Crude Oil: Congress Acts, Iran Hoards, RTX Soars

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.

Margin Requirements

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

Comments

[JREwing]

I am so relieved. Now that congress acts, things must be getting better. (sarcasm)

Calling this act a farm bill is a contradiction in terms. If politicians around the world haven't regulated the agricultural sector to death for decades, there wouldn't be a shortage of food, today.

Every time some fool in some government tries to make food (or oil for that matter) cheaper than it would be normally, they make it more expensive, because they take away the incentive from the producers to produce more.

Then they have to subsidize farms and make food more expensive once again, because - unbelievably but true - taxpayers eat, too.


About the new refineries in India:

Reliance is gonna make a killing on those big boys.

Assuming demand for petroleum products will be flat until the end of time, we should be fine. I guess this justifies 10$ oil. (sarcasm again)

About the Russians:

The Lukoil boss said, that russian crude production will peak this year, and then fall. He didn't say it already happened. I going to believe him more than some Russian government dude. Wouldn't believe one of those, if he said water was wet. (Not sarcasm)

And if the Russians want to give a tax incentive for more oil production, why did they hike the export tax once again in April?

[JREwing]

Baltic Dry is almost at a new high, Singapore's economy seems to be doing fine, so is Japan and Indonesia, even Germany... all despite a so called US recession (still waiting for that one).

THERE IS JUST NO REASON IN THE WORLD, WHY OIL SHOULDN'T BE WHERE IT IS!

[dieuwer]

Suppose that in the case outlined above margin requirements on crude oil contracts rise very high, perhaps to 100%.
Why would any trader or commercial keep trading via a US exchange? Might as well move the capital out of the country in invest via London or Dubai where lower margin requirements are set.

This will just lead to an even larger loss of economic dominance.

[Mmarrkk]

Now I've heard everything. The Russian government, you know, those ex-Soviet socialists, are giving oil companies tax breaks to produce more oil. Specifically focused tax breaks. And here in the US, our own little Socialists, the Demoncrats, are talking about taking away tax incentives and in fact, specifically taxing 5 companies in a punitive way. Man, the world certainly has changed. Russia now has more of a free-market government than we do here in the US. And that's not to mention our friends up in Alaska, who now have one of the worst tax regimes in the world! Keep biting the hand that feeds and powers you, Demoncrats. Before long, all major oil and gas companies will be from non-US countries and the the US companies will either be greatly hurt or will leave the country.

[CLH]

Yes the nit wits in congress are at it again. Billions for the farmers--taken from the taxpayers. Spectulators? Everyone is a spectulator (the smart people any way). Everyone fills their gas tank in the evening because it will go up tomorrow. Even the nit wit congressman spectulate--its human nature.

Oil will soon crash and the mideast will be starving again as in the 1980s. No its not different this time. There is lots of oil. As the price goes up fewer people in the third world can afford it. Yes back to bikes.

People keep talking about running out of oil. This will NEVER happen. As its used the price goes up and the demand goes down. This is how capitalism works.

[JREwing]

Capitalism rules.

Oil won't crash. Looks to me like some of those 'Third World' guys are in a better position to afford the stuff, than us.

How can something finite last forever?

[CLH]

Mmarrkk I agree with with you. Socialism now is in Europe, Canada and even America. Capitalism is only found in the former socialist states because they know socialism does not work. They were forced to live under this horror.

[CLH]

JRE Everything is finite!! Even you. So what. Ever heard someone say---"they cant make more land". So what happened to real estate? Nothing goes up all the time. ITS NOT DIFFERENT THIS TIME!!!!

[JREwing]

What has the housing bubble to do with the amount of land?

I just said oil won't crash. A lot of people can afford it. Doesn't seem to me, that gas is too expensive. As long as there are people drag racing towards red lights, I guess there is some upside left.

The economy is either going to adapt by a more efficient use, or it will go to hell. Big Deal.

It astonishes me every day, how worked up people get, when it comes to oil.

[richjoy]

I think I'll stay out of this one...not much left to say among the noise anyway.

[coaster]

My father bought a VW in 1956 and was delighted that he could drive it for a penny a mile, which would be eight cents today. I drive my Camry Hybrid for about ten cents a mile and believe me that car is like a Rolls compared to the 56 VW. Gasoline is not expensive!

[CommodityBubbleproponent]

Two comments:

1. This is clearly a bubble.

2. I used to agree with this author on the issue of trying to raise margin requirements, etc. These things aren't going to work.

Goldman Sachs, Morgan Stanley, etc. are commercial hedgers b/c they own oil storage facilities around the world. So, we're stuck with them whether we like it or not.

What is going to change this is if the Federal Reserve decides to turn off the easy money spigot and start tightening up to combat inflation, like they should have been doing for the last year instead of trying to save some dumbasses on Wall Street from feeling pain.

This tightening will cause the recession the world so desperately needs to clear out all of the junk debt, overinflated asset prices, etc. out of the system and return to something that actually is based upon reality

[jjason]

I happen to agree with Congress when they think that margin requirements should be increased for buying oil futures contracts. In my opinion, the speculators should be put out of business by making it illegal to buy futures contracts in everything.

What is the matter with you people. Speculation in real estate has screwed up the housing market AND EVERYONE WILL SUFFER FROM IT. There is a big difference in producing something and gambling ( speculating is a form of gambling).

If the American people cannot use common sense in their personal lives and in their businesses...then expect laws to be passed to control the bad behavior.

It is terrible that there are so many idiots on these message boards.

[JREwing]

Oh yes jason, laws.

Let's make some laws. Considering the guys, who make the laws, I am not looking forward to this.

Let's take away some freedom in order to make little jjason feel better. Socialists of the world unite! You guys are really little people in more than one sense.

The US once almost regulated itself to death. Let's do that again. That makes sense. Let's have every part of our lives regulated by the government. I am sure this will be an improvement.

Commodity bubble proponent

Goldman has tank farms? How desperate are you? I bet they have tanks deep beneath Manhattan where they a re hoarding trillions of megatons of oil in order to make you suffer. MUHAHAHAHA!

Dude, You should see someone about that.

This site is full of commentators and contributers who want to take part in the capital markets. As soon as the market doesn't do what they want it to do, they turn communist and demand regulation and taxation.

That is the behavior of a loser. There are some commentators who argue with logic and valid facts and numbers. However most folks around here simply are great reminders of the fact, that democracy is not perfect.

I will delete SA from my favs and will never again go to this site.

[pockyclips2020]

Again, there is no free market in oil. Hasn't been since the 1870's. Our government, Arab governments, and Big Oil are part of the big circle jerk. And guess who's in the middle, catching.

[brian514]

hmmm....baby food, diapers or gas to go to work...so I can afford the baby food and diapers....and the gas to go to work...hmm..guess I just went full circle on this one.

[jjason]

JREwing. Glad to see you go.

[Vikram]

JREwing:

Goldman and Morgan Stanley indeed have oil tank farms. That is why they can act as commercial hedgers. It seems last week even JPMorgan decided to get in the physical commodity business (Bear Sterns had a strong commodity trading group).

JPMorgan's action seems to be designed to pre-empt any effort to have a dual margin structure (hedgers vs speculators).

The large investment banks have a their finger on the pulse of almost everything in the capital markets; it is not wise to bet against them. Goldman will drive the super spike, which will eventually result in a dramatic shift in oil consumption patterns.

[Kunst]

The flip side of high leverage is that small drops in underlying price can wipe out your margin in no time. What goes up fast can also come down fast. Supply/demand is a fairly gradual upward price slope; what we are seeing now is gambling.