP, and superior market positioning if I were Goldman Sachs.

But I guess that's why they're all millionaires and I'm not.

As I have said up-thread in the discussion, I see the long term price move as up, since I subscribe to the Peak Oil thesis, and the short term as a collapse.

But in the medium term - it's not clear at all, except to say that I don't see either financial demand or stock financing by banks re-emerging in a hurry.

Chris Cook
Thanks for an informative post.
Foundationally I see oil prices having quadrupled from $25 to $100/bbl, similar to the 1973-81 OPEC oil crises, just not publicized. While I see economic and speculating driving the price up to $147 and down to $33/bbl, it still comes back to about the current $100/bbl.

Quadrupling the price tells me that desires have exceeded current supply and that buyers have bid the price up, (dropping off the poor who could no longer afford that price.)

Associated with that is the marginal cost of production has increased as heavy oil, deep offshore oil, and oil sands have had to be brought on line. See CERA graph of marginal cost vs cumulative production.

Unless demand strongly drops - eg from economic depression, why should not the price remain above the marginal cost of oil sands production? i.e. above $80-$90/bbl?
To bring prices back down, would not alternative cheaper fuels be needed in sufficient quantities to displace the highest priced marginal producers?

(Either by larger discoveries of less expensive hydrocarbons, or by less expensive gas to liquids or coal to liquids?)

In my world, refineries closed due to reduced demand for their products imply a reduction in demand for crude oil: but not, apparently, on the Planet Hype of investment banks with funds to sell.

History does not repeat itself, but it does rhyme, and my forecast is that the crude oil price will fall dramatically during the first half of 2012, possibly as low as $45 to $55 per barrel.

What you appear to be saying, in these two paragraphs, is the the demand for oil, or rather the lack of demand, should have oil at $45 to $55 a barrel. But due to Hype the price is instead about $110 a barrel. In other words the price has been hyped up more than 100% of the what supply and demand would normally cause the price to be.

I would submit that this is an impossibility. The price of anything can be hyped up, perhaps by 10% or occasionally even 20%, for a very short time. But the one year average daily closing price for Brent in 2011 was $111.26. The price of Brent could not have possibly been hyped that high for that long. Demand had to have been there or the price would have collapsed.

In 2008 demand collapsed due to the economy collapsing and then rose again as the economy, very slowly, recovered. If we have another sudden and dramatic double dip, and demand again collapses, then the price could easily fall to $50 a barrel. But barring another economic recession such as we had in 2008, it just ain't gonna happen.

Right now the price of oil is determined by supply and demand, not hype.

Ron P.


Unlike the price, global physical oil production and consumption don't tend to change in a hurry.

Production, consumption and price

Cuts in demand tend to take some time to kick in, and as I recall demand fell, but hardly collapsed in 2008. I am sure there are experts here with detailed numbers I do not have.

As I have said up-thread there are always two pricing levels - a seller's market and a buyer's market.

A classic case of a market price discontinuity between the two was the overnight collapse of the financially inflated tin price in 1985 from the higher level of $8000/tonne to the new level of $4000/tonne when the producer cartel ran out of money to support it by buying in stocks

It is not hype that directly supports the price, but money buying oil: it was hype which brought in financial investment creating financial demand for oil using the leasing (sale and repurchase) technique I described, which is routine in other commodity markets but unknown until recently in oil.

Instead of borrowing from banks at interest, the producers could and did lend oil and borrow dollars from risk averse investors interest free.

It is not difficult for anyone with reasonably deep pockets to ensure that the Brent/BFOE price was gradually ramped up over time - with lots of hype, which continues to this day - to the upper bound through judicious trading in what is now a very thin market.

These have been two bubbles, both inflated with leverage: first, the long rise to 2008, and the spike which ended it, and second, the current bubble, which has been correlated across markets so we have seen the oil price curve and the S & P responding to every twitch in the dollar yield curve.

Personally I believe that oil prices should be kept as high as possible to throttle demand, and that the resulting surplus should be equitably distributed between producer and consumer nations, with as much as possible invested in renewable energy and energy savings.

But don't shoot the messenger.

I'm only saying what has (and probably has) been going on in the market; what my analysis is, and making a forecast on the back of it.

We'll soon see if I'm right.

On your "Production, consumption and price" graph, take a look from 1980 to present. There was about a 20 million bbl/day increase from about 1985 to 2005 - with production about plateaued after that. Compare the rise in price with the gap between that ramp and subsequent production.

Are there any ways to distinguish between demand inelasticity and/or increase in marginal production costs, vs the financial manipulations you describe?


You had similar, and equally compelling, comments in 2009:

As noted up the thread, I don't see what the mystery is. The supply of GNE & ANE are down relative to 2005, and prices are up to balance demand against a declining supply of exported oil.

Thanks Jeff, but I may have been mistaken about speculators not being able to affect the long term oil price. I did some calculating and I find that the price of oil should be about $160 a barrel. It's those damn speculators who are keeping prices down!

Speculators have jumped into the market and they are selling oil they don't even own. They just call up their broker and say something to the effect: Sell one February WTI contract at the market. And if enough of them do this then this drives the price down. And if they keep doing this, by the thousands, this keeps the price down. It can keep the price down for years because they roll their contracts over every month.

You see at or near expiration they must buy their contract back and then sell a new contract for the following month. Now you would think that buying this contract back would drive prices up by the same amount that selling it a month before drove them down. But nooooo. Everyone knows that speculators can only drive prices in one direction. And that direction is down. ;-)

Ron P.

The Speculators are Naked Shortselling. I see it in oil price almost every week. And the $9 billion Cook says exited is a very small drop in the bucket--just one days C+C extraction at $110/bbl.

I think the more interesting question is how an oil price plunge would correlate with other investments. The DOW/WTI correlation has been very strong for a couple of years.

So, if oil is $50/barrel will the DOW be 6,250? If you think oil at $55 and DOW (or NASDAQ or S & P) where it is now, you're kidding yourself.

Hi Chris!

First of all, thanks to Gail for posting this. I look forward to seeing various reports from Chris who always has valuable information. Here is another recent article about what is taking place in Iran:

Trying to predict what is going to happen with fuel prices is to a large degree a fool's endeavor. Chances are you are going to be wrong.

