Many of the world’s largest oil companies are thanking their lucky stars right now. Astutely, they decided to hedge themselves against a potential oil price plunge many months ago.

These oil companies successfully exported some of their risk off to the banks who control the oil derivatives market. What the banks have done with that risk, and how they will deal with it if the oil market does not rebound soon, is uncertain…

Oil companies tap Skyrocketing Derivatives Market

Thanks to the deregulation of the derivatives market near the turn of the century, estimates suggest it has expanded into a $700 trillion+ behemoth (approximate notional amount outstanding). That is an incomprehensible figure.

NYU reported that, “Around 25 years ago, the derivatives market was small and domestic. Since then it has grown impressively – around 24 percent per year in the last decade.”

As one consequence of this market’s growth, hundreds of oil companies have been able to hedge themselves, mainly with insurance (via the derivatives market) from the banks, against price collapses. We’ve seen this same strategy used by virtually all major producers of commodities in recent years.

But no commodity is as widely traded as oil, which makes this week’s Volume critical for you to read.

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Oil Derivative Market poses risk to banks

Very few investors have taken the time to research how the derivative market works, and the potential economic consequences of the oil hedges. In their defense, by design, the derivative market is highly complex and cloaked in a certain amount of secrecy.

The major issue is, of the estimated $700 trillion figure mentioned above, it is unclear what the exact net risk to the global economy is; nor the exact amount of risk on the major banks’ books from various forms of derivatives. The general consensus, however, is that there is enough risk from oil derivatives alone to create a new credit crisis if prices don’t rebound soon.

Insurance Policies or Gambles?

Derivatives in the oil market were intended to serve as an insurance policy of sorts for producers and end users (such as airlines, refineries, countries etc.). That was the intention

*Created to improve market efficiency, oil derivatives may have morphed into the next global economic threat.


Unfortunately, the oil derivatives market may have turned into a casino for risk-addicted bankers.

Mayra Rodriguez Valladares of the New York Times reported, “According to the Office of the Comptroller of the Currency, the four largest derivatives participants in the United States are JPMorgan Chase, Citibank, Bank of America and Goldman Sachs, which together represent more than 30 percent of the total global derivatives market.”

J.P. Morgan is the biggest player in the derivatives market; and it is especially significant in the energy sector.

The bank states on its website that, “J.P. Morgan provides clients with hedging services that result in commodity price certainty and capital relief. Our hedging products include fixed price, index-based pricing and other options structures.”

The bank also states that, “As a leading market maker in swaps and OTC options, J.P. Morgan has a significant presence in NYMEX futures and options. Our geographically diverse physical asset portfolio includes more than 40 North American locations. In addition, we are one of the largest natural gas traders in the U.K. and European markets, with daily volumes of approximately 100 million therms.”

It has been reported that there is more than $4 trillion worth of energy commodity derivatives exposure from some of the largest U.S. banks.


Exporting Risk Globally via Derivatives Market

Just like the subprime meltdown, which was exported from US banks to the rest of the world, a similarWall Street signstoryline may play out in the oil derivatives market. Further adding to the concern is the unknown answer of how much derivative exposure from the oil collapse do the banks have on their books.

Unfortunately, given how unregulated this market is, we likely won’t know exactly how exposed the banks are unless a crisis occurs, as was the case in the subprime meltdown.

In respect to the derivatives market, even before it was anywhere near the size it is today, the greatest investor of all-time, Warren Buffett, stated in 2003 that he and Berkshire “view them as time bombs, both for the parties that deal in them and the economic system.”

It is estimated that “the global derivatives market is about $710 trillion,” according to Mayra Rodriguez Valladares of the New York Times. That’s roughly ten times larger than the entire global economy!

It has been speculated that the oil derivatives market accounts for roughly 15% of the global derivatives market… reported that David Morgan,

who is also “a big-picture macroeconomist,” says oil derivatives could take down the system just like mortgage-backed securities back in the last financial meltdown. The Fed said the sub-prime crisis would be “contained.”  It was not.  So, could oil derivatives take down other derivatives in a daisy chain type of collapse?  Morgan says, “Absolutely, there is no question about it.  The main problem is the overleverage of the system as a whole.”

The article continued:

So, underwater oil derivatives in one bank could bring down the financial system?  Morgan says, “Absolutely, because it is all tied together, all the banks are interconnected.”


Oil derivatives market: Hot Potato

For the most part, banks control the oil derivatives market. It’s not for the mom and pop investor. The barrier to entry requires having a massive amount of capital, or supply (in this case oil), and being one of the good ol’ boys.

Given this market’s exclusiveness, banks are limited with who they can flog derivatives contracts off to. They often buy and sell oil derivatives among themselves and distribute them to their large clients (i.e. funds, airlines, countries), shuffling the risk like a hot potato all over the world.

*The oil derivatives market is highly complex. Determining who owns what, and how much risk they are carrying, is tricky.

Quick Crashes Can Kill in the Derivatives Market

Things can happen very quickly in the commodity markets. Take oil’s approximate 50% plunge in the last 7 months as an example…

And with an already leveraged to the hills industry like shale producers find themselves in, disaster is never far behind in the derivatives market after such steep price corrections.

