Introducing financial oil leasing

Posted by Izabella Kaminska on Dec 16 17:15.
The concept of ‘leasing’ commodities has been well established in the gold market for a while.
The lease rate for gold is derived from daily gold forward rates (GOFO) published by the London Bullion Market Association. You arrive at the rate by taking the GOFO rate — the rate at which dealers lend gold on swap against US dollars — from the day’s Libor rate.
The biggest lenders of gold have always been central banks, while gold producers have often been those most keen to borrow for the purpose of pre-selling bullion to cover operating and extraction costs.
But while there’s been much discussion about the financialisation of oil as an asset class, much less has been written about how that transformation would inevitably lead to oil becoming a leased commodity in the gold sense, too.
Among commenters who have observed trends on this front is Chris Cook — an avid watcher of crude and product market developments, a former director at the International Petroleum Exchange and regular FT Alphaville commenter.
As he explained in a recent comment on a post featured on The Oil Drum, where he also contributes (emphasis FT Alphaville’s) :
It was the Goldman Sachs Commodity Index (GSCI) fund – which had a high component of energy – which first introduced the concept of ‘hedging’ energy price inflation.
In other words, people became interested in off-loading dollar price risk in favour of taking on energy price risk. Anyone familiar with futures markets will see that this is directly opposite to the wish of producers wishing to ‘hedge’ energy price risk in favour of taking on dollar price risk.
The point is that the motive of investors in doing this is the complete opposite of speculation, and in my view, the wave of Exchange Traded Funds that have piled into the market are beneficial in the genuine liquidity they provide to the market.
Unfortunately it is they, rather than manipulative producers and speculator intermediaries who have been mistakenly pilloried as the culprits for the ‘Spike’.
Perhaps the most important recent development in recent years was the smart move by Shell in 2005 in entering into a joint venture with ETF Securities. What this enabled Shell to do was to put to work some of their idle capital sitting in the form of oil either in tank, or even in the ground (where storage is free). Essentially investors loan dollars to Shell, and Shell loans oil to investors.
And as Cook goes on, there may be a key macro economic consequence of all this that differentiates it to the gold scenario:
Other players were not slow to pick up on what Shell had done, and it is from this point on that we saw fund money – from 2007 on flying from financial market risk – pouring into the energy market facilitated by a great deal of hype, and an arbitrage taking place opaquely inside and by reference to the global market price set by the BFOE complex of contracts.
Since there are now only about 70 cargoes (of 600,000 bbls) a month coming out of the BFOE oil fields it will be seen that it does not take too much money on the part of anyone so minded to support the price, insofar as it was necessary – and it is of course the case that oil supply and demand are increasingly tight.
I think that some producers came to realise that oil is more valuable in the ground, and that it may be good business to support the price by influencing the BFOE price in a not dissimilar way to that in which the International Tin Council supported the tin price pre 1985 by buying in stocks of tin.
Oil producers’ motivation to do this redoubled after the financial crisis commenced and interest rates went essentially to zero – - the “zero bound”. Why produce oil and exchange it for financial assets yielding 0% ? Producers preferred to lease or lend their oil instead. At this point we were seeing not just oil but all commodities becoming detached from real world supply and demand, and the forward price curve in commodities began mirroring the yield curve.
All of which might help explain the perpetuation of the contango in the oil futures curve.
Related links:The business of oil leasing - FT Long RoomWas Volatility in the Price of Oil a Cause of the 2008 Financial Crisis? – The Oil Drum