What follows is a complicated piece by Chris Cook, former director of the International Petroleum Exchange (IPE). While there is no way to improve upon Chris’ own nuance and knowledge of the oil industry, as an outsider I had to study the argument rather hard to make sense of it – reflecting my limited knowledge of the industry rather than anything else. So, I provide a short summary of Chris’ overarching argument for the interested layperson.
Basically what has occurred in the oil markets in the past few years is that oil has begun to be traded as an inflation hedge. Investors trade dollars for oil to ensure that, in the event that the value of the dollar is eroded by inflation, they possess something that holds its value. It’s a bit like the strategy of the gold bug. Fearing inflation they give away their dollars that they think to be declining in value for something ‘tangible’ that they believe will hold its value or appreciate.
On top of this Chris tells us how Big Oil and Big Finance have locked arms in this regard. Each has something the other wants: Big Finance has access to dollar loans that can be used to ensure that, should oil decline in value, Big Oil has ample amounts of dollar liquidity lying around. Meanwhile, Big Oil has plenty of barrels of crude lying around that can be exchanged for dollars, thus allowing Big Finance to hedge against any inflation that may take place.
Such an institutional arrangement has given rise to a highly opaque and unstable market that few can see into. Indeed, no one really knows just how much oil is being ‘held’ as an inflation hedge by Big Finance. These stockpiles have even gained themselves an ominous name within the industry (recently christened by Izabella Kaminska over at FT Alphaville who has been doing some of the best work on this): Dark Inventory.
Looking at recent market trends Chris raises concerns that we could be seeing the beginnings of the end of a bubble that began to inflate in the oil market after the crash of the previous bubble in 2008. This bubble, Cook argues, was inflated due to inflation fears after the QE programs undertaken by the Federal Reserve and the Bank of England. With the markets awash with dollar and sterling liquidity, banks and investors piled into commodities to escape what they saw to be a looming inflation.
In recent months Cook focuses on the move of the market from a position of ‘contango’ to a position of ‘backwardation’ – which he sees as evidence of a bubble deflating. While some investors read in this that the short-run demand for oil has risen, Cook points out that with the global recession grinding along there is no fundamental reason that this should be occurring. Instead Cook sees in this move a sign that the long-run demand for oil is falling as the current bubble begins to burst.
Cook thinks that the price collapse is going to be very painful – falling possibly as low as $45-$55 a barrel. In response to this OPEC will try to ramp up prices by cutting production and a financial crisis of sorts will occur as inflation hedged investors see their net worth cut in three.
– Philip Pilkington