Here is what I see:

This is the continuous yearly Brent crude futures chart from TFC Charts (with additions).

- There is an ongoing bear market in crude since 2008. There is a short-term bear market that is ongoing since the beginning of 2011. Markets are manipulated but a trend is a trend.

- The secular bull trend that began in 1999 is credit dependent. There are two factors in the crude market: the oil and what is exchanged for it. The high price of crude is supported by credit both in and out of asset markets. High crude prices undermine credit, this is observable.

- This is a case of 'too much of a 'good' thing'. Too much credit and not enough oil has pushed the oil price too high. Reaction to the high price has damaged credit formation. Unsurprisingly, finance insolvents are also energy insolvents, unable to support their own consumption out of their own production (of fuel or otherwise).

- Oil prices are too low for producers but still too high for users to 'grow'. The result is credit shrinkage. Be skeptical but look at the COUNTRIES that are insolvent because they cannot borrow affordably. Repeat after me: CREDIT is industrial economies' ONLY product. All the other so-called 'products' are excuses to justify continuous credit expansion. For industries NOT to produce credit means that something is seriously wrong: NOT just excess inventories or too-high interest rates.

- Agents have had FIVE YEARS since crisis began to corral inventories, real interest rates (inflation adjusted) in industrial economies are LOW to NEGATIVE.

- Too high crude price means buyers' strikes in tract housing, autos, commercial real estate, highway/infrastructure construction 'investments' along with general credit revulsion. Without new credit, deleveraging is underway. Diminishing credit means less support for high asset prices. Ability to afford is declining faster than prices. This is also observable: job losses, increases in poverty, food stamps usage, business failures. Fuel prices for the moment are stickier than discretionary income.

- Crude market prices are declining toward the cost of production which is increasing at the same time for various reasons including social expenses/inflation inside producers along with difficult drilling environments. As prices fall below production cost the outcome will be shortages. THESE SHORTAGES will further effect industrial output and SHRINK CREDIT rather than force prices higher. Remember, it is credit that supports high prices.

- Shutting in production -- creating artificial scarcity -- will fail because this does not create more credit, the only way to lift prices. The only way for producers to meet quantitative money income goals will be to pump into shrinking markets pushing prices even lower. This will likely have little effect as the credit transmission structures are destroyed. Once the EU breaks up for instance -- caused by high crude prices -- lower prices will not put the EU back together.

- Credit rations access to crude. When credit ceases to do so, fuel will be rationed by physical availability. Before there are super-low prices are more likely to be shortages.

- At some point there will be little available credit and oil prices will be very low. At the same time these low prices will be unaffordable to those who have no money, no job(s) no car or house or any other means to waste fuel.

- What is taking place right now in Europe is the program for the rest of the world including China: insolvent countries see credit vanish and they de-industrialize. These countries -- right now Greece, Portugal, Ireland and soon Spain and Italy -- will become car-free. Fuel will only be available on black markets for $50 per gallon ... cash only.

- Peak oil ONLY exists in the context of automobile use/waste. Get rid of the goddamned cars and peak oil disappears. There is enough oil in the world right now for 1 million years of WD-40 consumption. Cars are a convenience/luxury not a necessity.

I expect shortages this year. The cost/production dynamic is inflexible it relates to EROI and credit availability. Shortages caused by inability to afford crude will be permanent.

Fuel price declines will also accompany dollar preference, hyperinflation in producer countries, loss of currency autonomy and collapsing domestic fuel demand in producer countries. 'Net Export' will cease to be an issue as producers will not be able to afford the means of consumption.

steve from Virginia
Your concerns are further detailed by Gail "the Actuary" at e.g.,
Is it really possible to decouple GDP growth from energy growth?

Financial Impacts of Reaching ‘Limits to Growth’

We need to focus our attention on energy sources with higher EROEI which can break through and provide growing transport fuel as conventional crude declines.

The $50/gallon black market oil price comment contradicts your other statements of a declining price. And hints as to the problem in the logic: Less credit means less spending. That does not necessarily mean a lower oil price, for two reasons:

* can buy higher-price oil but at an even-lower quantity, and

* can still buy oil, in preference to other things.

We see both of these things happening now in the US at the micro scale, as people drive somewhat less, but still spend a lot on the still high-priced fuel, while cutting back on other personal spending that is not deemed as essential. The interesting part is: how are these micro decisions adding up in their effect on the macro situation. E.g., buying less trinkets means less oil used somewhere, for the manufacturing and distribution of said trinkets.

"The $50/gallon black market oil price comment contradicts your other statements of a declining price."

Not really. If one follows Steve's logic, the black market situation occurs once the credit/production environment has crashed; a totally different market meme. Regarding the rest of your comment, consumers and markets are seeking their minimum operating level. Once this plays out, the pipeline freezes up so to speak (the credit/production pipeline in this case). Any remaining fuel which is available becomes an entirely different commodity. The "99%" won't be able to afford it at any price, and likely will have little remaining affordable use for it (chainsaws and tillers come to mind as justifiable applications). Once this shift occurs, and after the markets dump their contracts at a loss (ala $50/barrel), oil production becomes more of a cottage industry, not relying upon credit and markets as they do now; a much more "honest" market, at a much lower level. Of course, the guy running drugs or guns on his motorbike won't think much about paying $50 a gallon for petrol on the black market. Expect available supplies to be nationalized, subsidized, and rationed for critical functions. Small amounts may be rationed for subsistence farming, etc., but the joy ride will be over.

Under this scenario $50/barrel oil will seem like $500 today, the US will become more energy independent, and we will have a hundred years or more of oil left, mostly still in the ground. Of course, folks will continue to burn anything else they can find, until they can't.

Hey Steve,
I'm seeing a lot that I like in your analysis and am working my way though it carefully. But I have a question. In your final paragraph did you really mean to say, "....,hyperinflation in producing countries," or did you mean to say,"......,hyperinflation in consuming countries"?

Actually it is both, I didn't mean to be misleading.

Hyperinflation is a currency arbitrage, between a currency that one must use (for reasons of state) and another currency that one WANTS to use because it represents greater purchasing power over time. Usually this is dollars or euros or some other 'preferred' currency that is 'hard'.

