Commodity Volatility Deserves Our Attention
Today's regulators are fixated on banking reform, and rightfully so. Financial industries have buckled under fallout from the credit crisis. Although oil price gyrations also share blame for the recession, commodity futures markets are receiving less urgent attention than banking system repairs. Because crude oil prices have been relatively well-behaved in 2009, the dangers of spikes and squeezes seem less drastic now. Yet authorities who postpone energy regulation may do so at their peril.
Oil volatility inflicts punishment at large. On a macro level, economies suffer, as rising crude costs act like a tax, crimping growth. Higher fuel costs spur inflation, afflicting many inputs, manufacturing and distribution. Consumers wince when they fill up their cars, or heating oil tanks for their homes, and translate that pain into lower overall consumption, which feeds back into the larger economy. Sectors that bear the worst brunt, like airlines or truckers, cannot hedge indefinitely.
It is remarkable how swiftly even 30-days-out futures prices show up in wholesale markets. Notoriously, after Hurricane Katrina struck in 2006, among the 1200 wholesale gasoline and diesel terminals in America, 90% of them rose by 50 cents within 48 hours. "Retailers get killed by such volatility, and it becomes impossible for them to manage their businesses," says Dan Gilligan, president of Petroleum Marketers Association.
Two years after Katrina, the world was heading into recession in the summer of 2008. Prices of light sweet crude (WTI) careened between $147 in July to under $40 at year end. That summer price spike clearly contributed to factors precipitating the Great Recession. The significance has not been lost on Nicholas Sarcozy and Gordon Brown, who both pleaded for increased transparency and supervision of oil futures markets at the July G8 meeting, "to reduce damaging speculation."
The International Energy Agency, which largely attributes oil volatility to fundamentals, agrees that a return to prices over $70 could abort any economic recovery. So far this year, lower prices have provided a windfall for businesses and consumers, injecting much needed liquidity. Pavel Molchanov, energy analyst at Raymond James in Houston, delineates what each side can tolerate. "OPEC seems comfortable around $70, fearing that, below $60, many of its member countries face bankruptcy," he says. "And we know that triple digits represent a threshold of pain where consuming economies face dislocations."
Five years ago, $60 oil would have instilled trepidation. The intervening period has taught that, if prices rise gradually and steadily in a controlled fashion, resilient economies can adapt, up to a point. Any overnight disruption would be more sinister, as happened during the geopolitical shocks in the 1970's.
If energy prices constituted a tipping point - alongside bank leverage - in the current recession, going forward, it is crucial for regulators to take all feasible steps to monitor and manage wild fluctuations. Ultimately, it is uncertain to what degree they can exert any meaningful control. But at least they must first trace the path of the problem, by identifying the cause of the volatility, duly apportioning the blame, and then applying the remedies. The burning question: were market forces of supply and demand the real culprit behind the rollercoaster? Or did financial speculators also play a dangerous hand? What about extraneous factors, such as sentiment and psychology? There is a difference between manipulation and those bubbles that arise from pure market activity. "Was Nasdaq 5000 manipulation?" asks Molchonov pointedly.
World opinion remains fiercely divided, from banks, exchanges and hedge funds on one side, who plead market forces, to users, industry hedgers and others, who allege speculation. Academics, industry analysts, big oil producers and some regulators fall into each camp. The Intercontinental Exchange (ICE) asserts that "the evidence is inconclusive at best for speculation", citing comparable volatility in non-exchange, non-cleared OTC markets like iron ore. In July 2008, the FSA told the Treasury Select Committee that, "the involvement of financial players is not the main driver behind rising oil prices," and to date that body has not changed its view. The Commodity Futures Trading Exchange (CFTC) is still investigating. Its chief, Gary Gensler, branded media reports as "premature and inaccurate", which announced in late July that his agency was tilting toward the speculation thesis.
Disagreement over a common definition for speculation accounts for some of the controversy. The word itself has pejorative connotations; it really just means betting on future prices. Speculation, which may be the world's second oldest occupation, has always played a role in markets. The activity is distinct from manipulation, which carries more sinister overtones. Often, the terms distinguish between trading physical oil for commercial purposes and what expert Daniel Yergin calls "paper barrels", or financial assets. The CFTC divides its data into classes of "commercials" (airlines, producers, etc) and "non-commercials". While some industry observers conflate the latter with speculators, and both groups often do overlap, they are not identical.
One way to approach to the problem is to consider what the futures markets have been designed to do. Regulated commodities exchanges were originally established in America in 1936 to help farmers, bakers, or other physical handlers hedge their products. "By 2008, those exchanges had switched from assisting physical hedgers to becoming a plaything of speculators," says law professor Michael Greenberger at the University of Maryland. But Mark Young, a partner at law firm Kirkland & Ellis, hastens to remind that, "Those markets exist to provide a mechanism for price discovery as well as an avenue for hedging."
