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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.
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.