Streetwise Professor

February 8, 2015

When It Comes to Oil, the “I” in BIS is Superfluous

Filed under: Commodities,Derivatives,Economics,Energy,Regulation — The Professor @ 9:56 pm

The Bank for International Settlements  is creating some waves with a teaser about a forthcoming report that claims to show that financialization is largely responsible for the recent fall in oil prices. Even by the standards of argument usually seen criticizing financializaton, this one is particularly lame.

BIS notes that the upstream business is heavily leveraged: “The greater debt burden of the oil sector may have influenced the recent dynamics of the oil market by exposing producers to solvency and liquidity risks.” The BIS summarizes the well-known fact that yields on oil company bonds have skyrocketed, and claims that this has contributed to the price decline. But it is plainly obvious that cause and effect overwhelmingly goes the other way: it is the sharp decline in prices that damaged the financial conditions of E&P firms. The closest that BIS can come to showing the direction of causation going from debt to price is this: “Debt service requirements may induce continued physical production of oil to maintain cash flows, delaying the reduction in supply in the market.”

At most, this means that future output may be higher in the future than it would have been had these firms been less leveraged, thereby weighing on future prices and through inter temporal linkages (e.g., storage) on current prices. It is difficult indeed to attribute the earlier price declines that caused the financial distress to this effect. Moreover, the BIS suggests that oil output from existing wells can be turned off like a water faucet. Given that the costs of capping a well are not trivial, this is not true: except under rather extreme circumstances, producers will continue to operate wells (which flow at an exogenously determined rate) even when prices fall substantially. Thus, this channel is not a plausible contributor to an appreciable fraction of the 50 percent decline in prices since July.

Then BIS turns its attention to hedging:

Since 2010, oil producers have increasingly relied on swap dealers as counterparties for their hedging transactions. In turn, swap dealers have laid off their exposures on the futures market as suggested by the trend increase in the CFTC short futures positions of swap dealers over the 2009-13 period.

However, at times of heightened volatility and balance sheet strain for leveraged entities, swap dealers may become less willing to sell protection to oil producers. The co-movement in the dealers’ positions and bouts of volatility suggests that dealers may have behaved procyclically – cutting back positions whenever financial conditions become more turbulent. In Graph 2, three such episodes can be seen: the onset of the Great Recession in 2008, the euro area crisis combined with the war in Libya in 2011, and the recent price slump. In response to greater reluctance by dealers to take the other side of sales, producers wishing to hedge their falling revenues may have turned to the derivatives markets directly, without going through an intermediary. This shift in the liquidity of hedging markets could have played a role in recent price dynamics.

BIS’s conjecture regarding producers hedging directly can be tested directly. The CFTC Commitment of Traders data, which BIS relies on, also includes a “Producers, Merchants, Processors and Users” category. If BIS is correct and producers have gone to the futures market directly rather than hedged through dealers, PMPU short interest should have ticked up. So why they are guessing rather than looking at the data is beyond me.

What’s more, using declines in swap dealer futures positions to infer pro-cyclicality seems rather odd. Swap dealer futures hedges of swap positions means that they are not taking on a lot of risk to the balance sheet. That is the risk that is being passed on to the futures market, not the risk that is being kept on the balance sheet.

The decline in swap dealer short futures positions more likely reflects a reduced hedging demand by producers. For instance, at present we are seeing a sharp drop in drilling activity in the US, which means that there is less future production to hedge and hence less hedging activity. The fact that the decline in swap dealer short futures is much more pronounced now than in 2008-2009 is consistent with that, as is the big rise in these positions during the shale boom starting in 2009. This is exactly what you’d expect if hedging demand is driven primarily by E&P companies in the US. Regardless, the BIS release does not disclose any rigorous analysis of what drives swap dealer positions or hedging positions overall, so the “reluctance of dealers” argument is at best an untested hypothesis, and more likely a wild-assed guess. Using drilling activity, or capex, or E&P company borrowing as control variables would help quantify what is really driving hedging activity.

And the conclusion is totally inane: “This [unproven] shift in the liquidity of hedging markets could have played a role in recent price dynamics.” Well, maybe. But maybe the fact that the moon will be in the seventh house on Valentine’s Day could have played a role too. Seriously: what is the mechanism by which this (unproven) shift in liquidity in hedging markets affected price dynamics?

Further, if E&P company balance sheet woes are making it harder for them to find hedge counterparties, this would impair their ability to fund new drilling, and tend to support prices. This would offset the alleged we’ve-got-to-keep-pumping-to-pay-the-bills effect.