The exchange of dollars for crude (on demand) sets the worth of both items and makes the dollar and other reserves 'hard currency'. Priced in crude, dollars are worth something. Dollars are most preferred b/c they are in circulation everywhere in the world and oil producers accept them (or else).

The other currency trades at a steepening discount to the dollar (or euro, yen, etc.) over time, this discount represents (hyper)inflation.

Because Iran is in the oil trade there are dollars available, these are preferred to the degree that Iran's rial lost 20% of its worth last week. That is, Iranians bid up the price of available dollars with whatever rials they could scrape together at a rapidly increasing premium. As dollars were bought (fewer available) they became increasingly costly in rials.

Other countries have outside currencies circulating as well. Belarus' ruble is hyperinflating against the euro. Soon to come is the hyperinflating Greek drachma (against both dollar and euro). Hyperinflation in China between RMB and dollars which are in wide circulation. Dollar = crude oil so these will be preferred, particularly when prices decline and dollars become more scarce/rare and more valuable. Ten dollars will buy eleven times as much crude in Saudia when fuel is $10/barrel than ten dollars will buy now @ $110/barrel.

As price of crude declines dollars become very scarce and can command an extreme price in local currencies, whatever the market will bear. Monetary authorities must either add new money into circulation or risk deflation when local money disappears. Dollar holders can buy local currencies at increasing discount on f/x markets so as to obtain fuel in the local currencies. The country can print more local currency and risk hyperinflation or not print and have dollar holders buy up all the local currency and leave none available for the citizens.

By this subtle 'dollar attack' the local economy is dollarized. This dollar attack destroys the purchasing power of locals (which is why I disagree to some degree with Jeffrey Brown and net export model). As fuel prices collapse in dollars the means to consume -- cars, houses, jets, A/Cs, power plants -- become unaffordable. Local economies decline and citizens shift from being happy motorists to less-happy bicyclists who do not buy/compete for fuel.

Since Greece and other countries do not produce crude there will be many middlemen between producing countries and Greek 'consumers'. Transmission will break own. Customers will be forced to do without or pay top price in hard currency. At the $50 Greek price the fuel will not be available at any price in drachma. A dollar might cost 100 trillion drachma if it can be had at all. Meanwhile the same fuel will be cheap where it is produced, sold to the mafias who can afford the risks of bringing it into Greece and competing with different mafias/warlords/militants in Greece (not to mention the so-called government).

As CC points out, oil (products) are heavy, flammable and hard to transport.

Already the mafias are taking over in Italy. Our world to come is not going to be pleasant.

Soon to come is the hyperinflating Greek drachma (against both dollar and euro).

Steve, doesn't Greece use the Euro? No one is holding Drachma, are they? I have friends living and working in Athens. They agree that things are pretty bad; however, the do get paid in and conduct their transactions in Euros. So... if the Drachma inflates, no one cares.

Of course, Greece may be forced out of the EZ, and to reissue Drachma (holders of Euros would be expected to turn them in for Drachma at the market rate, I suppose). My question: Who would be foolish enough to do that? What? Will they make it illegal to hold or use Euros? Will the Germans come in and repossess them?

So, we will have a dual monetary situation. Officially the Drachma becomes legal tender (again). Trillions of them are printed (as the debt is restated in Drachma, of course, this will render existing Greek bonds worthless), and no one will really use them. They would be fiat money for the sole purpose of creating a "legal" way to accomplish Jubilee. Otherwise, they are valueless, ab initio

Meanwhile, Euros will likely be hoarded, and used on the Greek black markets. There would be no way to get new Euros into Greece legally except by exporting goods. And, yes, mafias and gangsters would join the banksters in robbing the populace!

Our world to come is not going to be pleasant.



It's always good to see an opposite perspective of things to come.
I think one of the reasons why Chris has been facing a bit of an uphill battle here is because he is, as Euan said, talking to us in a different language than we're used to.

He's essentially using economic models/explanations instead of geology.
I do believe that in the short term, economics may play a role in oil price, QE certainly did.

However, I also think he basis too much emphasis on economics than I would have. We saw a crash in oil prices in 2008 because of the incoming recession, mainly because of factors outside of the oil price but the very high oil price(and how quickly it rose) became an important co-factor.

It's more than possible that the oil price is going to collapse this year again, but then I'd blame that on an economic crisis(perhaps by a strike on Iran, which would first shoot it up very high, and then crash back down).

Nontheless, the long-term trend, aside from what the market does or not, is determined by geology and nothing else. If you cannot get enough out of the ground to meet demand, then prices will rise and stay very high until you get a recession.

Granted, there are different views on this, but oil extraction is a geological phenomenon and even if there are short term effects that the market can have, long-term you need a geological understanding of the oil production in the world and where it is heading if you want to anticipate where prices are going to be in the years to come.

Oil prices are too low for producers but still too high for users to 'grow'. The result is credit shrinkage. Be skeptical but look at the COUNTRIES that are insolvent because they cannot borrow affordably. Repeat after me: CREDIT is industrial economies' ONLY product. All the other so-called 'products' are excuses to justify continuous credit expansion. For industries NOT to produce credit means that something is seriously wrong: NOT just excess inventories or too-high interest rates.

well thats it. This is the financial discontinuity oft mentioned in passing.

its broke

midi - "Oil prices are too low for producers but still too high for users to 'grow'." I'm not sure if the "too low for producers" is the best characterization. At $80+/bbl any decent oil prospect is viable. Consider how much of the DW GOM oil plays have been develop, in spite of huge capex requirements, at prices significantly less than what we have today. Just speaking domestically for the moment, the problem US companies have is a severe lack of viable CONVENTIONAL OIL prospects. Remember what I do for a living. And we look at every prospect on the market in our theater of operation and rarely do we see a pure oil prospect for sale. And that goes all the way back to the $147/bbl days. International oil plays are much more common especially in areas that haven't been accessible for any number of reasons. But let's stick with domestic oil patch and see how that fits the idea of "credit".

