Fundamental Misconceptions in the Speculation Debate 31 comments
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Yesterday's Wall Street Journal features a misguided editorial blasting the CFTC for considering constraints on oil speculation. The piece serves as a good reminder of how often those schooled only in the stock and bond world misunderstand the function of the futures market and the role of speculators within that arena. The Journal’s editors and others are trying to apply the rules of those capital markets to contract markets like commodity futures. This makes no more sense than trying to play a game of baseball by the rules of football. In real life, as in the sports analogy, playing by the wrong rules leads to chaotic consequences.
Misconception #1: Who should determine price? In the capital markets, speculators and investors determine the price of securities. This is not the way the commodity futures markets are supposed to operate. Commodities are consumables, not investment vehicles. Economic efficiency demands that the price be determined by those that produce or use these resources. The role of the speculator in price discovery should only be on the margin, testing the limits to see when commercial demand or supply enters the market. Speculators in these markets should not be the primary determinants of price.
“Overspeculation” or “excessive speculation” exists when speculators become primary drivers of price. When this happens, commodities are no longer efficiently allocated – if prices are driven below the point where commercial supply and demand meet, shortages result. When prices are driven to excessively high levels, economically wasteful inventory buildup is created; Nobel laureate Paul Krugman recently reversed his opinion on the impact of speculation, pointing to huge oil stores as evidence that oil prices have been artificially inflated. More dire consequences also can be the result of these price distortions, including unnecessary and economically damaging price volatility and even the potential for a systemic crisis in the oil industry and it financiers.
Misconception #2: We need all this speculation for liquidity. The commodity futures markets absolutely need a healthy amount of speculation to bridge the gap between commercial interests who may not be in the market at the identical time. But just like any powerful medicine, an overdose causes more harm than good. Speculation is good only up to the point where speculation becomes the main determinant of price.
There has been a great amount of confusion between volume, open-interest and liquidity. Traditional speculators are short-term traders who are indifferent to being long or short the market — such volume indeed creates liquidity. Much of the problem has been created by the new breed of non-commercial participant, particularly the commodity indexed funds which are long term holders and are overwhelmingly oriented to the long side of the market. They represent not liquidity, but a big fat bid, which actually drains liquidity from the markets by crowding out long commercial interests.
Misconception #3: Investors need unconstrained access to the commodity markets to protect against inflation. The idea that commodities are the only inflation hedge available to investors has been heavily promoted by those that profit from selling commodity-linked products. This is simply a myth promulgated by Wall Street marketing departments. As I’ve written about before, investors have very real, and possibly superior, alternatives, from TIPS to commodity linked equities.
Misconception #4: Position limits are an abridgement of free market rights. The confusion of capital markets with contract markets comes into play here. The imposition of constraints on non-commercial participation is not about heavy-handed regulation, but about appropriate market governance. In the capital markets, I know of nobody who complains about rules against front-running, touting or insider trading. Those are rules designed to protect the integrity of capital markets. Contract markets like futures exchanges need rules to protect their integrity as well. It’s just that different markets require different types of rules. In the futures markets, integrity implies that commercial interests determine price, and this requires governance that restrains non-commercial participants. Speculative position limits are one of the time-tested ways to ensure this critical integrity.
Informed people of good will can argue whether the markets are indeed “overspeculated” at this point. We can reasonably debate whether position limits are the appropriate response, or whether whole different types of governance are needed. One can perhaps even argue whether the risks of overspeculation to the economy should be balanced against the risks to Wall Street profits from curtailing their activities. However, those that argue that the futures markets should play by the rules of the capital markets merely reveal their ignorance.
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Come to think of it, what speculators do is a win-win for everyone else: if they're right, the result is beneficial; if they're wrong, they lose money and the other side makes money. Gotta love speculators.
On Jul 30 01:05 PM JeffDB wrote:
> "Excessively high levels" is the key phrase here. If the speculators
> are accurate in their predictions of future price movements, the
> inventory buildup is not economically wasteful, but rather economically
> beneficial. I guess one of the key questions then becomes, will
> the proposed rule changes enhance or diminish the probability of
> the futures market accurately predicting those future prices.
> Who liked all the gyrations in commodities last year?
How about: any producers that hedged appropriately?
An oil&gas production partnership ran by some friends of mine last year bought up some crappy leases, drilled a whole bunch of wells that would be considered marginal under normal circumstances (breakeven around $80), and sold about 5 years of production forward at around $110. They made out like bandits. You as a consumer on the other hand get about 10 years (life of wells) of extra X barrels per day supply at low, low prices... so far, considerably below the price at which it would be economical to produce. What exactly are you unhappy about?
