The Failure of the Energy Markets

Friday's surge in oil prices was extraordinary to watch, but at the same time, I could not help but be a bit suspicious of the commodity’s price movement.  On the day, the price of a barrel of oil jumped over $10 dollars, closing at around $138 dollars a barrel.  This steep increase coupled with Friday’s dreadful employment data helped to give the market one of its worst days of the year.  Generally, signs of a weakening economy (as exemplified in the employment data) would cause commodities such as oil to retreat. 

This was not the case and will likely not be the case in future for a variety of reasons.   For the most part the Federal Reserve lacks the ability to support the dollar through higher interest rates as it is forced to attempt to ease the pain caused by the housing bubble and the seize up in the credit market.  The quagmire that the Federal Reserve has found itself in will likely result in an increase in inflation during the coming year, further weakening the dollar (my take on inflation can be found here).  In an attempt to profit and hedge portfolios from inflation and a declining dollar individuals have begun to speculate in mass in the futures of oil and other commodities, along with the stocks of any company related to the resources.  The resulting increase in the price of oil has only exasperated the job of the Federal Reserve, as the increase in the price of oil is putting massive inflationary pressures on the price of food and all other products that require a large amount of energy.  Dow Chemicals 20% across the board increase in prices is but one example of many more such increases to come if oil remains at its current levels. 

While I am sure that the Federal Reserve and the federal government are aware of the danger that such a surge in the price of oil poses to the economy, I have so far been disappointed in their responses.  Oil expenditures now make up a larger share of the U.S. economy then any period in the last 30 years and serious financial hardship will be brought upon U.S. consumers and manufactures by any further rise in the price of oil.  While I fully recognize the importance of speculators in well functioning commodity markets, I cannot help but wonder after Friday’s surge whether the energy markets in their current state can be considered well functioning.  In a world gripped by fears of “peak oil” and struggling to deal with the near collapse of the credit markets such erratic price movements in such a vital commodity can have profound effects.

Increased demand in the developing world has clearly been one driver in the increase in the price of oil but as we have seen in the past, the future of the U.S. economy often dictates the future state of the world economy.  This makes the current state of the price of oil even more surprising.  The fact that U.S. consumption of oil is actually down from the year ago period is even more interesting as it shows the world’s largest consumer making dramatic changes to slow its consumption.  The volatility in the commodities markets and the rise and speed at which the price of oil has advanced would, I believe, lead any normal person to wonder about the degree to which our commodity markets can be deemed to be considered well functioning. 

While I hate to admit it, I believe that increased supervision and regulation of the commodities market may be in order to ensure that they function properly.  If nothing else, it would allow a suspicious public to sleep easier at night knowing that their suffering is not resulting in exorbitant amounts of money being made by people on Wall Street.  What it comes down to I believe is making the market more transparent and eliminating many of the speculative aspects of the market. 

While speculators are clearly not to be entirely blamed for the dramatic rise in the price of oil they are certainly exasperating the situation.  One of the most potent weapons at the disposal of the regulatory bodies of the commodities markets would be to limit those involved in the ownership of futures contracts to those involved in the production, refining, transportation and usage of oil.  Since this would prove difficult to achieve the government could easily strengthen the Commodities Futures Trading Commission (CFTC) by giving it more investigative authority and the ability to inspect firms trading books.  The increase of margin requirements would also be effective.  Currently, margin levels are between 5-7% for hedge funds operating in the commodities markets, well below the requirement for individual stocks.  This would likely bring down speculation, as it would reduce the leveraged returns available for speculators, compelling them to reposition their capital in other areas in search for market beating returns.

One of the only non-governmental actions I see that would be capable of reducing the volatility and the affect of speculation in the oil market would be for the NYMEX to be merged with oil futures markets in London and the Middle East.  The increased liquidity and size of the market would hopefully quell the volatility and allow for more steady increases and declines in the price of oil.  Such a commodity exchange would also be much easier to supervise, limiting the opportunity for manipulation to occur.                  

While it is clear that the dollar must be supported in an effort to limit the surge in oil, other actions must be taken as the future of the U.S. economy depends on it.  As strange as it may sound, increased regulation and supervision of the commodities market is needed to ensure that the volatility and rapid rise in price that has occurred over the last year is not allowed to wreak havoc on the U.S. economy.  I am not against a rise in the prices of commodities such as oil, all I ask is that it occurs in a manner that prevents people from becoming suspicious of our country’s institutions.  

Comments

[DRich:]

Is it true that brokerages have the same right, under CFTC rules, to hold as many contracts in commodities as they want? If this is true, then GS & LEH & others can pump & dump the market, being so small, to meet those targets that make headlines while the world is helpless. I've read this several times, but combing through the website haven't come across anything like that yet. Could one of you professionals verify or debunk this for me or would that be counter productive?

2008 Jun 10 12:32 AM

[john s. gordon:]

question - should speculators & hedge funds be allowed to slaughter the airline industry? certainly increased government regulation is required.
> jack

2008 Jun 10 12:59 PM

[jjason:]

Drich, To answer your question...Go to Phil Davis and Anthony Schneider on SeekingAlpha and read their articles on speculation in commodity futures. Also, Rep Bart Stupak has information as well as Professor Michael Greenberger who teaches law at the Univ. of Md.

Greenberger's testimony to the US senate on June 3, 2008 can be accessed from the bottom of Anthony Schneider's article. I downloaded Greenberger's article and it is important to read it. You will then want to tell all your friends how we are being ripped off by ICE, NYMEX, Goldman Sachs, Morgan Stanley, I - Banks and the Commodity Futures Trading Commission. Federal laws must be changed to protect the consumer from the fraud and manipulation that is going on.

In most articles on hedge funds, hedging, futures trading and related things like going long or short commodities...do not believe anything you read. Most writers are interested in pumping their products to make sales.

2008 Jun 14 02:39 PM