Time To Ban CEOs and Senators from Derivatives Markets

Originally written on 7/18/2008

Pandering and Ignorance Not Limited to Washington
We've all witnessed the growing frenzy over derivatives speculation in Washington (see "The Rage Against Derivatives Speculators Is Unfounded" for more information). Senators and congressman have made a number of alarming appearances on the Sunday morning talk shows in recent months. These appearances have revealed a stunning ignorance of the derivatives markets and of the free market system as a whole.

Pandering to the masses with ignorance and fear is not exactly a new phenomenon in Washington. Unfortunately, Americans have come to expect that type of activity from their elected officials. However, we tend to expect more from CEOs in the private sector, especially when it comes to basic economics.

That is why an open letter from the CEOs of the major U.S. air carriers is causing such a furor. The letter has the misleading title "You Can Help Keep Travel Affordable" and is signed by the CEOs of AirTran, Alaska Airlines, American, Continental, Delta, Hawaiian Airlines, JetBlue, MidWest Airlines, Northwest, Southwest, United & U.S. Airways.

As you might have guessed from its title, this open letter focuses on speculation in the oil market. I have listed a few excerpts below for anyone that hasn't received this alarming missive in their email inbox:

An Open Letter To All Airline Customers
Our country is facing a possible sharp economic downturn because of skyrocketing
oil and fuel prices, but by pulling together, we can all do something to help now...

...Twenty years ago, 21 percent of oil contracts were purchased by speculators who trade oil on paper with no intention of ever taking delivery. Today, oil speculators purchase 66 percent of all oil futures contracts, and that reflects just the transactions that are known.

Speculators buy up large amounts of oil and then sell it to each other again and again. A barrel of oil may trade 20-plus times before it is delivered and used; the price goes up with each trade and consumers pick up the final tab. Some market experts estimate that current prices reflect as much as $30 to $60 per barrel in unnecessary speculative costs.

Over seventy years ago, Congress established regulations to control excessive, largely unchecked market speculation and manipulation. However, over the past two decades, these regulatory limits have been weakened or removed. We believe that restoring and enforcing these limits, along with several other modest measures, will provide more disclosure, transparency and sound market oversight. Together, these reforms will help cool the over-heated oil market and permit the economy to prosper.

The nation needs to pull together to reform the oil markets and solve this growing problem.

Fear Mongering.Com
The goal of the letter is to motivate readers to visit an appalling new website:
www.StopOilSpeculationNow.com/sos.

The website contains a registration form to join the "anti-speculation" movement along with a glossary of relevant terms and a selection of dubious quotes from economists. The site even has a link that allows visitors to "warn their friends" of the dangers of excessive oil speculation.

A Fundamental Problem
Longtime readers of www.TheOptionsInsider.com won't be fooled by the thinly-veiled fear mongering contained in the letter and on the SOS website. As a result, I won't waste time enumerating the many flaws undermining them.

Instead, I will take a step back to examine the burgeoning anti-speculation movement as a whole. Perhaps the most bewildering aspect of this movement is the qualitative difference it assigns to speculative trading vs. trading for delivery. The above letter and website both refer to speculative trading in a derogatory, almost immoral, manner.

Proponents of this movement seem to ignore the fact that hedging with derivatives is itself a speculative act. After all, if an airline purchases oil futures for delivery and the price subsequently drops, it could incur significant losses. The anti-speculator crowd also ignores the fact that many customers that hedge with derivatives don't take delivery of the underlying commodity.

Instead, they sell the contract prior to expiration and use the profits to purchase the asset on the open market when the need arises. This allows them to avoid the expense and hassle associated with taking delivery of a physical commodity.

No Place For Nuance
Are these customers speculators because they do not take immediate physical delivery? If so, is their speculation justified simply because they have a pre-existing stake in the underlying commodity? Following the logic of the above letter, their activity has contributed to the dramatic increase in core commodity prices. Unfortunately, nuanced arguments have no place in an organization that is bent on assigning blame and shaping public policy through fear.

