Providence Resources - Interesting Analysis: Dr Moors - ShareTweet+ 1Mail The conflict between...

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The conflict between OPEC and U.S. shale/tight oil producers has entered a new phase. And the result has been an accelerated decline in oil prices.

Last November (on Thanksgiving no less), Saudi Arabia led an OPEC decision to hold production stable, followed by a later significant increase in volume. For the first time, the cartel had opted to protect market share rather than price.

This certainly did not serve the interests of some OPEC members – Venezuela, Nigeria, Libya, Iran – who require much higher prices to balance unwieldy central budgets

The primary opponent was the new source of oil in the market – unconventional production from North America, the U.S. in particular. Thereupon began a tug of war that has largely determined the range of oil pricing variation over the past eight months.

This is what is strange about all of this. Essentially, the same market conditions prevail today as existed a year ago when crude oil was exceeding $100 a barrel. In fact, global demand is higher now than it was last July and accelerating. The price, on the other hand, has been cut in half.

To be sure, there is excess supply on the market (thanks to the remarkable recovery of American production, now at levels not seen in 40 years), and a correction was in order even without any OPEC move.

But that correction was more in the order of a decline to the low $80s or mid $70s. That has gone down much further because of what outside pressures have done to the trading environment.

Here’s my take on the international scheme to keep oil prices down…

The Big Players Still Play Dangerous Shorts

As I have noted here in Oil & Energy Investor on a number of occasions, the interchange between “paper barrels” (futures contracts) and “wet barrels” (actual consignments of oil) has been undergoing some major changes. It is the financial contract, not the allotment of crude, that drives the market.

When prices begin showing weakness, the manipulation turns to shorting oil. A short is a bet that the price of an underlying asset will decline. Control of a commodity (or stock shares, for that matter) is acquired by borrowing from a dealer. What is borrowed is then immediately sold. The short seller later returns to the market, buys back the asset, and returns it to the original owner.

If the short seller is correct (or has manipulated the market through huge positions to make it correct), a profit is made. Take this simple example. A futures contract in oil is obtained at $70 a barrel and sold at market. When the contracts are reacquired (i.e., the short seller buys at market to return the contract to its source), the price of oil has declined to $62. The transaction makes $8 a barrel (with the contract usually for 10,000 barrels), minus whatever small fee is paid for the right to use (temporarily) an asset actually held by somebody else.

Now, shorting is a component of the market. It remains quite dangerous for the average investor because there is theoretically no limit to how much you can lose if the value of the underlying asset goes up after the initial sale. It still must be bought back and returned, regardless of how much it has appreciated in price during the interim.

Some shorts are even more dangerous and are now limited or prevented by regulators. These involve running a “naked” short, a short contract without actually having the underlying commodity or stock to begin with.

Big players can sometimes do this by stringing together options and other pieces of derivative paper. Nonetheless, a really bad move here can bring down a trading house. For the individual retail investor, it is a direct way of losing the farm.

Two SWFs Have Been Shorting Oil…

But what if the underlying asset upon which the short is constructed – both its availability and amount – is under your control? What if you are shorting your own product?

Normally, this would be considered insane. Why deliberately reduce the price charged for your source of revenue? Why guarantee that you are going to be receiving less?

This makes sense only if the short is run for a different objective, one for which the short seller is prepared to take a price hit short term for more market control longer term.

Well, this is what OPEC nations have been doing at least over the past three weeks. Indications have surfaced from the volume and direction of paper makers in Dubai and on the continent that at least two Sovereign Wealth Funds (SWFs) from OPEC members have been shorting oil.

This is the latest stage in the competition with shale producers. By driving the oil price to below $58 a barrel, sources are indicating between 8 and 12% has been shaved off the Dated Brent benchmark price.

Brent is one of two major benchmarks against which most international oil trade is based. The other is West Texas Intermediate (WTI). Brent is set daily in London; WTI in New York.

…Depressing Brent Prices

Statistics for what shots are run in the U.S. are transparent. This is not the case in many other parts of the world. There, indication of movement is gained by what financing middlemen do.

As of Tuesday of this week, sources confirm that oil shorting contracts beginning on June 15 have increased markedly from Persian Gulf interests. Brent prices have declined 13.8% in the six weeks that followed.

According to sources cutting the paper, primary among the short contracts sold and purchased has been action sponsored by two of the largest SWFs in the world: SAMA Foreign Holdings (Saudi Arabia) and the Kuwait Investment Authority. In each case, financial intermediaries are used for the actual transactions. Other SWFs are suspected.

It is certainly possible that an SWF may short oil merely as a revenue-gathering device. After all, such funds are investing excess capital to gain a return and they exist all over the world.

But short sales are rather uncommon with these huge outfits; they would rather have longer-term returns from less volatility instruments.

Both of the SWFs identified obtain their funds from oil sales. The shorts constitute undercutting their own profits. However, the objective here is not to gain a return. They are, after all, assuring a reduced revenue flow from the very asset providing their own funding.

Why the Funds Are Playing This Game

This is a policy decision, not a fiduciary one. It is intended to drive the price down, prompting the closure and/or reduced operations of primary oil production competitors. And it is likely to have the intended affect as we move into unsustainable debt loads for many American shale producers, rising bankruptcies among smaller operators, and a resurgence in the M&A curve.

The shorts guarantee a loss of income but are orchestrated for other reasons. Obviously there are other shorts being run by interests having nothing to do with OPEC. In fact, as the major short positions emerge, it makes it that much easier for others to follow suit.

OPEC is proving a point by (at least in the short term) shooting itself in the foot to clear out competitors.

Short positions need to be unwound and settled. This will happen quickly. The Saudi Oil Ministry announced yesterday they expected the dip in crude prices to be ending soon.

Easy enough to say when major crude providers have been driving prices of their own product down all along.