Clarification Sought: Reading thru your reply, I can't understand. Have you changed your opinion based upon the comments?
My guess: no, you haven't.
On Jul 30 01:07 PM Jeffrey Korzenik wrote:
> A quick note of thanks to all those who post comments -- for example,
> JeffDB's and Rayden's comments today remind of the value I get from
> having my blog posts appear on SeekingAlpha. We may not agree, but
> I read everyone's comments and take the challenges very seriously
> -- and I've learned a lot from these, sometimes changing my opinion,
> sometimes forcing me to tighten my own arguments. It's great stuff.
> I'm paid to do this for a living. Many of you are not. I appreciate
> your time and effort.
On Jul 30 06:03 PM Living4Dividends wrote:
> Terrific article, Jeff. And your original source article was even
> better. I agree with your conclusions in the "300B Ponzi Scheme."
>
>
> Clarification Sought: Reading thru your reply, I can't understand.
> Have you changed your opinion based upon the comments?
>
> My guess: no, you haven't.
> My gut is that
> it is still economically flawed -- the most efficient ways to hold
> inventories in oil is by not taking it out of the ground, and the
> people who can make that decision are the best informed, too.
I'm very familiar with the upstream oil business, so I want to specifically address that if I could. Most oil wells have an optimal range of production rates. Producing at higher rates lowers both the future maximum production rate and the amount of oil you can extract, in a way that is especially hard to remedy. Producing at lower rates also lowers the future maximum production rate, but is more easily reversed through well stimulation (frac/acid), at least the first time around. Both cause damage, in the first case it's damage to the whole reservoir, in the second case mainly damage close to the wellbore. Ideally, producers prefer to run wells at some percentage of the peak rate that is calculated to maximize ROI. There is an adjustment range, but it's not a huge range. Shutting down wells completely for a short time is fine, this is more of a problem with longer shutdowns on the order of months. Also this depends a lot on the type of formation. The bottom line is, unless you want to damage your well, once it's drilled you're usually committed to pumping a certain amount. So that answers part of "more efficient to store in the ground".
The other part has to do with where in the world the inventories would be. One of the "Black Swan" risks to worry about is something along the lines of Iran nuking all the oil fields in the Gulf (or slightly less dramatic, blocking the Straits of Hormuz). It's not clear that, at 30-60 days global inventories, we even have enough to keep essential services going in such a scenario while we ramp up production or reduce consumption in an orderly fashion. I've looked at what would happen in such a scenario, and the conclusion is it'll "probably" work, but it'll be absolute chaos and a mad scramble. If it doesn't work, this is a nearly "end of civilization as we know it" risk. Do we want to find out? So that's a big argument in favor of aboveground storage.
Storage is cheap, a few cents per barrel per month. As far as I'm concerned, I'd much rather have a full YEAR's inventories aboveground and pay a dollar more for every barrel (that's about how much the storage cost would add), than not have them when they're needed: even if the odds of needing them are one in a thousand. That's a very cheap insurance policy, considering.
Most speculators give the argument – “it is my money I will put it where I choose to”. This is a dumb argument because these are the very same people who cry uncle and need bailouts. Another argument that there is no speculation it simply is people expressing their opinions using their dollars – this would defy the history of huge bubbles that we have seen through history and the biggest bubbles recently of course. We know when bubbles burst – there is huge fallout impacting not just the reckless speculators but also innocent bystanders – the common man- they end up losing homes and jobs. But not for the commodity bubble that Bernanke help engineer (at least turned a blind eye) – this great recession would have been much milder.
Yes I fully agree there should be higher regulation – disclosures, margins, position limits, and any other suitable curbs.
A few players are simply taking advantage of the low margins (designed for actual producers and users), combined with super low borrowing costs (courtesy of you, me, and our kids), to amass contract positions in paper pyramid style, with exemptions from the rules anytime the rules cause them inconvenience. Then you re-value those higher "appreciated" values on your balance sheets, borrow more, and stack again . . . The CFTC is late to the game, as usual. Leverage is way up, and it is with the implied backing of the us gov.
Uggggh.
On Jul 30 06:47 PM Jeffrey Korzenik wrote:
> I haven't changed my mind, but I'm certainly thinking about the economic
> efficiency of inventory building per the remarks. My gut is that
> it is still economically flawed -- the most efficient ways to hold
> inventories in oil is by not taking it out of the ground, and the
> people who can make that decision are the best informed, too. A
> lot of the oil is not be hoarded/inventoried with forethought, but
> purely as an arbitrage against the futures, and the futures are not
> necessarily being bought with conscious expectations, but rather
> because it backtested in asset allocation model. The other issue
> is this whole business of systemic risk -- if you overwhelm the cash
> market, that cash/futures arbitrage breaks down and you have a potential
> disaster with future becoming uncoupled from cash. That's big issue,
> improbable (I hope), but possible. The problem with the lack of
> oversight of these markets is that we can't even assess the potential
> for that systemic risk. Sounds crazy, but so did those who called
> the subprime disaster.
