Oil: The New Financial Product
Source: John Phillips, Oil and Gas Investments Bulletin††(10/18/11)
"Investment banks that now dominate trading have created a massive new market of buyers."
But the irony is they're doing it to themselvesby buying oil ETFs (Exchange Traded Funds) and ETNs (Exchange Traded Notes) and other financial derivative products based on oil.
I only came up for three gulps of air while reading the book, and I emailed Dan immediately afterwards asking for an interview. He writes in a simple, earthy and honest waythat I wouldn't have expected from an oil trader on the floor of the New York Mercantile Exchange.
One point he explained so well to me was that the investment banks that now dominate trading have created a massive new market of buyers, and only buyersno sellerswith their financial products like ETFs. And that has inflated the price of oil for consumers. The oil price nowadays is not just based on fundamental supply and demand.
"In 1980 oil demand was about 60 million barrels (Mbl) a day. In 1990 it was 70 million and in 2010 it was about 90 million. What's interesting is that demand has been fairly steady in how it's increased; about 10Mbl a day each decade."
"But the oil price has been entirely flat for 20 of those 30 years. What that says to me is that something clearly changed in how weíre pricing the stuff in the last 10 years."
And that something is the involvement of the financial industry, he says. "It's all about the pricing mechanism, who's involved and the money being thrown at it."
That money comes in the form of ETFs and index funds all geared around the price of oil, and are obviously set up by the big investment banks.
But Dicker says that is ALL "long" interest, meaning they are all BUYERS and not SELLERS. And we all know what happens to the price of something when are more buyers than sellers. The price goes up.
"What has happened in last 10 years, those who have been setting price based on fundamentals in the market have been swamped out by the financial sector, who have very little engagement with the physical product. Yet their input is equally important to the price of oil as those physically involved in the sector."
"The market is democratic, but it wasn't designed to be democratic."
And there is the irony! Oil becomes a democratic marketwhere institutional and retail investors get to help set the price by all of their buying in these indexes, ETFs and ETNs to gain exposure to the oil price (which isnít possible, Dicker writes) but in effect drive the price up. So they pay more at the pump. Democracy at work!
And sadly, the other side of the coin is that the investment banks make a nice share of the coin in the oil trade.
"The stock market can theoretically have a whole group of winners as the stock market goes upforever. With oil that's not true. When someone buys oil, someone has to sell it to them. At the end of the day or month or year when trades settle the amount of money won equals the amount of money lost. When institutions make money trading oil, that eventually comes out of the pockets of people filling their tanks, refrigerating their meatsit's a zero sum game."
Well, wait a minute Danyou just said everybody in oil is long, i.e. they're buyers, but then you just said there has to be a buyer for every seller.
"Yes, almost everyone who is investing and even hedging oil is long, so the market has to somehow generate sellers, something the stock market for example doesnít need to do. So how do you generate sellers where there arenít any to begin with?"
"Well, first, you must make the price pretty high: Imagine you own a $100,000 house in a neighborhood of $100,000 houses and all of a sudden, a new group of home buyers wants to have your house, for whatever reason.
What will get you to sell? Well, someone knocking on your door with a $200,000 check might get you to think about it. So, price is driven artificially higher, that's the first thing."
"But sellers in an oil market also donít have physical assets. Even when enticed by a high price, they need a hedge for those sales, because they don't have oil to deliver, any more than buyers want to actually accept deliveries of oil."
"So, in generating sellers, you also generate trade correlations. Like, the corn chart and oil chart look almost exactly the same. And the correlation between oil and oil stocks become uncannily close."
"So you get these trade correlations, but not a fundamental correlation. So we now have a very different correlation between the oil market and the stock market than what we had before."
"The oil market-stock market trade looks like a correlation, it's perceived as one, but it doesn't make sense, because high oil prices are intuitively not good for the stock market. So they call it a measure of growth."
"Now we're looking at a double dip recession and EU going down and oil prices more than $110how does that fundamentally make sense. It doesn't because the marketplace designed for producers and consumers is overrun by people who are financially engaged."
OK, now I am a believer that there is big premium in oil because it has become a financial product. How big is that premium and how does. . .can it ever go away. . .can we ever end The Endless Bid on Oil?
"You'll never know what the premium is until you remove this financial mechanism."
"The chances of ending it IMHO are pretty slim. The path to fixing this is simple to seebut making it happen is nearly impossible in practice."
"You would need to restore the market to close to the way it was before these financial influences took control of it, and let commodity markets operate the way they were intended. The financial industry will say that's a destructive rollback of investment trading. The banks and the entire financial industry have big stake in this."
In his book, Dan tells some great and funny stories about how he won, and lost, lots of money (for him) on the old NYMEX floor, despite being a very small independent oil trader. In between the wry smiles, you will get his core message:
"Treating what was a commodity as if it was a stock, is inherently a bad path toward a pricing model that will be volatile, unreliable and unfairly high."
"This is a commodity that people rely on (in their daily lives), and they're treating it like it's investableand the outcomes are fairly obvious to see."
You can buy Dan's bookagain, it's very simple Englishat Amazon. Here is the link: Oil's Endless Bid: Taming the Unreliable Price of Oil to Secure Our Economy