Streetwise Professor

September 22, 2008

Send Lawyers, Guns and Money . . .

Filed under: Derivatives,Economics,Energy — The Professor @ 9:39 pm

Sheesh, how many fans are there out there, anyways? (If you get this, and the connection to the title, you’re a Warren Zevon aficionado. If not, google “zevon lyrics laywers guns money.”)

I am referring specifically to today’s events in the NYMEX crude market. From Bloomberg:

Sept. 22 (Bloomberg) — Crude oil climbed more than $25 a barrel, the biggest gain ever, as the dollar weakened the most against the euro since January 2001, boosting the appeal of commodities as a hedge.

The October contract, which expires today, rose almost $12 more than the contract for November delivery, as traders rushed to close positions. Oil, gold, corn and other commodities climbed as the dollar dropped on concern that a U.S. proposal to buy $700 billion of troubled assets from financial firms will deepen the budget deficit.

“This looks like a squeeze play,” said Phil Flynn, senior trader at Alaron Trading Corp. in Chicago. “All of the contracts are up, but nothing like October. This is the last day of trading and someone is scrambling to guarantee supply.”

Crude oil for October delivery rose $18.05, or 17 percent, to $122.60 a barrel at the 2:30 p.m. close of floor trading on the New York Mercantile Exchange. Futures climbed as much as $25.45 to $130 a barrel, the highest since July 22. The more- active November contract rose $6.11, or 6 percent, to $108.86 a barrel.

It sure does look like a squeeze, Phil. During a squeeze the nearby price (October, in this instance) increases relative to the deferred prices (November, and later months.) On Friday, October settled $1.80 over November. At some point today, October traded at least $19.55 over November. Based on settlement prices, October gained $9.45 on November. That last number is a huge move, given the normal volatility in calendar spreads, but the $17.75 move is mind-blowing.

A squeeze would work by somebody holding a large long position refusing to liquidate that entire position. On the last trading day, refusing to liquidate is equivalent to demanding delivery. If the shorts perceive that deliverable supplies are inadequate to meet the long’s implied demand for deliveries, they are willing to bid up the price in order to offset their positions and avoid the prospect of making inefficient deliveries.

I would therefore like to see how many contracts liquidated. WSJ data report open interest of 23,130 contracts–or 23 million barrels of oil. I am pretty sure that this figure is yesterday’s open interest. That’s substantially more than the likely delivery capacity in Cushing, OK over the coming month. If one long, or a couple, held the bulk of these positions, or a large futures long also has a big long position in deliverable crude, they would possess the market power to squeeze the shorts. To the extent that the large long was also long in OTC instruments settled against the last NYMEX settlement price, they could profit even more from the price spike.

In some respects, this is a stunning development. Anybody even remotely familiar with these markets is aware of the intense scrutiny they are currently subject to. Any large long has to know that subpoenas are incoming. Knowing that the world–the regulators, the Justice Department, Congress–is watching, you would think that large longs would go out of their way to avoid doing anything even remotely manipulative. The most plausible explanation of today’s move, however, is that somebody squeezed October crude. Dunno about the guns, but money and lawyers will certainly be in play very, very soon.

Update: Another piece of information consistent with the squeeze interpretation.   October Heating oil and RBOB gasoline were up less than 5 percent on the day.   OCT and NOV HO were about by about the same amount, and OCT RBOB actually rose less than NOV.   The sharp rise in the price of nearby crude relative to products (i.e., the sharp decline in the crack spread), and the lack of steepening backwardation in products are what you would expect to observe in a squeeze of the CLV.

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  1. Professor,

    My knowledge of capacity in Cushing, OK is rather ancient as these things go but there were about 14 million barrels of crude storage capacity in Cushing 15-20 years ago. If that has changed, capacity has likely increased but probably not dramatically.

    If open interest in October was still 23k contracts (i.e. 23 million bbls) then the possibility of a squeeze (intentional or not)seems reasonable.

    Comment by John McCormack — September 23, 2008 @ 2:36 am

  2. That’s my recollection too. Key things are (a) how much oil is in the tanks, and (b) what is the amount of oil likely to flow into Cushing in the next month. With declining US domestic onshore production, and the effects of disruption of Ike and Gustav, the amount of oil flowing to Cushing may be constrained.

    Comment by The Professor — September 23, 2008 @ 3:17 am

  3. Love love love Warren. Miss him dearly. RIP. In the KP household we use your title a lot.

    Comment by Lynne — September 23, 2008 @ 3:17 pm

  4. I agree that it certainly looks and smells like a classic long delivery squeeze. I am stunned that anyone would be so foolish to do this in the current regulatory environment. Even though the actual impact on spot prices and resource allocation should be close to nil, its political impact may be explosive.

    Comment by Scott Irwin — September 23, 2008 @ 11:47 pm

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