Chris Cook: The Ghost of Enron Past Explains Oil Market Manipulation
Posted by Yves Smith - Naked Capitalism
By Chris Cook, former compliance and market supervision director of the International Petroleum Exchange
I outlined in a recent post my view that the oil market price has been inflated twice by passive (inflation hedgers) investors, albeit with short term speculative spikes from active (speculators) investors: once from 2005 to June 2008; and again from early 2009 to date. In attempting to ‘hedge inflation’ passive investors perversely ended up actually causing it, and allowed oil producers to manipulate and support the oil market price with fund money to the detriment of oil consumers.
But there has always been a missing link – precisely how has this manipulation been achieved?
While Izabella Kaminska’s Alphaville post was as interesting as usual, the real nugget on this occasion lay in the extremely well informed discussion which followed.
The protagonists were firstly, Patrick McGavock – a very clued up former banker whose blog rejoices in the name of the “Complete Banker”. The second commenter – whose nom de plume is “Free Again” – not only had technical mastery of a subject that has me reaching for an icepack for my head, but also displayed a comprehensive knowledge of Enron’s modus operandi.
Volumetric Production Payment (VPP) versus Prepay
The very name is enough to make the eyes glaze over, but in essence a VPP is a loan secured against a flow of production which remains in the ownership of the producer.
Prepay, on the other hand, is a forward sale of a commodity where the ownership rights to production pass to the financier.
The Alphaville dialogue is instructive as to the difference.
Free Again (to McGavock): Enron did two types of related transactions: Sales of Volumetric Production Payments (described below), which are being done today in much the same way, and Prepay transactions, which were round-trip trades (three parties involved) meant to create the appearance of Funds Flow From Operations, when it was actually funds flow from financing.
McGavock (to Free Again): Absolutely right. Although VPPs and prepays are essentially the same thing except for the ownership of mineral rights.
A day later came a response which I did not see until recently (my bold).
Free Again (replying to McGavock) Yes, I think we agree, but the most interesting distinction, and what may be relevant to the BP discussion, is the reason a company would choose a particular structure.
A VPP is a form of (acceptable) off-balance sheet financing. In most cases, reserve risk is transferred to the buyer (though the seller usually retains the operating risk).
A Prepay transaction is a little more insidious. It is a form of financing, but if structured as a commodity trade, can be made to look as if it is cash flow from operations.
This is particularly important to companies that use mark-to-market accounting, as there usually exists a huge gap between earnings and cash recognition. In order to maintain credit metrics when using MTM, the companies will structure misleading FFFO transactions, as a key rating agencies focus is FFFO/Interest Expense.
Prepay does not move the oil, which stays where it is in the ground or in tank. What prepay does is to create an ownership claim over oil which may be sold either temporarily (Enron-style) as an ‘oil loan’ to investors, or to refiners, who take delivery in due course of oil for which they have fixed the price by ‘paying forward’.
Investors prepay for physical oil which goes nowhere and stays in the custody of the producer, who has an agreement to buy the oil back from the investor, typically a month later in a forward contract that looks just like a futures contract. The outcome is that – facilitated by an investment bank intermediary – the producer lends oil to the investor, and the investor lends dollars to the producer.
Read the entire piece here