Raising Margin Requirements May Spike Oil Prices Higher

Commodity pricing theory mainly focuses on the transference of a “risk premia” from risk-adverse hedgers to speculators. This insurance-like context was first proposed by Keynes (1930) in his theory of normal backwardation. Essentially, Keynes believed that hedgers have to pay speculators a risk premium to convince them to accept their risk.  

Dr. Richard Spurgin (2000) explained it in the following way. There are four types of participants in futures markets: short hedgers, long hedgers, speculators and arbitrageurs. Short hedgers are commercial producers and long hedgers are commercial consumers. 

Arbitrageurs perform a special function, and exist to ensure consistent pricing across different types of instruments relating to a particular asset and its relationships (e.g., cash, futures, forwards, options, etc.).  

[Note: A discussion of commodity pricing theory as it relates to price convergence between the futures and spot price is a technical topic and overly complicates the purpose of this article. Suffice it to say that the futures-spot convergence is the principal objective that validates the futures markets’ economic purpose.] 

Speculators, on the other hand, are assumed to “hold the difference between the long hedger, short hedger and arbitrageur positions.” Accordingly, speculators are key to ensuring the futures markets operate smoothly, as shall be illuminated by Dr. Spurgin’s “hedging response function.” 

The hedging response model is intuitive and serves as a good basis for understanding the functionality of the commodity futures market, as well as for formulating legislation and regulations that promote the economic purpose of these markets without hindering innovation or normal speculative activities. 

According to Dr. Spurgin’s hedging response function, there are four asymmetric scenarios which theoretically produce excess return to speculators, and two symmetric scenarios which are zero-sum: 

A) a rise in commodity price (beneficial to producers) generates more initiative from producer short hedgers to lock in higher prices, hence a net short hedging position is established;  

B) a rise in commodity price (detrimental to consumers) causes consumers to be more concerned about guarding against margin pressure than producers are concerned about locking in higher prices, hence a net long hedging position is established;  

C) a drop in commodity price (beneficial to consumers) generates more initiative from consumer long hedgers to lock in lower costs, hence a net long hedging position is established; 

D) a drop in commodity price (detrimental to producers) causes producers to be more concerned about guarding against margin pressure than consumers are concerned about locking in lower costs, hence a net short hedging position is established; and 

E) a symmetric response results when the transaction is ‘speculator versus speculator,’ or

F) a ‘long hedger versus short hedger.’ Theoretically, the majority of futures transactions result in a symmetric response, and therefore it is the “net” hedging response that is of most interest. 

In accordance with Dr. Spurgin’s hedging response model, speculators fulfill an economic purpose by plugging the asymmetrical difference between a net long or net short hedging response. This is the reason why speculators provide an economically important role in the functionality of these markets. 

Anecdotally, “Scenario B” seems to be the current predominant “hedging response function” in the oil markets. If that is the case, then the question is, who are the “long hedgers” that are reflexively reacting or producing higher prices?  

There is evidence to suggest that a major constituency in this regard is the financial “investors” seeking to hedge inflationary expectations vis-à-vis commodity index funds. Another key constituency according to various news media accounts has been international governments who are ensuring they have sufficient stockpiles of a particular commodity (e.g., strategic oil reserves). This is in addition to traditional commercial long hedgers who can add to upside price pressure, as well as speculators engaged in “trend-following” strategies. 

However, the lynchpin is that if the hedging response is “Scenario B,” then on a net basis it is speculators who are actually the main sellers of futures contracts versus long hedgers.  

Speculators who are short (i.e., selling futures) are betting against the bullish trend on the speculation that prices will drop. But in order to be enticed to do so, they must be paid an excess premium for making such a bet, resulting in upward price pressure. That is the likely reason why we have been seeing oil prices consistently rise. 

If one agrees with this analysis as well as the viability of Dr. Spurgin’s model to provide insight into the workings of the futures markets, then the next logical question is whether the categorization of various constituencies accurately reflects a bona fide hedger or more accurately speculators. 

For example, should index funds continue to be categorized as a commercial, or re-categorized as either a non-commercial, or a separate category? The euphemism amongst veteran futures traders is that index funds represent “dumb money,” and that nobody wants “to get run over by a stampede of cattle.” Yet, an argument can also be made that long-bias index funds provide a “hedge” against inflation. On the other hand, the term “bona fide hedger” implies a commercial that is capable of making or taking spot delivery. 

There is an additional scenario referred to as a “market squeeze” which Dr. Spurgin does not discuss in his paper on the hedging response function. For example, commercial short hedgers who initially entered positions at a lower price by selling futures under “Scenario A,” get caught in a “short squeeze” whereby increasing upward pressure forces “short covering” (i.e., buying). 

This particular scenario often causes spikes in volatility, similar to what we experienced during February and March of this year in the wheat contract. Again, however, it was speculators who ultimately provide the liquidity which allowed these market participants to exit their positions. 

