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The new structural change caused the oil price Collapse

cushing Since the major oil companies started to share market power with OPEC in the 60s until today, the structure of the oil pricing has been evolving towards freer trading and price transparency. What happened in 2014 in the oil market was not only a sharp fall in crude oil prices, but rather another major structural change, revealing itself in the form of a price collapse.

Most people argue that "this is not the first time that crude oil prices experienced severe changes. It happened in the 70s, in the 80s and also in 2008, therefore 2014 is not an exception".

Granted, but this past volatility of oil prices was caused by structural changes from oligopolistic structure to more competitive and transparent electronic oil price discovery.

The wet barrel needs the paper barrel

In the 1970s, the official fixed price structure of "OPEC Benchmark Price” changed to “Spot Market Price Assessment by private agencies" Causing the price volatiles at the end of 70s ".

In the 1980s, another structural change in response to the immense volatility in the physical oil markets under a system of daily "Spot Price Assessments by private agencies " led to the need for hedging to manage market risk. The NYMEX in 1983 launched crude futures contracts and IPC (later ICE) successfully launched the futures Brent in 1988, as a "Risk Management System" (paper barrels) and as a result hedging emerged.on the futures market

In 2008, another structural change took place in the form of collapse of prices, as Screen trading on the New York Mercantile Exchange (CME) Futures Market became hyper-active in physical settlement with Cushing, Texas as delivery point . ICE , launched a successful and strong cash-settled WTI futures contract in Europe in 2006 which created the two price concepts, Brent "paper barrel" on ICE and WTI physical barrels on the NYMEX CME. Up to 2008 it was the tell of the two oil titans battling to win futures market supremacy

In 2014 again a new structural change has started and revealed that futures markets are mushrooming around the world and are showning how business in oil should be done leaving OPEC, the major oil suppliers, frackers, the bankers and even the governments stunned on the sideline as spectators.

ICE Brent became the world’s largest crude oil futures contract in terms of volume and its market share has almost doubled since 2008 becoming the basis for 70% of global oil trade. The growth of NYMEX Physical settlement ( wet barrel ) was also massive but the delivery point at Cushing could not handle the growing volume leading to increase of “ WTI-Brent spread” making WTI Irrelevant benchmark, compared to Brent cash-settled , with undefined seaborne delivery point .So, The increase in domestic crude oil production in the US from 2011 till now began to overran the Cushing ability to move out the contracted crude on NYMEX to where it should go on the Gulf coast (USGC), leading to a massive build-up of 55 million barrels of crude inventories in Cushing in June 2013.

This created a supply /demand imbalance at the hub, causing the difference between (Brent-WTI) the two crude benchmarks, to reach $27 in June 2013. That is the biggest gap in history of the two oil contracts, which during the past 20 years moved within a corridor of -$1 or $1

cushing However, after the modernization carried out in Cushing, where crude piped-out capacity is now larger than the amount piped in, a new structural change emerged which turned Cushing hub into an efficient delivery point unnoticed until it was too late. A false signal to the futures market from Cushing coincided with a false alarm by releasing SPRs in March 2014 caused the collapse of the oil price in 2014.and It started from the electronic screens of the futures market indicating the supremacy of the futures market as the new means of crude oil price discovery.

cushingToday, the major produces enjoy leadership only at certain price level. It is important to notice that the supply curve is not a continous curve, but kinked. The blue points on the curve ( the red is the supply curve) At a level below the " kink", say $50 price, the majors still have the role of price makers, based on " take it or leave it " pricing system, as few can supply at this price..... but above the kink, the supply curve becomes elastic and invites more suppliers to the market, but even at these price levels, the futures market will continue to decide the width of the price corridor, playing the role of balancing the market.The question is where is the "kinks" on the supply curve and who is monitoring these moving points on the curve?

The survival of the fittest

Briefly, in the 70s, the price was fixed by OPEC while the level of oil production was left free to be determined by the oil market, while in the 80s, the system was reversed. OPEC production was fixed and the crude oil prices were left for the market to choose.Now the new structure is left entirely to the Futures market to choose both prices and production level. The new system is clearly stated by many OPEC ministers "We will let the market to decide….".

The Search for the Kinked Point

With OPEC supplying around 30 Mb/d out of 92 Mb/d of world oil supply, now the "futures market" is searching for: "The Price" at which the remaining 62 Mb/d could be supplied from outside "OPEC". This is a hard pill to swallow, but that is the outcome of a sequence of changes in the structure of the oil industry over the past 40 years. The trend is clear that “Futures market “ is more suitable for price discovery for the physical barrel than the spot price assessment by private agencies

Cushing:Hell Gate


Enlarge Figures reported by the EIA on Dec 31 2014, (Click the left image) shows The two reasons for the collapse of the structure of the International Crude Oil system.The Cushing Crude oil inventories stood at 44 million barrels (see the graph) On Jan 20014, When the fastest and largest stock draw down started in living memory to reach its minimum 0f 19 million Barrels In September 2014 .

