Zero interest rates, regulation, and the financialization of the crude oil market...
THE GAP BETWEEN crude oil benchmarks North Sea Brent and US West Texas Intermediate has jumped to record highs, notes Julian Murdoch at Hard Assets Investor.
What's driving this record-wide spread? To separate facts from the fluff, Hard Assets Investor here sits down with Chris Cook, former compliance and market supervision director of the International Petroleum Exchange (IPE) in London, to get an expert's take on oil's rise...
Hard Assets Investor: For several months now, Brent crude oil has traded at a premium to WTI. Why is this – and can it continue?
Chris Cook, former IPE director: If you look at WTI, it reflects that there's actually plenty of oil in the market. If anything, the market is slightly oversupplied; the storage at Cushing is full of oil. Cushing's price, I think, reflects the actual reality of fundamental supply and demand, consumption and production.
But the Brent market is the one that actually sets the global price these days, and it has been this way for a few years. Many people remain under the misapprehension that WTI has anything at all to do with global prices, but it hasn't done that for years. And it's not the Brent futures that set the price, but the price of the physical cargo that comes out of the North Sea.
But the amount of oil in the actual spot cargoes is gradually declining. It's been in secular decline for some time. So the fewer and fewer cargoes there are knocking about, the easier it is for people to actually influence it.
HAI: Has the lower North Sea supply led to higher volatility in that market?
Chris Cook: Basically what's going on are these trading games among consenting adults in the Brent market. This does have a spillover effect into the global price of crude, and it accounts for volatility. But it doesn't account for crude's astronomic price. In my view, that has a medium- and longer-term effect, which I don't think people understand. As I said about a year ago, the market has become almost entirely "financialized". The price is artificially inflated.
In any given market, you have two price levels. You have a lower level, the buyer's market – when the market's oversupplied and the buyers can name their price. And then you have the higher-level price, the seller's market. That's when demand destruction sets in. The market tends to be at either one or the other – it'll zoom up and then come back down again.
HAI: To what extent do speculators play a role in setting that level?
Chris Cook: It's fund money, not speculators. That's a big misconception. The reason that the oil price is being supported at these higher levels is that there are billions of Dollars of index money and ETF money which has gone into the market. With the yield on the Dollar at 0 percent, these guys are putting their money anywhere that's in Dollars. So stocks go up, commodities go up, oil goes up, and all of the prices are financially inflated – not by greedy money, but by fearful money. So it's risk-averse investors hedging inflation that are responsible for pumping Brent prices higher over the past few months.
Now, there was a speculative spike in 2008. That spike then was caused basically by Goldman pillaging the producers. But now what we're seeing is an unstable equilibrium, one that's gradually ramping up. Brent is being financially pumped up, while WTI is more rooted in the market, because it's deliverable. So I think we're seeing some trading games pump up the arbitrage between the two contracts.
HAI: But can this relationship hold long term?
Chris Cook: That's a really interesting question. Historically, WTI is always priced over Brent, because it's of higher quality. In past years, it's always been ahead, save a few instances where you had trading games going on. So if there is a Brent manipulation or Cushing became oversupplied, or whatever, you would see a short-term spike and arb would go the other way. But historically it's been a fairly settled sort of relationship, because the one is of higher quality than the other.
The relationship codified into this new pricing structure is entirely a financial one. It has nothing whatsoever to do with physical market expectations, and only to do with the Dollar yield curve. All the markets – the commodity markets, the stock markets – with forward curves are moving in lock step with the Dollar yield curve, and this is what happens when interest rates are at the zero bound. So the markets have been completely financialized and no longer fit their purpose, in my mind.
HAI: So is it time for regulators to step in, then?
Chris Cook: The regulators are completely missing the point. The FSA has always ignored this, and the CFTC, well, they actually thought they mattered; they talked about closing the "London loophole", in reference to the US oil contracts trading on the ICE in London [without sticking to US exchange position limits].
But WTI has nothing at all to do with the real world. What WTI does is of sublime disinterest to the rest of the world. What matters – and I gave evidence on this to the UK parliament two years ago – what matters is what Brent's doing. They really should come back and have another look at this market, because it is completely and utterly dysfunctional, and ruinous for everyone in it, in my view.
My recommendation to the politicians would be that they should, as soon as possible, put together a commission of inquiry to both houses of parliament and the UK Treasury Select Committee to hold an inquiry into the global market of oil. Because it's completely sociopathic.
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