BIS also offers this pearl of wisdom:

Rather, the steepness of the price decline and very large day-to-day price changes are reminiscent of a financial asset. As with other financial assets, movements in the price of oil are driven by changes in expectations about future market conditions.

What, commodities have not previously been subject to large price moves and high volatility? Who knew? I’ll bet if I dug for a while I could find BIS studies casting doubt on the prudence of bank participation commodity markets because the things are so damned volatile. And what accounts for the extremely low volatility in the first half of 2014, something BIS itself documented? Is financialization that fickle?

Moreover, why shouldn’t oil prices be driven by changes in expectations about future market conditions? It’s a storable commodity (both above and below ground), and storage links the present with the future. Furthermore, investments today affect future production. Current decisions and hence current prices should reflect expected future conditions precisely because of the inter-temporal nature of production and consumption decisions.

In fact, oil is not a financial asset, properly understood. The fact that the oil market goes into backwardation is sufficient to demonstrate that point. But it is hardly a sign of inefficiency, or of a lamentable corruption of the oil markets by the presence of financial players, that expectations of future conditions affect current prices. In fact, it would be inefficient if expectations did not affect current prices.

I understand that what the BIS just put out is only a synopsis of a more complete analysis that will be released next month. Maybe the complete paper will be an improvement on what they’ve released so far. (It would have to be.) But that just raises another problem.

Research by press release is a lamentable practice, but one that is increasingly common. Release the entire paper along with the synopsis, or just shut up until you do. BIS is getting a big splash with its selective disclosure of its purported results, while making it impossible to evaluate the quality of the research. The impression has been created, and by the time March rolls around and the paper is released it will be much harder to challenge that established impression by pointing out flaws in the analysis: that’s much more easily done at the time of the initial announcement when minds are open. This is the wrong way to conduct research, especially on policy-relevant issues.

Update: I had a moment to review the CFTC COT data. It does not support the BIS’s claim of a shift from dealer-intermediated hedging to direct hedging. From its peak on 1 July, 2014 to the end of 2014, Open interest in the NYMEX WTI contract fell from 1.78 million contracts to 1.46 million, or 18 percent. PMPU short positions fell from 352K to 270K contracts, or about 24 percent. Swap dealer shorts fell from 502K to 326K, or about 36 percent. Thus, it appears that the fall in short commercial positions were broad-based. Given that PMPU positions include merchants hedging inventories (which have been rising as prices have been falling) not too much can be made of the smaller proportional decline in PMPU positions vs. swap dealer positions. Similarly, dealer shorts include are hedges of swaps done with hedge funds, index funds, and others, and hence are not a clean measure of the amount of hedging done by producers via swaps.

I am also skeptical whether producers who can no longer find a bank to sell them a swap can readily switch to direct hedging. One of the advantages of entering into a swap is that it often has less stringent margining than futures. How can cash-flow stressed producers fund the margins and potential margin calls?

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  1. “Moreover, the BIS suggests that oil output from existing wells can be turned off like a water faucet.”

    As you say, this is nonsense. In general, all companies maximise the production rate of a reservoir whilst maintaining the reservoir integrity to get the maximum yield over about 25 years (although these days it’s more like 10-15 years as few newly discovered reservoirs will produce at or near to plateau for 25 years). The surface facilities are designed to cope with certain production rates driven mainly by the reservoir characteristics but also things like water cut and committed gas sales. It is possible that any surface facility could cope with a prematurely reduced production rate, but it might require replacement or addition of equipment to deal with it: for instance, the separator might not function efficiently under lower flow conditions, meaning additional equipment needs to be added downstream. This is complicated, expensive, and needs a shutdown of the facility to install. In addition, when you are in the deep offshore or have long production lines, flow assurance comes into play: you need the linepipe to operate at certain pressures and flowrates otherwise funny stuff starts happening, such as hydrate formation. Also, you will now be in a position where you are not making full use of your asset. In effect, you’ve spent billions in CAPEX on a giant facility capable of handling 150,000 bbl/d of liquids and now you’re running it at 100,000 bbl/d. This is not a smart use of CAPEX. Also, the production profile usually has to be approved by the host government, either as a condition of the licensing agreement or because they are a partner in the development (which is almost always the case these days). An oil company cannot unilaterally reduce production even if it wanted to. I understand the Saudis are able to shut in production, as their production systems are very simple and probably not designed or operated with efficiency in mind. But for most others, it is far from simple.

