Crude Oil Trading Regulation: A Terrible Idea Whose Time Has Come

If we’re going to trade crude oil like a currency, we should regulate it like a currency, too.

I hold an apparently quaint and obsolete belief: “Not everything that can be traded should be traded. ” Specifically, there’s great danger in using long-term, long-only commodity futures positions as an investment asset class. The same is true of the derivative baskets of commodities that replicate such futures positions. Please note that I’m not talking about futures funds (which trade both sides of the market and are generally in positions only for the short term), but rather the way that commodities are increasingly being used by pensions, endowments and hedge funds as investments rather than short term speculations; this has sometimes been called “index speculation,” to distinguish it from the traditional variety.

Investment flows into the futures market can distort the pricing that should instead be determined by producers and users of commodities. Price distortions of this type cause enormous economic inefficiencies, are deeply injurious to the world’s poorest, and create significant structural risk in the markets. The chart below is a good illustration of just how “financialized” energy prices have become, charting the trade-weight U.S. Dollar index (the dashed line) versus the DJ-UBSCI Energy Spot index (the solid line) since the beginning of the year:

Dollar vs Energy Prices

As emphasized by the arbitrarily drawn horizontal line, these plots are virtually mirror images of each other (running a regression results in a correlation of -0.88). This corresponds to the type of linked price action we saw during the buildup to the commodity frenzy last year. It’s interesting to note that commodities like gold show nowhere near the correlation (-0.177) with the dollar over this same period. Clearly, the pricing of crude oil and energy products have become dominated by financial, not commercial interests. Specifically, oil is being treated as a currency and not as a commodity. This is a terrible idea, but apparently a terrible idea whose time has come.

While using crude oil as a currency/asset class is a bad idea, there are some good (or at least interesting) ideas on how to address the associated risks. I have been a fan of applying speculative position limits to energy contracts, importantly including the OTC swaps market. This approach has some downsides: a) it may be ineffective since the problem is really that all the positions in aggregate are dangerously large, but perhaps not on the individual basis constrained by position limits, and 2) it may simply migrate investment interest away from futures and into hoarding physical oil. In some ways this has already happened, as the speculative interest in crude oil (”virtual hoarding”) has created a cotango market that has resulted in a massive, arbitrage-induced inventory buildup (physical hoarding).

Last July as crude was peaking, my friend, Tom Rooke, submitted an alternative idea to the House Committee on Agriculture, the Congressional committee which oversees the Commodity Futures Trading Commission. With the bust in crude prices in the latter half of 2008, this whole issue was put on the back-burner. With energy prices once again being pushed up by speculative forces, it’s worth reexamining Tom’s idea. By way of credentials, Rooke has extensive experience in the world of commodities, having served as the head of UBS PaineWebber’s futures division for many years. He is an expert in the term structure of futures contracts and in cash/futures arbitrage.

Rooke’s proposal, in essence, regulates crude oil much like some of the ways that money supply is regulated. In his creative structure, the U.S. would require that holders of crude be required to maintain a reserve requirement which would be controlled by a central governmental authority, much like the Federal Reserve can change reserve requirements for banks. This would raise the costs of hoarding crude (probably not a bad thing), represent a second, private strategic petroleum reserve in event of national emergency (definitely a good thing), and provide a stabilizing buffer in crude oil pricing (much like what OPEC used to do when it had more market power). In the proposal, the initial transition period and reserve buildup would be eased through using depository receipts issued by the Strategic Petroleum Reserve. Tom’s submission can be read here: TWR Letter. The specific proposal starts on page 10, although the earlier pages include a discussion of index speculation and the evidence that it was impacting crude oil prices. It’s worth noting, that at the time the crude oil futures were in clear backwardation and the impact of speculation was more muted (Tom estimated 10% of price increases, I guessed around 20%); with the cotango markets we’ve seen more recently, speculation plays a more direct and potentially greater role.

It is critical that this issue be addressed. Rooke’s proposal may not be the right way to go, but it deserves serious consideration. On the third page of his letter, Rooke outlines just one type of structural risks we could face. We’re flirting unnecessarily with danger. What’s truly amazing is that without greater regulation of the commodity swap market, we won’t even know how close to the precipice we are or how far the fall might be.

Comments

[MinAkkar20:]

"While using crude oil as a currency/asset class is a bad idea"

Quite a blanket statement. Bad for whom? Throughout history, people have always resorted to alternative forms of currency in the face of devaluation. Gold, salt, whiskey, saffron, cigarettes have all experienced the same phenomenon because they can be arbitrarily created out of thin air. With the exception of water, oil is one commodity that will be unmatched at maintaining its store of value in the future. Regulating capital movements in and out of any commodity right now is saying "here's your crappy dollar sandwich, and you have to eat it too".