Everyone agrees that fundamentals played at least a substantial role in the 2008 run-up. ("They'll get you to about $90, but the remainder, up to $147, must come from somewhere," cautions Mohsin Kahn, senior fellow at the Petersen Institute for International Economics, and former Middle East director at the IMF.) Industrial demand from emerging economies like China was racing ahead, as Asian consumers "got off their motorcycles" and bought automobiles, says Rob Lutts, president of Cabot Money Management in Salem, Massachusetts. Even during last year's downturn, auto growth in China rose about 30%, nearing 11 million vehicles.
Supply, meanwhile, is shrinking. Most reserves and wells are on large decline curves, many running above 7%. "No one wants to discuss that skeleton in the closet," says Lutts, who notes that none of the major oil companies are providing fresh data. Instead, they offer the same reserve data of 15 years back. This year alone, producers have slashed exploration budgets. Per Baker Hughes, in September 2008 international drill rigs numbered 2032, bottomed out in June 2009 at 880 and recently edged up to 970. When demand resurfaces, it still takes time to reprocess capital allocation budgets and logistics.
Causing additional supply pressures in 2008, European and American regulators imposed divisions in crude hydrocarbons between sweet WTI and sour (with higher sulfur content). The supply of low sulfur crude shrank, especially as the U.S. began adding to the Strategic Petroleum Reserve in 2007. Notwithstanding, as Kahn points out, the price of sour crude continued to track closely on the heels of WTI, peaking around 125 when sweet approach 147.
The chapter, in fact, begins earlier, in about 2003. Many American pension funds became concerned that their sizable bond portfolios might become vulnerable to inflation. Seeking an asset class negatively correlated with inflation, they allocated, say, 5% of their portfolios to an inflation fund, which would typically include a large component of energy. The sheer size of those inflows impacted a crowded market. Paul Smith, chief risk officer at Mobius Risk Group in Houston does not specifically label the groundswell as speculation, which he regards as buying, selling and trading. "These guys were always buying - every month - from the same side, driving demand and supply out of balance."
Gilligan notes how oil also became an expression of a short dollar play. "As the dollar weakened, investors flocked to energy, as a place to park money safely. Banks constantly argued they needed the oil market to protect themselves against the declining currency. I say, ‘Baloney'!" Gilligan retorts. "The oil market was not set up for hedging currency." In another dollar play, a number of hedge funds and speculators borrowed greenbacks and purchased oil.
Index traders who decide not to use the futures market directly can turn to swap dealers to obtain equivalent exposure. Swap dealers may then try to reduce their net price risk by laying it off on a long or short counterparty in the futures market. Thus, those dealers may be acting as a conduit, offsetting existing price risks rather than instituting proprietary trades. Many capital market players and traders regard the oil price as a proxy for the global economy. "It's a rational viewpoint, with no manipulative intent," says Young "You can't outlaw that."
Despite plausible explanations for massive inflows in earlier years, something less explicable has transpired since 2009. During the past eight months, world supply has actually risen as demand has fallen. Yet, contrary to fundamental arguments, prices have been rising.
Bart Stupak, a Michigan congressman, who also chairs the prestigious Oversight and Investigations Subcommittee of the Energy and Commerce Committee, perceives shadowy activities conducted by sovereign wealth funds and nations, including Iraq, Saudi Arabia and some European countries. "The Bush administration would not discuss it, because they claimed it was a national security issue," Stupak says. He connects vast flows to contracts moving among "swaps, dummy corporations, pension funds and SWF's." For example, a large player might buy at 80, turn around and sell at 82. "As long as you keep moving the contracts, you keep taking profits and influencing the price."
At the moment, there is no mechanism for providing a clear picture of aggregate world trades and positions across all the dark markets. An organization like Goldman Sachs or JP Morgan, can operate across the board on Nymex, ICE or Dubai exchanges, without reporting total commitments. "Total trades in all those markets would allow them to influence the price, without showing where the excessive profits come from," says Stupak.
Some American politicians have objected that traders use the London contracts to finesse CTC requirements. Although the FSA regulates ICE, this summer the American CFTC has started presenting more data to show energy positions on ICE. Stupak, who would still like to see a more unified oversight of international exchanges, argues that the contracts should be regulated according to their American destinations, or at least where the traders' computer terminals sit.
Those contracts have a way of altering their specifications as chameleons change color. When a tanker leaves the Middle East, it takes two months to reach New York terminals. During those months, the oil in it might be traded half a dozen times, perhaps starting out as "commercial", and switching back and forth several times to "non commercial". Moreover, total oil inventories remain one big question mark. Even the International Energy Agency has no idea of the total extent, since the IEA can only reports OECD inventories, which represent 50% of world demand. "Anyhow, everyone goes by US inventories, and oil at sea even distorts US data," says Kahn.
To give it due, the CFTC is making some effort to present its published data with more transparency. "We plan to disaggregate," said a spokesman on August 21, "though we are still working on the new titles of the four categories." One class will represent swaps and dealers, another will be managed money and hedge funds, a third will be producers, merchants and users, while the fourth catch all will comprise "others". But do not confuse the public transparency initiative with the agency's own market surveillance. Young notes, "They have always had more granular information themselves for surveillance than material published in the Commitment of Traders report. They are not bound in the slightest by what appears in the COT."
