One Way to Tame Speculation in Oil Futures
By Daniel Dicker
6/27/2008 12:20 PM EDT
The solutions recently floated in Washington and by the talking heads on CNBC to remove speculation premium in the oil markets won't work. I'm not advocating it, but there is one idea that would work in testing how much speculation is really in the market: mandating a "liquidation only" restriction, which has in fact been used in the past.
Let me tell you about this idea and why I believe this is going to happen and what it will mean for the oil markets and your portfolio.
I've been a strong advocate for the position that the price of oil, while under fundamental upward pressure, contains an enormous speculation premium, perhaps as much as 50% of the price. Being a believer in the speculation argument has gotten me in a little bit of trouble, because my points have been easily misunderstood. For one, I've always argued that the speculation in the market has not been manipulative but just a rush to improve gains in commodities when "regular" asset classes haven't performed as well (boy, is that an understatement).
The futures markets, however, were designed as simple price discovery mechanisms and were never intended to be used as large-scale investment vehicles. Because of this, the rush to invest in oil and other commodities has had a geometric effect in price that you would not witness with other asset classes. In previous columns we have discussed these subtle but critical market differences.
Another difficulty in pointing out the overarching price inflation of speculation has been the obvious follow-up: What to do about it? Everyone wants to save the world in 30 seconds. And while I am convinced that speculation is driving the price of commodities ever higher, I am far less convinced of the efficacy of any of the proposed solutions that I continue to hear coming out of Washington and elsewhere in removing that premium. Unfortunately, some problems do not lend themselves to simple solutions, and this is one of them. Let me tell you why.
Congress, by a 402-19 vote yesterday, passed a bill "requiring" the CFTC to use its authority to curb excessive speculation in the oil market. It may be politically useful to overwhelmingly vote for a measure that makes it appear to your constituency like you're doing something, even if the measure will have no effect. And here we are faced with precisely that. Two instruments are called upon to rein in excessive speculation: position limits and margins. Let me add two more that will surely be called upon soon: a ban on pension and indexed investment in commodities. Let's take all four and describe why they'll be less than useless.
Margin increases will have a very limited effect on the commodity markets, because the leverage on them is so high to begin with. On the New York Mercantile Exchange, for example, the current margin on a lot of crude oil for clearing members stands at $8,750. In a market trading with $140 oil, that equates to a 6.25% margin requirement. You might contrast that with your local stockbroker, who will require a 50% margin on the stocks that you own. Even with a doubling of margin requirements -- an enormous leap -- the cumulative effect would be small.
Position limit tracking would be practically impossible and even less useful; those who wanted to skirt them could easily set up associate limited liability companies and multiple outside accounts that they could move wherever they wished and avoid all invented limitations on positions. Who would be charged with keeping track of all those commodity accounts floating around out there in the many different clearinghouses and associating them with their owners? I doubt the CFTC, or anyone else for that matter, is up to the task.
More interesting is the idea of limiting pension and indexed investment in oil. But here too, the managers of those funds would be easily able to access the over-the-counter markets domestically that are either exchange or bilaterally cleared. Indeed, the oil desks at Goldman Sachs would be delighted to create any kind of strip or swap for these managers, match them through their internal desks and push the remaining lots through one of the futures markets as commercial (non-speculative) volume. Quite apart from the idea that these limitations would force business offshore, it would in fact force it back into the shadows, into the dark over-the-counter markets where the discovery of price is far less transparent than the system we are dealing with now.
You see, all the solutions that I have heard proposed require that you define the motive of the participant -- that you somehow figure out which contract of oil is initiated as a true hedge or as a speculative investment, and in this, even the participants themselves would be hard-pressed to know.
