Derivatives Are Becoming a Problem... Again

Recently, I gave a briefing to some finance folks associated with the trading of global oil.

The topic was the escalating problem with derivatives in that trade, and the difficulty that usage was creating in determining a market value for the underlying commodity.

We have discussed this matter a few times in Oil & Energy Investor.

However, a recent uptick in the intermediary paper used to arbitrage oil trade - that is, bringing the values of a "paper barrel" (a futures contract) with a "wet barrel" (the actual consignment of oil in the market) together when the former is expiring - has created a concern.

The matter is getting worse, masked only by the prolonged period of languishing crude prices that is now coming to an end...

Déjà Vu With a Bitter Kick

As I pointed out to them, the lessons of the mortgage-induced credit crunch and subsequent asset failure collapse are again playing out.

Now, my column today will not be an easy read, but it addresses an important development.

It is a disquieting reminder of things past.

Déjà vu with a bitter kick.

For some, we are past the credit collapse of a decade ago. For others, the use of derivative paper has not so much disappeared as changed market sector. Then, the base was mortgages (subprime being the culprit).

Today, it is something else.


It is important, however, to emphasize the bottom line up front.

The Difference Between Assets and Future Returns

Extorting paper profits from securitizing the difference between assets and future returns on those assets initially will increase the apparent market value of the underlying asset itself.

That was certainly the case with real estate for well more than a decade.

That is, initially the expansion of paper value will raise the market price of the asset itself.

Nonetheless, this is not sustainable.

Two elements come into play, both reflective of the underlying fallacy predicating the process.

These were all too clear in the mortgage crisis giving rise to the worse attack on dollar-denominated asset values worldwide.

Unfortunately, the same pattern is taking shape today in the world of oil trading.

First, to keep the increasingly artificial securitization sequence going, the price for the actual asset subject to physical exchange in the market (10 years ago, residential or commercial property; today oil) becomes dependent upon the need to extract continuing levels of return from paper issued not to reflect that asset value but dictated by return requirements.

When that no longer can occur, a credit retrenchment follows.

Second, in what follows the pattern of a genuine Ponzi scheme, new and more inventive paper must emerge.

This started as a further relaxing of initial mortgage requirements a decade ago to continue the flow of new debt, thereby further weakening the overall mortgage pool.

However, another parallel development also emerges...

What's Poisoning a Worldwide Array of Assets

Progressive uncertainty further erodes confidence in a much broader array of debt paper generally considered secure.

Additional derivative paper, tying the weakening securitized paper to usually unrelated collateralized debt, emerges. This intensifies concerns over the creditworthiness of wider swaths of the market.

This is what ultimately poisoned a worldwide array of assets.

What we experienced in the subprime mortgage securitization debacle is the first credit collapse resulting from a prolonged inability to see adequate market-sustaining asset values translated into the value of future paper.

More to the point, the return demand of the paper drove the price requirements of the underlying asset to unsustainable levels.

We are fast approaching that point in the oil market, where the fallout is likely to be worse.

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Even if legal, much of what the market experienced in 2002-2009 in the real implosion was due to practitioners who knew that Rome was about to burn.

They just thought the really nasty outcomes would not happen on their watch.

Perhaps more accurately, they believed that there was always somebody else prepared to buy it, thereby delaying the conflagration indefinitely.

How the market articulated such a "principle," the belief that massive amounts of risk could be offloaded without jeopardizing the cash cow as a whole, makes this financial collapse fundamentally different from others.

What makes this stand apart was the belief that a mechanism had emerged to relegate such crises to the pages of history.

Simply put, practitioners had succumbed to the idea that new breakthroughs would allow the market to continue expanding risk without a corresponding bubble burst.

Even if all participants had the best of motives (a stretch, I admit, that strains both credulity and logic), the result would have been essentially the same.

This was a systemic failure, an endemic collapse so ingrained in the fabric of the financial world that there is nothing of substance to prevent it from happening again.

The classic, and still widely accepted, explanation of financial crises is to regard them as resulting from excesses (usually monetary), leading to a cycle of booms and busts.

Analysts initially concluded that this is what began in 2005, becoming widespread by 2007 and reflected most emphatically in a volatile cycle in real estate prices.

However, this crisis was markedly different.

We do not have an example here of typical cycles operating in a way to confirm any traditional understanding of the general equilibrium theory; its origins actually began with a fundamental departure from the idea that markets react to changes in supply and demand, replacing one level of market equilibrium with another.

