From the October 2013 issue of Futures Magazine • Subscribe!

Dan Dicker: How electronic trading changed (ruined) crude oil prices

FM: Let’s get back to the markets. What do you see as the influences on crude oil, natural gas and the products today? What’s your perspective, especially on crude, as it’s still in backwardation. 

DD: [Here are] some of the basics about futures that a lot of people don’t know: All the volume and open interest is in front two-three months. You go [to the back months] and there’s nothing. Nymex has close to 2 million in open interest at this point — a new record — but the first three months have about a million of that. I’m sure the first month has 500,000 of that and the second month  300,000. But if you got [past]  the first four or five months, there’s nothing out there.

Now the growth of volume, [which] to me isn’t even arguable, is the growth of those players who have absolutely zero physical interest in oil; they don’t care how it’s used. And their primary way of dealing with that is in the most unsophisticated, unindustrial, unmanageable way, and that is to go in the front month to buy or sell it, because that’s what dumb investors do. Not only do dumb investors do it, dumb investment vehicles do it. And that’s what drives, and has been driving the oil market for sure. WTI particularly, because WTI has lost entirely its connection with global crude oil. It’s now starting to catch up a little, but for the last three years, the price of WTI did not represent any crude oil in the world except Cushing. And yet this is still the nexus of where financial crude maintains to trade. 

So you have a market of real players, people with real physical interest for the most part, people who are doing legitimate hedging, people who are trying to manage a spread of risks they have and they are doing it throughout the curve because they have to. Exxon has to plan ahead for the next season — they aren’t farting around for the most part in the front months. If they can get liquidity down say 18-22 months, you bet your life they are taking it. The guys in the back months are what I call the real players and the price in the back months represents the real prices. 

You have a backwardation market,  like you have now, where you go out two years and [there’s] $80 crude. You get all the guys who really need to buy the stuff and all the guys who really need to sell it and you put them in a room and shake up until they come out with some number that both of them agree upon….that’s how open outcry works. But once you apply literally tens of thousands of illegitimate — strange word — financial players into the game, you get a skewing of prices that do not represent the fundamental nature, and, in my mind are anti-futures. They skew the mechanism via which price discovery has worked so well up until about 2003 or so.

To me what’s important that if you’re looking for legitimate price, what oil is fundamentally worth, you need to go out at least 20-22 months. The further out you go, the more legitimate it gets — because you are chasing away all the guys who either due to lack of credit or lack of good sense, aren’t out there. So that to me is basically my thesis in crude oil, and that’s been since 2005, and is to me the main focus of my book [ “Oil’s Endless Bid,” John Wiley, 2011]. How this market has changed from what I call legitimate players to this sort of anti-futures kind of construct, which it will be unfortunately defended by everyone in the industry, particularly the exchanges. For every buyer there’s a seller, for legit prices, buying is good, liquidity is great…all these nonsensical [statements], to increase volume and get more commissions out of it. So for the financial industry, the oil game is wonderful, [but]for me it’s very much anti- consumer, anti -fundamentals and anti-fair price.

FM: Do you think that will change? 

DD: No. We want Exxon and BP to tell us what the stuff is worth again, what [it really costs] to go 3.5 miles deep in [to the] Gulf of Mexico to get a barrel of oil out. That’s been lost. And the instant proof of that would be natural gas, which is localized and you can’t fake it. If there is too much supply, the price goes to zero; if there’s not enough, it goes to 14, and there’s no in between.

FM: Why do you believe supply and demand aren’t the key drivers for oil prices? Is it these financial players?

DD: Yes….but their reasons could be legitimate. They could be looking for a diversifier for stock assets. They could be worried that Obama’s going to put boots on the ground in Syria. But none of that goes to the fundamental nature of oil supply: Where it is, what oil companies [pay] to get it and what consumers are willing to pay. The things that [now]play first [are] how much money is being driven here, how long is it going to be driven here, is a bubble being created and who will be first  guy out of the port hole? These aren’t the same as “I am an oil producer with 75,000 barrels of crude in the 4th Q of 2014-2015 and I need to legitimately hedge those over that time period.” On the other side is “I am a refiner in the in midcom who needs to have some idea what my base price is going to be going to in the first quarter of 2015 …so I have to buy a couple futures as a risk hedge.” And between those guys and hundreds like them you get a legitimate price. [But today] if someone says [John] Kerry is going to get Obama to put boots on the ground in Syria, I’ll buy 3,000 lots in October….that’s anti-futures.

FM: But hasn’t a speculative component always been there, at least in commodities? Hasn’t that been always built into the price?

DD: The answer is yes, but the difference was in 2003 the electronic access swamped by many orders of magnitude those legitimate components that until then had a fundamental logic in those prices. Now you’ve got a footprint of players who dominate it that have zero [connection] to oil. That includes funds, investment banks, and the Asia payment machines. 

FM: What is the speculative premium?

DD: I know exactly what the speculative premium is.  It runs all the way through the [back month] prices. It gets less the further you go back.  So [today] CL closed at over $109. I show Oct. 2017, in four years at $83. So that’s $26 [differential]. There’s a speculative premium even in the back somewhere because it’s showing up. What the hell Syria could have to do with October 2017,  I don’t know. My belief is with a backwardation like this, where from October 13 to 14, you have a $14 [differential], that’s premium — at least $25. There were some years, like when we had [the] Libyan war and the stock market wasn’t as good as it is now, they drove it to the moon, particularly Brent, where the speculative premium was $40.

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