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The Crude Oil Futures Bubble

Commodities / Crude Oil Mar 26, 2010 - 08:07 AM GMT

By: Money_Morning


Best Financial Markets Analysis ArticleKent Moors, Ph.D writes: Sometimes big things come from small meetings.

As an example, consider one particularly contentious 1927 session at the Royal Institute of International Affairs that took place at Chatham House in the center of London's Westminster. It originated an idea now used worldwide - the famous Chatham House Rule. Under its most recent revision (2002), the Rule allows the participants of a meeting to use the information received there, but prohibits them from revealing the identity or affiliation of anyone else present.

The Chatham Rule also governed the meetings I attended at Windsor Castle outside London from a recent Friday through to the early-morning hours of the following Monday. These meetings were the annual consultations of the Queen's Windsor Energy Group, which were meant to be private, high-level, discretionary advisories. This is one of the few "old boys" clubs left in the world where talk can translate directly into action.

Twenty-seven of us comprised the formal consultancy under the Rule. We came from around the world to meet, review the year's energy developments, and make recommendations. We stayed in the castle and held closed sessions, where some very heavy hitters hammered out the "Windsor Perspective."

About 50 other figures made up the audience at larger daytime sessions, although those individuals left the castle grounds each evening. The group included ambassadors of nine countries and representatives from five others; four British cabinet ministers; members of Parliament; officials from the Bank of England (BOE), the European Union, and the European Central Bank (ECB); as well as principals of major oil-and-gas companies.

But the real action was in the small consultancy meetings.

And here the Chatham Rule kicks in. I cannot mention the participants. I cannot give you the true flavor of the most enthralling policy debates I have ever experienced without violating the "who said what" part of the Rule.

However, I can tell you what resulted.

A strategy was worked out and recommended. It provides a new and more-direct avenue for investors to profit from what is coming. It will initially emerge in the way oil financing is worked out in London (now the leading center for such things).

And you are literally hearing about it here first.

The Oil Futures Bubble
I intended to propose at Windsor a way to improve investor prospects in the new oil environment that's forming as the financial crisis levels off. Well, I made the proposal, and some of the most amazing minds in the industry helped to improve it.

What resulted in the wee hours of March 8 could well change how you approach investing in oil. It will almost certainly improve the prospects of the average investor.

As volatility intensifies in the oil market (still the lightning rod for the entire energy sector), determining genuine asset value and investment decisions becomes more difficult. While oil prices will be increasing, the rise will not result in corresponding increases in the genuine value of underlying assets.

This problem has occupied much of my time over the past several months, and the reason is simple - if left unchecked, this gap will result in a global financial bubble far worse than the subprime mortgage meltdown.

There is a solution, but it requires the market to have sufficient liquidity provided by small investors - like you.

Why? Because the major players straddling the paper barrels (futures contracts) and wet barrels (consignments of actual oil) are designing new, ever-more-complex, synthetic debt and swap instruments to make the increasingly square pegs of futures fit into the round holes of oil deliveries.

Simply put, the market price for oil futures does not reflect the actual value of the oil itself. What it does reflect is the value put on derivatives by traders who need a profit spread on that paper to stay in business.

Sound familiar? This is exactly how the current mess started.

With oil, however, the impact will be far more pervasive.

Oil is now a financial asset, not simply a commodity. That means trade in its future prospects attracts a lot of speculative attention bearing little relation to the oil itself. Much like one can bet on the total number of points scored in a football game (the "over-under") without caring who wins, so we are witnessing growing interest in maximizing the price spread of futures over "real oil." Both are derivatives - one on a sporting event, the other on a commodity. Neither should be considered reality as such.

Unfortunately, that is what has happened with oil. Greater investment concentrations into futures from investors with little interest in oil deliveries will produce new derivatives to squeeze speculative value out of yet other derivatives. That progressively undermines the market value of the oil itself.

Unless, of course, we change access.

That would require broader-based participation in price-setting, and at Windsor, we ironed out a way to do just that.

A Tradable Connection Between Oil Futures and Oil Barrels
Within the next few weeks, the Windsor Perspective will propose to the London Stock Exchange financial gurus the introduction of new exchange-traded funds (ETFs) reflecting the value relationship between oil as a commodity and oil as an asset - to bridge the gap between the oil of the speculators and the oil of the delivery market.

The difference over what currently takes place is this. An instrument so designed would allow hundreds of thousands of small investors to price the relationship and thereby provide a way to peg futures contracts more firmly to the value of the underlying asset.

It allows the little guy to participate in the arena where the big profits are being made.

Now, an ETF needs a real tradable asset upon which to operate. In oil, that has meant instruments based on oil for delivery. As the derivative market progressively established its own asset (the futures contract), an ETF based on the actual crude oil provided little reflection of what was developing (or, for that matter, where profits were being generated).

However, we have now reached a point where a tradable connection between two divergently developing oil assets (futures and barrels) is not only possible, it's necessary.

The approach should be pilot-tested in private trade, followed by the announcement of a London index reflecting a moving average (probably 30-day) to act similar to volatility indices (VIXs) already in use.

That will be followed by a new tradable paper that should finally give the average investor access to the real money-making. One of the side benefits should also provide some stability for traders to set realistic option swaps for futures contracts, curbing the primary problems resulting from cycles of volatility in pricing futures contracts.

Seems the little guy is back in the game ... and now with an opportunity to change how that game is played.


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