The hot oil plays in the US are the fractured shale plays. Some seem to be providing a decent ROR. Many seem marginal but remember a significant motivator for the public oils: increasing reserve base the keep Wall Street hyping their stock. I keep hearing rumors that financing those pubcos heavy into the shale plays is becoming more difficult. Along that line a TOD post the other day noted something in excess of $6 billion of unconventional oil lease have been sold by their current owners. Chesapeake sold 30% of its interest in 600,000 acres in one play to a Chinese company. And there's that bit of disconnect: OTOH CHK keeps hyping how good their shale plays are and what massive URR's they'll yield. And then they sell a big chunk of their holdings. Typically you lay off a portion of your higher risk exploarion wells and keep as much interest in your low risk development wells. And the pubcos in the shale plays keep pitching them as low risk wells. Pick your explanation: 1) the buyers are paying more than these leases are worth; 2) CHK has all the capex (including borrowing base) they need to drill 100% but doesn't think the plays justify that amount of exposure; 3) they would be glad to drill up their acreage 100% but they don't have an adequate credit facility to do so. I can't argue the point too strongly but my guess is that CHK and the plays lack sufficient credit worthiness to generate the required capex from outside sources.

And that plays to the thought: "For industries NOT to produce credit means that something is seriously wrong..." With oil prices where they are today (but NG has just dropped below $3/mcf) one would think those "huge" in ground reserves would garner a fat credit line. And maybe they do...or don't. All we can do is speculate on the various bits of info we get. But in the oil patch we have our own "banks". Essentially partnerships that finance capex for operators. And they don't just charge a simple interest rate: it's not uncommon for one of these mezzanine bankers to end up owning 15% to 25% of the project AFTER the loan has been repaid. And during the process they tend to exert a lot of control over operations. I don't have much contact with the MB's these days so I don't know what their position might be. But with the potential for such profitable loans and the hype with the shale plays one might think a lot of capital would be available.

BTW: did I mention that these "bankers" tend to hire the most experienced folks available and pay them very well? While there are big profits to be made with such loans the potential losses are equally huge. Typically the only thing backing the loan is the production. If that production doesn't materialize then there's nothing left to cover the loan. And these are not like your friendly neighborhood bankers...they'll cut your financial throat and leave you a ditch to bleed out. Nothing personal...just business. LOL. They invest soley to make a profit from folks who have no other source of capex. So if they don't see enough profit then there's no capex put on the table.

The thing that scrambles my noodle is I can't escape the notion that this is all a vast chasm of meaningless numbers detached from reality.

its the old adage

"it may look like a pile of mumbo jumbo and it may sound like a pile of mumbo jumbo, but don't be fooled it is a pile of mumbo jumbo"

If I understand all this as half as much as I believe the world economic system is institutionalised insanity on a scale and in a fashion my brain finds hard to accept... which is why I keep returning to the issue of how the markets work because I can not believe what I am seeing.

It is thou it is more plausible that I have it completely wrong. "It can not really be this nutz, there must be something fundamental I do not understand"

I trust that Chris is talking from a position of expertise but if you strip his argument all back the distortions are all premised [if real?] on the perception by traders in the market who can not differentiate between bits of paper and oil. in a nutshell..... none of what he says can be true unless the majority of the market flows have this innate in-built blindness.
It really has to be that stupid

It used to be said that "Time is Money". Now it is (can be) said that "Everything is Money".
Welcome to Antlantic/Vegas world.

Sponia - "Everything is money" as opposed to time is money. That caught my eye. We've discussed before how the oil patch hangs on NPV (Net Present Value) to quantify a company's assets taking into account the time domain. Of course while how fast a company produces its reserve base plays heavily into computing NPV, the reserves have to actually exist in the first place. Throughout my career (working with pubcos) I've probably spent at least 2X as much time trying to justify a reserve audit as I did trying to generate a new drilling prospect. And always focused on presenting the most compelling support for my numbers to third part reserve auditors. And all with one single goal: "booking" the largest reserve base possible. And always with a single purpose: developing the companies borrowing base. And the magnitude of that borrowing base always impacted the future drilling budget significantly.

Essentially using that borrowing base to pay for drilling today that would (on paper) generate the income to pay off the debt as well as generate the profit margin. And it's good to remember that pubcos just distribute a relatively small portion of the cash flow to the shareholders as dividends. The bulk of the income goes back to debt service, over head and capex. Now to take the specualtion one step further: it might not take a very great drop in oil prices to cripple the bulk of the shale players. "IF" sourcing capex is already becoming a problem, any further drop in confidence could severely impact those driling programs. And "IF" they slow up new drilling the high decline rates of most of the plays will become very obvious. This could lead to a very destructive feed back loop.

Again, pure speculation on my part, but if the finance sources are beginning to lose faith in the shale players and are holding back that may explain what we've been seeing with the divestiture of shale leases by the primary players. Perhaps the money lenders are having difficulty raising capital but I would guess that with $100/bbl oil and all the Wall Street hype investors would be shoving money at these "bankers"/investment companies.

Maybe I should say it like this "Shy Money Hides Everywhere".

And let's make it "Vegas/Atlantic City/World" while we're at it.

Everyone is entitled to their opinion, but $55 oil is a long shot. Why? I think WestTexas and Darwinian give the best arguments. WestTexas argues that global exports have shrunk over the last 5 years and this has had the effect of keeping prices high, and I agree with him. Darwinian states that the average price of oil last year was not a fluke of financial manipulation, and I agree with that too.

But the reason I think $55 oil is not something we will see again, is the crude oil decline rate versus the new crude oil production rate. Everyone has their favorite facts to understanding the oil market, and those are mine. The decline rate is very close to 5% today (I would say +/- .5%), and the new oil rate is now less than the decline rate (I think 2012 is the year this phenomenon begins). Thus, even if global demand slackens (which is primarily Gail's argument for prices to fall below $55), the downward sloping supply curve of crude oil will combat a crash in prices. In fact, sometime before 2015 we will likely see a spike in prices that does not correct.

So, instead writing a hypothesis about $55 oil (sorry for the criticism, and I hope you are right), we should be focusing on the looming energy crisis of HIGHER prices. This is not likely to happen in 2012, and we could see spike down to $65 for a very short period in the event of a stock market crash. But the trend for oil prices is higher and the impact will likely be dire for the global economy and our standard of living. Until enough people wake up to the fact that we need to prepare for a looming energy crisis, nothing will be done.

