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Chris Cook ... Oil - Taking Stock Of The Big Long

Burgess COMMENTARY

Peter Burgess

Oil - Taking Stock Of The Big Long

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Summary

• The Big Long thesis proposes that Saudi/Gulf Producers supported oil prices since 2009 by swapping use of Petrodollars/Petroeuros for 'Dark Inventory' of producer oil in storage or reservoir.

• The transactions through which the Big Long has been implemented are the same Prepay transactions which defrauded Enron investors and creditors for a decade.

• The Oil Bubble and crash from 2005 to 2008 was caused by prepay transactions between North Sea producers and passive funds via swap dealers.

• Since 2001, the oil market has ceased to be a market of oil as a commodity and has become a financialised oil-as-an-asset market.

• The liquidation of financialised oil-as-an-asset is leading to a market which is dangerously exposed to shocks such as increased interest rates.

Introduction

I recently made a presentation at the Iraq 2016 oil conference in London entitled 'Iraq at the Crossroads.'

It began with a brief review of oil market history and distinguished an era of Oil as a Commodity - running from the Oil Shock in 1973 to 2001 - and an era of Oil as an Asset from 2001 to date, which I went on to propose will be replaced by Energy as a Service.

I suggested that the milestone event which could be said to mark the end of the oil commodity era was the Fall of Enron. I went on to distinguish further between two phases of the Oil Asset era: firstly an oil bubble until July 2008, followed by collapse, and then - coming to the subject of my Seeking Alpha series - the 2009 to date 'Big Long'.

Following a great deal of interaction with the extremely knowledgeable and astute Seeking Alpha commenters who have engaged with my thesis, I thought it would be useful to take stock at this point so we are all on the same page.

Enron

Anyone who doubts the possibility of support of the oil market for a decade by oil producers may take as a starting point a recent paper, 'How Enron Used Accounting for Prepaid Commodity Swaps to Delay Bankruptcy for One Decade: The Untold Story' by A Rashad Abdel-Khalik.

The key takeaways from the paper are:

'Enron borrowed a total of $8.7 Billion between 1992 and 2000 using debt contracts disguised as commodity swaps.

Seventy-one percent of the reported cash flow from operations between 1997 and 2001 came from these contracts.'

In other words, for some eight years, Enron disguised its insolvency by opaquely funding itself through prepay transactions. These transactions disguised as commodity trade flows what were in fact loans structured as tripartite commodity sales and repurchases - via special purpose vehicles set up by JPMorgan Chase and Citigroup.

Similar tripartite transactions on the London Metal Exchange disguise interest-bearing loans as Islamic Finance.

My Big Long case is that the funding mechanism which enabled the Enron fraud has since been used to perpetrate the greatest market deceptions the world has ever seen or will see.

Bubble and Collapse

In July 2009, in the aftermath of the Bubble and Collapse, I wrote my first long piece on the Oil Drum site, 'Oil: the Market is the Manipulation,' and this sets out in detail the history of the manipulation to that point.

In January 2012, I wrote 'Naked Oil,' in which I attributed the 2009 price re-inflation to the same passive fund investors. I forecast in that article that this bubble would collapse to $45-55/bbl upon the end of QE... as it eventually did almost three years later.

In a nutshell, the 2008 bubble and collapse was driven by North Sea producers and investment banks with access to passive investor funds.

The mechanism was that rather than the passive funds such as the GSCI fund conventionally buying and rolling over exchange futures contracts to obtain exposure to the oil price, they dealt off-exchange through what became known as Swap Dealers - such as Goldman Sach's J Aron arm - who would then contract with (say) BP Plc (NYSE:BP) or Statoil (NYSE:STO) to borrow crude oil through purchase and resale agreements.

For years, I assumed that the Saudis were themselves borrowing dollars from passive investors through prepay deals, but I could not work out for the life of me how that could work in practice - firstly, bearing in mind the scale of Saudi oil production, and secondly, that the Saudis were not exactly strapped for dollars, with prices soaring over $100/bbl.

It took years before the penny dropped that the Saudis were using the BFOE tail to wag the oil market dog. In other words, from 2009 onwards, Saudi/GCC capital augmented and replaced the shrinking number of passive investors who had funded the previous bubble, and who remained in the market because they still wished to hedge inflation.

The reason that the market price is inflated by prepay funding deals is that to the extent that producers such as BP and Statoil can sell the economic interest of oil in inventory or even in the ground, they do not need to sell physical oil into the market. This restricts supply and sees the same physical demand chasing less oil.

This inadvertent funding by passive investors of supply withheld from benchmark qualities of crude oil, combined with a genuinely tightening market and hysterical forecasts of $200 oil by investment bank analysts led to the ramping up of the price from 2005 to 2008 to bubble levels, eventually ending with what some observers believed was an engineered market coup.

The Tail and the Dog

The decline of North Sea oil production over the years necessitated the introduction of new streams - Forties, Oseberg and Ekofisk - to supplement the original Brent crude stream and maintain the credibility of the benchmark through a sufficient number of cargoes.

