Why It's Crucial to Reduce Leverage in Oil

After a year and a half of incredibly volatile oil prices, the recent rally had Congressmen clammering once again for increased regulation. Throughout 2007 and into 2008, crude oil prices saw a 150% increase before topping out just under $150 per barrel. As the bubble popped, traders ran for the exits and prices collapsed 75% dropping nearly $120 per barrel. Yet, the volatility had yet to end as March saw oil prices begin to rally eventually gaining over 100%.

What is causing all this volatility?

It seems rather difficult to believe that supply/demand dynamics of the physical commodity are truly at play here. Something does need to change in this market. A stable, functioning commodity market is crucial to the global economy and especially now in a time of turmoil. Price stability must be achieved for the efficient functioning of the millions of businesses dependent on commodity prices.

The massive use of leverage in futures markets is causing exacerbated price swings unreflective of the supply/demand dynamics. The original intents of leverage were practical as the markets were dominated by hedgers. Reducing the upfront cost to a business hedging its risk was warranted. The business then received delivery or delivered the commodity as per the contract.

Now, the markets are radically different. Speculators dominate futures markets and fewer than 5% of contracts actually result in an exchange of the physical commodity. The leverage ratios are similar to what the stock market saw during the Great Depression.

From Margin Requirements, Margin Loans, and Margin Rates, New England Economic Review, Sept-Oct, 2000, by Peter Fortune:

The Crash of 1929 and the subsequent depression in both stock prices and economic activity were attributed, in part, to excessive use of debt to buy common stocks. At the time, brokers would lend as much as 90 percent of the money that customers paid for stocks, leaving only a 10 percent equity margin to cushion declines in stock prices. This lending, it was argued, not only stimulated demand for common stocks, thereby elevating stock prices and encouraging a subsequent crash, but also promoted a sharper decline in prices when customers' equity positions vanished and brokers made margin calls requiring a deposit of additional cash and securities to restore customer equity. As we show later, margin calls can also force liquidation of shares valued at a multiple of the value of the margin call, thereby exacerbating the effect on stock prices.

Are we repeating the same mistakes of the Depression? Do our current rules stimulate massive price swings?

It seems likely. The liquidity in most futures markets is not an issue. With margin requirements between 5-15% on most commodity contracts, speculators are given very high leverage enabling the herd to exaggerate every move in price up or down.

In a market so incredibly important to the well-being of our economy, it seems silly to allow for these leverage levels. A margin requirement of 50% as enforced in the stock market seems reasonable. Special exemption could be made for those delivering or receiving delivery to not hinder business operations of hedgers.

Otherwise, let's take back our commodity markets from these unneeded uncertainties.

Disclosure: No relevant positions.

Comments

[A Barrel Full:]

....Speculators dominate futures markets and fewer than 5% of contracts actually result in an exchange of the physical commodity......

When you want to hedge a price risk, you do not need to enter into a contract that actually involves a physical product. You already have the product you need, you just don't want the associated risk.

So equate the lack of exchange of physical product with speculation is wrong.

Working as I do in the oil sector, being immersed in the atmosphere that existed in 2008, I don't need to look for bogeymen to blame the anomalies on. It was a clear case of GROUP THINK. Everyone really thought that oil could only go up. So everyone was building stock to sell tomorrow at a better price. When it didn't there was complete panic. Everyone sold off inventories, whatever the price.

Intellectually it was on a par with the Tulip buyers of old.

Jul 21 05:05 AM

[SteveK:]

Great perspective. Minimizing the participation of "non-possession or non-delivery" speculators in the oil commodity market will be quite a challenge. Perhaps a rule change, ala 50%+ margin requirements for "non"-participants, is a step in the right direction.

Surely a reasonable argument can be made that market participants who either have possession of or are able to take possession of oil are less risky than those who cannot. Why should "non" participants enjoy the same risk profile as those with a tangible stake in the marketplace. More regulation along these lines can help minimize the price gyrations of GROUP THINK speculators whose actions only disrupt demand/supply dynamics and negatively impact consumers in an artificial yoyo market.

