FT Alphaville’s three-part series attempting to explain the current backwardation in the market…
Index funds the new swing producers?
In many ways, Saudi Arabia’s position as the ultimate swing producer in the oil markets is key. It can be seen as an example of the self-regulating hoarding mechanism of the market being hijacked for the benefit of price control or smoothing. Since Saudi is able to retain stock from the market (by hoarding supply yet to be produced) when prices are low, it can support prices much in the same way. When supply is tight, it can release that inventory back into the market. The very fact it can control a large float of stock helps it to control the price where it wants it. The bigger the float (the spare capacity) the bigger your power.
Currently, Saudi Arabia is producing at 9m barrels a day, with a still hefty 3.5m barrels left.
Which is slightly weird. If the physical market was really as tight as is being claimed by market participants, Saudi should theoretically be incentivised to release its float to the market.
Is it thus possible that a new swing producer has at least, temporarily, entered the market?
We would argue that yes, in some way funds have replaced Saudi Arabia as price controllers, and were the key reason why massive inventories were created over the course of 2009 and 2010. With spare financing available to them (possibly through QE) and fears of longer-term inflation, growing Chinese demand, and global growth in their heads, they were prepared to channel QE money straight back into energy markets in the form of compensating producers and traders for stashing inventory (and creating fake demand).
From the industry’s perspective this was free financing.
In fact, the flow of finance was such that if you were correctly positioned as an intermediary — and could anticipate financial flows — you could easily set yourself up speculatively to benefit from some of that flow yourself. The funds essentially became the elephants, and a free financing ride for anyone in the market — at least for as long as they were prepared to overpay for futures compared to demand.
If, on top of that, you were a key gate-keeper to those flows you could to some degree also influence spot prices at the same time. In other words, you would have the means to fine-tune prices to your needs (if your buffer of financial long positions was big enough).
For example, if you felt prices were too low, you could pass on the flow into the real market to encourage inventory-building. If you felt prices were too high, you could retain flow on your own account. To do this, the ability to internalise flow and keep it out of the public market (possibly within your own dark pool) would be key. At the point that these internal positions became too large to carry internally, meanwhile, you might be encouraged to use them to guarantee the performance of an oil index fund instead. This would take the positions in some way off balance sheet.
Once a sizeable off-market position had been formed, you had the opportunity to divert its influence in and out of the market as it suited you. New flows could either be encouraged to circumnavigate the public market completely (and be stashed straight into funds) or washed through the market if you wanted their price influence to be felt. Either way, the price discovery process of the public market was compromised. And since you were the gate keeper of the only mechanism that allowed ETF flows to influence the public market (as an authorised participant say), you could ultimately dictate and predict price moves (if the flow and buffer you were managing was large enough).
If flows were so large that it made sense for you to channel them into funds all the time — circumnavigating the futures market — you would effectively be ‘snatching’ financing from the real market all the time. These, after all, would otherwise have been encouraging inventory building in the market.
You would make money from the drawn from investors financing, the ETF fees as well as from your positioning on the curve — after all, you controlled the scale of the contango formation and could as a result position yourself accordingly. What’s more you had a better idea than anyone else how long it would last, since you could keep influencing it via the slow-release of your internalised flow into the public market.
If physical demand soared (as per Libya) while financial demand was still high, you would then be incentivised to allocate more of that flow into the funds so as to encourage destocking rather than inventory building while keeping prices suppressed.
The problem is, what happens when a physical demand spike coincides with a sudden shortfall of off-market financial inventory?
In our next post in this three-part series we will explain why this fact could be behind the current super backwardation, as well as the bizarre behaviour of the WTI-Brent spread this year.
Related links:
Just when it makes sense to sit in oil futures… - FT Alphaville
Brent’s got its problems too – FT Alphaville
‘WTI about as useful as a chocolate oven-glove’ – FT Alphaville
Bye, bye Cushing syndrome (possibly) – FT Alphaville
Article Series - Explaining backwardation
- The curious case of super-backwardation
- Are index funds the new swing producers?
- The WTI-Brent anomaly