These figures were taken by the Futures market, as shortage of supply consequently the Market went bullish WTI on futures market NYMEX ( CME )jumped to its maximum see (Graph)

cushingWait . In fact , that was the worst signal the futures market have ever received from Cushing, The massive draw down of crude of inventory in Cushing was not because of excess demand , but due to The moderation of the infrastructure in Cushing(as mention above)j Crude oil inventory was just moving from Cushing hub Storage to USGC Storage. And also to storage in Pad1Leaving the overall USA inventories to escalate to its maximum of 388 million barrels in March and the WTI also standing at its maximum!!!

(Click the next image) for the level of commercial crude oil inventories in USA

That is to say, with weak demand, the Total Commercial stock of crude oil in USA increased, and not decreased prices should have gone down during that period, ( click the image).The lesson is, never look at Cushing again for Signal it has change. Cushing is just an oil Junction now .To know the true inventory level , one should look at the USCS plus Cushing inventory for any Market signal.

SPR the bullet in the head

cushingThe second reason was, that pushed inventory up even further , was The USA state Department decision to release crude from SPR (Strategic Petroleum Reserve was 700 Mb of crude oil on Jan 014 ,stored in vast salt caverns used only if USA is confronted with an economically-threatening disruption in oil supplies.).

In the past, SPR releases have occurred three times . First, in 1991, at the beginning of Operation Desert Storm,The second was in September 2005 after Hurricane KatrinaThe third on June 23, 2011, during the unrest in Libya.

We must also mention that twice in the past, the Administration has conducted test sales to ensure the readiness of the Reserve . The first took place in 1985 and the second in the 1991's before Operation Desert Storm. Also Non-Emergency Sales were made three times during 1996, to raise revenues. The total quantity sold was 28.1 million barrels from the SPR

The USA State Department, took the market by surprise.On March 14,2014, during the crisis in Ukraine, and the annexation of Crimea by the Russians , the white house decided to release 5 million barrels of crude from SPR to be released on May 10 2014 .The reason for the release was given "Due to the recent dramatic increase in domestic crude oil production, significant changes in the system have occurred . The White House said the release was only a test and was not linked to tensions with Russia .

That was the mind blowing decision, ,and all were caught by surprise because any withdrawal from SPR , no matter how small, is confined to Emergency , but carrying out SPR test at the height of Ukraine crisis , it amounted to advertising the seriousness of the situation, and surely gave the wrong market signal. Which oddly enough with a false signal from Cushing.With an earlier warning by Henry Kissinger: If "You Cant Hear the Drums of War You Must Be Deaf" caused panic stocking building, and who wouldnt panic.

So, This was taken by the Futures Market to mean starting from March 2014 ,as "Emergency, full your tanks ,and there is a "threat to supply interruption from Russia". As a result, the Futures Market went bullish ,prices increased , the USA Crude inventories reached maximum for speculative purposes, because speculators were still looking at Cushing inventories which showed mistakenly at minimum

During this period, Export of petroleum products stayed at its lowest point at 2668 Mb/d , while import of crude was still arriving to refineries that were working already at their lowest utilization for the year.,at a time the Russian were threading to stop the gas supply, giving more imputes to Brent price to rise .

A False Signal and a False Alarm from Cushing to NYMEX

cushingWe saw for the first time both crude prices and Inventory level moving in tandem reaching the maximum . That was the situation in May and June 2014,all was bullish and USA production of crude was increasing too,until, suddenly, the gate of hell was opened on the Oil Industry in June and July 2014, when the market discovered that ,the prospect of supply interruption was false alarm( see the Time line) , the drums of war went quite again, The, avalanched started, traders and oil companies began to move their crude oil out of the giant tanks faster than at any time in recent memory. selling at any price, export of petroleum products increased sharply to reach 38404 mb/d , import of crude was reduced leaving the international market with surplus: and Brent WTI spread reaching the minimum for the year, see graph , refiners returned to %84 utilization and With weak demand camouflaged by events in the middle east, which we reported at that time ( Read below Hydra)

Prices began caving in. While who knew what was going ,went "short" and made billions , as for those who listened to the drums of war should be deaf by now.... The lesson is: Emergency Reserve is for emergency, and the timing of the release, if it was for "testing" then it was badly timed and proved to be the reason for the crisis, at a time when Cushing was also discreetly changing from Gate of Hell to an ordinary junction

Economical to restock at $55

That is not the end of the story. Destocking during this period in panic, meant a fall in commercial inventories from 388 to 233 which is just too much. Therefore a new wave of crude oil stocks has started again and also beyond and above the seasonal requirements everywhere. China is restocking, and Cushing is full again.( Even the crude oil producers in OPEC and Russia are also Stocking( another way of production cut!!!) Because at $55 per barrel it is economical to add to inventory, if they are full, then slow steaming tankers will be a better choice, this process will go on until March. . we have now the new catalyst For revival of demand, which restocking.

We also still have the statement of HE Saudi oil minister, that "Crude price falls are temporary". Indeed, part is temporary but the other part has to wait for the economic rebound in the global economy. But according to our data , the global economic situation is now at the top of the recovery that started in 1982, and we are heading now in a cyclical manner towards the next mini recession in 2016.

While all are busy nursing their wounds. we have the Futures Market is searching for the price that will balance the market again. The Oil prices remain a mystery , as long as the picture between USA and Russia changes Constantly

The Oil prices remain a mystery , as long as the picture between USA and Russia changes and the Middle east Constantly

Jabbar al-Jaf former OPEC Econometrician Analyst