From the introduction in 2001 of Forties, BP was in a position to control the North Sea market, with Statoil joining in later with Oseberg and Ekofisk. But one of the key developments in the creation of the market mechanism which enabled the Big Long was the Saudi use of the BWAVE - which is the weighted average of trading on ICE BFOE contract - to price European sales. There is no better way to accommodate automated algorithmic support of market pricing than the BWAVE.

The Macro Picture

There are two market trend prices in any commodity market. There is the Seller's Market level of structural undersupply, where sellers have the upper hand and demand is destroyed or substituted, and then there is the Buyer's Market level of structural oversupply, where production is shut in. Boom and Bust between these levels is hard-wired into commodity markets, and is amplified by leverage from debt and derivatives.

This chart strikingly illustrates the divergence of oil and gas prices during the period of the Big Long. Then, there is the matter of US gasoline prices and the massive blowout in the Brent/WTI spread, particularly in 2011/2012.

I observed at the time that it was strange that fleets of Saudi tankers were delivering oil West to the US at prices some $20/barrel less than they could obtain by selling their crude oil to the East.

I have long suspected that there was an implicit agreement between the US and the Saudis to put a collar under the oil market price of (say) $80/barrel on the one hand, and a cap on US gasoline price levels of (say) $4.00/gallon on the other (which could have been detrimental to presidential re-election chances).

But that's pure speculation verging on conspiracy theory...

Big Long Mechanics

On the basis of the Big Long assumption - which is the lens through which I view oil market events - it is possible to make assertions. However, in order for assertions to be credible, they must have supporting data and information, if only circumstantial.

Because I do not have either access to sufficiently detailed data or detailed market knowledge, I invite my constructive critics of the Big Long at Seeking Alpha once again to bring their considerable insight and expertise to bear on the question of precisely how the Big Long developed.

It seems to me that the first leg of the macro Big Long trade was the support of the Brent/BFOE crude oil price at $80/bbl through purchases of Dated Brent/BFOE crude oil below that price.

The second leg of the Big Long trade appears to have been the sale and supply of US gasoline at any price above (say) $4/gallon, and I would say that the Saudi/Shell Motiva refinery was instrumental in achieving this.

Add to this the probability that it was PetroEuro capital and Euro QE which was used in Q1 2015 to re-inflate the market price to $60/bbl, and the mechanisms become seriously complex. But my instinct is that changes in the €/$ exchange rate; the reported CFTC Commitments of Traders (COT) positions of Swap Dealers and Managed Funds as between Brent/BFOE and WTI; and finally, a blip of the spread to positive territory were not unrelated.

Finally, I have no doubt that the unaccountable moves in inventory which continue to routinely make analysts look idiotic may be accounted for by opaque transfers of title 'in tank' of oil and products.

The capital necessary to support the flow of oil and products through the Big Long position over time came from the flush of Petrodollar assets, which was the whole point of the Big Long in the first place. The liquidity which flowed through the position came from QE accessible by Swap Dealers - where JPMorgan took up the running when they recruited Jeffrey Frase (who had been head honcho at Goldman Sachs during the Bubble years) as Global Head of Oil.

Big Long Now

Once again, we see a constituency of analysts hyping all the supply disruptions - of which there are indeed many - but largely ignoring any other data such as Iranian and Iraqi production or the existence of buffer stocks, which contradicts the bullish case. Being a cynic in these matters, I tend to think the investment banks and their favoured clients (in that order) need muppet buyers to whom to sell.

Meanwhile, in the real world of oil inventories, tankers and traders, all is not at all well, as last year's cash and carry positions expire, leaving traders with inventory which needs a home and requires bank finance in the meantime, plus massive clusters of oil tankers waiting to offload - or simply waiting - particularly off Singapore.

A Perfect Storm?

On the face of it, traders are protected, since they rarely (unlike hedge funds) take absolute long or short positions, but sell futures to hedge the physical positions through which they exploit arbitrage opportunities. However, the entire Big Long strategy is predicated upon zero interest rates combined with QE to enable banks to access liquidity at nil cost.

One or two observers - notably the astute Logan Mohtashami - have observed the continuing inverse correlation between oil and the dollar index and believe that this reflects causality, and is not, as I propose, a temporary - if long-standing - phenomenon.

So Logan has bet me that if and when the oil price gaps down, it will be as a result of the dollar gapping up, and he may well be right in the first instance. But any rise in interest rates could disrupt a Big Long funding mechanism which depends upon ZIRP. So the risk is, then, that the oil price could rapidly see a rush by traders for a crowded exit, with banks abruptly closing the liquidity taps as collateral values collapsed. That's before we even mention option dealers hedging put options...

In my view, the inverse Dollar/Oil correlation observed by Logan is prima facie evidence of the financialisation of oil as an asset, and if my Big Long thesis is correct and the market breaks down during Q3 or Q4 this year, the inverse correlation with the dollar will break down with it.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.