Saturday, 10 January 2009

Arbitrage by piracy

When the Sirius Star oil tanker was captured by pirates on 15 November, the crude oil price was around $55 a barrel.

It contains about 2 million barrels of oil, now worth $40 each, so its value has fallen from $110 million to $80 million in the intervening period. Thus, aside from the rumoured $3 million ransom payment, the owners have lost $30 million in value of the commodity - plus whatever it costs to borrow $80 million for two months (not much these days).

Yesterday, with oil getting close to its lowest point in a couple of years, the tanker was released.

What possible economic explanations are there for this behaviour? And what does it tell us about oil prices?
  1. The owners may expect that prices are going to fall further, and decided that now is the time to get their oil back and sell it. Therefore they were motivated to deal now rather than putting it off.
  2. The pirates may expect that prices are going to fall further, and decided that their likely ransom would diminish. Therefore they were motivated to make a deal now, before having to renegotiate.
  3. The owners may expect prices to rise, and that the pirates' demands would increase. Therefore they want to make a deal before the pirates realise this.
  4. Both parties may be keen to deal as soon as possible, but transaction costs and information asymmetries meant that it took two months to reach a market-clearing price.
In theory, if the first of these scenarios were the real one, the owners could simply hedge by selling 2 million futures contracts instead of the physical oil - though they'd be exposing themselves to the risk that the tanker still isn't free by the time the contract expires. Given that the tanker is owned by the Saudi government, though, they'd probably manage to cover it somehow. So we should believe in factors 2, 3 or 4.

No doubt some combination of these factors applies. But if you're looking for insights into the future direction of oil prices, look at the behaviour of those who may have inside information.

The owners of the tanker, as a state-owned Saudi company, could possibly hold privileged information about planned future Saudi oil supply levels. And the pirates might also know something about future increases or decreases in piratical activity off Somalia.

Factor 2 implies that the pirates think piracy is going to decrease, reducing the future price of oil. If this were true, it would also encourage the Saudis to deal, because the moral hazard effect of doing so would be reduced.

Factor 3, on the other hand, implies that the Saudi government thinks supply will decrease, increasing the price of oil.

Of course, both of these factors might be true - after all both parties have willingly entered into this deal. At the margin, the two factors should balance each other. What's more, eight of the pirates have been drowned after taking their share of the ransom money, which will also reduce piracy.

In which case your best bet is to find other commodities subject to piracy, whose price will also fall if piracy drops, and sell them. Anyone currently holding Ukrainian tanks is advised to get out of the market now.

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