A Modest Proposal for Rising Oil Prices 18 comments
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Editor's Note: These days, everybody's blaming commodity index funds and other "speculators" for driving up the price of oil. Those arguments seem like a stretch - index funds are still small players in the enormous oil market, as pointed out eloquently in this op-ed by Don Luskin in The Wall Street Journal. But Congress and the CFTC are still stepping up efforts to regulate oil investment. It's a climate that needs fresh ideas, and one is offered below by the folks at Trim Tabs, a leading Wall Street research group.
The
ridiculously low 7% margin requirement for crude oil futures contracts
means that oil producers, big or small, could easily be manipulating
the price of oil for their own benefit. That's not to say that pension
funds and other hedge players aren't also going steadily long crude oil
and other commodity futures. But it is in the obvious self-interest of
oil producers to have an ever-rising price of crude.
For
example, suppose the "players" who run Russia (or Iran, or Venezuela or
any major or minor producer) decided a year ago to invest $200 million
per month as margin to go long oil futures. Margin of $200 million
could control as many as 25,000 contracts at $8,000 per contract, which
would be equal to 5% of notional open interest. Wouldn't adding 5% of
notional open interest per month to the long side be enough to produce
the crazy oil market that exists now?
Publicly available sources
indicate that Russia produces 9.4 million barrels of oil per day, Iran
4.0 million bpd and Venezuela 3.0 million bpd. The increase in oil
prices from $60 per barrel to $130 per barrel in the past year for
Russia alone has translated into an additional $20 billion per month
(9.4 million barrels per day * 30 days per month * $70 increase per
barrel = $20 billion). Not only would higher prices mean more cash now
but also higher values for what's left. Let's not forget that someone
who bought $2.8 billion worth of oil last year at $60 per barrel using
$200 million in margin is sitting on a profit of over $3 billion per
$200 million investment.
We have no evidence of any kind that
oil producers are pumping up oil prices, but they could. If we were
producing millions of barrels per day of oil, we would consider going
long oil futures, putting up $1 to control $14 dollars of crude, to
ensure that prices keep rising.
Our modest solution to oil
price spike: U.S. should divert money saved from ending strategic
petroleum reserve purchases to go short oil futures.
One obvious
way to burst the oil bubble would be to boost the margin requirement
for oil futures. Since exchanges and brokers earn big bucks from
trading lots of contracts, we therefore doubt margin requirements will
be boosted any time soon.
But there is another way to bring the
oil mania under control. If it is logical for oil producers to go long
oil futures to enhance the future value of their remaining oil, why is
it not logical for oil consumers to go short oil futures? Japan, are
you listening?
The U.S. recently suspended its daily purchases
of 70,000 barrels of oil for the Strategic Petroleum Reserve. Why not
use the savings of roughly $275 million per month to short oil futures
(70,000 barrels per day * 30 days per month * $131 per barrel = $275
million)? That $275 million would be enough to short 34,400 contracts
per month. The U.S. has more than 700 million barrels of oil in the
Strategic Petroleum Reserve, which exceeds the notional open interest
of oil futures. In essence, the U.S. would be offering to sell at a
high price the crude it bought at much lower prices. For the future,
would the U.S. be better off with lower oil prices or more high-priced
oil in salt caverns?
The TrimTabs-BarclayHedge Hedge Fund Flow Report
indicates that $1 billion per month flowed into commodity hedge funds
in the first three months of 2008. If half of that $1 billion, or $500
million, is invested in oil futures, it is enough to go long 62,500
contracts, which would be equal to 12% of notional open interest. But
what if oil users shorted enough contracts to counteract that $500
million?
The world consumes 85 million barrels of oil per day.
At $131 per barrel, the world is paying $11 billion per day, or $334
billion per month, to oil producers. If oil prices fell back to $80-$90
per barrel - prices at which almost all alternative energy schemes are
profitable - the world would save $105 billion-$129 billion per month
on its oil bill. Is that savings not worth shorting $500 million in oil
futures per month?
