Bursting the Speculative Bubble

The CFTC pushed by Congress may be sharpening the point on the pin that bursts the price balloon.

The volume of email commenting on the Michael Masters testimony before the Senate was surprising to say the least. While we disagree with some of his comments comparing the number of futures contracts to physical barrels, we do agree with the basic analysis and believe it helps explain some of the oil price increase over the last few ears. Since all of our readers are not familiar with the ins and outs of the futures market, we will start with a review of futures markets and the relationship to the cash or physical markets.

Simply put NYMEX has established a market whereby individuals and corporations may buy and sell contracts for the delivery of crude oil at some future point in time. Each contract is for the delivery of 1,000 barrels of crude oil over the course of the contract month. The oil is of a specified quality and the delivery point is at Cushing, Oklahoma.

In many ways an oil futures contract is similar to a contract to buy or sell a home. The home buyer pays earnest money to guarantee performance. Similarly, participants in the futures market are required to maintain a certain margin which is currently close to $10.00 per barrel. If the price of the futures contract increases the purchaser is required to add enough money to their account to maintain the margin. If the price increases $5 then buyer would have to add $5 to his margin account.

There is a separate contract for each delivery month through 2012 and currently June and December contracts through 2016. The current front month is July, 2008 which has been trading for several years. On about the 22nd of June its trading will stop and those who still hold the contract to buy (or sell) will receive (deliver) 1,000 barrels at Cushing, Oklahoma in July at the price to which they initially agreed to purchase (sell). The current price of the oil is not involved as the contract price was agreed at the time of purchase. In practice, relatively few barrels are physically delivered with the buyer (seller) offsetting their position with the sale (purchase) of a contract for the same month some time before the 22nd when the contract expires.

The futures and cash markets are linked. Let’s say that yesterday we could purchase a physical barrel of crude oil from a producer for $100 per barrel and that the futures prices for July delivery was also about $100 per barrel. Today there is a problem in Nigeria and another 500,000 b/d of production is cut off by a MEND attack on a pipeline. In response, crude oil futures for July delivery are up $5 per barrel at $105. While it is a futures a futures contract for July delivery, it has an impact on today’s cash price.

The mechanism works like this: A refiner approaches a producer that has crude oil at Cushing and offers $100 per barrel for oil. The producer responds that he has the oil, but isn't willing sell it for yesterday’s $100 price. Rather the producer asks $105 or something close. The producer’s logic is simple. It costs far less than a dollar to store a barrel of oil for a month. He can realize almost all of the $5 increase in price that he sees in the futures market. To do so he could sell a futures contract at $105 for July delivery and leave his oil in storage until then. The storage cost would be under $1 per barrel and the $105 is a sure thing as he can make delivery in July. The refiner needing the oil now must respond with an offer of at least the futures price less the storage cost. The result is that the futures market has moved the spot or cash price up by almost $5 per barrel. In other words whenever the futures oil price rises there is strong pressure for cash prices to rise to within a month's storage cost of the futures price.

The strong connection between the two is easily seen in the graph of the front month contract and spot prices.

George Soros is scheduled to testify before the Senate next week. He has already publicly blamed speculators for higher prices.

NYMEX Light Sweet Crude -4.41 $126.62
IPE Brent -4.04 $126.89
RBOB Gasoline NY Harbor -0.0434 $3.4042
Heating Oil NY Harbor -0.1358 $3.6885
NYMEX Natural Gas -0.442 $11.474

Why purchase an oil futures contract in the first place? One of the simplest examples is a trucking firm or manufacturer of a plastics product whose costs increase with the price of oil. If they purchased a contract at $100 per barrel and the price increases to $130 they can sell the contract at a $30 profit and use that profit to supplement the higher cost of fuel or products.