What do you expect commodity prices to do when money supply is doubled 2x? Isn't inflation (or preventing deflation) the stated goal of doing so? The Fed has tried to steer those extra dollars to stop the real-estate free fall by keeping mortgage rates low and having Congress push tax credits. Because the new bubble is occurring in commodities, your solution is to have some Fed-like central authority set up a cartel to affect prices? I can't wait to see the brilliant proposals coming out of Congress.

Oil as a store of value isn't a bad idea. This article is a bad idea.

Jun 24 07:38 AM

[MinAkkar20:]

**typo - meant to write gold, salt, etc CAN'T be created out of thin air

Jun 24 07:39 AM

[john s. gordon:]

......whose time came at least 12 months ago and was ignored among the general hysteria (thank you goldman sachs).
> jack

Jun 24 08:32 AM

[Righteous Dude:]

An ultra liberal guy from Boston thinks the government should regulate yet another market.... film at eleven

Wonder if the author knows that the junkie doesn't get to regulate the drug market? Does the author know the US is a net importer of oil?

OPEC hasn't been able to manipulate oil prices, despite controlling far more of the oil market than the US ever did. Why does this author believe the US, which is dependent on oil imports, is going to achieve something the biggest suppliers in the world cannot?

If the US is stupid enough to listen to people like this author, our economy cannot be saved. The government is not omnipotent and never was. Moronic suggestions like this is why the US is in long term decline

SHAME ON SEEKING ALPHA FOR PUBLISHING THIS ARTICLE!!!!

Jun 24 09:19 AM

[The Greates...:]

For some good reading on this subject check out this site.
Global Research.
www.globalresearch.ca/...
It could explain a lot to those who wish to be informed.
Big business, big Oil and our big Congress are why we are where we are today. Interesting article.

Jun 24 10:33 AM

[JeffDB:]

I agree with the "A Terrible Idea" part of the headline.

Somehow, I don't believe creating another government bureaucracy will be a big help for our economy.

The reasons for the negative correlation between the value of the dollar and the price of crude isn't necessarily *caused* by "speculators". Both respond to similar external causes, such as prospects for a growing economy. Since oil is currently priced in dollars, a drop in the value of the dollar makes oil cheaper for those in countries with a currency that isn't being similarly devalued. If the dollar goes up, so does their cost for purchasing oil. That obviously affects demand and hence the price of oil. Producers also take the value of the dollar into account when setting prices.

Having a new bureaucracy controlling private oil supplies and transactions on the options markets won't affect those types of forces on the price of oil.

If one is worried about the price of oil going up too high because the value of the dollar is dropping too rapidly, perhaps the better solution would be to protect the value of the dollar rather than printing and spending them like drunken sailors.


BTW, if the Fed could keep the value of the dollar a little more constant,

Jun 24 03:08 PM

[JeffDB:]

On Jun 24 10:33 AM The Greatest Rip Off of our Time wrote:

> For some good reading on this subject check out this site.
> Global Research.
> www.globalresearch.ca/...;aid=8878<br/>It
> could explain a lot to those who wish to be informed.
> Big business, big Oil and our big Congress are why we are where we
> are today. Interesting article.
-------

I expressed some skepticism about the conclusions of this article in an earlier post:

seekingalpha.com/user/...

Jun 24 03:13 PM

[The Greates...:]

JeffDB
Interesting conclusion, while if someone keeps saying the sky is falling enough times, loud enough, eventually someone will always look up. Having thirty years in the inside of the drilling for oil and gas in Texas, I can say that there are PLENTY of capped wells on land and off shore that have not even been used other then for testing purposes. Some well platforms have up to 14-28 drilled wells in one platform alone.
Do not underestimate the power of propaganda, until the black energy trading area of commodities has a real watch dog on duty, there will always be lots of people running the end around game for profit.
Further, the $25 to $100 scenario situation is a world event that actually happened in 08, truckers parked their rigs, food has gone up 30% at the store, the balance that you speak of has been breached, 10,000,000 Americans have lost their job in the last year and we are still loosing more jobs at a 450,000 a month rate even as we speak. But there is light at the end of the tunnel, Americans are driving far less then the oil companies thought they would this year, that resulted in a 1.3 million barrel increase in the barrels of gas on hand. There is a 20 year surplus of crude oil to the extent that the oil industry has been pay tankers to hold oil in storage at a cost of $75,000 a day fee. The world oil surplus has been on the rise over the last 6 years. It is not about supply and demand anymore, it is about control of the market that supplies the product.