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Producers probably are manipulating this market. The government needs to eliminate all the speculators who don't plan to take the delivery of anything. The futures system is broken. One hedge fund, Amaranth was able to double the price of Nat gas...
Imagine if the government sold 10 million barrels of oil/week from the SPR for the next 3 weeks...
For this to work, the refiners would need to be willing to pay those prices for oil. Without that, the whole scam falls down. The only reason they would be willing to do so is if there was no one else around to sell them oil at a cheaper price. (After all, a futures contract is just a promise to buy or sell at a certain price. In and of itself, the willingness of SOME market participants to pay stupid prices doesn't require everyone to do so.) For any manipulation to be successful, aren't all oil producers required to be in collusion? If so, then that's too much for me to believe. There is no honor among thieves. (Just look at OPEC's legendary levels of cheating amongst its members.)
Frankly, I think it's more likely that demand temporarily exceeded production capacity for light sweet crude. Though not yet publicly acknowledged, I also think current demand has slipped back below that magic line, and a consequent, and sharp, pullback is imminent. But I digress....
Futures markets shouldn't be able to drive actual settlements. How can the willingness of the few to pay stupid prices compel the whole to do the same?
"Al": "sharp pullback imminent" ? Hope you're right. Fills my heart with optimism (Go DUG !)
In the long run, supply and demand will govern, but recent volatility (like up $12/bbl in two days) seems to be clearly driven by speculation.
??????
I agree. Speculation yes, manipulation no. Maybe I'm completely missing the obvious here, but it seems to me that futures players are at the mercy of market prices, rather than the other way around. I think this guy has it backwards.
These so-called manipulators will have their butts handed to them if the market goes the wrong way, and I don't think there's much they can do about it. Bottom line, for awhile there we couldn't pump oil fast enough, so the price skyrocketed because it's not something economies can do without.
At eight-five million barrels per day, the U.S. is drinking about 25% of world production. About half of that goes into our cars, and probably half (??) could easily be cut back (e.g., lose the SUV's, carpool, get more efficient cars, economic slowdown, etc...). Regarding economic slowdown, that could be a worldwide phenomenon, and would have a dramatic effect on demand.
Think about it. All of these examples are happening at the same time (now) in response to the shocking increase in prices. Everyone was shocked at the same time, everyone is reacting at the same time, and the consequent reduction in demand will be startling. All it needs to do is get back below production levels to hack out the legs of this price run up. Am I long USO at these levels? No way.
Being too early is almost as bad as being wrong of course, but if this baby starts to burn, I'll be throwing some logs on the fire.
Luck to all, ...except those betting opposite me.
And you don't understand the futures markets. There's never a need to deliver or take delivery; you simply sell your contracts. As long as the price keeps going up, long positions will continue to generate profits.
If you care, read what Phil Davis and Anthony Schneider have written on SeekingAlpha this week. Then follow some links to what has been presented to Congress this week.
The Commodity Futures Trading Commission has not done their job to protect the American Consumer from price manipulation.
It is similar to the price fixing at Enron. Fixing prices in the US is illegal. The firms, executives, and commodities exchanges involved in this should be sued, convicted and sent to jail.
Ok, I don't understand the futures market ...guilty ...probably. I certainly don't have any experience with them. Given that you seem to, you're probably the guy to repeat my question to. How can the contracts drive the market prices, rather than the other way around?
Regarding the suggestion to just sell your contracts, you're right. That definitely works as long as the price keeps going up. But isn't the price going up dependent on underlying demand/supply curves? If, at the end of the month, someone tries to get rid of their $138 contract, but real barrels (in response to falling demand) are selling for $120, isn't the contract holder screwed?
Speculation can certainly drive up the price of the contracts, but without real need to pay that much for a barrel, it just seems that someone will be left without a chair when the music stops. Can you please explain what exactly it is that I'm missing on this?