Submitted by Tyler Durden on 07/30/2009 17:10 -0500
Alan Grayson Bank of America Bankruptcy Banks Ben Bernanke Bonuses Cash CEO Commercial Paper Compensation Comptroller of the Currency Credit Debt Derivatives Earnings FDIC FED Federal Deposit Insurance Corporation Federal Reserve Federal Reserve System Goldman Sachs Jamie Dimon Lehman Brothers Liquidity Merrill Lynch Money Morgan Stanley New York Times Office of the Comptroller of the Currency SEC Speculation TARP Toxic assets Trade VaR
By Nomi Prins, via Mother Jones
July 28, 2009 -- This is perhaps the most important thing I learned over my years working on Wall Street, including as a managing director at Goldman Sachs: Numbers lie. In a normal time, the fact that the numbers generated by the nation's biggest banks can't be trusted might not matter very much to the rest of us. But since the record bank profits we're now hearing about are essentially created by massive federal funding, perhaps it behooves us to dig beneath their data. On July 27, 10 congressmen, led by Rep. Alan Grayson (D-Fla.), did just that, writing a letter to Federal Reserve Chairman Ben Bernanke questioning the Fed's role in Goldman's rapid return to the top of Wall Street.
To understand this particular giveaway, look back to September 21, 2008. It was a frenzied night for Goldman Sachs and the only other remaining major investment bank, Morgan Stanley. Their three main competitors were gone. Bear Stearns had been taken over by JPMorgan Chase in March, 2008, Lehman Brothers had just declared bankruptcy due to lack of capital, and Bank of America had been pushed to acquire Merrill Lynch because the firm didn't have enough cash to survive on its own. Anxious to avoid a similar fate, hat in hand, they came to the Fed for access to desperately needed capital. All they had to do was become bank holding companies to get it. So, without so much as clearing the standard five-day antitrust waiting period for such a change, the Fed granted their wish.
Bank holding companies (which all the biggest financial firms now are) come under the regulatory purview of the Fed, the Office of the Comptroller of the Currency, and the FDIC. The capital they keep in reserve in case of emergency (like, say, toxic assets hemorrhaging on their books, or credit derivatives trades not being paid) is supposed to be greater than investment banks'. That's the trade-off. You get access to federal assistance, you pony up more capital, and you take less risk.
Goldman didn't like the last part. It makes most of its money speculating, or trading. So it asked the Fed to be exempt from what's called the Market Risk Rules that bank holding companies adhere to when computing their risk.
Keep in mind that by virtue of becoming a bank holding company, Goldman received a total of $63.6 billion in federal subsidies (that we know about—probably more if the Fed were ever forced to disclose its $7.6 trillion of borrower details). There was the $10 billion it got from TARP (which it repaid), the $12.9 billion it grabbed from AIG's spoils—even though Goldman had stated beforehand that it was protected from losses incurred by AIG's free fall, and if that were the case, would not have needed that money, let alone deserved it. Then, there's the $29.7 billion it's used so far out of the $35 billion it has available, backed by the FDIC's Temporary Liquidity Guarantee Program, and finally, there's the $11 billion available under the Fed's Commercial Paper Funding Facility.
Tactically, after bagging this bounty, Goldman asked the Fed, its new regulator, if it could use its old risk model to determine capital reserves. It wanted to use the model that its old investment bank regulator, the SEC, was fine with, called VaR, or value at risk. VaR pretty much allows banks to plug in their own parameters, and based on these, calculate how much risk they have, and thus how much capital they need to hold against it. VaR was the same lax SEC-approved risk model that investment banks such as Bear Stearns and Lehman Brothers used, with the aforementioned results.
On February 5, 2009, the Fed granted Goldman's request. This meant that not only was Goldman getting big federal subsidies, but also that it could keep betting big without saving aside as much capital as the other banks. Using VaR gave Goldman more leeway to, well, accentuate the positive. Yes, Goldman is a more risk-prone firm now than it was before it got to play with our money.