Accordingly, we can arrive at the following conclusion… 

It would be reckless and irresponsible for the U.S. Government to force regulators to raise margin requirements under current market conditions, specifically with respect to the oil markets. 

In April 2008, U.S. Sen. Byron Dorgan, a North Dakota Democrat, told Congress, “There is an orgy of speculation in futures markets. This is a 24-hour casino with unbelievable speculation.” He and others in Congress have been raising the idea of changing margin requirements that traders must pay up front in order to engage in oil speculation. Dorgan said stock speculation requires a 50% margin, but commodities like oil demand a much lower threshold, just 5% or 7%. 

According to Senator Dorgan’s and other Congressional members’ analysis/opinion/rhetoric, excessive speculation is driving prices up, not fundamental demand-supply factors. If this is the case, then increasing margin should theoretically bring about an exodus of speculators from the futures market, causing oil prices to come back down. 

But as our analysis reveals using Dr. Spurgin’s model, the oil market currently indicates that there is a net hedging response where long hedgers are willing to pay short speculators excess premia to enter into a contract. As Michael Masters posited, the predominant long hedgers may very well be the commodity index funds. Yet it should also be noted that these same index funds will not be materially impacted by an increase in margin because they are fully-funded.  

Hence, while the hedging response function may or may not be causing the market to steadily rise, it is prudent to err on the side of caution. If our thesis is correct, then raising margin requirements will result in a disastrous short covering rally. 

At $135 a barrel per oil, we are beginning to see indications of demand destruction. It may in fact be the case that threats from Congress are already having a detrimental impact on the oil markets. 

Governments and regulators should beware… the law of unintended consequences rules the market!

Comments

[Brian Pursley:]

I can't think of anyone who actually wants the commodity price of oil to go down. Democrats want the price to go to infinity so they can have their beloved alternatives. If they wanted the price to go down they would allow domestic drilling to increase supply. Republicans, the smart ones anyway, are long oil. So who exactly wants the commodity price to go down?

2008 May 27 04:34 AM

[Brian Pursley:]

The issue of speculators and margin requirements is just an excuse for totalitarians to seize more power for the federal government and destroy economic liberty and personal freedom.

2008 May 27 04:45 AM

[ship shape ...:]

This is what happens, when people try to regulate things they do not fully understand. The changes made in the flora and fauna of Australia are a perfect example for the immense problems such ignorant behavior causes.

The problem is, that people just don't want to face facts. I guess that's why Rome fell.

Is it possible, that a new kind of fungus affects wheat prices? Oh no, it must be speculators.

Is it possible, that all the good iron ore and copper mines are already in a mature phase. So now mines with lower grades have got to be brought online, which makes these minerals obviously more expensive.
Oh no! It must be speculation!

The same thing would be true for oil and a lot of other stuff.

On top of that: People are stuck in the past. They really have trouble to accept, that once 'savage' economies like China are becoming a force.

If we don't start to face facts and make the necessary changes, we will fall like Rome.

Burning witches never saved a problem, it only calmed down the mob.

2008 May 27 05:31 AM

[buyitcheap:]

Outstanding! Your thesis regarding a short covering rally is amazingly logical. The time frame then, if I understand it correctly, would be around a political or CFTC(?) decision to raise margin. The only "low" risk play then on the oil is a strangle to catch an extreme swing down, or up.

2008 May 27 07:38 AM

[buyitcheap:]

And with regard to a political fix, let's start electing small business owners(who know the value of a buck), retired military (who know the value of a life), and farmers (who know the value of everything else) to Congress, rather than electing "know nothing" lawyers, perhaps that's a reasonable place to start.

2008 May 27 07:40 AM

[SW Richmond:]

Michael Masters' portfolio is full of airlines. His "testimony" isn't any more complicated than that.

www.tickerspy.com/memb...

2008 May 27 08:16 AM

[Timmothy Posey:]

Speculation can occur without margin. ETFs are cash-based, and any mom-and-pop investor can buy cheap ETFs (DBE is only $50) and without having to take delivery.

2008 May 27 08:08 PM

[jjason:]

In my country, monopolies are illegal. OPEC is a monopoly and I hope Congress can be effective in destroying the ability of OPEC to control oil prices. Those of you who think that buying a commodity and hoarding it for profit is fair are SOB's.

Take gold for instance. I have none in my possession and do not invest in any gold futures, stocks etc. I consider gold to be a waste of money. Others disagree. I can do without gold. Gold does not affect my standard of living. On the other hand, water is important to me. I have lots of it. No one can push the price of my water to $130 per gallon. But in the western US, water is not as plentiful in some areas so it is more expensive if you need it.

The world needs oil for a lot of things. The more expensive oil is the more expensive food is. Shame on those who are causing supply disruptions and refuse to admit that it is wrong.

Finally, I am already using the sun to heat water. The setup to do this cost me about $24.00 and a little time. I will not have to use oil for heat or hot water for seven months. I am building a solar collector to see if it will heat my house for two or three additional months. Eventually, others will do the same. It will take time to solve my countries problems. I am working on it.