That is the environment we have created. Everyone's a trader -- very little in the futures markets is "purely" hedge or "purely" speculation anymore. I remember going for an interview at a mid-cap consolidated oil company in Houston in the mid-'90s. Its physical assets (transport, refining) were significant, but its trading room was enormous, and the activity in it was far larger than the direct management of its assets required. I remember asking the VP in charge of the trading room, when is the trading you do hedging? When is it speculation? He looked at me slyly, this old Texas wildcatter, and explained, "You see, Dan, when we sell 'em and the market goes up, that's a hedge ... when it goes down, that's speculation." That simple lesson was never lost on me.
Remember, this was at one small oil company in the '90s. Today, that attitude toward oil trading and risk management has been multiplied a thousand-fold with practically every participant in the oil markets today. If Morgan Stanley sends an order based on a transport asset requirement in Oklahoma through five of its internal trading desks before a piece of what's left hits the markets at the Nymex, are those lots speculative or a hedge? I'll give you a hint: By the time it arrives, it's far more of a speculative position than a risk-management tool.
Most every hedge position, you see, has a speculative bias to it, an excess, a risk taken -- another greater profit is attempted. The risks that all of these desks take vary, but we know from the profit statements of many of these companies that the trading desks account for enormous additional revenue; none of them is engaged in pure risk management.
Silver as a Case Study
In one instance, however, the speculation premium was "successfully" tested - in the silver markets in 1980 when the Hunt brothers attempted to corner the market. As silver approached $50 an ounce in January 1980, the commercial participants asked for relief from the enormous margin calls from ever-rising prices. The CFTC and the Comex (the predecessor to the Nymex) responded effectively by imposing "liquidation-only" trading -- traders were allowed only to close existing positions and not permitted to initiate new positions.
This forced purely speculative positions to be closed rapidly, as they could no longer be "rolled" into future months at expiration. This caused the price of silver to drop by $12 the day after it was imposed, a decrease of over 20%! Over the course of the next three months, as contract months expired, the price dropped over 50%.
Silver, Historic Prices
Click here for larger image.
While I do not advocate such a move, I believe I'm not the only one in the world who will explore this idea, and I believe that in an election year this will inevitably be suggested and implemented. The effects would be astonishing and immediate. Energy funds would be buried, and commodity-biased portfolios hurt badly.
On the other side, the overall economic effect would be obviously improved enormously. Consolidated oil stocks, which would initially get hurt, would surprisingly represent terrific value again, in my view. Refining stocks would be helped as margins were restored, as would obviously the airlines and the other transports.
One thing is for sure: A "liquidation-only" market would settle finally and for all time the argument about speculation premium in the oil markets -- we'd know for sure how much of this price inflation was being driven by purely fundamental factors. For that reason alone, I expect this idea to be floated and in fact implemented soon -- and you should be prepared for it.
At the time of publication, Dicker had no positions in stocks mentioned, but positions can change at any time.
Dan Dicker has been a floor trader at the New York Mercantile Exchange with more than 20 years' experience. He is a licensed commodities trade adviser. Dan's recognized energy market expertise includes active trading in crude oil, natural gas, unleaded gasoline and heating oil futures contracts; fundamental analysis including supply and demand statistics (DOE, EIA), CFTC trade reportage, volume and open interest; technical analysis including trend analysis, stochastics, Bollinger Bands, Elliot Wave theory, bar and tick charting and Japanese candlesticks; and trading expertise in outright, intermarket and intramarket spreads and cracks. Dan also designed and supervised the introduction of the new Nymex PJM electricity futures contract, launched in April 2003, which cleared more than 600,000 contracts last year alone. Its launch has been the basis of Nymex's resurgence in the clearing of power market contracts over the last three years. Dan Dicker has appeared as an energy analyst since 2002 with all the major financial news networks. He has lent his expertise in hundreds of live radio and television broadcasts as an analyst of the oil markets on CNBC, Bloomberg US and UK and CNNfn. Dan is the author of many energy articles published in Nymex and other trade journals. Dan obtained a bachelor of arts degrees from the State University of New York at Stony Brook in 1982.