Which brings us back to these recent quarterly earnings. Goldman posted record profits of $3.4 billion on revenues of $13.76 billion. More than 78 precent of those revenues came from its most risky division, the one that requires the most capital to operate, Trading and Principal Investments. Of those, the Fixed Income, Currency and Commodities (FICC) area within that division brought in a record $6.8 billion in revenues. That's the division, by the way, that I worked in and that Lloyd Blankfein managed on his way up the Goldman totem pole. (It's also the division that would stand to gain the most if Waxman's cap-and-trade bill passes.)
Since Goldman is trading big with our money, why not also use it to pay big bonuses? It's not like there are any strings attached. For the first half of 2009, Goldman set aside $11.4 billion for compensation—34 percent more than for the first half of 2008, keeping them on target for a record bonus year—even though they still owe the federal government $53.6 billion, a sum more than four times that bonus amount.
But capital is still key. Capital is the lifeblood that pumps through a financial organization. You can't trade without it. As of June 26, 2009, Goldman's total capital was $254 billion, but that included $191 billion in unsecured long-term borrowing (meaning money it had borrowed without putting up any collateral for it). On November 28, 2008 (4Q 2008), it had only $168 billion in unsecured long-term borrowing. Thus, its long-term unsecured debt jumped 14 percent. Though Goldman doesn't disclose exactly where all this debt comes from, given the $23 billion jump, we can only wonder whether some of it has come from government subsidies or the Fed's secret facilities.
Not only that, by virtue of how it's set up, most of Goldman's unsecured funding comes in through its parent company, Group Inc. (Think the top point of an umbrella with each spoke being a subsidiary.) This parent parcels that money out to Goldman's subsidiaries, some of which are regulated, some of which aren't. This means that even though Goldman is supposed to be regulated by the Fed and other agencies, it has unregulated elements receiving unsecured funding—just like before the crisis, but with more of our money involved.
As for JPMorgan Chase, its profit of $2.7 billion was up 36 percent for the second quarter of 2009 vs. the same quarter last year, but a lot of that also came from trading revenues, meaning its speculative endeavors are driving its profits. Over on the consumer side, the firm had to set aside nearly $30 billion in reserve for credit-related losses. Riding on its trading laurels, when its consumer business is still in deterioration mode, is not a recipe for stability, no matter how much cheering JPMorgan Chase's results got from Wall Street. Betting is betting.
Let's pause for some reflection: The bank "stars" made most of their money on speculation, got nearly $124 billion in government guarantees and subsidies between them over the past year and a half, yet saw continued losses in the credit products most affected by consumer credit problems. Both are setting aside top-dollar bonuses. JPMorgan Chase CEO Jamie Dimon mentioned that he's concerned about attracting talent, a translation for wanting to pay investment bankers big bucks—because, after all, they suffered so terribly last year, and he needs to stay competitive with his friends at Goldman. This doesn't add up to a really healthy scenario. It's more like bad déjà vu.
As a recent New York Times article (and many other publications in different words) said, "For the most part, the worst of the financial crisis seems to be over." Sure, the crisis may appear to be over because the major banks of Wall Street are speculating well with government subsidies. But that's a dangerous conclusion. It doesn't mean that finance firms could thrive without the artificial, public-funded assistance. And it certainly doesn't mean that consumers are any better off than they were before the crisis emerged. It's just that they didn't get the same generous subsidies.
Additional research by Clark Merrefield.
Article From Mother Jones, h/t amsterdamtrader
There is no oil shortage, just the ultra rich playing in the oil commodities market and pushing the price up and taking gas and diesel along for the ride. This is also finishing off whatever chance America had for a rebound from the coming Second Great Depression. It is not about supply and demand anymore, rather it is control of supply.
We can all blame Phil Graham with the Commodity Futures Modernization Act passed in 2001. That 262-page bill led to the Enron mess, the sub-prime lending disaster, and opened the door to the “Dark Energy” speculation trading.
For some good reading on this subject check out this site.
Global Research.
www.globalresearch.ca/...
Also read more about it at this site:
losangeles.injuryboard...
The really shocking thing about the Swaps Loophole is that Speculators of all stripes can use it to access the futures markets. So if a hedge fund wants a $500 million position in Wheat, which is way beyond position limits, they can enter into swap with a Wall Street bank and then the bank buys $500 million worth of Wheat futures.
In the CFTC’s classification scheme all Speculators accessing the futures markets through the Swaps Loophole are categorized as “Commercial” rather than “Non-Commercial.” The result is a gross distortion in data that effectively hides the full impact of Index Speculation.
> The really shocking thing about the Swaps Loophole is that Speculators
> of all stripes can use it to access the futures markets. So if a
> hedge fund wants a $500 million position in Wheat, which is way beyond
> position limits, they can enter into swap with a Wall Street bank
> and then the bank buys $500 million worth of Wheat futures.