    What I believe is happening (and this is happening more and more, not just in relation to the oil price) people rush to the most convoluted explanation they can find involving grand conspiracy theories. I think in this case the reasons are twofold: individuals spout this nonsense to make themselves sound informed without going through the necessary labours of actually boning up on economics, history, and technical subjects to understand how the industry operates (for instance, the Venezuelan president believes the USA is flooding the market with crude whilst simultaneously banning its export). Secondly, tinpot governments (such as the aforementioned Venezuelans) and oil company execs have let their spending spiral out of control to such an extent they simply cannot contemplate having to live with lower prices (and $50 per barrel is not especially low). Their own survival depends on it going back up, and it is easier for them to rail against mysterious outside forces bent on their destruction than it is to admit they haven’t got a clue how to deal with an economic reality they should have seen coming. It’s exactly the same as what we saw with the GFC and house prices: despite all the conspiracies about Big Finance, the root cause was banks lending money to people who couldn’t pay it back.

    Comment by Oilfield Expat — February 9, 2015 @ 1:38 am

  2. SWP:

    OFX’s comment on your article is the reason VP VVP keeps coming to your site often.

    Thanks to all contributors.

    VP VVP

    Comment by Vlad — February 9, 2015 @ 11:19 am

  3. @Vlad-Hurt to the quick. I thought it was me!

    Kidding aside . . . yes, it was an excellent and informative comment and a service to the readers that I essentially free ride on.

    The ProfessorComment by The Professor — February 9, 2015 @ 12:08 pm

  4. Hear hear. It’s a shame there’s so much of this BS floating around and so little of the wisdom like Oilfied Expat’s in mainstream coverage. There are big, obvious stories out there to explain the price drop. There’s the extent to which producers’ own consumption was driving demand, and as prices fell they are consuming less and putting more on the market (at least relative to projections). There’s the lack of price pass-through in many EMs that are using the price fall to get out from under their traditional subsidies of energy prices. But who wants to cover the real news, when people so love to imagine that everything’s being manipulated by the Great Oz.

    Comment by Tom — February 9, 2015 @ 12:08 pm

  5. SWP:

    It is the forum that is so fascinating. Your ideas generate such (for the most part) well-reasoned comments.

    Unfortunately, there are folks who read your blog who never take the time to read the comments.

    Thank you for the site. As always, one of my favorite ways to start the day or end the day.

    😉 Probably something was lost in ‘translation’ of my original reply.

    VP VVP

    Comment by Vlad — February 9, 2015 @ 3:43 pm

  6. Thanks, gentlemen. Indeed, one of the great things about (certain) blogs is the specialist knowledge that the author and commenters bring to a subject, and this is why I find blogs to be a more reliable source of news analysis than newspapers of television. Of course, one needs to choose the blogs carefully and weed out the nonsense, but I found myself reading a handful of blogs (of which this is one) which add a lot of value by way of introducing professional (or advanced amateur) knowledge and experience to the discussion. There are certain blog commenters I know who are able to explain (and argue!) the detailed reasons of how and why the F-14, F15, and F16 aircraft were developed, for example. When two such people get to arguing, they disagree over the minor details but you get a great overall picture which would be extremely hard to find elsewhere. I find some of the specialist knowledge on blogs and in the comments fascinating: on one of Tim Worstall’s posts, a discussion got going on bell ringing of all things, and one chap popped up who turned out to be a keen amateur bell ringer and proceeded to let us in on the design, workings, techniques, and specialities of English bell ringing! As the moniker suggests, my business is oil…hence I add my experience/knowledge when I can.

    Comment by Oilfield Expat — February 10, 2015 @ 1:34 am

  7. CFTC Commitment of Traders data for WTI may not be the best to use as OI is heavily dominated by non-commercials. ICE publishes the same analysis for Brent and from my memory this has more PMPU players than WTI has players of all kinds all added up.

    Comment by Green as Grass — February 10, 2015 @ 7:55 am

  8. Dare I mention that the oil industry has always been subject to “boom and bust” cycles?

    Oilfield Expat mentioned that $50 is not especially low.

    Heck, a lot of people in oil-producing states can remember when it was about $10 – and that was not that long ago. Then the climb started – except this time it seemed to be much quieter than in the late 1970’s and early 1980’s.

    One can look to about the 1930’s roughly when oil was being sold for below the cost of production. A lot of it was being transported by railroads.

    Comment by elmer — February 10, 2015 @ 10:39 am

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