The problem with ETFs is how they function. The 50/50 bet may take place on exchanges – the NYMEX or ICE – which act like casinos. But if ETFs are unable to participate in exchange traded derivatives then their only option is to enter into over-the-counter swap contracts with trading intermediaries. And the price upon which these contracts are based or “derived” comes from the wildest game in town: the Brent/BFOE complex of contracts in North Sea crude oil.
The BFOE Last Chance Saloon
The global benchmark price for crude oil has nothing to do with exchanges; they are the visible tail of an invisible dog.
The price is actually based on prices reported by Platts for “dated” cargoes of 600,000 barrels of BFOE quality oil (from the Brent, Forties, Oseberg and Ekofisk fields in the North Sea) available for spot delivery. Over 60% of world prices are set directly against this benchmark, while most others are priced indirectly through arbitrage on the ICE Europe platform between the BFOE contract and the “clone” of the NYMEX's WTI (West Texas Intermediate) contract.
Neither the ICE Europe’s BFOE futures contract nor its WTI contract are physically deliverable – both are essentially financial bets on underlying market prices. The BFOE contract is based on the price of the BFOE forward contract (known as the 21 day contract due to its delivery cycle) which allows BFOE producers to sell their production forward, giving rise to “dated” deliveries of cargoes.
North Sea production is in secular decline and there are now only about 70 BFOE cargoes produced per month, worth (at current prices) around US$3 billion. It seems to me that it is well within the financial capabilities of major traders such as BP, Goldman Sachs, Shell, Vitol and Phibro to secure enough cargoes (by purchasing 21 day BFOE forward contracts) to manipulate the short-term market price at will. It is even possible that with a self-fulfilling campaign of manipulative price forecasts, judicious intervention, and leverage based upon hundreds of billions of dollars in ETF investment in the market, these traders could influence medium term prices.
In the long term supply and demand for physical oil will of course set its price. But in the short and medium terms volatility can be created, not by ETFs but by the speculative activity of trading intermediaries.
So What Are Your Real Odds?
The first thing energy ETF investors need to know is what odds they really face. These are decided by a few key factors.
The first is the cost of trading. This has three components: management costs, which are reasonable compared to actively managed funds; commissions, which may be minimal but do add up given that positions roll over once a month; and finally the “dealing spread” paid when an ETF, for example, sells January crude oil futures at a counter-party's bid price and buys February futures at the counter-party's offer price.
The second factor is the market price structure, which is something of a wildcard. If the market price is in contango (i.e. earlier months cost less than later ones) then the ETF loses money when it rolls over from month to month. Conversely, if the market is in backwardation then the ETF makes money.
The final factor is the return ETF investors receive with respect to their cash balances.
So in reality, working out what return you will get from an energy ETF isn't as simple as it first looks.
Being Asked To Leave The Casino
In casino parlance, an ETF is a “whale” – a big player. Unfortunately, it looks as if the casino regulators – the CFTC – are about to limit the maximum bet by imposing position limits, effectively obliging ETFs to go to a private OTC swap game if they want to play.
Energy ETFs are, as the marketing literature makes clear, actually an inflation hedge. They offload the price risk of money and take on the price risk of energy. ETFs are prepared to buy futures every month when producers hedging the price risk of production wish to sell. Better still, they may do so at levels which are advantageous for both parties – in contrast to those available from the trading intermediaries who own and control the casinos.
The only market participants capable of manipulating the physical market price of oil in the real world are those capable of making or taking delivery, and ETFs are categorically unable to do so.
Does anyone seriously think that if exchange position limits were good for ETF investors then investment banks would go along with them? They know that limits will drive ETFs straight into the BFOE Last Chance Saloon.
The “London loophole” gleefully jumped upon by uninformed US politicians simply does not exist. The real problem is the global “physical loophole” in the actual market in real, not paper, oil. If you have any doubts then ask yourself this question: Why is GLG – noted as one of the smarter hedge funds around – setting up a physical energy operation? Answer: Because that's where the money is.
Chris Cook is a well-known commentator and expert on the petroleum markets. He was formerly Director of Compliance and Market Supervision at the International Petroleum Exchange.