In the past, the dominant thinking assumed (and virtually always required) an appreciable restructuring and downsizing of return expectations before the correction took hold. That is, profits would take a hit before the market could return to positive territory.

This time, purveyors of the new financial sleight of hand challenged one of the major premises upon which markets had traditionally operated...
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What the Markets Are Ignoring

They came to the unsettling conclusion that the market could now effectively ignore the relationship between the extension of credit and the assumption of risk.

Such a judgment ushers in one of the most serious and questionable introductions of moral hazard.

Undercutting one of the fundamental restraints relied upon to limit market overextensions, they believed (and in several quarters still do) that it was possible to continue the profit-making exercise without having to shoulder the risk attendant to the securitized assets in question.

Despite the initial provision of, and subsequent crunch in, credit as a central element in previous financial crises, this time around, practitioners believed they had found a way to evade the downside in the expanding pursuit of return.

Asset securitization introduced the belief that risk could be repackaged, sold, and cleared in such a way as to:

  1. Reduce the corresponding downside to manageable terms;
  2. Generate additional asset (and collateral) value; and
  3. Remove the traditional market impediment to expanding such value.

This last aspect is the real culprit.

It removes the essential ingredient that had served essentially to cap earlier attempts to play musical chairs with the world of finance.

The original issuer of subprime loans no longer carried the risk of the creditor's performance moving forward.

The original mortgage had been bundled with others, divided into parcels, and sold as new investment instruments.

Therein lies the quintessential "bubble accelerator."

What Could Inflate the Problem Out of Proportion

The mortgage-backed security (MBS), along with its cousins the collateral debt obligation (CDO) and a myriad of asset-backed security (ASB) clones, hardly ushered in the real estate collapse.

However, the approach certainly did inflate the problem out of all proportion.

It likewise illustrated the very myopic view prompted by a mainstay in traditional free-market thinking.

The tacit expression of this view surfaced shortly before the real estate bubble had burst, but the inability of market supporters to accept it indicated the size of the blinders.

The one fatal flaw in this logic is the same shortcoming I see all the time in public sector advising.

It views only one-half of what you need to make the transaction work.

With the real estate market, as with the problem of unfunded mandates in government circles, players have managed to emphasize widely shared desires to own property (policy outcomes in public decision making) while avoiding the question of how to finance it.

The real estate bubble provided clear indication that the desire to own a house is widely shared by all.

Unfortunately, the ability to finance it is not.

Seen in their best light, subprime mortgages provided that opportunity, but increasingly to a segment of the population having little realistic chance to pull it off.

The securitization schemes also introduced two major roadblocks preventing the market from easily correcting the overheating spiral.

Toxic Assets

First, since the "toxic" assets in question had been parceled out into so many derivative issuances (both the initial MBS offerings and secondary/tertiary papers based upon them), a relatively insignificant percentage of overall debt outstanding caused a significant constriction in liquidity.

The subprime loans were now so thoroughly intermixed with other debt holdings, themselves representing a paper asset and collateral value for an even greater range of investments, that it prompted wide areas of the market to come under suspicion, brought into question huge holdings by major banks worldwide, and ushered in a cataclysmic credit freeze.

This was accentuated by the fact that securitization by its very nature decreases transparency.

Therefore, once there is a question about the structural integrity of asset-backed securities, the loss of confidence or trust becomes more difficult to attenuate.

Second, this is a classic example of moral hazard, since those who are responsible for issuing the loan, to begin with, are no longer the parties shouldering the risk if the creditor defaults.

That bifurcation of responsibility is not axiomatically a problem.

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Nor for that matter does it explode automatically into a significant moral hazard concern - unless the advantage from exporting the risk entices an overextension in the issuance of credit.

After all, securitizing debt, utilizing assets as collateral for additional applications, and the spreading out of risk are not bad ideas per se.

In fact, I have personally designed securitization programs in the past for oil projects, pipeline capacity, refinery crude oil cuts, surplus electricity, discounted sovereign defaulted debt, even the financing of first-run Hollywood films that achieved their purposes without engendering a run on banks or an epileptic seizure of credit.

It is not the process per se.

Rather, it is the way the paper is used to generate artificial value and avoid the normal consequences of risk.

And this is what is now facing the oil markets.

Liquidity + Oil Contracts = Volatility

In oil, the ever-expanding appetite for new paper prompts the move in liquidity from producers/consumers to broker dealers.

This is not a short-term phenomenon.

Pricing in the crude oil futures market continues to reflect changes in volume, indicating that the market is not yet overheating.