It amazes me that we are so close to this event, and still the average person is oblivious. For instance, did you hear one Republican presidential contender even mention it? Yes, several of them spoke of the importance of an energy plan and the threat of energy supplies. But not of the FACT that we face a looming energy crisis that is inevitable and cannot be avoided. No one said that. And that is the truth everyone needs to be told. We are in a countdown and yet most people don't even know it. I've tried to tell at least 100 people and they all think I'm a conspiracy nut. Until it's on the cover of Time magazine, no one believes it.

Following is a graph for production, consumption and net exports for “Export Land,” assuming a production peak in 2000. Note that on the upslope, the rate of increase per year in net exports exceeded the rate of increase in production, but on the downslope, the rate of decline in net exports exceeded the rate of decline in production.

Following is a graph for production & consumption for the top 33 net oil exporters and for Chindia’s net imports, from 2002 to 2010. As the model predicted, the rate of increase in top 33 net exports (GNE) exceeded the rate of increase in production from 2002 to 2005, but from 2005 to 2010, the rate of decline in net exports exceeded the (very slight) rate of decline in production.

If we simply extrapolate the 2005 to 2010 rate of change numbers on this graph, the 2010 to 2020 rate of decline in ANE would accelerate to about 5%/year, and if we extrapolate the other rates of change, and assume a 1%/year production decline rate for the top 33, the ANE decline rate would accelerate to about 8%/year from 2010 to 2020:

0.1%/year Production Decline (2010 to 2020), Top 33 Net Oil Exporters:

1.0%/year Production Decline (2010 to 2020), Top 33 Net Oil Exporters:

I estimate that there are about 157 net oil importing countries in the world. If we extrapolate the Chindia region’s rate of increase in their combined net oil imports, as a percentage of Global Net Exports of oil (GNE), in 19 years just two of these oil importing countries--China & India--would consume 100% of GNE.

I continue to be mystified that the GNE/ANE situation is not the #1 story in the world. Following is an excerpt from an essay I wrote on the WSJ front page story about the US becoming a net fuel exporter:

Here is an interesting comment from a blogger on The Oil Drum (tye454):

‘. . . the government and banks are going to pull every trick or lie or cheat that they're able to, because the alternative is their very own destruction.”

My comments:

I suspect that this is one of the primary reasons that we will probably never get most government officials, members of the MSM, etc. to actually acknowledge the reality of Peak Oil/Peak Exports. It is of course related to the famous Upton Sinclair quote, "It is difficult to get a man to understand something when his job depends on not understanding it."

I think that we are seeing cognitive dissonance on a global scale. Government officials, the MSM etc. generally refuse to acknowledge resource limits. It's as if, once the Titanic hit the iceberg, the officers resumed the voyage, and ignored reports of flooding.

Any futures contract that does not have a credible threat of delivery in its terms will simply reflect the net flow of funds into/out of the contract in the price. It will have a life of its own independent of the supply demand profile of the underlying commodity. Goldman et al discovered this some time ago and began estimating the future price of crude based on a comparison of expected net funds flow in the contract with the impact on pricing of historical funds flow. None of the parlimentary. congressional etc commisions looking into the role of speculation on the price of commodities grasped this simple fundamental point. The price WAS being set by the financial community once they added crude to the list of investment classes for their "gullible" clients.

Although I doubt the authors estimate of how low prices might go in the event his theory is correct, I can't see anything wrong with the theory as such-if we accept the proposition that the oil companies and banks would one, be willing to manipulate the markets in the fashion he describes, and two, are able to conceal the manipulation.

As far as their being willing, there can be no real question, if a suitable division of the profits can be decided upon;and profits can come in secondary ways.A company as big as BP could lower production and stockpile a lot of it too, during the temporary market crash, so they wouldn't lose nearly so much as one might think at first glance.They could also take the opportunity created by the temporary price crash to buy up the assets of small companies caught in the resulting financial bind at firesale prices.

Very little oil, so far as I can discover, is actually sold in spot markets by the big oil companies;they contract the deliveries well ahead if they sell it, and lock in the price.So BP for example might lose very little indeed, in terms of cash per delivered barrel, during a short term price collapse.

The money the perps will make will be made by skinning anybody caught on the wrong end of a contract that they can';t fill-the "skinnee" who has made a bad bet will have to pay up in cash to settle his obligation.

Now I am not a conspiracy theory nut cake;I take pride in being a realist, and think very much like Darwinian.

So I try to draw my conclusions by observing what has proven to be possible-and proven to be so.There have been so many gigantic semi legal or illegal schemes bordering on outright fraud , or deservedly described as outright fraudulent, in recent years, that I must conclude that the foxes are in charge of the hen house, and that the farmer-er , taxpayer- is none the wiser, excepting a few hard core liberals and hard core conservatives who find common ground in believing that corrupted government is one of the primary sources of our problems.

There is no reason why such a scheme can't work, given the size and market dominance of big oil and big banking, if it can be kept quiet.Anybody who doesn't believe it can be kept *quiet enough* should reflect on the ignorance and apathy of the public, and he is apt to change his mind.

There is no reason such a scheme can't work in the face of the export land model in particular and peak resources, including oil in general.This is because it does not change the fundamentals of supply and demand in any truly significant way;it only creates temporary turbulence in the markets.

Think of a bunch of kids playing in a very small stream, a couple of feet wide and an inch deep, which I did often as a child with other kids. We built little dams out of rocks and sticks and clumps of grass and old boards and cardboard and pieces of tarps and anything else handy, and managed to create temporary little lakes sometimes as much as a couple of feet deep.

Such a pool while filling slowed "downstream delivery" of water for a little while, and when the dams broke or leaked, as they inevitably did within a few hours, down stream deliveries were temporarily enhanced for a few minutes or hours, depending on low fast the leak drained the pool.But over the course of a day or two, our manipulations would have no effect on the total flow of water.

This was true no matter if the stream was low and getting lower because of dry weather, or stable, or rising due to rainy weather.

Analogously, the scheme outlined by the author can work independently of the larger geophysical and geopolitical realities of peak oil;it wouldn't change anything in the long run;it would simply slow down and speed up deliveries long enough for those on the inside and in the know to make a huge amount of money.

I wouldn't bet much against him.

Any futures contract that does not have a credible threat of delivery in its terms will simply reflect the net flow of funds into/out of the contract in the price.

Sorry Wilson but this is simply not so. Both speculators and consumers, both long hedgers and short hedgers are constantly watching the price of crude oil. If they perceive, or just believe, that the contract price is higher than supply and demand justify, they will quickly jump in and sell contracts at this high price. This will in turn drive prices back down.

