City Insider: Rusty pipes not evil traders to blame for oil spike

City Insider - A City perspective on the travel industry from FT journalist David Stevenson

The pain of high oil prices won’t last forever – and the finger of blame is being pointed in the wrong direction, says David Stevenson

Ever get the feeling that our society is increasingly reliant on the whims and fantasies of the oil market?

The travel sector in particular seems to be particularly vulnerable to the machinations of oil traders. If prices whiz up, the outlook seems to become much gloomier, and all manner of airlines and travel operators announce special surcharges.

Consumers run away frightened and there’s much muttering about high petrol pump prices encouraging consumers to stay at home and spend less. This view subsequently follows into an even more seductive argument which suggests that evil speculators are increasingly dominating the markets, pushing up prices beyond a sustainable level.

Cue the most exquisitely seductive version of the argument which is that sensible companies like Tui Travel or IAG spend a disproportionate amount of their time trying to hedge oil prices like maniacs, all because dumb-ass speculators in the US are pumping money into obnoxious futures based funds.

These funds apparently buy up vast quantities of oil and leave it marooned in oil tankers-turned-storage dumps somewhere off the coast of Singapore.  It’s a hugely appealing argument and subscribers to this world view include lots of very smart people who I have a great deal of time for. Unfortunately it’s probably not true.

Oil prices have increased over the last few weeks, for sure, and money has been flowing into oil futures funds, but nowhere near at the scale that many commentators might imagine. More on that later. First let’s look at why oil has actually been increasing in price.

Spot oil markets only tell us about oil trading at the margins. Most contracts for oil are of a longer term duration and at lower prices – the spot price is really only relevant for trading accounts where a position is being rolled over or a hedge position opened up to protect an actual physical position.

Oil markets are also fragmented with very different prices for oil from west Texas, and Brent and other intermediate grades. Refiners, in particular, care enormously about getting the right kind of sweet oil, at the right time, and at the right place.

Yet even if you ignore all these massive variations two simple truths emerge. The first is that in the period between 2007 and mid 2009, a vast swathe of energy projects were cancelled because of the global crash. This precipitous collapse in the funding of new projects created a supply side squeeze that lasted right up until the end of the recession.

Many of these projects have now been re-commissioned and we’re now experiencing a massive boom in multi-billion dollar oil projects in place as varied as Vietnam, Brazil and the Arctic Ocean. Sadly these projects will take many years to come to fruition and in the meantime we’re at the mercy of countries such as Saudi Arabia to turn on new capacity in a matter of weeks or even days.

Unfortunately the oil produced by these wells isn’t the perfect kind of oil for most western refineries and as a consequence, supply gaps open up leading to sudden price spikes. The other obvious truth is we should always expect oil prices to rise substantially at the start of a global recovery. Oil is the classic cyclical resource and none of us should be at all surprised that oil prices are rising at the rate they are.

What really hasn’t helped are some less obvious supply shocks that have nothing to do with the Gaddafi family. Only a few days ago, for instance, a pipeline in the mid-west of the US, outside of Chicago, ruptured shutting down crude flows between USA and Canada.

This pipeline was owned by an outfit called Enbridge and can bring in nearly 700,000 barrels of oil a day from the big Canadian oil fields into the heartland of the US.  Crucially this pipeline is part of a system which accounts for nearly 70% of the oil flows into the mid west – and this rupture was the second in almost as many months. 

The really big debate here is about the creaking US infrastructure – many of the pipelines that zig zag through the mid-west are desperately old and outdated and obviously need updating, at vast expense – spend which will be made much easier if oil prices remain at high levels.

Add together a resurgent global economy, short term infrastructure problems in the crucial North American oil market and global supply constraints and you have a perfect storm for spot oil prices. Who needs obnoxious oil speculators when you have rusty old oil pipes.

The point here is that oil prices will ebb and flow, largely with perceptions of the strength of the global economy as well as local supply and demand conditions. In reality oil speculators have very little do with the price of oil.

Take one of the largest oil funds on the US stock market – it’s called the United States Oil Fund and it trades under the ticker USO. This is one of these evil futures based funds that are frequently cited by outsiders as a source of speculative frenzy that is helping push oil prices up. Back in the real world that I inhabit it’s far from being an investment hot spot. In fact over the last few months’ it’s been a terrible investment precisely because it’s actually based on those supposedly evil futures contracts.

The vast majority of investors don’t trade in spot prices but in futures contracts  with a duration of anything between 1 and 12 months. These futures derivatives are constantly rolled over in the fund and the difference between futures prices and spot prices creates a carry or roll that can either super charge returns or kill them dead.

In the case of USO, it’s mostly been the latter. USO has been a stinker in relative terms as futures markets have produced a perverse phenomena called ‘contango’ (buy a future and watch the value of it fade very fast over time because the forward price is above that of the spot price).

Note my use of ‘relative terms’ to describe recent returns – USO has indeed risen in price and money has flowed into it from US investors. But even at current levels this leviathan of the US futures markets is currently valued at just $2 billion which in financial terms is almost insignificant.

Or maybe we might take a sneaky look at a fund called the Ultra Dow Jones UBS Crude Oil fund with the ticker UCO. This gives investors a geared ride on oil – you get 2 times the return on oil as it increases in value. Money has undoubtedly flowed into this but it’s currently valued at just over $350 million, which wouldn’t pay for the peanuts supply of a  CEO at a large investment bank.

To be fair to the critics, these funds are only two examples and there’s a much larger grouping of funds available to speculative investors and hedgies.  One of the most popular funds in the massive US market is called the Energy Select Spider fund from State Street.

This tracks a wide range of energy based index prices, and assets under management at the end of February were a much larger $10 billion. Crucially turnover on this fund was $25 billion in February, with a net $1.5bn coming in during the month.

These are much bigger numbers and could have an effect on oil prices at the margin but they are still tiny compared to the much bigger main markets for oil.  So, the next time you see a frenzied report about oil hitting a new high, ignore what’s happening in Libya or in the City of London.

Think about the US pipeline infrastructure and remember that spot oil prices will probably plummet at the first hint of a monetary tightening instigated by the central banks. The pain will not last forever.

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