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Oil market speculators profit as central banks hand out free cash

Oil markets
By Paul Hodges on 21-Mar-2016

Oil Mar16

Oil markets are entering a very dangerous phase.  Already, many US energy companies have gone bankrupt, having believed that $100/bbl prices would justify their drilling costs.  Now the pain is moving downstream.

The problem is the central banks.  Hedge funds have piled into the oil futures markets since January, betting that there would be lots more free cash from the Bank of Japan and the European Central Bank.  They also gambled correctly that the US Federal Reserve and Bank of England would back off the idea of interest rate rises.

Brent Mar16So, once again, markets have lost their role of price discovery, based on the fundamentals of supply and demand. Instead, prices have jumped 50%  in 2 months, as financial speculators have rushed to buy oil in the futures markets:

  • As Reuters noted at the beginning of March, “Hedge funds have switched from a very bearish view on crude oil prices at the end of last year to a much more bullish one
  • The red line in the chart highlights the dramatic shift that has taken place
  • By 1 March, they had created a 445 million barrels net long position – equal to 5 days of total world demand
  • They added 61mbbls in just the first week of March, building their longest position since the summer

This move had nothing to do with the fundamentals of supply and demand, which are still getting worse, not better.

As I describe in the video interview with ICIS deputy news editor, Tom Brown, the rally mirrors what happened a year ago in the SuperBowl rally – when traders put about the story that a fall in the number of US drilling rigs would reduce production.  Of course that didn’t happen, because the rigs are becoming very much more productive.

But the hedge funds didn’t care about that – they simply knew there was money to be made as the central banks handed out vast quantities of free cash.

Now the central banks are doing it again.  And so, once again, oil prices have jumped 50% in a matter of weeks, along with prices for other major commodities such as iron ore and copper, as well as Emerging Market equities and bonds. In turn, this will force companies to buy raw materials at today’s unrealistically high prices, as the seasonally strong Q2 period is just around the corner.  Some may even build inventory, fearing higher prices by the summer.

If this happens, and prices collapse again as the hedge funds take their profits, companies will face the risk of bankruptcy as we head into Q3.  They will be sitting on high prices in a falling market – just as happened in January. Only Q3 could be worse, being seasonally weak, and so it may take a long time to work off high-priced inventory.

We cannot stop the central banks handing out free cash to their friends in the hedge fund industry.  They think high commodity prices are good news, as they might create inflation and reduce the real cost of central bank debt.  All companies and genuine investors can do is to instead avoid taking any positions, long or short.

As experienced poker players say, “If you don’t know who the sucker is at the poker table, then it is probably you”.

My weekly round-up of Benchmark prices since the Great Unwinding began is below, with ICIS pricing comments:
Brent crude oil, down 62%
Naphtha Europe, down 58%. “Petrochemical cracker margins drop off”
Benzene Europe, down 55%. “The upward momentum on crude oil was keeping the market volatile, and perhaps also limiting any spot trading as players waited for clearer direction.”
PTA China, down 42%. “Dips in upstream crude oil and energy prices in the first part of the trading week exerted downward pressure on PTA prices”
HDPE US export, down 35%. “Expectations of tightening supply because of the onset of the plant turnaround season.”
¥:$, down 9%
S&P 500 stock market index, up 5%