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Ambush in the Oil Market

By Mad Hedge Fund Trader | Thu, 30 June 2011 00:38 | 1

The most significant development in the financial markets during my recent sojourns in Europe was the International Energy Agency’s shocking release of strategic petroleum reserves. Unprecedented during peacetime, the move caught oil traders completely by surprise and prompted an immediate $6 drop in crude prices.

The howls of leaked information and insider trading were so loud that they could be heard in the distant recesses of the Swiss Alps. This is what you usually get when several leading players lose a huge chunk of money overnight.

The move was orchestrated by President Obama’s White House, and quickly found several willing coconspirators in Japan, Germany, and South Korea. Ostensibly done to address the 1.6 million barrel a day shortfall in light crude supplies caused by the Libyan civil war, there are in fact far broader implications for all of us.

This is the first real attempt by the consuming nations to eliminate the oil risk premium, which has been variously estimated at up to $50 a barrel. Take away the instability from the Middle East, the chicanery by short term traders at hedge funds, and more recently, the entry into the market of high frequency algorithms, and crude should be trading at a mere $50 a barrel. This is the point where virtually all oil majors believe would be supported by weakening global economic fundamentals, and on which they based their own multibillion dollar long term capital spending and development budgets.

The amount of oil involved was really quite small, some 2 million barrels, or 2.3% of a single day’s global consumption. That is not important. The impact at the margin where prices are made was large. Goldman Sacks said that this would cut oil prices by $10-$12 a barrel over the next three months, while JP Morgan predicted a whacking great drop from $130 to $100 for Brent crude.

The game changer is that the move reflects a new interventionist, activist approach by governments towards the commodity markets in general and the energy space specifically. Traders may bet against the national interest, but now do so at their peril. Volatility and unpredictability in the oil markets have just taken a quantum  leap up.

That leads to an automatic increase in SPAN margin, making it more expensive to maintain positions. Hedge fund risk managers will also be taking an ax to oil trading books. While the profits to be made from oil trading are quite substantial, they are now higher risk and of lower quality, justifying lesser amounts of capital. Over time this should shrink the speculative demand for oil in the market place, especially if the IEA repeat the action in the face of rising oil prices.

The impact on the global economy can be quite large. World oil consumption is at 87 million barrels a day, or 31.8 billion barrels a year. At today’s $95 a barrel, that costs consumers some $3 trillion a year out of a $60 trillion world GDP. If the IEA’s strategy works, and prices stay down 10% over time, this would inject $300 billion into the world economy. A 20% decline generates $600 billion, exactly the amount of money the financial system is losing with the expiration of Ben Bernanke’s QE2.  Call it QE3 in black?

You won’t hear any carping from me, as I have been playing oil from the short side over the last two months, all the way down from $118, as part of a generalized “RISK OFF” trade, buying puts on the oil ETF (USO), and buying the 2X inverse oil major ETF (DUG). The IEA action gets us within striking distance of my downside target of $84 a barrel, the price that prevailed before the onset of the Libyan war and a six month low. That is the neighborhood where I start to buy again.

By. Mad Hedge Fund Trader

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  • Anonymous on June 30 2011 said:
    If I were in a seminar or at a conference, and somebody presented a paper such as this, I would personally see to it that they were glad when the referee called time.This is not the place to go into the issue, but as I point out in my forthcoming energy economics book, these high oil prices cost people/countries on the wrong side of the oil market more than price (p) x quantity (q). That immediately leads me to say...well, I'll save that for my next lecture.

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