Jul 21 06:58 AM

[Douglas Hvi...:]

A cautious investor can take advantage of volatility, while also acting against it. I'm not into commodities, but with stocks: once the quality of a company has been determined, my buy bid starts near the 52 week low. If no nibbles, it is raised by about 10% of the high-low difference next month. For companies owned who are at the bottom in quality, with the sales, the opposite pattern is used. Some buys and sells are missed, but it improves the odds of buying low and selling high. The effect of one small investor on volatility is small, but if many followed a like pattern, it would add up.

Jul 21 07:51 AM

[Jrbarnes:]

I am in the oil business, and when I hedge, I do not take possession of the oil that I do a futures contract on, nor do I ship my production to Cushing, Oklahoma where contracted oil is stored, nor do other oil companies that I know. If my oil does not sell for the price that I hedge it for, I sell it at market where it is, and make up the difference with the profit or loss from my hedge that month, with the net result being that I net the price that I hedged, thus keeping my bank happy. Similarly the buyer of oil who hedges, does not normally take possession of the oil in Cushing, but buys it in the normal course of his business, using the profit or loss on his hedge to end up with the net price hedged.

Jul 21 11:01 AM

[TWS Investm...:]

Clearly I believe it was a result of GROUP THINK. But, as I argue, "speculators are given very high leverage enabling the herd to exaggerate every move in price up or down." It seems to me in a market so vitally important to economic stability, the price swings can hold economies hostage. One way to reduce unneeded volatility is to reduce the embedded leverage.


On Jul 21 05:05 AM A Barrel Full wrote:

> ....Speculators dominate futures markets and fewer than 5% of contracts
> actually result in an exchange of the physical commodity......<br/...
>
> When you want to hedge a price risk, you do not need to enter into
> a contract that actually involves a physical product. You already
> have the product you need, you just don't want the associated risk.
>
>
> So equate the lack of exchange of physical product with speculation
> is wrong.
>
> Working as I do in the oil sector, being immersed in the atmosphere
> that existed in 2008, I don't need to look for bogeymen to blame
> the anomalies on. It was a clear case of GROUP THINK. Everyone really
> thought that oil could only go up. So everyone was building stock
> to sell tomorrow at a better price. When it didn't there was complete
> panic. Everyone sold off inventories, whatever the price.
>
> Intellectually it was on a par with the Tulip buyers of old.

Jul 21 11:03 AM

[TWS Investm...:]

Very true, and I concede your point. Though, I am attempting to say that the markets have changed dramatically. Futures were built on forward contracts and delivery was assumed for the last 100 years before 1981 and the development of the cash-settled Eurodollar contract. Exchanges further moved towards cash settlement in all markets in the 1980s and the following increase in traders has brought actually delivery to less than 5%.

This has had some unintended consequences. I am trying to propose a solution that would not hamper business hedging risks yet not give unnecessary leverage to participants simply betting on price movements. I have absolutely no problem with speculation, I just do not understand why we give them 10-to-1 leverage as a basis for the contract. That leverage, I argue, exacerbates price movements in markets crucial to our economic health.


On Jul 21 11:01 AM Jrbarnes wrote:

> I am in the oil business, and when I hedge, I do not take possession
> of the oil that I do a futures contract on, nor do I ship my production
> to Cushing, Oklahoma where contracted oil is stored, nor do other
> oil companies that I know. If my oil does not sell for the price
> that I hedge it for, I sell it at market where it is, and make up
> the difference with the profit or loss from my hedge that month,
> with the net result being that I net the price that I hedged, thus
> keeping my bank happy. Similarly the buyer of oil who hedges, does
> not normally take possession of the oil in Cushing, but buys it in
> the normal course of his business, using the profit or loss on his
> hedge to end up with the net price hedged.

Jul 21 11:27 AM

[Ferdinand E...:]

The more speculation, the easier it is to hedge. I can't understand how anyone can fail to understand that, because when futures markets fail it is because of a shortage of liquidity - the liquidity provided by speculators.