However, the market environment is undergoing considerable change.

While liquidity increases, promoting its usage on oil derivatives and related securitized paper, the volatility in the futures contract prices will not find a counter-balance in an equivalent rise in demand for the underlying asset.

The increase in demand for crude oil and oil products will lag the price acceleration in futures contracts fueled by the liquidity overhang and attendant concerns about a weakening dollar exchange rate.

As liquidity continues to move into oil contracts, volatility will rise significantly.

It is tempting to view the widening spread between paper and wet barrels, along with the increasing volume in futures contract volume and the accompanying rise in volatility, as the result of speculation.

Public opinion, occasionally encouraged by the media, often charges speculators with causing most of the problems in the oil trading market, especially since there is a clear relationship between increasing futures contract volume and a rise in speculative activity.

Speculation is really nothing other than an attempt to maximize a return from financial activity (usually investments, issuing loans, buying and selling assets, or acquiring low-rated paper) by increasing risk beyond the level at which the security of the initial principal sum is guaranteed. The overall margin of safety is significantly less than conventional investment.

Speculators tend to take shorter-term positions and react to current events in a market rather than subject them to analysis and typically utilize a higher degree of leveraging.

Given the shorter time frame involved and the need to have a sufficiently liquid market in which to act, commodities like oil tend to attract such actions.

Commodities also attract speculation because the action usually prefers the buying and selling of an asset, for which the speculator expects the futures contract or some other derivative price to change irrespective of the actual market value provided by the underlying asset.

Usually, speculators will prefer a market in which the future price is appreciating, although an environment in which prices are falling will also attract speculators to short the market.

We have witnessed such an action in both directions for oil prices since late 2014.

The frequency, on the other hand, has been intensifying recently.

Other market participants generally prefer to have the participation of speculators because they provide two desirable factors.

First, they add liquidity.

Second, given their interest in acquiring a quick and maximum return, they tend to cover the more extreme positions.

After all, if I want to conduct a trade, I need somebody on the other side prepared to take a financial risk.

If there are no speculators present, only producers and end consumers control the transactions.

The oil sector went through a period in which the large international oil companies set prices (the so-called "Seven Sisters") followed by OPEC and other producers exercising similar control.

Neither provided a market where the equilibrium had anything to do with setting genuine market prices. That changed with the introduction of crude oil futures contracts in the 1980s.

However, the futures market only took off, providing a modicum of predictability and broader investor ownership, once the actual buying and selling moved from the initial controlling buyers (major international oil companies) and sellers (producing countries). That required both formal and informal sources of liquidity - institutional investors in the former case andspeculators in the latter.

The current situation, already providing a surfeit of liquidity from other sources, does call into question the position of speculators moving forward.

The Real "Unknown" for the Oil Market

One of the primary justifications for speculation has been its ability to add needed liquidity to the market.

However, liquidity is not the current market problem, given the excess cash injection from the government.

Yet, anecdotal analysis (amounting to what I would label "speculation on speculation") claims upwards to 60% of the volume in the crude oil futures market is actually coming from speculators.

That should mean additional speculation would run the risk of overheating the market.

The real unknown for the oil market is the effect of increasing speculation in an extended volatile trading environment - either up or down.

There is trading evidence that rising volatility tends to result in an increase in both hedging and speculative activity.

We should expect this since each either seeks to protect a position or profit from maximizing the spread between futures prices and the actual value of the underlying asset.

The great unanswered question is the impact on the liquidity-speculation connection from the kind of pronounced and escalating oil instability developing.

There are two things to keep in mind as the market moves into this extended volatility.

There is no equivalent trading period to which we can turn.

The previous bouts with instability since the mid-1980s (and the rise of crude oil futures trading) faced a market having far less volume, in which the pricing of crude was not as dependent upon the corresponding pricing of derivatives as it is now.

In addition, trading was not as dependent on the level of liquidity.

Such considerations may mean we are emerging into a rapidly changing market environment.

We are once again moving into unchartered waters.

Unfortunately, I shall have more to say on this rising crisis in due course.

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About the Author

Dr. Kent Moors is an internationally recognized expert in oil and natural gas policy, risk assessment, and emerging market economic development. He serves as an advisor to many U.S. governors and foreign governments. Kent details his latest global travels in his free Oil & Energy Investor e-letter. He makes specific investment recommendations in his newsletter, the Energy Advantage. For more active investors, he issues shorter-term trades in his Energy Inner Circle.

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