You, and others, don't seem to understand that the thousands of speculators that trade some some one million contracts per day, are constantly trying to figure out the price of oil justified by expected supply and demand in the next few months. If they think the current futures price is too high, they will sell immediately. This happens thousands of times every day.

The flow of funds you speak about is constantly chasing the fair price of oil, or what they believe the fair price of oil will be in the near future.

News events can move the price of oil. If people expect the Straights of Hormuz to be closed this cause the price of oil to go higher. If a scarcity is expected in the near future this will cause the price of oil to rise. If a glut is expected in the near future then this will cause the price to fall. Then if Iran were to say, "we will not close the Straights of Hormuz" this will send prices falling.

If what you say above is true then supply and demand would have no bearing on the price of oil. Only what speculators are willing to pay for contracts would matter. Clearly this is not the case. If there was a glut of oil on the market then speculators could not possibly bid the price up to $110 a barrel is producers could only get $75 on the spot market. And the vast majority of oil is sold by individual contract between buyer and seller. That is called the SPOT market.

Good God guys, think about the case you are trying to make!

Ron P.

During the famous Goldman run up to $145/bbl in 2008 (they were forecasting $200/bbl) no tankers incurred demurrage because they failed to load promptly. The supply demand balance did not tighten. If the contract structure does not accomodate the extinguishing of a paper position with the delivery of physical how can the producer who can only get $75/bbl take advantage of a paper price of $120 when he cannot deliver his physical and reap that value. Lack of a credible delivery mechanism disconnects the paper and physical markets. During the 2008 spike many of the captains of the oil industry were expressing some surprise beacuse there was no shortage or tightness in the oil price.

Ron P

The forward price curve in oil markets; in equity markets and in several correlated commodity markets came to have - with the exception of the spot month in deliverable contracts - precisely nothing to do with expectations in relation to supply and demand (commodities), or to future dividends and value flows (equities) and everything to do with expectations of the future price of dollars ie the yield curve.

There is no other explanation for these correlations: the S&P/WTI correlation has been remarked upon up-thread. Changes in the dollar yield curve immediately translated to changes in forward commodity price curves.

These markets have become almost completely unfit for purpose because of the participation of passive investors with no interest in supply and demand of the underlying - as Mike Masters presciently pointed out as long ago as June 2009 in his Senate Committee Testimony (see pages 2 and 3 - and page 25 onwards re passive funds)

You are missing the point that a market has developed to give these funds exposure to the market price - almost entirely opaquely - in entitlements to oil which have completely killed the market's original function which you fondly remember.

Interesting view, thank you Mr. Cook for sharing your knowledge, I certainly hope this is not your last post on this forum. My concern about this article is that you provide no data to back up your claims, usually extraordinary claims require extraordinary evidence. I've seen many articles over the past 8 years claiming that oil prices are being manipulated by speculators and are about to crash. A few comments:

    1- The Null hypothesis here is that oil prices are simply a consequence of the adequation between supply and demand, when one look at the data this appears to be indeed the case, it was done here, here and by the IMF here (WEO, Chapter 3). The question is then why do we need a complex financial scheme to explain oil price levels whereas simple economic 101 suffices?
    2- In addition, when one look at the commitments of traders (CoT), the change in positions by non commercial traders tend to follow price fluctuations and not the reverse supporting the fact that traders are trend followers (See Dwight R. Sanders, Keith Boris, Mark Manfredo, Hedgers, funds, and small speculators in the energy futures markets: an analysis of the CFTC’s Commitments of Traders reports, Energy Economics (26), 2004, pp. 425– 445).
    3- The sheer size of the NYMEX market makes a manipulation by a few players very unlikely (the total NYMEX oil futures trading activity represents the equivalent of 600 million barrels, which is about seven times the daily volume of current oil demand).
    4- The recent production increase by Saudis is perfectly explained by an increase in their domestic consumption and a lower relative inventory levels for the OECD.

Sam Foucher

Thanks for the welcome. I have actually posted a couple of times, but a long while ago.

Firstly, the key point is that what we have been seeing is not 'speculation' in the sense of putting capital at risk in pursuit of a transaction profit. It is the precise opposite, being risk averse investment with the objective of capital preservation.

This investment - which is pretty opaque, but there are visible instances like Shell/ETF Securities which prove it is not just my imagination - has created correlated bubbles across markets which have become financialised as a result and divorced from the real world of physical supply and demand (commodities) and value creation and distribution (equities).

NYMEX these days is simply a pool of investor funds where risk gets kicked around by locals and high speed traders, and customers pay highly for liquidity and exposure to oil market prices set elsewhere. NYMEX has little or nothing to do with oil price formation, being merely the tail (via massive Brent/WTI arbitrage) of the Brent/BFOE dog which actually sets the price - and does so off-exchange, opaquely and in a routinely manipulated way.

This macro manipulation - as I hope I made clear - does not take place visibly on-exchange.

Inventory levels are low because in the absence of a contango and debt financing it is not profitable for traders to maintain them. Saudi consumption peaks in the summer, not November, and their oil minister claimed the high level of production that month was due to massive demand, which was strangely enough not visible to most others in the trade.

Best Regards

Chris Cook

A couple of points:

(1) The mid 2008 price spike was caused by an extra demand of crude from China for the games. I call it the OILympic peak

The Saudis couldn't deliver fast enough, as predicted in Matt Simmons' twilight book

(2) If oil prices were to go to as low as $45 - $55 for a longer time, that would spark social unrest in Saudi Arabia, with unforeseeable consequences.

"We believe Saudi Arabia now requires oil at $92 a barrel to break even fiscally, up from $60 a barrel in 2008, on higher post-Arab Spring spending," Deutsche Bank oil analyst Paul Sankey wore in a research note earlier this month. The Saudis "will cut production to defend $92."

(3) Iran

"In my view, there is little or no chance of military action against Iran"

The brinkmanship seen in the Middle East will go wrong one day even if unintentionally

Iran playing war games but not in video arcades

It is unlikely that peak oil, which started in 2005, evolves without another oil war.

Thanks for the post Chris.

Bottom line……oil will go down if more people sell than buy.