The CFTC is has recently intensified its focus on curtailing concentrations of market power among traders. For many years, its regular surveillance has encompassed any traders, hedgers or speculators, whose disproportionately large positions might create undue influence over price. A proposal under study, to impose position limits, is not intended "to remove speculators, but to ensure minimum amounts of participants," per the CFTC spokesman.
Whether or not the agency does impose position limits, the CFTC appears to be undergoing a cultural shift. Hitherto, it has espoused a laissez faire approach that markets best regulate themselves. That philosophy was supported by legislation in 2000, says Greenberger, who himself headed the CFTC's Division of Trading and Markets in the late 1990's. Gensler, the current chairman, had worked at Goldman Sachs for 18 years, where he advocated more freewheeling futures markets - as did many other experts at the time. As a Clinton Treasury official, he also blocked proposals to regulate derivatives. During a challenging nomination process this year, some senators expressed concern they might be putting the fox in charge of the henhouse.
The agency held hearings in this summer, to examine potential causal links between speculators, index traders and swap dealers. Congressman Stupak testified on July 28that, whereas in 2000 physical hedgers accounted for 63% of the WTI crude market, and speculators for 37%, by April 2008, those figures had been reversed, with speculators controlling 71%. What had changed the equation so markedly?
As they prepared for the hearings, Stupak's oversight investigation staff came across an unexpected reference to a ‘no action' letter from the CFTC in 1991 to J. Aron, the commodities trading arm of Goldman Sachs. Aware of Stupak's subpoena power, Goldman Sachs produced the letter, which granted J Aron an exemption from position limits for trading swaps, including agricultural commodities. Until then, "it had always been understood that the only way to be a bona fide hedger was by trading physically handled product," says Greenberger. He adds, "the person who granted the letter in 1991 was my predecessor at the CFTC. Neither Brooksley Born, who was then head of the agency, nor I, had any idea this precedent had been established. Brooksley, who was actually very concerned about opaque ‘no action' letters, set up a formal system to prevent such ‘back room deals'."
In 2000, Congress passed the Commodities Modernization Act, containing a provision known as the "Enron loophole", which exempted most over-the-counter energy trades from regulation. "Legislators were persuaded that the CFTC would no longer need to intervene, since traders had become so sophisticated!" explains Stupak. (Later, during his presidential campaign, Barack Obama called for repeal of that loophole.) It is no coincidence that after 2000, the CFTC granted 117 further exemptions to major financial institutions for trading on Nymex.
If it is indeed correct that speculators control well over 50% of the market, "an alarm bell should be going off," says Gilligan. Clearly, an ideal structure would comprise a balance among investors, between speculators and commercial hedgers. Perhaps the CFTC might create some kind of sliding scale, once accepted data and numbers have been established. For example, at various given levels of speculative interest, increasing restrictions might apply.
Free market advocates for a whole host of financial activities often highlight dangers inherent in country-specific regulation in a global marketplace. They warn that oil trading will shift to alternative centers, like Dubai. Others, such as ICE, are wary of severe restrictions, insisting that they may impede liquidity and make markets dysfunctional. "Restricting positions could be counterproductive, reducing efficient activity and preventing the price setting mechanism from operating properly," Molchanov warns.
Smith is not confident that the CFTC potential changes can successfully tamp down on money flowing into the WTI market. Consider the following causal sequence of events, leading to price spikes and exacerbated volatility. If the agency does impose some of the changes under review, "market makers, who have capital at risk, may not be able to invest in the position size they want, or take on the customers they prefer," he explains. If those players retreat from the market, their absence could result in less liquidity across the curve, so the bid ask spread widens out. When stronger players face less competition, there will be fewer buyers available to serve traders who would like to get out of their positions.
As a further consequence, the cost of capital for exploration and production deals may rise. "With capital shut out, E&P companies will become more dependent on where current spot prices are trading," Smith continues. If their banks are reluctant to take on additional exposure, the money they must borrow will become more expensive, and their projected future revenue streams become riskier. The scenario gets even bleaker. If capital grows more expensive for them, it will increase the cost structure of the E&P's delivery. Therefore, if prices fall too low, they will be less inclined to produce. When capacity plans are shelved, even more extreme imbalances could ensue. Then we come the full circle to more volatility, Smith concludes, since lower production "would make for price spikes, since demand can pick up faster than supply can deliver into."
As a still fragile recovery appears to be gaining traction, the last thing the world's economy needs is another wave of oil price volatility, perhaps even more damaging than that of 2008. The CFTC and other regulators confront a daunting responsibility, to ensure they strike an appropriate balance, by holding firm against a battalion of entrenched interests and lobbies.
Right now, each group paints a different picture of market reality, based on its commercial and political interests. All are quick to mold the statistics to fit their agendas. It is unsurprising that the exchanges, such as Nymex and ICE would advocate against position limits, and resist relinquishing their own authority to set them. The industrial users, who suffer from price fluctuations, are pleading for stricter regulation. The entire Wall Street community, hedge funds and others who use the commodities market as an investment tool, want the freest possible rein. "They will spend a lot of money and hire every lobbyist in town," Gilligan predicts. It is to be hoped that authorities will compromise by imposing reasonable and moderate limits as a safeguard, without disrupting market integrity.