For every futures contract purchased there must be a seller. An oil producer might choose to sell a contract to hedge against lower oil prices. If a producer is concerned that prices may fall from the $100 per barrel price, he could sell a futures contract at that price. If price dropped to $80 per barrel the oil producer could buy back the contract for $80 and use the $20 per barrel proceeds to supplement the revenue from his production which is now selling for $80 per barrel. The $80 he receives for the physical oil plus the $20 proceeds on the futures contract allows him to gross $100 per barrel. However, if the price increased to $130 per barrel the producer would pay to buy back the contract and lose $30 on the transaction. This effectively reducing the $130 price received for his oil to $100. In other words, by selling the contract he locked in a price of $100 per barrel for his product.

Speculators play an important role in the futures market. It is unlikely that there would be the same number of energy producers wishing to hedge against lower prices and energy consumers desiring a hedge against higher prices. Hedgers are analogous to purchasers of insurance and speculators to the insurance company. The speculators provide liquidity in the futures market and in return for that service expect to make a profit. Hedgers do not expect the make a profit but guard against potentially catastrophic price moves. The traditional speculator at various times is both a buyer and seller of futures contracts.

If for some reason the demand for a product or service rapidly increases, the price increases until the higher price encourages more suppliers or producers into the market. The same is true of oil futures contracts. For the moment forget about the fact that the purchaser of a futures contract can take physical delivery of the oil since relatively few do. Rather, think about an oil futures contract as the new must-have electronics device. We will call it an X-pod. Our X-pod has been around for a while but has never really taken off. Now you are given a glimpse into the future and know with a certainty that X-pod sales will triple in the next few years. What would you conclude? Along with the need for more manufactures of X-pods you would expect that higher demand would also lead to higher prices. There is no revelation here. It is what could be expected of any product whose popularity increases. The same is true of oil futures contracts.

In decade preceding 2003 open interest (the number of oil futures contracts outstanding for all months that are traded) ranged between 400,000 and 600,000. Since 2003, open interest almost tripled. In the last 5 years the price of futures contracts has quadrupled. There is little doubt that a good part of the price increase is due to increased demand for futures contracts. The total value of the open interest has increased from an average of $17 billion in 2003 to $174 billion as of April 22nd.

The U.S. Commodities Futures Trading Commission (CFTC) tracks the number of contracts outstanding and categorizes them as commercial (hedgers), non-commercial (speculators) and non-reporting. The last category includes small speculators and small hedgers. If the increased price is due to speculators we would expect a large increase in the number of contracts they hold and in particular their long positions. A purchaser of a contract is said to be long the market and a seller is said to be short. If more investors want to buy (long) than sell (short) then the price rises. Through a loophole the investment bank purchases of the contracts to support the indexes are not classified as speculators but rather as hedgers. Therefore, it is difficult to identify the impact of the institutional investment in the market.

Over the past five years the interest in funds which purchase commodity futures has dramatically increased. Institutional investors often purchase these funds in the expectation that the commodity price will increase and they will benefit. The problem is that these funds are always long the commodity. In other words they are always net buyers of futures contracts. That they are speculating on the commodity is beyond dispute. The only way that the index fund purchaser can profit is if commodity prices, in our case oil prices, go up. Unlike other speculators the institutional investors are always long.

How much impact has this had on the market? According to Masters the number of crude oil contracts underlying the index funds has increased by 538,000 since January 2003. The total number of contracts increased 904,000 in the same period. That means that 60% of the increase in futures contracts traded was due to institutional investors. Institutional investors currently represent 36% of total holdings. Our conclusion, with the help of Masters’ calculations on the volume of oil futures contracts represented by institutional investment in indexes, is that a significant portion of the run-up in prices over the last five years is due to this class of investors. The reason is not just their participation in the market, but that it is one-sided and long only. That means someone else must come into the market to take the short side of the trade and sell a futures contract. The only way to lure them in is to offer to buy the futures contract at a higher price.

The CFTC is considering changes. The two that are likely to have an immediate impact are:

“Review of Trader Reporting and Classification: The Commission will develop a proposal to routinely require more detailed information from index traders and swaps dealers in the futures markets, and to review whether classification of these types of traders can be improved for regulatory and reporting purposes.

