John Kemp of Reuters-accompanied by cheerleading by Izabella Kaminska at FT Alphaville-is going on about the “disconnect” between nearby and deferred Brent. He blames-wait for it-hedge funds. Natch.
The Brent market is currently in a steep backwardation. I demonstrated empirically almost 20 years ago that backwardation is associated with low correlations between spot and futures prices for oil and a variety of other commodities. Indeed, my 1994 criticism of the Metallgesellschaft 1992-1993 “hedging” strategy-which led to several confrontations with Merton Miller-was based on the fact that MG’s “hedge” of long the nearby against distant deferred short positions was in fact risk increasing due to the fact that MG implemented this strategy during a backwardation, and this reduced substantially correlations thereby making the MG position very risky. My 2011 book provides a robust model that predicts exactly this result.
The intuition is quite straightforward-as I’ve been teaching for about 20 years too. Inventory is what connects spot and futures prices. When inventories are large, the market is in contango, and spot and futures prices move together: cash-and-carry arbitrage connects these prices. In contrast, when inventories are low, the market is in backwardation, cash-and-carry arbitrage doesn’t link the spot and the futures, and the correlation between these prices can go very low. Hence the association between contango and high correlations.
Note: hedge funds, speculation, yadda yadda yadda have nothing to do with this.
Kemp does note that there is physical tightness that does explain the backwardation:
Overlaying all these broader factors are continuing problems with production of the four North Sea crude streams (Brent, Forties, Oseberg and Ekofisk) that physically underpin the Brent futures prices. BFOE crudes remain in short supply, keeping the market in a steep backwardation, with futures prices tending to rise sharply in the run up to contract expiry.
But then he discards this fundamental fact, and mounts his favorite hobby horse of bashing hedge funds and speculation.
Note even in this paragraph there is a telling piece of information that contradicts his view: “with futures prices tending to rise sharply in the run up to contract expiry.” Uhm, that’s exactly when hedgies and other speculators are liquidating-selling-their nearby contracts and rolling them into the deferred months. This should put downward pressure on nearby prices, if the speculators were really in command. Completely inconsistent with his assertion that hedge funds are driving the disconnect between spot and futures.
Kemp also makes a comparison to spot price and curve movements in 2008 to more recent movements. But as I also show in my book, to explain commodity price dynamics you need multiple shocks of differing persistence. Curve shape is driven mainly by transitory shocks: that’s what inventory is used to smooth out. The level of the curve is largely driven by persistent, business-cycle type shocks. This means that conditioning on price levels alone is insufficient to make an apples-to-apples comparison. The 2007-2008 boom was driven more by long run, secular factors-namely the Asian/Chinese growth boom. This resulted in a rise in the price level and only a modest increase in backwardation. That is completely different from current conditions-hence the different behavior.
Similarly, the differences between high correlations pre-2010 and low correlations now are readily explicable. The market was much more abundantly supplied in 2009-2010 due to the severe economic contraction following the financial crisis, and as a result, the market was in contango most of that time-at times in a “supercontango”. Again, one would expect this to be associated with high spot-futures correlations.
Moreover, there is a big difference in the composition of shocks, and the magnitude of these shocks that also explains the observed declines in correlations. The 2009-2011 period was dominated by macro uncertainty driven by the financial crisis and then the Eurozone crisis. These shocks tend to be persistent, affecting both current and expected future economic conditions in the same way, thereby contributing to high correlations between points on the curve; moreover, they tend to affect all commodities and asset classes similarly, leading to high correlations across commodities and asset classes.
At that time, macro volatility-as measured by the VIX-was high. In early ‘09, VIX was in the 30-50 percent range, and remained above 20 percent for most of 2010-2011, with spikes up to 35-40 percent. Now VIX is tame, with levels in the low-teens, just like during the period of the “Great Moderation.” High macro volatility tends to lead to high correlations along the curve and across commodities and between commodities and equities: common shocks dominate, especially when they are big. The decline in macro volatility means that commodity-specific, relatively transient shocks tend to dominate: this tends to depress correlations along curves and across commodities, and between commodities and equities. These are exactly the patterns observed in the past months.
That said, there are reasons to suspect the backwardation and the decline in correlations might be overdone, but not because of the malign influence of hedge funds. Specifically, given the declining Brent supply base, it is reasonable to ask whether the backwardation is excessive. At present, Forties is cheapest-t0-deliver, and this represents only about 350kbd of production. Overall BFOE production is only about 1mmbpd. Given the immense open interest in Brent futures and OTC derivatives, it is more that possible that large players are exercising market power by taking delivery of too much physical oil, thereby exacerbating the backwardation (i.e., creating an artificial scarcity).
If you want to identify who might be doing that, look at who is taking the physical cargoes. Those parties would be the squeezers. If hedge funds are the culprits, they should be taking a lot of physical supply. Kemp certainly doesn’t provide any evidence of this, and his piece suggests these players are just playing with paper barrels, not wet ones: that’s my understanding too. Historically, the Brent market has been the scene of many squeezes, but the squeezers have tended to be trading companies (e.g., Arcadia) or perhaps supermajors.
Brent was a squeezers paradise in the 1990s due to declining physical volumes and growing paper volumes. Platts’s addition of Forties, Ekofisk and Oseberg to the delivery slate increased supply sufficiently to mitigate the manipulation problems. But the decline in production has continued inexorably, and Brent is increasingly vulnerable to squeezes. Which is why Platts and Shell have competing plans to tweak the pricing mechanism, namely by providing premiums for OE (Platts) or BOE (Shell), thereby reducing the delivery pressure on the cheapest-to-deliver Forties.
Squeeze-driven backwardation also tends to reduce spot-forward correlations. The spot price is driven by squeeze-related technicals, the forward price by longer run fundamentals. Squeezes also distort the inventory holding decision, and cause a breakdown in the cash-and-carry arb mechanism. As I show in another book (and many articles).
So Brent may indeed be broken, but hedge funds haven’t broken it. It is a classic problem in derivatives markets: a burgeoning derivatives market balancing on top of a declining deliverable supply. I often analogize this to an inverted pyramid: and in Brent, the base of the pyramid (the paper market) is growing while its point (the physical market) is getting sharper.
Fixing Brent requires enhancing deliverable supply. Not an easy thing to do.
Again contrast Brent and WTI. Brent boosters have constantly bashed the WTI disconnect. But this can be fixed by investments in infrastructure, which are being made, though not as fast as expected or as needed. But building infrastructure is a helluva lot easier than building a new Buzzard. Trust me on this.
So in the medium term, I expect Brent will get broker, and WTI will get better, leading to a shift of much futures and index trading activity (including hedge fund trades) back to WTI, which will no doubt lead John Kemp to saddle up his hobby horse and ride west into the Oklahoma sunset.