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Derivative Manipulation Hits the Oil Market

by | published May 7th, 2012

Friday, the price of West Texas Intermediate (WTI) crude, the benchmark oil contract traded on the NYMEX, fell 4% ($4.14). It opens today below $100 a barrel for the first time since February 10.

The one-day decline is the steepest since WTI fell 5.1% ($5.12) on January 3.

The other major benchmark, London-set Brent, also was hit, but less significantly, falling 2.6% to open today at $113.16. It was the largest Brent decline since a 4.6% dive on December 14.

And the dip in both is likely to continue a few sessions more.

However, the Brent-WTI spread is now increasing again. As of the close on Friday, the spread as a percentage of the WTI price (the better way of looking at it) stood at 14.9%, the highest differential in more than two weeks.

Two important questions follow.

First, why did this happen? Second, what is that spread again telling us?

The answers will surprise you.

Roll Out the Usual Suspects

As prices fell, TV pundits immediately paraded the usual suspects. They cited disappointing U.S. job figures, renewed concerns over European debt in general, and the Spanish situation in particular, while so-called “analysts” clamored over a possible double-dip recession.

These concerns are not new, nor are they revelations.

Plus, the essential reasons why the price should be moving in the opposite direction – namely up – haven’t gone anywhere. The constriction produced by supply/demand considerations remain, and the insufficient volume available to meet unexpected demand surges and the geopolitical environment – especially the impending European boycott of Iranian crude imports – remain in full force.

The overall market dynamics still point strongly to a rise in price.

Yet the overall movement of crude oil futures has remained peculiarly restrained. In fact, WTI has given back 6.1% in the past week, and some 2.7% for the month.

Here’s what’s really happening…

Preparing for the Next Price Rise

The real reason we have witnessed a retreat in crude pricing has little to do with the condition of the market or the actual demand for product. It is the result of a classic yo-yo short in anticipation of a major advance in the price.

In other words, some very large traders in oil futures contracts – the so-called “paper-barrel” speculators of future actual consignments of oil (or “wet barrels”) – are manipulating a short-term cut in price after establishing a position that will profit with the price going down.

This amounts to a “put” clone resulting in an exaggerated decline in the crude pricing level, usually orchestrated on a five-day pricing spread introduced by a sequenced derivative move on the futures contract itself.

The trader profits when the price goes down by exercising the “put” to sell options on the futures contract at a higher strike price than that provided by the market by redeeming the derivative.

Of course, when that happens, the market price will increase. The trader then profits again by having derivatives on the increasing price already in place.

The price is manipulated just like a yo-yo moving up and down. Now the maneuver is only doable during periods of lower-than-average futures contract volume and a narrow period in which the price is not likely to spike because of outside developments (for example, natural disasters, a rapid escalation in hostilities, blockage of transit, collapse in production, and so on).

It becomes less useful when the market indicators themselves are decidedly moving up. The approach succeeds by wider market perceptions, not fact. It ends when the actual pricing dynamics take over. In between, a few traders make some bucks by manipulating the margins.

There will be little opportunity for this device to operate again as we move into the summer volatility.

The Iranian Embargo Looms

As for the second question, that widening Brent-WTI spread is signaling a renewed concern about the real market impact coming from the EU-Iranian embargo and the increasing inability of other producers to make up the difference over the long term.

Saudi Arabia has agreed to cover the initial shortfalls to the most highly vulnerable European importers – Greece, Spain, and Italy. But that additional volume will not guarantee price moving forward. And it will also result in both price increases and market dislocations in other regions relying on Saudi exports – Asia especially and, in particular, India.

Spain attempted to secure additional oil from Nigeria but was told the African producer could not cover additional needs resulting from the embargo. Russia may benefit in the near term, but that will certainly increase prices paid by Europe.

All of this is reflected first in Brent because it is the benchmark most impacted by these developments. However, it will be translated into rising WTI prices as well, since the price in the U.S. is still reflective of the price in Europe due to imports.

The increasing spread, therefore, tells what is really going to happen.
Crude is going up.

