The spike in the price of crude in May is having the anticipated effect of arousing the Congress in this election year. Earlier this week, Congress passed a bill with veto-proof margins to suspend intakes into the Strategic Petroleum Reserves till crude oil prices go under $75/barrel and stay there for ninety days.
Enron Loophole: Position Limits
Close at the heels of the SPR bill, the current Farm Bill has provisions which will plug the so-called ‘Enron Loophole’ which allows speculators to bypass regulations regarding position limits enforced by the Commodities Futures Trading Commission [CFTC]. The bill again passed with a veto-proof majority.
This bill empowers CFTC to monitor trading on electronic platforms, like the Atlanta based Intercontinental Exchange (ICE), which presently is outside the purview of the CFTC. ICE, and other similar exchanges, will have to limit the number of contracts a single investing entity can own and will require large traders to report their positions.
There are also some rumblings to increase margin requirements for energy futures trading. Right now speculators need to put between 5-7% cash margin to trade crude oil futures. This provides a huge amount of leverage and which stands out in contrast to the 50% margin typically required for stocks. Low margin requirements are a useful tool for commercial hedgers to manage their exposure without undue financial burden. However they also permit speculators to control a huge amount of oil supply with a significantly lower financial outlay.
Increasing margin requirements will reduce the degree to which speculative money can influence the price of oil. Ideally, the exchange should adopt a two-tier system which enforces one set of margin for commercial hedgers who take physical delivery of crude oil, and speculators who do not take physical delivery. The margin for speculators should be significantly higher than commercial hedgers; some observers have suggested even 100% margin requirements!
Investor Classification Conundrum
Another area of review should be the classification system used by the Commitment of Traders report which breaks down positions between commercial hedgers and speculators. Over the past few years banks like Goldman Sachs have offered total return index swaps, linked to commodity indices, which allow investors to speculate in the commodities market. With the commodities market outperforming other asset classes like equities, bonds and real estate, a large number of institutional investors, including large pension funds like Calpers have invested in index linked products. The banks have been selling these products under the umbrella of asset diversification and passive index based commodity exposure exceeds $250B today. Bloomberg carried an article by Caroline Baum, with a detailed discussion of how these positions are showing up as commercial hedges instead of the speculative positions, since they are traded via the intermediary bank, even though the original investor is a pure speculator.
Presently, the Commitment of Trader reports show that commercial hedgers are net short while speculators are net long. The true picture will be even more distorted if the effect of the money invested via passive index funds is considered. As Ms. Baum put it, this is a classification conundrum; this should be resolved before creating a two-tier margin structure.
Sour Crude: Refining Capacity to Spike Up
Earlier this week, crude oil rallied on NYMEX trading on the news that Iran was thinking of cutting production. Further investigation revealed that Iran has run out of storage facilities and is renting tanker ships to store its crude oil off-shore, while it waits for buyers. Iran is one of the largest producers of sour crude oil, which has a higher Hydrogen Sulphide content than the Light Sweet Crude.
Sour crude is better suited for producing distillates products like diesel, jet-fuel, gasoil and heating oil. Heating oil, which is often treated as a trading proxy for distillates, has been on a tear lately due to shrinking stockpiles in Europe. The shortage is being attributed to seasonal maintenance related shut-down in refineries. However, with all news being bullish, traders bid up crude oil, including the sweet crude contract traded at the NYMEX following the run by heating oil. However, the shortages in distillates are likely to end soon as a new mega-refinery comes online to soak up the sour crude piling up in the Gulf.
In July, Reliance Industries, the petro-chemical giant based in India will be bringing its second large refinery on-line. This refinery has a capacity to process 580,000 barrels of oil per day. Further it is designed to thrive on sour crude, and not only produce the traditional distillates but also high quality purified gasoline which means tight Western standards. This refinery will go a long way in increasing the uptake of sour crude and reduce the pressure on sweet crude.
Russia: What Decline?
The fear of drop in crude oil output from Russia is one of the key drivers of the peak-oil scare and the current bull-run. Over the past week Russian leaders have come out swinging, addressing concerns about oil production. Putin has pledged to extend tax breaks to companies exploring for oil beyond the current Eastern Siberian region. Russian tax policy was seen as the key barrier to the growth of the Russian oil industry since it discouraged investment. Deputy Prime Minister Igor Sechin went on to say that he does not expect a decline but an increase this year. These statements sent the RTX, the country's benchmark stock index, to a record high of 2,406.05, surpassing the previous high hit last December.
It will be interesting to see whether this news affects the bullish sentiment in the oil trading pits. The June contract traded in a $6 band on Thursday, with the June futures options expiration adding to the volatility introduced by the Farm Bill.
Disclosure: Vikram holds equity, equity options and futures positions (both long/short) in oil and energy related industries