> In the CFTC’s classification scheme all Speculators accessing the
> futures markets through the Swaps Loophole are categorized as “Commercial”
> rather than “Non-Commercial.” The result is a gross distortion in
> data that effectively hides the full impact of Index Speculation.
Mr Greatest Rip Off - nice summation, all correct, the only question is what to do about it. I would say that swap dealers should be strictly pass-through, that is transparent in terms of both position limits and spec/hedger character. In your example above, there wouldn't be any limit for the swap dealer, but the normal limit would apply to the hedge fund buying swaps, just as though they had bought futures directly. Similarly, ETFs should be passthrough to their individual holders. If an ETF holds a position of $500M in wheat and you hold 20% of all the ETF units, then the limit would apply to your holding of $500M * 20% just as though you had that position in futures directly. ETFs holding swaps would pass through the underlying position through both to the ETF unitholders. Essentially, how you end up with a certain position shouldn't matter, only the resulting position should matter. Long an ETF which owns swaps which are hedged with futures is exactly identical to long futures. This is just common sense.
> I haven't changed my mind, but I'm certainly thinking about the economic
> efficiency of inventory building per the remarks. My gut is that
> it is still economically flawed -- the most efficient ways to hold
> inventories in oil is by not taking it out of the ground, and the
> people who can make that decision are the best informed, too.
One more idea about this which took some time to develop... A thought experiment: if I am an oil producer, why could I not simply shut down my production for a year, lock in better prices for a year in the future (taking advantage of the steep contango), and then produce twice as much next year? Result: get an extra $8 or so for every barrel of oil i withheld from the market this year. Obviously, producers *aren't* doing this. A complete shutdown is unrealistic for the reasons I described earlier, but a 20% cutback would be possible. Similarly producing twice as much is not possible, but even at regular production rates, the producer would still realize higher prices per barrel of reserves if they delay production. They may be holding back a little, but nothing like what you'd expect based on the extremely steep contango. Why not? That is ipso facto evidence that producers do not consider themselves to be able to "store in the ground" very economically: the value of current production is higher, when taking all factors into account, than the value of delayed production less the cost of the delay ("storage"). Producers are one of the groups that can flatten the contango, but, apparently, they're not the most competitive "contango flatteners".
This actually makes intuitive sense to me: I would guess the cost of delayed production is somewhere north of $5/year, while the cost of aboveground storage is only $1-$3. The cost of delayed exploration, on the other hand, is gonna be very much lower. So what you're gonna see is that producers still pump at roughly the average rate, but simply stop exploring for new reserves.
> A quick note of thanks to all those who post comments -- for example,
> JeffDB's and Rayden's comments today remind of the value I get from
> having my blog posts appear on SeekingAlpha. We may not agree, but
> I read everyone's comments and take the challenges very seriously
> -- and I've learned a lot from these, sometimes changing my opinion,
> sometimes forcing me to tighten my own arguments. It's great stuff.
> I'm paid to do this for a living. Many of you are not. I appreciate
> your time and effort.
Jeff - thanks for the acknowledgement, I appreciate that. I also do this for a living (trading, not writing) and jousting with you on the commodity index speculator issue has helped develop certain ideas I have about the structure of the markets, which has actually been very helpful.
My article on position limits (zachstocks.com/2009/07.../) inspired a lot of comments on both sides of this argument, but I would always consider opinions with respect even if they didn't match my own.
The futures market is part of capital markets and is vital for the functioning of the cash markets. An active and broad assortment of traders (both speculators as well as commercials) will give us the best price discovery. We SHOULD act to keep large players from manipulating markets but there's less evidence of this type of activity than many realize.
What worries me is that limiting position sizes is just one of many steps away from a free capitalistic market and towards one where the government influences prices. That's manipulation from a player that is MUCH larger than any Goldman or Morgan Stanley trading desk.
Oil consuming nations seek to manipulate oil prices also and make it to be lower than actual worth by cooking the markets. The commodity markets, financial markets and stock markets are all heavily manipulated, through zero interest rates, printing cash, agricultural subsidies, futures markets dominated by big players who issue upgrade/downgrades while trading the markets instantly and so on. Of course there are players in the markets who seek manipulate the already manipulated markets and that is why in midst of 150$ oil, a market would rally and get overheated which is then followed by a crash.
To seek cheaper oil than the cost of extraction by manipulating the markets is not unusal and it has been promoted to boost the battered economies which have wasted vast amount oil using larger vehicles than are needed for transportation.