Another Oil Bubble Brewing?February 24, 2011
There’s trouble in paradise again. It looks like oil prices are taking off as political tensions rise in the Arab world. In addition, there is a puzzling spread in pricing between two of the more important benchmark crudes, with Brent trading at wide margins to the West Texas Intermediate (WTI). What the heck is going on?
The extraordinary volatility of oil markets in the past few years has been a function of several major developments: (1) there have been significant changes in the oil ‘formula pricing’ regime in the past few years, (2) Index ‘securitization’ of commodities has become big business and (3) there is heightened political risk, driving oil and other commodities on an historic run up in prices.
Oil’s Formula Pricing Model
The older system for pricing oil contracts was fairly simple. Contract prices were determined by adding a premium to, or subtracting a discount from, benchmark crudes. Generally, West Texas Intermediate (WTI) was used as the benchmark for oil sold to North America, Brent for oil sold to Europe and Africa, and Dubai-Oman for Gulf crude sold in the Asia-Pacific markets.
However in the past few years this all changed when Middle Eastern producers noticed that the spot market was subject to increasing manipulation. Basically producers didn’t trust the market so they changed the rules of the game. Instead of using dated Brent as the basis of pricing crude exports, Saudi Arabia, Kuwait and Iran came to rely on the IPE Brent Weighted Average (BWAVE). The BWAVE is the weighted average of all futures (Brent crude) price quotations that arise for a given contract of the futures exchange (IPE) during a trading day. These changes in ‘formula pricing’ have placed the futures market at the heart of the Brent oil pricing regime. So unlike the more spot oriented WTI, which is experiencing a localized over-supply of NA crude, Brent benchmark pricing is going its own direction; factoring in the growing political instability in North Africa and the Middle East.
On top of all this, commodity markets tied to the futures market, the Brent benchmark in particular, are subject to a volatility accelerator in the form of index Speculators; major institutional investment in the oil futures market, trying to cash in on market instability. Index speculation in commodities is being driven by a potent cocktail of political instability, a lack of confidence in global stock markets and rising commodity prices. Importantly – there are enormous volumes of index speculation sloshing around in the futures market, and after recent events the vast majority are leaping on preprogrammed ‘long’ positions in oil. The net effect is to drive oil-futures yield curves into the stratosphere in a self fulfilling death march to oil bubble land. I believe we’ve seen this movie before, a couple of years ago in fact.
Things to Think About
- Could it be that the Brent – WTI spread, which has been as high as $15 a barrel, is really a measure of the speculative bubble in oil pricing?
- If history has any lessons, it’s that these markets are not accurately pricing crude which is likely going to over shoot its strike price in both directions. Timing is everything in life, it’s the difference between winning and losing in oil markets these days. Heads up.