“Examine Trading Practices for Index Traders: The Commission will review the trading practices for index traders in the futures markets to ensure that this type of trading activity is not adversely impacting the price discovery process, and to determine whether different practices should be employed.”

If the CFTC does as we expect and reclassifies index traders and swaps dealers as speculators instead of hedgers it will increase their margins substantially and more important it will impose position limits. If this happens prices will drop. We have no clue about timing. It could be two weeks or two months, but when it comes there will be a substantial drop in crude oil prices.

If activists are looking for a cause they could push for the California Public Employees' Retirement System (CALPERS) and others of that ilk to stop allocating a portion of their portfolios to index funds. If successful that could help move the process along.

Our conclusion: Barring the usually caveats (Venezuela, Nigeria, Iraq, Iran and Gulf of Mexico hurricanes) oil prices should be markedly lower before the summer driving season comes to an end. This is not a time when it is comfortable to be long oil contracts as the move could be substantial.

It was common in those days, as it is in ours, to identify the Communists as leftist and the Nazis as rightists, as if they stood on opposite ends of the ideological spectrum. But Mises knew differently. They both sported the same ideological pedigree of socialism. “The German and Russian systems of socialism have in common the fact that the government has full control of the means of production. It decides what shall be produced and how. It allots to each individual a share of consumer’s goods for his consumption.”

The difference between the systems, wrote Mises, is that the German pattern “maintains private ownership of the means of production and keeps the appearance of ordinary prices, wages, and markets.” But in fact the government directs production decisions, curbs entrepreneurship and the labor market, and determines wages and interest rates by central authority. “Market exchange,” says Mises, “is only a sham.”

Mises’s account is confirmed by a remarkable book that appeared in 1939, published by Vanguard Press in New York City (and unfortunately out of print today). It is The Vampire Economy: Doing Business Under Fascism by Guenter Reimann, then a 35-year old German writer. Through contacts with German business owners, Reimann documented how the “monster machine” of the Nazis crushed the autonomy of the private sector through onerous regulations, harsh inspections, and the threat of confiscatory fines for petty offenses.

“Industrialists were visited by state auditors who had strict orders to examine the balance sheets and all bookkeeping entries of the company or individual businessman for the preceding two, three or more years until some error or false entry was found,” explains Reimann. “The slightest formal mistake was punished with tremendous penalties. A fine of millions of marks was imposed for a single bookkeeping error.”

Reimann quotes from a businessman’s letter: “You have no idea how far state control goes and how much power the Nazi representatives have over our work. The worst of it is that they are so ignorant. These Nazi radicals think of nothing except ‘distributing the wealth.’ Some businessmen have even started studying Marxist theories, so that they will have a better understanding of the present economic system.

“While state representatives are busily engaged in investigating and interfering, our agents and salesmen are handicapped because they never know whether or not a sale at a higher price will mean denunciation as a ‘profiteer’ or ‘saboteur,’ followed by a prison sentence. You cannot imagine how taxation has increased. Yet everyone is afraid to complain. Everywhere there is a growing undercurrent of bitterness. Everyone has his doubts about the system, unless he is very young, very stupid, or is bound to it by the privileges he enjoys.

“There are terrible times coming. If only I had succeeded in smuggling out $10,000 or even $5,000, I would leave Germany with my family. Business friends of mine are convinced that it will be the turn of the ‘white Jews’ (which means us, Aryan businessmen) after the Jews have been expropriated. The difference between this and the Russian system is much less than you think, despite the fact that we are still independent businessmen.”

As Mises says, “independent” only in a decorous sense. Under fascism, explains this businessman, the capitalist “must be servile to the representatives of the state” and “must not insist on rights, and must not behave as if his private property rights were still sacred.” It’s the businessman, characteristically independent, who is “most likely to get into trouble with the Gestapo for having grumbled incautiously.”

