Wednesday, June 21, 2006

The two realities of the oil market

There are two markets in the oil industry ,the paper or derivitives and the wet barrel or physical market.

Dhatz has some interesting observations on the twin realities .

Afterall, for several years (since 1988), the price of oil is set by "paper barrel" trading in the derivatives markets, but these markets increasingly have NO connection whatsoever with the supply/demand picture in the market of physical oil market of real "wet barrels".

The secretary general of the Organisation of Petroleum Exporting Countries (Opec), Rilwanu Lukman, says the world oil market is held captive by the derivatives markets. The old rules of supply and demand have been distorted, he says, by the creation of what he calls "paper barrels" of oil.

The physical ("wet barrel") market is awash in oil. Saudi Arabia, the world's top exporter, had to cut production from 9.5Mbpd level of the past 2 years down to 9.1Mbpd (-400,000 barrels per day) since April-06, because it can find no buyers for it, The Wall Street Journal quoted Oil Minister Ali Al Naimi as saying on 5-Jun-2006.

All "demand" keeping prices at these absurd levels of $70+/bar is happening in the futures derivatives markets, off which real physical oil is priced. Derivatives is what OPEC calls "paper barrels", with open contracts just in NY futures market being ~1.6 BILLION "paper barrels". Nearby month futures contracts in NYMEX and ICE trading about ~250 million "paper barrels" per day (vs ~80 million barrels per day world production).

The current oil price discovery mechanism is broken. Given relatively small spare production capacity for the types of oil used in futures markets (WTI light sweet crude or UK Brent, where e.g. Brent represents 0.4% of world's total oil production but is used as benchmark to price 60% of world's oil) results in lack of meaningful arbitrage ability between physical and derivatives.Consequently, "investors" ("speculators") aided by other factors (e.g. price insensitive filling of SPR in 3yr if you believe in coincidences) were able to drive oil to $70+/barrel on sheer buying power of billions $$$, as price is set at the margin.

There was some strange statements a main investor in the London oil trading market set up early last year with prediciton satements of 100+per barrel,they also were underwriters of the float of REFCO a major worldwide derivititves trader and commodities trader,unfortunately this seemd to have been run by some very dodgy operators.

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