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The Underlying European Oil Contagion

by Dr. Kent Moors | published August 19th, 2011

As we await another down day on Wall Street, attention once again turns to weakness on European banks as the culprit.

Actually, that seems to be only half the situation.

Crude oil in New York is poised to move down again this morning, following upon an almost 6% drop yesterday. Brent in London, however, dropped only half that and, despite the bank problems and the ever-present continental debt worries, is going back up again today.

At close yesterday, the spread between the Brent benchmark crude price and WTI (West Texas Intermediate, the benchmark used in NYMEX trading) stood at over 29% of the WTI price.

Remember, as I have mentioned here many times before, WTI is a better grade of oil than Brent. That should mean, if normal market conditions actually dictated trade, WTI prices would be at a premium to Brent. And they were consistently… until last year at this time. For the past twelve months, the reverse has been the case.

Brent Prices Reverse Course

Now, I have also noted before some of the reasons for this, with the primary cause being the fact that Brent is now used as the standard for discounting more actual crude physically traded worldwide than WTI. The vast majority of daily global transactions are in oil having more sulfur content than either of the primary benchmarks. Neither Brent nor WTI, therefore, really represents the world’s stock of crude.

However, of late my curiosity has been poking around elsewhere. How can the effective pricing of Brent remain at such levels, given the fiscal malaise that is Europe?

My initial take on this was presented to the Greek Finance Ministry in late June, during an eventful stay in Athens marked by high humidity and higher tempers in the streets. My preliminary analysis had concluded that as much as 28% of the Greek debt problem had effectively been discounted and transferred into Brent oil futures.

After I gave my briefing, the ministry released a truncated press release holding the rest of Europe responsible for a quarter of the country’s debt mess! That was hardly my intention, but it did give me some reason to consider this further.

Later events have simply reinforced the following observation: The European price for oil is supported by its debt problem.

We have spent so much time treating European debt in isolation – regarding it as a sovereign fiscal problem or a result of undercapitalized banks – that the analysts as a whole have been missing something important.

As the concern over European debt contagion increases, the oil contagion is taking place almost unnoticed.

Oil Trading Moves Off The Market

It happens this way:

Crude oil is a financial asset as well as a commodity. That means the contract has a collateral (and a fungible, for that matter) application. It can be exchanged, leveraged or used to buy and sell other assets. Anything that has this flexibility and has an underlying market value to boot has a larger market presence than simply the contract itself.

Now any financial asset has this utility. Some, such as agricultural commodities (which have a striking parallel to oil contracts in market dynamics), are so well known for doing this that their trade is heavily regulated on exchanges.

There are also the matters of ease of transfer and ready liquidity to purchase. I may have considerable asset value in my house, for example, but it is released only if I can sell it. That is a big unknown in the current market. So what do I do? If I need the cash, I will take out a home equity line of credit.

And that gets us back to the European oil situation.

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