Thanks in advance,
Al
The comparison with Enron kind of puts me back where I started. The sons-of-bitches in question were definitely manipulating the market, but they ultimately did it by manipulating actual power supplies. Hard to believe, I know, but my recollections from "The Smartest Guys in the Room" are that they had contacts at various power stations that could actually shut down plants at opportune times for trumped up reasons (maintenance, safety checks, assorted bs...). Ultimately, they worked hard to create the perception of shortage, so that real world prices would jump. I still think futures must have underlying support from real world payments.
Happy to confess my ignorance on this one, and be more happy to understand how actual manipulation mechanics would work. Just bidding something up doesn't seem like a sustainable strategy.
I also found the following excerpt from the responses: "Second, his statement regarding open interest in futures markets, contract rollovers, etc, shows either an absolute ignorance of how futures markets work or an intentional attempt to deceive his readers. Actually deliver seldom takes place in most futures markets, whether it be oil, pork bellies, eggs, corn or precious metals. Front month contracts are usually closed in the last day or two of trading (and the open interest therefore declines dramatically) either by the purchase (sale) of offsetting contracts, perhaps with a corresponding sale (purchase) of similar contracts for farther out months. Consider this simple example of a perfectly legitimate hedging transaction, and it is only an example, not my personal situation (wish it was). I am a producer producing a fairly steady level of crude oil volume of 12,000 barrels a month, with such level expected to continue for the next year at a slowly declining rate , but remaining above 10,000 barrels a month even after a year. I wish to insure a steady cash flow over this period.... To hedge the anticipated cash flow, I sell between 12 and 10 contracts a month for each of the next 12 months, based on the forecasted production for each month. As the front month approaches expiration, I close the contract (and if wanting to maintain a rolling 12 month hedge open a new series of contracts in the new 12th month out, perhaps for a lesser number of contracts if my production is expected to decline or for a greater number if production is expected to rise). Note, I am hedging my production values with no intention of making actual deliver (my production may have no access, for example, to the contract delivery point in Cushing, OK for WTI). The price of the futures contracts (paper barrels in the jargon of the market) will close to the price of the physical (wet barrels) in the spot market in the last hours of trading. If the price of wet barrels has risen over the period in question I gain from the rise in price but the cost of closing my futures contracts will result in a loss there (consider it the price of insuring my cash flow). Conversely, if the price of wet barrels has fallen over the hedge period I receive less for my physical oil but make a gain on the paper contracts which offsets, at least partially, the loss. on the physical barrels, which I may be selling to a refiner three states away from Cushing. That's simplistically how futures markets work, no conspiracy, no illegal activity, and never any intention on my part to make actually physical delivery.
Again, how on earth can futures prices drive prices for wet barrels? It would be like buying a bunch of calls to drive up the price of a stock, ...doesn't follow.
can we conceive any better cause for the development of trading platforms in foreign nations?? the Middle East for instance. some of the USA populace still hasn't got the message-- this nation is no longer the center of gravity for worldwide economics. self centered???
wake up America, get out of your stupor. your only one of the players, NOT THE ONLY PLAYER.
I see in Michael Greenberger's testimony to Congress that the "One of the fundamental purposes of futures contracts is to provide price discovery in the 'cash' or 'spot' markets. Those selling or buying commodities in the 'spot' markets rely on futures prices to judge amounts to charge or pay for the delivery of a commodity."
Oh my God.
How can this be? It goes against every standard of the free markets. Worse, it simply BEGS the Wall Street bastards to steal money from the public. This is worse than when they made Joe Kennedy the first chief of the SEC (lol, talk about letting the fox guard the henhouse).
So, let me make sure I get this. GS owns a huge minority (27%?) of the futures contracts in oil. The prices in these contracts are used to "discover" how much oil should cost (insert sound of hand hitting head while vomiting here). These contracts are legally traded on UNREGULATED EXCHANGES(!!!!). GS puts out terrifying press releases about $200 oil, and the price jumps ten bucks in one day.
Oh my f***ing God.
Man, if this kind of thing is allowed to fly, then we (the public) are completely screwed. God help us all.
