<DrumBeat: March 29, 2007 The Oil Drum GAO Peak Oil Report Thread>

120 comments on Financial Intelligence: How Arbitrage Forensics Provide Insight into Saudi Knowledge

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bunyonhead on March 29, 2007 - 10:07am Permalink | Subthread | Comments top

- "If the future contract is trading at higher than this predetermined cap, then arbitrageurs can make risk-free profit—they sell the future contract, buy the spot oil, and store it until the future contract matures, collecting the excess as profit."

Try booking 12 month storage at Cushing from the storage owners, they will extract the full rent the market pays in the forward contango and you will end up losing money. There is no such thing as a risk free profit except in text books.

- "If it can get $68 today for oil to be delivered in 2012, and it honestly expects oil to be trading in the $60s in 2010, it would be crazy not to sell the future today and invest the money in a bond or other financial instrument. Even at a 3% rate of return above inflation, selling a Dec. 2012 contract today for $68/barrel is the same as selling that same oil in Dec. 2010 for $81/barrel (in 2007 dollars). "

The seller of 2012 $68 futures contract will only get paid the money on delivery of the product in 2012. Thus the NPV (at 3% bond rates) is $55, not $81 (haven't checked the math, but going by the example given)

In simple terms, imagine agreeing to sell your house to someone else for $X, the sale to go through in 2012 and money to change hands then. To monetise this, you have to take the contract to the bank who will then discount the value by the interest rate applicable and the risk of the eventual buyer defaulting at some point between now and 2012.

The bank is going to discount by a rate higher than the average 5 year interest rate and then give you a credit haircut on top of that, and a risk haircut if your house is in Iran, Angola, Saudi, etc, for example....

In other words, though futures prices are nominally higher, they are lower than spot prices in terms of net present value.

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jeffvail on March 29, 2007 - 10:18am Permalink | Subthread | Parent | Comments top

Bunyonyead-

Two good points that both represent barriers to entry to the world of arbitrage for small-timers. But they don't apply to producers and institutional players--the ones whos behavior are dictated by these dynamics.

If I want to go book storage for a thousand barrels of oil, I won't get a great price. Major players, on the other hand, can demand efficient pricing for oil--because they have the leverage to own their own storage facility if industry providers aren't providing it at a competitive price.

Likewise, if you sell one 2012 future, not only do you not get the money now, but you have to actually put up money to cover your liability. Major producers, however, are treated differently. They get a significant chunk of the money today if they operate on the NYMEX, and they can do even better if they enter into forward contracts that track NYMEX prices.

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bunyonhead on March 29, 2007 - 10:36am Permalink | Subthread | Parent | Comments top

Jeff,

Agree in theory. However.....

Building new tanks may be more difficult in practice than in theory, planning permission etc. You still have to pay to access pipelines, etc. Anyone building new tanks is doing it on the Gulf Coast where the real market for crude is, not in Cushing.

Major producers sell forward swaps to banks (Goldman, Morgan Stanley, etc). The banks discount them for interest rates, credit risk, location risk (resource nationalism etc), war risk, etc, etc, etc. Ultimately they get less than spot price on this...

I am not aware of any major producer selling futures strips on NYMEX, margins are too high and liquidity is too low. The banks do all this business and there is constant flow of forward producer selling in the swaps market.

Addendum: a LOT of forward producer business has been done in "costless collars" where producers buy a put option below the market and sell a call option above the market (eg $50 and $80). They are therefore guaranteed a minimum of $50 and a maximum of $80 and take floating price vs NYMEX for anything in between. There has been so much of this business in the last few years that put options are priced relatively higher than call options, known as an inverse risk reversal skew. Crazy, but true, and a reflection of real pricing flows in the market...

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SonicTheHedgeFund on March 29, 2007 - 11:25am Permalink | Subthread | Parent | Comments top

For those who may not be familiar with the term "risk reversal", it commonly refers to the difference in option implied volatility between the .25 delta calls & puts.

I first encountered these in the FX markets back before the Euro came into existence. "Back in the day", large volumes of risk reversals traded on Dollar-Mark, Dollar-Paris, etc.

Correctly modeling the skew is crucial to more than just the pricing of risk reversals, but to screwball derivatives of all types (e.g., single- & double-barrier knockouts & knockins, in-the-money payoffs raised to a power and then capped, etc.).

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memmel on March 29, 2007 - 11:15pm Permalink | Subthread | Parent | Comments top

Trying to translate using my other post. I thin they are trading out to their strong probability positions.

Assuming I'm right and hedges are use to setup big win probability distribution and limit losses. At the end of the day I cant see how positions don't translate into probability maps of gains and losses with various crystal balls. This means even slight contango in the market snapshot is a big deal.

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wstephens on March 29, 2007 - 10:53pm Permalink | Subthread | Parent | Comments top

"They get a significant chunk of the money today"

Are you sure about this? My understanding is that commercials get a lower margin than specs but that it's still a margin. Your comment seems to refer to forwards (off exchange) rather than futures.

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OilcoEx on March 30, 2007 - 4:48pm Permalink | Subthread | Parent | Comments top

forwards are not settled until the positions are closed either. Low credit players might have to put up an L/C to cover the risk, but no money changes hand. Better risk players will have margining agreements with each other...

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OilcoEx on March 30, 2007 - 5:41pm Permalink | Subthread | Parent | Comments top

wrong

Major producers, however, are treated differently. They get a significant chunk of the money today if they operate on the NYMEX, and they can do even better if they enter into forward contracts that track NYMEX prices.

all players on the NYMEX have to post margin. It's less for the big boys with good credit, but there are no freebies. And no one collects on open positions until they are closed.

No one pays on forwards until they are closed either. margining takes place unless the entity is given open credit. No doubt Saudi would get open credit from Morgan, but no money flows would take place until settlement.

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wstephens on March 29, 2007 - 10:21pm Permalink | Subthread | Parent | Comments top

"buyer defaulting"

The exchange prevents this from happening in futures contracts by acting as the intermediary party -- and keeping margins current by daily settlement.

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Jack on March 30, 2007 - 1:16am Permalink | Subthread | Parent | Comments top

I also don't think it is correct to use the risk free rate to discount Saudi's cash flows.

The discount rate should be Saudi's cost of capital, or the return they would get on the next best investment with a similar risk profile. Storing a volatile commodity is hardly risk free, even though Saudi may have special knowledge and ability to influence the price. I would be an interesting exercise to try to calculate an appropriate cost of capital for this investment. There are an awful lot of factors involved. I would guess a reasonable estimate would be more like 7-8%.

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OilcoEx on March 30, 2007 - 4:50pm Permalink | Subthread | Parent | Comments top

the debate is meaningless. The saudis don't hedge. Neither does Exxon or any of the other majors on their forward crude production. The sellers down the curve are smaller players that have high cost production and banks eager to make sure their loans get paid.

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120 comments on Financial Intelligence: How Arbitrage Forensics Provide Insight into Saudi Knowledge

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