From reading your post I got the idea that you think the coming price collapse is going to be from system wide issues in how the oil market is structured but by reading your comments you seem to be on the side of there is too much speculation and the main reason the price is this high is because of speculators??

You seem to be making the argument that this dark inventory will come back onto the market and have to be sold and possible the catalyst for this is the world economy going into recession. This could be true but demand will fall off a cliff so the price should go down. Back in 2008-2009 you had forced selling. Banks, brokers… everyone wanted their money back and the whole system had to deleverage quickly and it didn’t matter if it was stocks, commodities, physical oil… had to deleverage which meant sell at any price. Currently we don’t have this type of leverage in the system mainly because banks won’t extend the same amount of credit they extended a few years ago. It seems like you are also anticipating stable production profiles from producing nations and possibly the risk (or fear) premium will come out of the market at some point causing the speculators(the ones holding the dark inventory) to sell. Over the next year I don’t see the world becoming a more stable place in oil producing regions of the world….it could happen……I listed a few things that would be nice to see……

1) The rhetoric about Iranian sanctions calms down
2) No one bombs Iran and the rhetoric about bombing Iran calms down.
3) The violence in Iraq doesn’t escalate after U.S. troops have left
4) The protests in Nigeria over petrol price increases calms down and no disruptions of production happens.
5) No other Arab Spring type events
6) Kazakhstan doesn’t kill any more striking oil workers possibly leading to crisis possibly hurting oil production
7) We won’t get any type of BP Macando type spill increasing regulation on offshore drilling delaying drilling projects thus reducing future production.
8) Overall stability in the middle east.

We live in a world where we will always have some risk premium in the oil market( can’t see this going away) and because we do.....we will always have speculators.

Jonathan Callahan said:

Would you care to wager a guess as to what the annual average price might be in 2012?

No -- but I can give you the distributional parameters that have held with a 94.3% success rate since 1960 for WTI. The 2012 mean is $116.25, CI 99.9%, 57.84 - 173.68 (note). The "Projected vs. Actual $/b" plot for 1960 - 2010 has a correlation coefficient of 0.96. It does, however, have to be understood that Geo-political events can have a considerable effect on short and longer term pricing. As an example, OPEC's attempt to drive up oil prices between 1980-1985 (by withholding production) forced prices above their mean in 1985 by 3.2 std.; a 0.07% probability event. Once OPEC realized that it was destroying its own market and normal production resumed, prices immediately fell back to their norm. In 1986 the annual price was $12.51; slightly overshooting its mean of 14.73.

Even though random events can significantly, and shockingly change pricing for a period, oil price and production of course, must follow the laws of physics. Like a rock hanging against a mountain side for thousands of years, entropy will eventually win out and it will roll to the valley floor below. Prices, being controlled by the irrevocable laws of nature, have and always will revert to their mean.

note: the transformation function of the lognormal distribution used for price determination results in a larger interval than would be obtained by the unit normal distribution. The resulting t-statistic is 3.550 with 40 df. All the parameters for this quantile function, Q(p), may not have been completely identified.

It is election year in the states, so I wouldn't discount anything.. As trade becomes more regionalised by network shipping costs, so will commodity demand, which by definition means a global market must morph into regional markets for it to take into account local demand/supply relationships... so in part I agree the existing global market is not suited for the current environment of higher cost (notice I didn't say price) oil.

"In this post I forecast the imminent death of the crude oil market"

You are one gutsy blogger Gail.

'Twas not Gail... but she is a gutsy blogger :-0

Right, the author of that line was Chris Cook.

In this post I forecast the imminent death of the crude oil market and I identify the killers; the re-birth of the global market in crude oil in new form will be the subject of another post.

We are going to see the death of the crude oil market and then the rebirth of the crude oil market in a totally different form, or at least according to Chris. I think Chris is talking about the Crude Oil Futures Market, not the actual oil market. That is where 99 percent of all oil is traded. That is by contract agreement by buyer and seller. Only a very small amount of oil is ever delivered as the result of a futures contract.

The futures market may change but I doubt it seriously. It has existed for many decades now. Of course computer trading has largely replaced the "Open Outcry" system, though that still exist also. But the contract method, agreement between buyer and seller will not change. How could it?

At any rate, regardless of any changes in the spot or futures market, supply and demand will still determine the price. It always has and barring any rationing or government price setting, it always will.

Ron P.

Much more fascinating is the complete and totally unprecedented collapse in natural gas future prices. This is more important than crude oil prices for alt energy alternatives, for bio fuels (most of which rely on natural gas to be created at all) and even low sulfur Diesel (cleaned by natural gas). Natural gas is now at a DECADE low, in other words, if you went long natural gas in 2000 and stayed long, you are in about the same place as if you had bought the Dow or Bank of America in 2000 (!!!) Incredible financial development, meaning that massive shorting of natural gas over the decade would have made you RICH (!!!) Once more we are running blind, but then I said that a half decade ago when I first arrived here. Make no mistake, the forward visibility on oil is no better.


Make no mistake, the forward visibility on oil is no better.

We found that with horizontal drilling and fracking, we could extract one hell of a lot of "tight" natural gas... and a little oil also. And you Roger, are saying, something to the effect: We just might, with this method, extract gushers of oil also.

Well that is always within the circle of possibility. But I am betting that is not the case. But if it is then of course the price of oil will collapse back to where it was a decade ago. It a supply and demand thing you know. But I would bet a ten dollars to a doughnut that it just ain't gonna happen.

(I started to say "a dollar to a doughnut" but then I thought; hell, that's approximately what a doughnut costs these days.) ;-)

Ron P.

Chris Cook, co conspirator ;)

I understand not half of this.

But it sounds like selling morgage backed securities to investors but meanwhile shorting your own positions in the very same products knowing these are crap?


I've followed your articles and your posts on FTAlphaville with interest.
Have you any on the Brent Minute Marker?

Many Thanks,


I'm a reasonably intelligent guy. I've been at the peak oil thing for some 4 years now and 'I GET IT' in capital letters.

I also come back to the Oil Drum now and again for an educated update, of where we are. I'm never disappointed because the people on this site give a clear and well thought out analysis of where things are. For me, the likes of westexas, ROCKMAN, Darwinian, oldfarmermac, and Gail's own web site keep things grounded in some kind of reality. And boy do I need reality !!!