Despite what a few very large short artists will pull off now and then in the hazy funny paper world of exotic derivatives.

Sincerely,

Kent

Editor’s Note: Kent uncovered this WTI-Brent story months ago, and with the summer fast approaching, now is the time to get set up to profit… before we see oil prices spike through the roof.
To learn more, go here now.

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  1. May 7th, 2012 at 12:01 | #1

    SIR. what happen to oil & Energy Investment,with 8 mini-penny
    philippine oil Shares. thank you ED.

  2. Roger Richards
    May 7th, 2012 at 12:08 | #2

    Your analysis on the oil price status was right on except for your explanation on India’s oil requirements. I have recently read that India has solved their oil supply problem by making a contract with Iran to supply their oil!!

    Is this true?

    Thanks,

    Roger

  3. May 7th, 2012 at 12:17 | #3

    I am using Kent’s analysis as my contrarian opinion. Refiners in the US are exporters of gasoline and still losing money and several have shut down. Oil usage is trending down due to more efficeint vehicles and useage of natural gas as well as the world wide recession. Sure the Arab production problems ‘loom’ but one cannot invest on a possible disaster event. Keep your higher oil prices story going!

  4. May 7th, 2012 at 12:18 | #4

    ..if you were to purchase 3 of your recommended stocks, which 3 would you select?

  5. stan
    May 7th, 2012 at 12:36 | #5

    The boycott of iranian noil is obviosly a joke

  6. John Walker
    May 7th, 2012 at 19:59 | #6

    Obama is in full re-election mode and Saudi Arabia announced they would pump all they could pump untill Obama is elected. Enjoy while you can!

  7. Stephen Arbeit
    May 7th, 2012 at 21:48 | #7

    I know you won’t criticize a fellow analyst, but your comment on the following quote from the S&A Digest would be greatly appreciated by those of us investing in your portfolio.

    “Oil falling to $70 a barrel?… Porter’s bearish forecast. . . Is the big oil correction finally here? Last week, WTI crude oil plunged 6.1% to reach its lowest price in four months. Several analysts at S&A say the press is missing the big picture: that oil prices are poised for a big decline. Thanks in part to new technologies allowing domestic drillers to access vast new resources, oil inventories are historically high right now… and set to grow over the coming years. This will push the price of oil down significantly from its current highs. The most outspoken “oil bear” is Porter Stansberry. Porter told the audience that oil is headed for a big move down. Porter says this bear market will be driven by the large and growing new supplies coming from recently discovered shale oilfields. He says many heavily indebted oil and gas companies will go bankrupt as a result of the supply surge. . . . prices have surged from $70 a barrel in 2010 to nearly $110 a barrel this year. But last week’s 6% plunge produced something called a ‘downside breakout.’ This is a term used to describe when an asset breaks through to new price territory. If Porter is right, crude oil could easily return to 2010 levels… or lower.”

  8. sfamc2
    May 7th, 2012 at 21:55 | #8

    What does this mean:
    The real reason we have witnessed a retreat in crude pricing has little to do with the condition of the market or the actual demand for product. It is the result of a classic yo-yo short in anticipation of a major advance in the price.

    In other words, some very large traders in oil futures contracts – the so-called “paper-barrel” speculators of future actual consignments of oil (or “wet barrels”) – are manipulating a short-term cut in price after establishing a position that will profit with the price going down.

    This amounts to a “put” clone resulting in an exaggerated decline in the crude pricing level, usually orchestrated on a five-day pricing spread introduced by a sequenced derivative move on the futures contract itself.

    The trader profits when the price goes down by exercising the “put” to sell options on the futures contract at a higher strike price than that provided by the market by redeeming the derivative.

    Of course, when that happens, the market price will increase. The trader then profits again by having derivatives on the increasing price already in place.

    I understand Kent’s analysis, but NOT this time?

  9. Vir
    May 7th, 2012 at 22:13 | #9

    Hello,
    When i should make entry in Silver upword rally.

    thx,

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