Jun 24 03:37 PM

[greg weitzner:]

People tend to do things that they believe will benefit them. If people think that oil is a good investment and decide to invest in and if people think that oil is mispriced and decide to use futures and options to speculate, then so be it. If anything this makes the price of oil more efficient and accurate and has clearly taken away OPEC's power. We no longer hold our breath when we wait for Saudi oil production plans. There are clear reasons why oil has been so volatile of late. The economy overheated and crashed and now the federal reserve and the government are pumping cash into our economy. Some people are saying hyper-inflation is the new worry while others are saying deflation is still the fear. Either way with so much confusion about the state of our economy, oil volatility is inevitable with or without heavy trading. Too much trading of oil is not the problem. Too little trading, through regulation could end up being the problem.

Jun 24 03:50 PM

[prudentinve...:]

What an absurd article ! There are many speculative, distortive, and destructive derivatives being traded. These warrant regulation, if not an outright ban, before even talking of regulating future contracts on legitimate and useful commodites.

Jun 24 03:58 PM

[JeffDB:]

On Jun 24 03:37 PM The Greatest Rip Off of our Time wrote:

> JeffDB
> Interesting conclusion, while if someone keeps saying the sky is
> falling enough times, loud enough, eventually someone will always
> look up.

Thanks for the reasoned response.

>Having thirty years in the inside of the drilling for oil
> and gas in Texas, I can say that there are PLENTY of capped wells
> on land and off shore that have not even been used other then for
> testing purposes. Some well platforms have up to 14-28 drilled wells
> in one platform alone.

But that doesn't necessarily prove anything in and of itself as far as I can tell. I believe I've read that on average only some 30% of the oil in a given well is economically recoverable and that capping them off at some point is a normal part of the life cycle of well.

> Do not underestimate the power of propaganda, until the black energy
> trading area of commodities has a real watch dog on duty, there
> will always be lots of people running the end around game for profit.

I'm not sure how this government watch dog on duty is going to help the consumer out in any way. The oil companies can cap wells whenever they want to, or drill or not, or set prices at whatever point they think the market will bear with or without any such watchdog and with or without any speculators.

> Further, the $25 to $100 scenario situation is a world event that
> actually happened in 08, truckers parked their rigs, food has gone
> up 30% at the store, the balance that you speak of has been breached,
> 10,000,000 Americans have lost their job in the last year and we
> are still loosing more jobs at a 450,000 a month rate even as we
> speak.

I think that run-up in oil prices actually started in about 1999, and the price in 2008 was always above the $25 mark.(1) But to an extent that is really irrelevant to the question at hand. Namely, was that price jump due to "speculators" or was it a function of the market forces such as supply and demand. Pointing to a price jump, even a significant one doesn't prove what the underlying cause of the jump was. Neither does pointing out the pain that such a jump may have caused to an individual or to a society.

> But there is light at the end of the tunnel, Americans are
> driving far less then the oil companies thought they would this year,
> that resulted in a 1.3 million barrel increase in the barrels of
> gas on hand.

But I don't see how spawning a new government bureaucracy to regulate who can buy or sell futures &/or to regulate the private ownership of oil is going to help the consumer here. Are they going to nationalize the oil companies and tell them when they can cap an oil well or perhaps tell them when they must uncap them? Are they going to dictate the pricing to them? Are they going to do so for the refineries as well? I don't believe all of them are owned by oil companies.

> There is a 20 year surplus of crude oil to the extent
> that the oil industry has been pay tankers to hold oil in storage
> at a cost of $75,000 a day fee.

I'm rather skeptical of the 20 year surplus of crude oil. I thought the government had been shooting for something like a 90 day supply though they may have bumped that up *a little* when the prices tanked last year. Alaric Nightingale of Bloomberg quoted a number of $68,000/day paid by Morgan Stanley for a tanker to hold some 2 million barrels for them (2) but as discussed in the article & in this post (3) that was due to a rather unusual confluence of events that was expected to be a short lived "window of opportunity" for them to profit on the contango in which a price in the next month (in the futures market) is sufficiently higher than the current month such that the difference will pay for the temporary storage fees.

Not only do the futures prices have to be sufficiently higher, but the current demand has to contain enough slack that there are empty tankers who can and will take on the storage duties.

