You can’t print oil as fast as money

Oil markets

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WTI futures Jan15There has never been any fundamental reason for oil to trade at $100/bbl since 2011:

  • There hasn’t been a single moment when a consumer failed to get the supplies they needed
  • Inventories in the major markets such as the US have always been at very healthy levels
  • And all the time, more and more production was coming online, as well as more gas supply

The chart, however, tells us why the price (blue line) quadrupled from $30/bbl at the end of 2008 to peak at $125/bbl in March 2012.  It was the explosive rise in the volume of oil being bought via ‘paper contracts’ on the futures markets (red line).

Financial players had discovered after Hurricane Katrina in 2005 that huge profits could be made from trading in these markets.  Their activity would normally have died back again in 2007.  But this was the height of the sub-prime mania, when speculation was widespread in almost every market.

Of course, the speculation collapsed at the end of 2008, as the financial Crisis began.  But then the US Federal Reserve revived it on an even bigger scale from 2009 owards, with its 4 Quantitative Easing programmes :

  • The major pension funds realised that one key aim for the Fed’s was to boost exports by devaluing the US$
  • So they looked for a ‘store of value’ to preserve the value of their cash
  • Oil (unlike gas and other commodities) was a vast and highly liquid market, and it was priced in dollars
  • So futures volumes actually increased still further – all financed by the Fed’s zero interest rate policy

By 2011, futures volume was an unbelievable 616 million bbls/day, more than 7 times physical production of 84 million bbls/day.  And these weren’t day-traders dipping in and out of the market.  These were some of the largest pension and hedge funds in the world, allocating $bns to the oil market on a ‘buy and hold’ basis.

No wonder prices rose so sharply.  The Fed can print electronic money in milliseconds.  But it takes years, sometimes decades, to find new oil supplies and bring them to market.

But none of this was real demand.  It was indeed just ‘paper contracts’.

Equally important was the impact of China’s vast stimulus programme, where lending rose from $1tn to $10tn between 2009 – 2013.  Financial investors read about the property and lending boom – some of them even visited the new housing and office developments being built.

But they failed to realise this was simply US sub-prime on steroids.  They thought that China, with average urban incomes of $5k/year, really had become ‘middle-class’ overnight.  So they saw oil prices rising, and thought that real demand growth was taking place.

Today, sadly, they have realised their mistake too late.  Futures market data shows that it was only at the end of 2014 (when oil was already $60/bbl), that financial investors began to realise prices were not going back to $100/bbl.  Yet this comes too late to stop the growing supply glut created by this paper demand.

Of course, the Federal Reserve will refuse to accept any blame for this disaster.  But had they not embarked on QE, and not pushed interest rates to zero level, oil prices would never have risen.  Today’s collapse could then never have occurred.  And US oil producers and others would not now be heading for bankruptcy.

 

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