In oil’s derivative market, risk exposure is falling on oil companies, refineries, other forms of utility firms, airlines, countries, pension funds and banks. The risk is systemic. The end users (airlines, refiners, even countries) are of lesser concern in all of this because they actually have intentions to use the product. They need it to run their businesses/economies. But the banks, and funds, well… they’ve simply been making bets.

2008 Repeating Itself With a Different Asset Class?

Tim Mcmahon of reported,

“The crash of 2008 in the stock market and the real estate market was largely the result of a derivatives market run amok. Prior to 2008 there was a theory that by combining loans into giant bundles you could decrease the risk of any individual default, thus were created CDO’s or collateralized debt obligations. Derivatives were then used to slice these bundles into high risk loans and lower risk loans and then other derivatives [sic] credit default swaps (CDSs) [sic] were sold to insure against the risk of these “tranches”. The problem resulted when they failed to recognize that if everyone in the tranche was in roughly the same economic situation if one defaulted the others would probably default as well. So those providing the insurance had not calculated the default risk correctly, eventually resulting in a domino effect as the homeowners, then the insurer and then his client were unable to meet their obligations.”

The grain of sand that could send this whole market into a rock slide would be one major oil producer, regarded as an industry bellwether, defaulting on its debt. You’ll recall a similar scenario during the subprime meltdown which started with Bear Sterns and then Lehman.

Remember last weekend’s report when we explained the massive increase in leverage by oil companies participating in the American shale revolution?

According to Zero Hedge, the amount of shale energy companies that are now credit risks has exceeded 1,000 firms. Click on the chart below to read the related article from Zero Hedge.


An exorbitant amount of producers, and even explorers, now find themselves over-leveraged and nearly out of options. Banks were more than willing to lend to them at $80+ oil, but now they won’t touch US frackers with a ten foot pole.

In a best case scenario, oil companies enter the secondary debt markets which result in new loans being granted, but at interest rates not seen since the 1980s. Worst case scenario, the oil companies which can’t find secondary loans are on track to default. And the longer oil stays below $60, the higher the likelihood of this happening. Hundreds of oil companies are at risk, both big and small.

Who may have to pay if this market comes crashing down?

Ellen Brown reported in an article published on the Huffington Post, just before the New Year, that,

“Among the banks’ most important commodities bets are oil derivatives. An oil derivative typically involves an oil producer who wants to lock in the price at a future date, and a counterparty — typically a bank — willing to pay that price in exchange for the opportunity to earn additional profits if the price goes above the contract rate. The downside is that the bank has to make up the loss if the price drops.”

The article also stated,

“Senator Elizabeth Warren charged Citigroup last week with “holding government funding hostage to ram through its government bailout provision.” At issue was a section in the omnibus budget bill repealing the Lincoln Amendment to the Dodd-Frank Act, which protected depositor funds by requiring the largest banks to push out a portion of their derivatives business into non-FDIC-insured subsidiaries.”

“Warren and Representative Maxine Waters came close to killing the spending bill because of this provision. But the tide turned, according to Waters, when not only Jamie Dimon, CEO of JPMorgan Chase, but President Obama himself lobbied lawmakers to vote for the bill.”

Brown’s article reported that,

“A fraction, but a critical fraction, as it included the banks’ bets on commodities. Five percent of $280 trillion is $14 trillion in derivatives exposure — close to the size of the existing federal debt. And as financial blogger Michael Snyder points out, $3.9 trillion of this speculation is on the price of commodities.”

“As Snyder observes, the recent drop in the price of oil by over $50 a barrel — a drop of nearly 50 percent since June — was completely unanticipated and outside the predictions covered by the banks’ computer models. The drop could cost the big banks trillions of dollars in losses. And with the repeal of the Lincoln Amendment, taxpayers could be picking up the bill.”

Read Ellen Brown’s full article here.

Supplementary reading on this issue:

New Law Would Make Taxpayers Potentially Liable For TRILLIONS In Derivatives Losses

Banks Get OK to Use Taxpayer Money for Derivative Speculation


How Does ‘Average Joe Investor’ Get Insurance Against a Collapse?

As you can see, the speculation regarding exactly how much exposure banks have to potential losses, due to this oil price collapse, varies. Nevertheless, the sum is consistently in the trillions of dollars…

The somewhat unregulated nature and consistent growth of the derivatives market, specifically in respect to oil, cannot be ignored. This market has the potential to trigger the next financial crisis. If oil prices don’t rebound within a few months, many industry professionals believe the crisis will take hold.

If another bailout by the taxpayer was to take place at the behest of banks making risky bets on oil, look out. Aside from the civil unrest that could follow, citizens of America may lose what little faith they have left in the nation’s fiscal and monetary policy – ultimately leading to a crisis of confidence in the entire banking system.

If this occurs, and we truly hope it will not, a rush to long-standing safe havens, such as gold, will ensue (recent market action suggests it may already have started). With US banks likely to be at the center of this potential crisis, and north of $5 trillion already on the Fed’s balance sheet, a large stimulus would fail to strengthen the USD as it did in 2008.

Gold is up roughly 9% since Christmas, by the way…

All the best with your investments,



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