Oil Market Advantage Shifts from Speculators to Physical Traders

(image: gasstationnearme.com)

To grossly over simplify things, there are two ways to trade oil. You can actually move oil, or you can move pieces of paper—contracts—for oil without ever taking delivery of crude. Oil companies and oil trading companies, such as BP, Vital, Trafigura, or Hess, move oil. Banks and hedge funds mostly move contracts, speculating (or gambling, to be blunt) on the price of oil: they sell the contract before delivery is due because the last thing most banks actually need is a million barrels of oil.

In recent years, the big banks, investment funds, and hedge funds have been betting big on oil and making a fortune on paper speculation. What they’ve been doing is similar in many ways to how financial firms trade securities based on homes without ever dealing with a buyer or seller. And just as the paper market for real estate-backed securities came to dwarf the actual value of the land and homes it represented, the paper market for oil came to dominate oil trading.  The volume of crude oil contracts being traded in 2008 exceeded the actual volume of crude by a factor of eight.

The pendulum has started to swing back in favor of physical trading of oil. As Reuters recently reported, physical traders are making record profits at the same time that the financial industry has been retrenching on much of its investing, including in oil. For example, BP—a trader as well as producer—added $500 million in profits to its bottom line in the first quarter of 2009 purely from stepped-up oil trading. BP and other trading firms have also been hiring away top Wall Street trading talent to augment their trading arms, in a man-bites-dog or mouse-eats-cat sort of reversal of the normal career and hiring paradigm. After all Wall Street is Wall Street—usually they headhunt the top talent away from other industries, not the other way around.

What’s behind this reversal of the normal course of events? Are pigs flying? Hell hosting the Winter Olympics? Nothing so surreal or apocalyptic: it’s a natural outgrowth of the financial crash, the Recession, and government action.
First, let’s look at it from the banking side—why are they down?

•    To begin with, many banks and other financial firms are facing restricted liquidity and credit; in short, they may be banks, but they have less money—or at least, less unencumbered money—to throw around.
•    Because of backlash over last year’s financial meltdown and the rise in oil prices, which many blame on speculation, the financial sector is facing increased scrutiny and regulation of both derivatives and oil contracts[http://heatusa.com/blog/economic-data/calls-regulation-energy-derivitives-trading-intensify/].  Even though the rules have not really hit them yet, the mood in the air is already one of greater caution and conservatism.
Now, why are the physical oil traders up?
•    Not being banks, firms that physically trade are subject to less regulation than banks—especially now, when the financial sector is under an unfriendly microscope. That gives them more flexibility.
•    Unlike banks, which have faced a shortage of cash and credit, the oil sector has plenty of money from last year’s record profits. It also has more physical assets, such as drills, refineries, storage tanks, ships, and the oil itself, to use as collateral to obtain financing.
•    Contango. Right now, the price of oil for spot, or immediate, delivery is less than the price for future delivery. That means you don’t need fancy trading models or complex derivatives to make money—you just need to have the cash and ability to buy a lot of oil now and store it someplace for delivery later.

Of course, not all banks are down in terms of trading oil. As The HEAT Zone reported, JPMorgan is betting big on heating oil futures.  And there are other banks, like Goldman Sachs or France’s BNP Paribas, who are also still big in oil trading. But those are the exceptions, and in many cases, they’re doing it by taking a page from the physical traders—JPMorgan rented a supertanker long term to actually hold heating oil for future delivery.

What does this mean? Nobody expects banks to be down forever. And similarly, there’s no reason to think the physical traders will continue having things all their way, either. For example, if the spread between current and future prices narrows, or even reverses (so that spot prices are higher), storing oil for future delivery will no longer be a way to mint money. However, for however long it lasts, the shift from oil trading being dominated by the financial sector to it being dominated by the physical traders should cool off some of the occasionally fevered pace of speculation—nobody leverages or  speculates like the big banks. That has the potential to moderate speculation-driven price increases, since you can only store (and so speculate on) so much physical oil—but there’s no limit to how many contracts or derivatives you can have.

And, for those of us old enough to remember a time before bank deregulation, there is something satisfying in seeing the paper world of bank trades subordinate to the real world again, even if only for awhile.