One last thought for ship shape and bristol fashion: I have been a sailor for 35 years. Most sailors I know are helpful people and go out of their way to help a mariner in distress. It's a talent that seems to be lacking in the investment community. Greed seems to be more important. A well run ship is run well for everybody.

OBAMA 08

2008 May 28 06:11 AM

[GINGER 1978:]

Raising margin requirements requires more capital. The long term market value of the asset or whatever it is that requires more capital after than before will always decline as the market will reposition capital to where the capital is treated the best. Look out below.

2008 May 28 08:09 PM

[GINGER 1978:]

Remember the internet stock crash of 2000-2001? The margin requirement was changed by NYSE member firms on various internet stocks. The requirements varied. Some companies required investors to put up 100% cash for purchase and others something less and others got by with the regular margin requirment. The mistake by all was not to recognize upon first notification that the requirements had changed, that the securities should be sold and then shorted.

2008 May 28 08:15 PM

[citizen782:]

"If our thesis is correct..."
That's the bigger factor isn't it? If your thesis is wrong based upon Dr. Spurgins hedging response function and it is not what's causing prices to rise then increasing the margins should in fact result in a dramatic drop per barrel. Also, even if there was a short covering rally, who's to say that might not be the temporary pain (shot in the arm) necessary to bring market prices on futures back to reality?

2008 Jun 09 09:39 AM

[citizen782:]

A thought crossed my mind. Watch out. If margins were implemented with immediate effect (no warning) wouldn't that curtail any short term rally on short futures?

2008 Jun 11 03:14 PM

[Voice of Sa...:]

"wouldn't that curtail any short term rally on short futures?"

Of course it Would. If a speculator with 60k to put into Crude oil futures(enough to hold 1 million dollars worth of Crude off the market today) had the margin requirement for Crude Oil jump to 60% over night, they would still have only 60K to invest but could then only buy/hoard 100k worth of Crude. The title of this article is completely bizarro.

2008 Jun 17 08:34 PM

[jwalpha:]

Perhaps the CFTC and the Federal Reserve need to step in and limit futures contracts to only those buyers that will actually take delivery. Margin requirements need to be raised to make it more costly for hedge funds to speculate. We need more transparency.

2008 Jun 29 08:22 PM

[Bill G. fro...:]

The idea that increasing margins will raise prices does not pass the common sense test. People are bidding to control a barrel of oil, either to sell it at a later date for some profit or to refine it into a consumer product. At a 6% margin the speculator controls a barrel of oil for about $9 while a consumer must pay the full market price, who will control more barrels? If the price does up $10 per barrel the speculator makes 100% profit thus it is in their intrest to control as much oil as possible, if the margin were increased to 50% they would only make about 15% profit on the same price increase thus lessening their desire to control oil the reward has been significantly lowered while risk remains the same. Thus the investment is no longer as benificial and thus less desireable. Net effect is less people bidding to control oil so price goes down.

2008 Jul 16 09:12 AM

[User 254952:]

Let me try to alleviate the confusion here...

For every buyer of a futures contract there is a seller. Additionally, both longs as well as shorts put up the same amount of margin to establish a position. Further, commodity-linked ETFs and other "securitized" commodity products are derived from futures contracts.

Here is a mind experiement to explain the thesis:

Let's assume there is one short seller who puts up $6k margin to control 1 contract/$100k short position. Let's also assume that there is one long offsetting this short who has fully funded his long position (ie, invested $100k) and purchased an ETF. For argument sake, let's say that the ETF provider who is backing the ETF buys 1 futures contract/$100k long position (requiring only $6k margin) versus the short seller previously mentioned and leaves the $94k balance in cash.

This is essentially an asymmetrical situation...

Now, if margin requirements are raised, who is going to have to come up with more $$$ to cover the requirement?

The short seller... he/she will have to either cover the position (that is, buy the contract causing upward pressure on prices), or he/she will have to come up with more money to maintain the position.

Meanwhile, the long ETF position which is fully funded will not be impacted in anyway, and he/she can remain long without having to come up with additional funds as he/she already put up $100k.

BTW, citizen782 understands the inside joke and is correct in his additional analysis.

As a final comment, let me explain why I wrote the article.

First, it was to highlight the potential distortions that securitized commodity-linked products have on the proper functioning of the futures market. Some of the responses here reflect misunderstandings of how futures markets work and how securitized commodity-linked products are derived from such markets.

Second, I wanted to point out the how improperly vetted legislation (eg, raising margin requirements) could cause price distortions. Enough time has passed since writing this article, and there has been sufficient documentation in the financial press of short term spikes related to short covering to validate that certain 1-2 day spikes were related to hedge fund short covering in oil. However, there is insufficient empirical data to relate how an increase in margins may have had an impact, although the NYMEX did raise margins on oil a few months ago.

2008 Sep 03 09:06 AM