And A BARREL FULL, it's nice to see the reference to the tulip bubble, but I have some diffifulty equating tulips with a commodity like oil.

Jul 21 12:54 PM

[erewhonman:]

When oil trades in a price range that closely reflects the costs of that marginal barrel of oil, it is daft to say that current prices are in a speculative bubble. For all the froth and the shorter-term economic turmoil, oil still remains in a tight supply/demand range and longer term the only direction it will break out is upward. I speculate that these guys who think everything is manipulated by speculators are merely speculating.

Jul 21 01:32 PM

[B.K.:]

I think it is telling the the only defense of the Oil Speculators comes from two people who are admittedly Oil Speculators.

Jul 21 01:49 PM

[TWS Investm...:]

I would ask then, if the built-in leverage to contracts was 100-to-1, would oil prices have greater volatility? If you don't believe so, then we fundamentally disagree. But, if you grant that, then a reduction from 10-to-1 to around 2-to-1 should reduce volatility.

Thank you all for your comments on my article! I appreciate the interest.


On Jul 21 12:54 PM Ferdinand E. Banks wrote:

> The more speculation, the easier it is to hedge. I can't understand
> how anyone can fail to understand that, because when futures markets
> fail it is because of a shortage of liquidity - the liquidity provided
> by speculators.
>
> And A BARREL FULL, it's nice to see the reference to the tulip bubble,
> but I have some diffifulty equating tulips with a commodity like
> oil.

Jul 21 02:54 PM

[HardwoodFlo...:]

There was a great article by two guys from Stanford that laid out just how easy it was to control world wide oil with just $11bln.

I've been talking about this subject on this site since $150 oil. the correlation between the dollar short trade and oil bet and the stock market collapse.

It's absurd in this day and age that markets can be controlled with so little capital- so little at risk.

The idea that our economic system can be brought to it's knees with by so few is amazing. There is nothing efficient about market dynamics that are so easily manipulated.

Jul 21 04:24 PM

[A Barrel Full:]

On an intellectual level its the same. When we all start believing the same thing, we are in big trouble.

Everything has a value to someone and normally the best measure of that value is market price. However, when investors all start buying something, stock, commodity, real estate, not for the cash flows, but for the chance to sell it to a bigger mug, then market price starts to reflect something other than reality.


On Jul 21 12:54 PM Ferdinand E. Banks wrote:

> The more speculation, the easier it is to hedge. I can't understand
> how anyone can fail to understand that, because when futures markets
> fail it is because of a shortage of liquidity - the liquidity provided
> by speculators.
>
> And A BARREL FULL, it's nice to see the reference to the tulip bubble,
> but I have some diffifulty equating tulips with a commodity like
> oil.

Jul 22 02:07 AM

[bartpr:]

the futures market is a zero sum transaction. for every winner there is a loser. what is the problem with that. contracts that are long may be sold as short. one will gain and the other lose. there regulators dont want to tlk about the real workings of speculators. without them there is no market. who will porvide the liquidity. just the seller of oil for future delivery and the buyers of oil for future delivery. what is there is a massive imbalance of one or the other at a given moment.
then you will see massive swings in futures prices.

Jul 23 08:34 AM

[TWS Investm...:]

The paper transaction between two traders is not what I'm worried about. Futures market prices affect real world prices impacting millions of businesses around the world. The excessive leverage is not granted in any other market. Why, in a market crucial to our economic stability, do we allow such leverage? I want speculators, I just do not see the need to offer them 10-to-1 leverage.


On Jul 23 08:34 AM bartpr wrote:

> the futures market is a zero sum transaction. for every winner
> there is a loser. what is the problem with that. contracts that
> are long may be sold as short. one will gain and the other lose.
> there regulators dont want to tlk about the real workings of speculators.
> without them there is no market. who will porvide the liquidity.
> just the seller of oil for future delivery and the buyers of oil
> for future delivery. what is there is a massive imbalance of one
> or the other at a given moment.
> then you will see massive swings in futures prices.

Jul 23 10:22 AM