Even in those somewhat unusual situations, I don't think that such a play necessarily has an adverse impact on the consumer or upon an economy, and in fact, if the "speculators" are correct in their pricing estimates, it can actually be a benefit for all involved.

Sure it will take a little supply of the market in the current month, but one of the requisite conditions for this play is that there is some slack demand and also some excess supply of both oil and storage, so it shouldn't be causing great hardship and shortages. If they are correct and demand is higher or supply is lower in that future month when the oil will in fact be delivered it will help ease any price hikes in that month which more likely needs the additional supply more than was the case in the prior one.

In other words, it would help to moderate the price swings. It would raise the bottom of the price trough, but would simultaneously lower the price when it presumably would have been higher yet. Moderating that roller coaster of prices is a good thing for the consumer, and minimizing the effect of the boom and bust cycles is a good thing for the producers as well, helping them to consistently maintain production rather than canceling or postponing projects because prices dropped too dramatically. That would be the case for the conventional oil producers as well as the bio-fuels and other unconventional producers as well.

> The world oil surplus has been on
> the rise over the last 6 years. It is not about supply and demand
> anymore, it is about control of the market that supplies the product.

I don't think the world surplus has been on a consistent rise over the last 6 years, though that would probably be a good thing if it were. I believe we were actually having a draw down on inventories when supply was booming during the 2004 to 2008 time frame. In any event, I would prefer a healthy inventory to a "just in time" type of inventory system to give us a bit of a cushion for hurricanes, wars, insurrections or other world events outside our control.

I think OPEC is the big dog with respect to "controlling world markets" and we can't legislate what they do any more successfully than we would be in trying to outlaw hurricanes. Oil companies can pretty much produce as much or as little as they want regardless of what new governmental departments are created or which new government "Oil Speculation Czars" are appointed to head them. I doubt they need to hire super tankers to hold their inventory either. It's probably cheaper and easier for them to just slow down production, cap an old well or not open up a new one. Having the earth hold it for them is probably cheaper than pumping it into a tanker whether they are charged $68,000 per day/tanker or $75,000 per day.

Endnotes:

1. Energy Information Administration chart of spot prices
tonto.eia.doe.gov/dnav...

2. Morgan Stanley Hires Supertanker to Store Oil
www.oilandgaseurasia.c...

3. seekingalpha.com/user/...

Jun 24 04:36 PM

[dcb:]

could you please site the specific article. there are many and the link does not go directly through


On Jun 24 03:13 PM JeffDB wrote:

> On Jun 24 10:33 AM The Greatest Rip Off of our Time wrote:

Jun 24 04:42 PM

[JeffDB:]

On Jun 24 04:42 PM dcb wrote:

> could you please site the specific article. there are many and the
> link does not go directly through

I believe you are referring to the one posted by "The Greatest Rip Off of our Time":

www.globalresearch.ca/...

It was apparently truncated by the software when I quoted it, but it did work on his original post.

If you are referring to a different link, let me know.

Jun 24 04:50 PM

[The Greates...:]

JeffDB
Interesting conclusion, while if someone keeps saying the sky is falling enough times, loud enough, eventually someone will always look up. Having thirty years in the inside of the drilling for oil and gas in Texas, I can say that there are PLENTY of capped wells on land and off shore that have not even been used other then for testing purposes. Some well platforms have up to 14-28 drilled wells in one platform alone.
Do not underestimate the power of propaganda, until the black energy trading area of commodities has a real watch dog on duty, there will always be lots of people running the end around game for profit.
Further, the $25 to $100 scenario situation is a world event that actually happened in 08, truckers parked their rigs, food has gone up 30% at the store, the balance that you speak of has been breached, 10,000,000 Americans have lost their job in the last year and we are still loosing more jobs at a 450,000 a month rate even as we speak. But there is light at the end of the tunnel, Americans are driving far less then the oil companies thought they would this year, that resulted in a 1.3 million barrel increase in the barrels of gas on hand. There is a 20 year surplus of crude oil to the extent that the oil industry has been paying tankers to hold oil in storage at a cost of $75,000 a day fee. The world oil surplus has been on the rise over the last 6 years. It is not about supply and demand anymore, it is about control of the market that supplies the product.