I've read the whole of this thread.

It's very clear to me that Chris is a very intelligent guy, but I have to say that I have understood 'NOT one word' of his posts here. In contrast, I have understood many of the comments that are trying to make sense of what is being said here, but also (like me), failing to grasp the essence of this logic.
Chris is clearly smart, but I fear I am being led into a vortex of short term thinking of the kind that only economists and traders understand.

Will Oil go to $55/bbl? Maybe. Maybe for 5 days or 5 months, but this is nothing more than trader talk. Geology and thermodynamics have the final word.

Economics of the kind that Chris speaks of, has been around decades.
Thermodynamics, has been around since,....well since the big bang.

I'm going to go with thermodynamics.

One day, the car on my driveway will be worth less than the petrol in the tank.
One day the paper in my wallet may, or may not, buy me loaf of bread.

No amount of clever shorting and arbitrage is going to change that.

Indigoboy, I know exactly what you are talking about. I had similar problems trying to understand just what Chris was trying to say. I finally just had to come to the conclusion that he was saying that crude oil prices were controlled by something other than supply and demand. Exactly what I am still not sure. Anyway that was enough for me to know that I very much disagreed with him.

Will oil collapse back down to $45 to $55 as he predicts. Of course it could if the economy drops off a cliff. But barring that it just ain't gonna happen.

Ron P.

Thanks Darwinian

This is a difficult time for us all. Some are luckier than others in that they have people close at hand who 'get it' sufficiently to work together to fabricate some sort of descent plan.

There are Transition things going on here were I live, but I fear that it is not enough.

This talk of oil at $55bbl is fascinating in the extreme, but it is frankly immaterial. The price of fuel is relative to how much I have in my wallet.

As I have repeatedly noted up the thread:

Global Net Exports (GNE) of oil rose at 5.1%/year from 2002 to 2005, and Available Net Exports of oil (ANE, which are GNE less Chindia's net imports) rose at 4.2%/year from 2002 to 2005.

GNE declined at 1.3%/year from 2005 to 2010, and ANE declined at 2.8%/year from 2005 to 2010.

In response to declining volumes of GNE & ANE, in the absence of a substantial decline in total demand for exported oil, should we expect annual oil prices to:

(A) Increase
(B) Stay the Same
(C) Decline

Annual Brent crude oil prices doubled from 2005 to 2011, from $55 to $111, as the available annual export data, through 2010, showed about a 7% decline in GNE, relative to 2005, and about a 13% decline in ANE, relative to 2005.

If we simply extrapolate the 2005 to 2010 rates of change in production & consumption for the top 33 net oil exporters and for the Chindia region, we would see, by 2020, about a 50% decline (relative to 2005) in the volume of net exported oil available to importers other than China & India.

This is an great summary of the influences of various factors on oil prices. Thanks all.

Many comments are particularly astute, and show a great depth of understanding on this issue.

While I did see the great price rise coming from 2007 to 2008, I did not see the great collapse in prices. Frankly, while this comment may seem trite, the collapse was mostly due to the concurrent collapse in the financial system - which was more like the financial panics of the late 1800s then anything else experienced in our lifetimes. In such a situation, predicting the low in prices becomes almost impossible.

Could the panic of 2008/2009 happen again? Possibly but very unlikely. If that were to happen in 2012, I would guess the most likely reason would be a sudden collapse in the value of the US dollar, a sudden rise in interest rates, and a dumping of commodities due to the high holding costs - at first. However that situation would not last long and commodities would bounce back higher than before as the dollar lost value.

I predicted a likely 50% rise in oil prices in about three months in late 2010, which I called a superspike, and prices did rise about 50% - but took about five months. That could well happen again but the reason I am not predicting that now is because the IEA is already making a lot of noise about releasing reserves onto the market if there are any supply disruptions.

So if one is looking to where the oil market price can be manipulated, they should look no further than the IEA. Note that oil prices peaked last year just about the time governments called upon the IEA to release reserves - which they did.

However neither the IEA nor any group of speculators will change the fact that net world oil exports are falling - and that means the trend of higher prices will continue in the long run.

[quote]Other countries have outside currencies circulating as well. Belarus' ruble is hyperinflating against the euro. Soon to come is the hyperinflating Greek drachma (against both dollar and euro). Hyperinflation in China between RMB and dollars which are in wide circulation. Dollar = crude oil so these will be preferred, particularly when prices decline and dollars become more scarce/rare and more valuable. Ten dollars will buy eleven times as much crude in Saudia when fuel is $10/barrel than ten dollars will buy now @ $110/barrel.[/quote]

There's a slight problem with your theory: it has nothing to do with reality. Greece still uses Euros and the RMB just appreciated vs. the USD yet again for the 7th year in a row at an average rate of 5% per year. Japan just bought Chinese debt, denominated in RMB, and from now on will be conducting business in Yen and Yuan, not USD. Russia and China will also be conducting business in rubles and RMB. This is important, as Russia is a major oil exporter that just needs to lock in the Chinese market, and itself needs a place to park its spare rubles.

In China and its periphery, the USD is quickly losing purchasing power, not gaining it, and no one is trading in USD except pegged Hong Kong, pegged Singapore and banana republics like Myanmar and Vietnam, whose currency lost 20% value in 1 year. Even India, whose rupee dropped from 40:1 to 50:1, isn't trading in USD.

USD is hard currency because it buys oil and the US military enforces it, but as Japan quickly learned, RMB buys the things you need to get away from oil (rare earths) and isn't going to be inflated to vapor with trillion unit dumps into the economy.

I would not bet on anything near a RMB hyperinflation. The inflation occuring right now in China is due to China's agricultural and agricultural supply chain management's natural inefficiencies and the very low EROI of Chinese agriculture limited by exhausted soil, and is being controlled right now with more efficient management and mechanization (see the decreasing food inflation in Nov-Dec). If anything, the reduction in China's exports should have a deflationary effect, as China has excess capability and excess goods, not excess money supply. The inflation occuring in the US is due to dumping money supply.

I'm betting on a dollar hyperinflation before 2016 and the RMB remaining strong for the forseeable future.

I will be back in June to tell you, you were wrong about the price of oil, it will never see $45, $50, or even $55. It will not break below $80.00.