Farmers and CEOs
If we followed the logic of this letter to its extreme, only farmers and airline CEOs would have access to the derivatives markets. Those without the means, or the desire, to take physical delivery of their commodities would be barred from participating.

Many politicians have already embraced this idea by proposing drastic alterations to the current derivatives framework. There is talk in Washington of imposing limits on derivatives positions based not on risk or the available capital but on the type of customer involved (pension funds, hedge funds, etc). Some elected officials have even gone so far as to propose banning these "speculative" customers from the derivatives markets altogether.

Misguided as it may seem, there are many in Washington (and in boardrooms across America) who believe that cutting hedge funds and pension funds out of the derivatives markets will solve our current oil crisis. Fundamental economic factors, such as increased international demand for oil and a lingering war in one of the world's leading petroleum producers, apparently do not factor into their considerations.

A Glaring Irony
The sad irony of the above letter is that many of these airline CEOs would not be in the position they are in today if they had used the derivatives markets for their stated purpose. While a few companies on that list had the foresight to hedge their oil exposure with futures, the majority of them did not. As a result, they are suffering the terrible effects of the recent surge in oil prices.

In an industry that lives or dies on the price of crude oil, such an oversight is tantamount to a breach of fiduciary responsibility. The shareholders of these companies are understandably out for blood. Given the dire failings of these CEOs, it is hardly surprising that they would search for a scapegoat. Even though they have fixed their sights on an obvious straw man, their actions could have lasting ramifications for the derivatives markets. If you are at all interested in the world of derivatives, then you need to get involved.

Fight Fire With Fire
Contact your representatives and senators and let them know that you are tired of this fear mongering. If possible, vote with your wallet. Donate to candidates that oppose the current proposals or cut a check to one of the many political action committees that oppose these movements (CME PAC, etc).

It's time to fight fire with fire. Perhaps it's also time to ban the senators and CEOs from the derivatives markets.

Disclosure: None

Comments

[Teddn1:]

What exactly is the benefit to our economy or society in general to have wealthy hedge fund owners, for example, inserting themselves as cost added middlemen in a business where they have no business? Creating a market for Oil? ....not hardly. This type of speculation is merely another tool for the wealthy, influential, insider-informed, few to take from the productive section of society while contributing nothing more than added costs to everyone else.

2008 Aug 14 11:08 AM

[Dawson Lodge:]

Well said. It's all about the Peter principal. Any clown that whines about speculators is just demonstrating his ignorance and collectivist leanings. Probably a Keynesian, and got his position through cut-throat office politics instead of merit.
Well, that's over. After this depression merit will again rise to the fore. Speculation is a holy advocation. It is the foundation of true capitalism (we ain't seen much of that in these huge companies). Speculators add liquidity to markets, damping excesses by taking risks. They are the people that business operators should transfer the risks to, instead of gambling with their profit margins.

Any CEO that spouts this ignorance should be removed by their board. If these guys are not smart enough to calculate at what price fuel costs will negatively impact their operating margins, and use the market for price insurance as it was intended, they better read some Ron Paul.
They are the speculators. Essentially they were short energy and were wrong. Speculating with the capital of their shareholders. It is just incompetence.

If I can lock in a price for fuel that guarantees my margins, I had better do it. If I don't, it is pure negligence,
the tools are there. If you can't manage risk, and get caught with your pants down, go back to school.

Better yet, hire a rogue economist that understands the realities of the market, can use cycles and trends to identify the risks, and understands your business.

My clients didn't get caught with "unexpected" price rises,
because I have trained them to be pro-active risk managers. Anybody caught by "surprise" shouldn't be blaming the guys who provide the grease that makes capitalism work. Or maybe they would prefer the
Chinese system, where gross misallocations of resources are made for political reasons. They will
crash like Russia.
Great article.

2008 Aug 14 06:01 PM

[User 245062:]

For more on UAL's management mishaps, check out unitedairlinesinvestor.../

2008 Aug 18 03:39 PM