Jun 24 10:23 PM

[The Greates...:]

JeffDB
Lets try this from a different angle, if I have something that everyone in the world wants I am in a good position no doubt. Now lets start at the beginning, say around 1999, and close 26 refineries between 1999 and 2001 on the west coast alone. At that time frame crude was relatively dirt-cheap, now lets do some merging over the next 5-6 years in which we end up with 5 major oil firms. Even today, oil is pumped out of the ground in Saudi Arabia for around .25 a barrel, so it was real cheap in 1999. Then in 2001 Phil Graham re-writes the futures commodity legislation and opened the door for hedge funds and future buying in the speculated market in energy. Which led to the Enron mess, traders do not answer to anyone here in the US and purchase fees are cheap enough that the can purchase large shares in the crude oil market with out any intention of using the oil, just sit on the contract until the three month period is up and then sell at a profit if possible. No one can deny the huge net profits of these companies over the last 6 years or the balance sheet they are caring today. Not to mention the fact that all 5 of the major oil companies are currently buying their stocks back at record levels today. It is reminisce of the Hunt brothers and the corning of the silver market, ah, but they got caught. Energy companies are currently giving millions to the lobbyist in Congress right now to kill green energy programs. And they are giving so much that they will spend millions more this year then last year. (opensecrets.com)
A de-facto tax cut for American motorists. Each $1 per barrel drop in oil increases U.S. GDP by $100 billion per year and every 1 cent decline in gasoline increases U.S. consumer disposable income by $600 million per year.
The last 20 years have been characterized by rising U.S. oil consumption, but now the U.S. Energy Information Agency. incorporating the most-recent changes in U.S. consumer behavior, says there will be no appreciable growth in U.S. oil consumption between now and 2030, with biofuels accounting for all of the growth in liquid fuels. So, if you’re the average American family, working two jobs and commuting 30 miles both ways, the cost of a gallon of gas is very important to them. If this trend continues, there will be just two class of Americans, the have’s and the have nots. People with out working income become desperate, they lose their hope and their dreams. Not to mention the rising cost in utilities, food, or basically every single thing made, shipped, barter, sold or bought in America cost more when fuel goes up.
So, what benefits the whole world if oil costs go through the roof? It has already cause the current economic down turn, which will never turn around if the energy market continues to operate the way they have been allow to do. At some point there will be a depression of huge impacts that the world may never recover from. I have enjoyed the banter, yet I still do not see how manipulation of this one commodity is a good thing for the rest of America.
Oh, and Peak Oil is still just a theory, remember the power of propaganda.

Jun 24 11:14 PM

[The Greates...:]

For some good reading on this subject check out this site.
Global Research.
www.globalresearch.ca/...

Jun 24 11:15 PM

[The Greates...:]

And of course, there is always that old famous line,
" I am from the government and I am here to help"

Jun 24 11:17 PM

[The Greates...:]

Further, the only reason the oil industry is paying tankers for storage is because they have their hands on the valves. It is a mathematical equations as to how long the current surplus will last. Also, they did not see the bottom falling out in Aug 08, and it did take them by supprise. They already had the oil out of the ground when the market went south. I am sure they will continue to cut back production until demand is artificially running ahead of the current supply.

Jun 24 11:28 PM

[dilton:]

What a stupid idea. Guess what, significant investment flows into markets tend to make those markets go up, ie. oil. U.S debasement of the dollar tends to make the dollar fall and oil rise.(priced in dollars). Maybe the govt. should regulate prices of all commodities. Ridiculous, but yes it happens under Marxism.

Jun 25 01:39 PM

[mmunro:]

responding to these comments that compare oil futures with other commodities, saying..."regulating oil...you want to regulate all of them".

What makes oil different is that it is fundamental to the foundation of all Societies. If you raise the price of oil, it impacts virtually every part of the life of every person. Virtually every major oil price spike has preceeded a resession (70's, 80's, 00's). Only now, instead of just impact one country, it's global...and global inflation and the resulting recession impacts EVERY economy around the world. This causes massive pain and suffering in the poor and the rich, such as unemployment, food shortages, budget shortfalls in subsidized countries (e.g. India) resulting in service cuts...

So, if high oil prices (for whatever reason) causes societal problems, you are going to get government intervention. This is because it is the central purpose of virtually every government to ensure the health (medical, food) and safety (rule of law) of it's population.

So you can expect government to step in to ensure that oil prices are free from any type of "artificial manipulation" (and PVM incident shows how this could happen) that causes price to move independent of the fundamental (physical) supply and demand are going to be targeted.

Why intervention is happening shouldn't be surprising for anyone and is debatable only by the terminally argumentative...

Whether they do a good job or not is a different debate...

Jul 08 12:52 PM