How Oil Prices Are Held Hostage By Derivatives

The price of oil might just be the single most important number in the modern economy.

Not only does it determine how much it costs you to drive to work, to pick up your kids, or to go get groceries…

But as the fuel that powers almost all transport of goods worldwide, the more expensive oil is, the more everything in life costs – food, medicine, toys, you name it.

For all these, and countless other, reasons, having an accurate picture of where oil prices will be in three, six, twelve months is invaluable.

So it’s no wonder that every investment bank, research outfit, and energy association out there puts out regular oil price forecasts.

But take a closer look at them, and you’ll quickly notice something isn’t quite right.

Here’s what I mean…

Just recently, French banking giant Societe Generale (SCGLY) put oil prices at $54 per barrel in 2018.

But OPEC, the oil cartel, predicts oil at $45 next year. That’s almost 17% lower.

JP Morgan Chase & Co. (JPM), meanwhile, comes in below even that, at $42.

All the while, the World Bank predicts an average oil price in 2018 of $60 per barrel.

There’s a simple reason why these oil forecasts vary almost as wildly as the price of oil itself…

Oil Derivatives Help Traders – Not Investors

In several previous issues of Oil & Energy Investor we’ve discussed the curious world of oil investment derivatives.

This is not a subject for the faint of heart.

It begins with the distinction between oil consignments and futures contracts. The former are made up of actual physical crude oil being traded in the market. These are sometimes called “wet barrels.”

Futures, on the other hand, are contracts that control future volumes of oil. Because they’re not made up of actual shipments of oil, futures are also called “paper barrels.”

This connection between wet barrels and paper barrels generates the first layer of “derivatives” in oil trading. A derivative is a trading instrument whose value depends on something else.

In the wet barrel/paper barrel situation, the underlying oil – the wet barrels – has a value determined by market use. However, aside from introducing a new piece of paper on which trading can take place, the futures contracts – the paper barrels – have no implicit value at all.

In other words, derivatives add to the trading volume but not to the total physical value.

Related: Daily OPEC Oil Prices Now Public For The First Time Ever

And that’s how, with a bang, a single commodity has spawned a whole new class of things to trade. Of course, that’s only the first level of oil derivatives…

There Are So Many Derivatives Out There, They Distort the Price of Real Oil

On any given day, there are far more futures contracts than consignments of oil being traded.

But traders also take out options (another form of derivative) on those contracts, to hedge against a rise or fall in the underlying value of oil.

The options, in turn, allow buys and sells to be cancelled before the expiration date in the futures contract – the point at which the paper and wet barrels converge, and the buyer of a futures contract ends up actually getting a consignment of oil delivered to their doorstep.

Most forecasters would like to make the forward-looking wet barrel/paper barrel intersection curve be the basis for estimating future oil prices.

Yes, they often couch this in discussions of supply and demand. These are, after all, the market factors that ought to be the basis for price calculations.

But supply and demand are functions of the physical market in oil consignments. That is, they are telling us about actual oil being actually traded…

Not about the trade in paper barrels and other derivatives.

Unfortunately, that’s what really determines the price of oil – financial transactions involving oil derivatives, not the trade in oil itself.

And here, there are several additional levels of derivatives impacting on the perception of price…

“Shorting” Oil is the Main Culprit

The most important are “short contracts.”

Simply put, these are bets that the price of oil will fall. A “long” position, on the other hand, is the opposite – a trade that pays off when oil prices rise.

Especially these days, shorts offer a much quicker route to profits.

It’s for this reason that the expansion of shorts has been the single greatest addition to the number of derivative plays on oil.

The short contract is purchased when oil is at one price and the profit is made by “redeeming” the short when oil registers a lower price.

Yet, it can also be a recipe for a major loss.

If the value oil spikes, there is theoretically no limit to how much can be lost.

That’s why short traders apply a range of options, to limit their losses.

Shorts are now the most pronounced artificial element preventing the accurate forecasting of oil prices.

Because not only do they drive prices down when there’s a lot of them…

But when prices start recovering, short traders will quickly close their positions, making the rise in price speed up even more – and often overshoot.

And that’s just the shorts. There are even more exotic derivatives out there…

Future Oil Prices are Held Hostage to the Whims of Derivatives, Not Supply and Demand

These have an even less direct connection to the wet barrels, to the actual oil.

They also introduce a disturbing parallel to the “asset-backed” securities largely responsible for the subprime mortgage meltdown a decade ago.

In these cases, there is no reason to have this paper other than to create additional trading markets for the paper itself.

Such paper adds nothing to the value of the oil upon which the entire house has been built. It succeeds only in providing other avenues for the paper traders to make additional profits. At this point, it is all about “spreads.”

It’s like being in Vegas and betting on a football game. You don’t care which team wins, so long as the over/under is hit.

It’s the same with derivatives traders. They don’t care what oil does – whether it moves up, down, or sideways in price. What they care is that the “spread” between some combinations of derivatives prices goes their way.

All told, derivatives add up to between 25 and 50 times the total value of the oil upon which they are (increasingly only tangentially) based.

This makes forecasting future oil prices almost impossible.

When I do so, I generally stick to the physical elements in the market, buttressed by geopolitical and other tangible impact considerations.

That’s what I did in my latest oil price forecast, available here.

That will get you an accurate long-term picture of oil prices.

Related: The Next Big Catalyst In The U.S. Oil Export Boom

The practitioners of the derivative “paper chase” would claim they do the same. However, they will always overcompensate for insular or expected factors.

Notice how most forecasters will shroud their projections using the same few factors (e.g., excess supply, shale volume, concerns over OPEC continuing production cuts, civil unrest somewhere, and so on).

The same factors are used to justify forecasts moving in very different directions. What is a complex interchange is diluted to a few simplistic causes. The results are hardly encouraging.

Last week, Argus Energy’s Charles Cherington made a comment that was only partially tongue in cheek. “All forecasters share a common trait: they are wrong,” he said. He then added: “Some are only wrong most of the time and most are wrong all the time.”

Given the machinations of the secondary, tertiary (and beyond) derivatives, that’s no wonder. This is no longer about actual barrels of actual oil.

It’s about how many derivatives you can trade on it.

By Dr. Kent Moors of Oil and Energy Investor

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