Ass-rape-in-progress,
Al
On Jun 06 06:22 PM you_can_call ll_me_Al wrote:
> Jason,
> I see in Michael Greenberger's testimony to Congress that the "One
> of the fundamental purposes of futures contracts is to provide price
> discovery in the 'cash' or 'spot' markets. Those selling or buying
> commodities in the 'spot' markets rely on futures prices to judge
> amounts to charge or pay for the delivery of a commodity."
>
> Oh my God.
>
> How can this be? It goes against every standard of the free markets.
> Worse, it simply BEGS the Wall Street bastards to steal money from
> the public. This is worse than when they made Joe Kennedy the first
> chief of the SEC (lol, talk about letting the fox guard the henhouse).
>
>
> So, let me make sure I get this. GS owns a huge minority (27%?) of
> the futures contracts in oil. The prices in these contracts are used
> to "discover" how much oil should cost (insert sound of hand hitting
> head while vomiting here). These contracts are legally traded on
> UNREGULATED EXCHANGES(!!!!). GS puts out terrifying press releases
> about $200 oil, and the price jumps ten bucks in one day.
>
> Oh my f***ing God.
>
> Man, if this kind of thing is allowed to fly, then we (the public)
> are completely screwed. God help us all.
>
> Ass-rape-in-progress,
> Al
>
If US shorts oil, producers just have to cut back production to get prices back up.
The SPR is not to be played with, it is our insurance in case it hits the fan, not to bring down prices so we can go on driving our Hummers to the grocery store.
Our biggest weapon as a consuming country is conservation, but for some reason its considered un american, to drive smaller cars, carpool, or heaven forbid use mass transit.
Conserve and Opec will feel our pain.
I did not know anything about Enron until I started investing in the stock market. I saw that Enron stock was $1.00 per share and as I did my research I saw Enron had been as high as $90.00 per share.
My next question was "Why the huge drop in price". The balance sheet, cash flow statement and income statement helped to answer my question and I said "Enron is headed for bankruptcy". You know the rest of the story.
So, lets say the analyst at Goldman or Morgan Stanley says oil is going to go to $150 per barrel by July 4, 2008 and $200.00 per barrel by January 2009. Everyone then goes out and buys an oil futures contract so they can profit from the increase in price. Well, as Phil Davis pointed out, the contracts are on paper, hardly anyone takes delivery of the oil, then they buy another contract ( or sell to the next bigger fool ). This is done because of the failure of the Commodities Futures Trading Commission to do its job properly.
Most people, including myself, do/did not know that this is/was going on.
Now I know...and you know too.
I sent Michael Greenberger's report to Vermont Senator Bernie Sanders and to ten folks I have on my email list ( one of them is the Canadian Finance Minister, Jim Flaherty ) on June 7th.
Senators Bob Casey and Arlen Specter and Congressman Paul Kanjorski and 10 more people on my email list will get the report too.
Then I will get Greenberger's report to people in my area who worked for Senator Barack Obama's Presidental campaign AND Senator's Obama and Clinton.
I have no respect for the unethical SOB's who are responsible for the ARTIFICIAL run up in commodities prices.
Lastly, Congressman Bart Stupak is also starting to investigate this problem.
I would not invest in commodity futures or commodities because:
1. commodities do not pay dividends.
2. I do not have any need for commodities and would never want to own 1,000 barrels of anything.
3. I believe that the whole idea of commodities futures are for the producers and the users/manufactures to allow them to properly function to provide the end users (ie. consumers ) a product.
4. The huge run up in prices does us no good. When writers ( on SeekingAlpha and other sites ) started writing about the subprime mess, ALT-A mess, the housing bubble...NO ONE LISTENED.
5. I do not want to suffer losses in another bubble. ( I sold all of my oil stocks )
Finally, I would like to congratulate you for doing the research work that I recommended. If you go to the LA Times website and search Commodities Futures Trading Commission you will find links to other reports. Jeffrey Harris works for the CFTC as an economist and his report to the Senate is badly done and he and the Commissioners of the CFTC who are not doing their jobs should be fired or told to resign.