“Of all businessmen, the small shopkeeper is the one most under control and most at the mercy of the party,” recounts Reimann. “The party man, whose good will he must have, does not live in faraway Berlin; he lives right next door or right around the corner. This local Hitler gets a report every day on what is discussed in Herr Schultz’s bakery and Herr Schmidt’s butcher shop. He would regard these men as ‘enemies of the state’ if they complained too much. That would mean, at the very least, the cutting of their quota of scarce and hence highly desirable goods, and it might mean the loss of their business licenses. Small shopkeepers and artisans are not to grumble.”

“Officials, trained only to obey orders, have neither the desire, the equipment, nor the vision to modify rules to suit individual situations,” Reimann explains. “The state bureaucrats, therefore, apply these laws rigidly and mechanically, without regard for the vital interests of essential parts of the national economy. Their only incentive to modify the letter of the law is in bribes from businessmen, who for their part use bribery as their only means of obtaining relief from a rigidity which they find crippling.”

Says another businessman: “Each business move has become very complicated and is full of legal traps which the average businessman cannot determine because there are so many new decrees. All of us in business are constantly in fear of being penalized for the violation of some decree or law.”

Business owners, explains another entrepreneur, cannot exist without a “collaborator,” i.e., a “lawyer” with good contacts in the Nazi bureaucracy, one who “knows exactly how far you can circumvent the law.” Nazi officials, explains Reimann, “obtain money for themselves by merely taking it from capitalists who have funds available with which to purchase influence and protection,” paying for their protection “as did the helpless peasants of feudal days.”

“It has gotten to the point where I cannot talk even in my own factory,” laments a factory owner. “Accidentally, one of the workers overheard me grumbling about some new bureaucratic regulation and he immediately denounced me to the party and the Labor Front office.”

Reports another factory owner: “The greater part of the week I don’t see my factory at all. All this time I spend in visiting dozens of government commissions and offices in order to get raw materials I need. Then there are various tax problems to settle and I must have continual conferences and negotiations with the Price Commission. It sometimes seems as if I do nothing but that, and everywhere I go there are more leaders, party secretaries, and commissars to see.”

In this totalitarian paradigm, a businessman, declares a Nazi decree, “practices his functions primarily as a representative of the State, only secondarily for his own sake.” Complain, warns a Nazi directive, and “we shall take away the freedom still left you.”

In 1933, six years before Reimann’s book, Victor Klemperer, a Jewish academic in Dresden, made the following entry in his diary on February 21: “It is a disgrace that gets worse with every day that passes. And there’s not a sound from anyone. Everyone’s keeping his head down.”

It is impossible to escape the parallels between Guenter Reimann’s account of doing business under the Nazis and the “compassionate,” “responsible,” and regulated “capitalism” of today’s U.S. economy today. At least the German government was frank enough to give the right name to its system of economic control.

Here is the link for this article:

http://mises.org/story/47

Doesn't work that way, Nic.

If we do something stupid such as raising margins to prohibitive levels (say, 50% of gross contract value), you're right, the big specs will move offshore. That, however, is not what is being discussed by CFTC right now, only by a few idiots such as Sen. Bunghole Bingaman.

The problem here is not mkts, but that enormous capital pools have been allowed to skirt the position limits in mkts, and have created a huge artificial demand component, thus driving price well above what it would be due to strictly actual supply/demand considerations.

The proper move, and CFTC are considering it now, is to reclassify investment banks as specs (as they are classified in their own trading accounts) not ''commercials'' (as they are classified when acting as agents for a client, like, say CALPERS or one or another pension fund).

The second move is to tell these bloody pension funds that, no matter what their lawyers tell them, ERISA prohibits their participation in speculative mkts. In short, get them entirely out of the futures game. They don't belong there in any case (you've heard of the ''prudent man'' rule, I'm sure), and nobody who receives or expects to receive a pension from these chaps would approve of their dealing in crude and copper and bean futures.

Nobody (for once) is proposing mucking around with mkts; reclassifying some big players and enforcing position limits will put the affected markets' price at clearing levels in very short order.

Nor will there be any incentive to trade on other futures exchanges outside the US. Why? Because every exchange in the world has position limits in place for physical futures mkts, and would-be expatriate traders will see no advantage in dealing offshore.

FReegards!

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