Are Commodity Traders the Most Powerful People In the World?
It was May 5, 2011, Osama Bin Laden had just been captured and killed, and general instability in the Middle East was on the uptick. Surface logic might dictate a spike in oil prices, and BlueGold Capital Management co-founder Pierre Andurand had an $8 billion dollar oil position that was set to soar in value assuming a rise in the price of crude. Thus begins CNBC reporter Kate Kelly's new book, The Secret Club That Runs the World: Inside the Fraternity of Commodity Traders.
The problem for Andurand, as Kelly reported, was that oil prices were declining sharply, so much so that the London-based Frenchman instructed his traders to sell out of their bullish position. As he put it amid a bloody day for his fund, "Sell a few hundred million worth! See how the market takes it."
By the end of trading BlueGold had suffered losses of $500 million. As Kelly explained, "Unloading a multibillion-dollar set of trades was extremely difficult to do without losing money," and Andurand "was in a state of shock." Having been on the correct side of oil's rise to an all-time dollar high (my emphasis) in 2008, followed by further correct positioning as oil declined later in that year, Andurand had missed the latest swing.
All of this is important mainly because it calls into question the most prominent assertion underlying Kelly's book about commodity traders. Marketed in somewhat breathy fashion as an account of the powerful men and women who allegedly "run the world," Kelly perhaps unwittingly revealed from the very first page of her book how very misleading is its title. Far from powerful, the individuals who trade commodities are all too human; ever eager to be on the right side of up and down commodity-price lurches, and hopeful that some buyer or seller will have a view opposite their own such that they can move in and out of trading positions.
Powerful? Run the world? Not really. Traders of commodities are essential price givers like those who speculate on any other market good, but as evidenced by the short shelf-life that defines hedge funds (the pay isn't high for the best and brightest because it's easy), most with enough of a track record to enter the space to begin with are rendered weak in short order. Commodity traders are no different, and while there were other factors in play that drove Andurand and his partner to eventually close BlueGold, the fact that the once high-flying fund found itself on the wrong side of oil's direction not too long ago clearly loomed large.
All of this isn't to say that Kelly's book isn't worth reading as much as it is to say that beyond a title that is belied by her own reporting, the book is incomplete. More on its incomplete qualities in a bit, but first it's important to stress that Kelly's book provides very valuable economic information to the individual who reads the book with a discerning eye.
First up is the reason that Andurand left Goldman Sachs to eventually start his first hedge fund in the first place. Kelly reports that "he felt stymied by Goldman, which had strict risk controls that prevented him from making larger bets." It's popular to believe that the big investment banks swing for the proverbial fences without regard to potential losses, but nothing could be further from the truth as the Andurand example makes plain. It should be said that the bailouts of banks, including Goldman in 2008, were an abomination that ultimately weakened Wall Street, but what can't be forgotten is that bonus pay at these institutions largely comes in the form of restricted stock. Precisely because it does, financial firms are defined by close oversight of those in their employ. This doesn't mean that they don't blow up on occasion, but as the wealth erasure of former Lehman Brothers and Bear Stearns employees reveals, banks work feverishly to limit errors that could wipe out employee wealth.
Second is her essential, but almost wholly misunderstood point that commodities, by virtue of being "commodities," are "easily found and not overly valuable." This is important simply because going back to President Nixon at least, nearly every president since then has argued in favor of the U.S. becoming "energy independent." This policy focus fails in three important ways.
For one, Switzerland and Hong Kong have long been "dependent" on the production of all manner of goods, including oil, with no ill economic results to speak of for being that way. Being "dependent" hasn't hurt them mainly because the very notion of trade involves exchanging what we have and what we're good at for what we don't have or what we're not comparatively good at. Though money is the facilitator of exchange, ultimately we trade products for products. Switzerland and Hong Kong may be bereft of natural resources, or "commodities" like oil, but their genius in the areas of finance, watches and chocolates (to name but three) means they're able to trade the fruits of their labor for the oil byproducts that they don't have.
Applied to the U.S., we're "dependent" on Japanese televisions, Italian shoes and Guatemalan bananas, but far from our dependence impoverishing us, it in fact enriches us. That we import all three frees us up to start Google, Microsoft and Intel.
Second, the logical reply to the above is that producers of commodities like oil could embargo those to whom they sell, but if so, so what. Basic economics dictates that there's no accounting for the final destination of any good, so assuming all the world's oil producing nations were to place an embargo on Switzerland and Hong Kong, the citizens of both locales would continue to consume oil and its byproducts as though it were sourced from the waters of Lake Zurich and Victoria Harbor. They would simply buy from those not embargoed.
Third, and going back to Kelly's very important description of commodities as "easily found and not overly valuable," when U.S. presidents call for "energy independence" they are explicitly seeking a policy that, if implemented, would be economically crippling for the U.S.
That oil is everywhere signals that the profit margins in the sector are rather slim; 112th among industry sectors according to AEI scholar Mark Perry. That the margins are slim is a certain reminder that oil exploration within these fifty states takes place at the expense of economic activity that is often far more enriching.
None of this should in any way be seen as a call for government to force U.S. commerce out of oil exploration (government should stay out of private industry altogether), but it is to say that it shouldn't surprise readers that the latest American oil renaissance has taken place amid weak economic growth. The rush into oil amounts to an explicit rush into yesterday's innovative work; work geared toward finding the prosaic alongside lower profit margins. In short, the oil boom in concert with a broad commodity boom signals an economy-weakening blast to the past for the U.S. economy. Kelly glossed over the negative economic implications of our latest commodity boom, and her book suffered for the omission.
Still, those presumed omissions (there are more) shouldn't be seen by readers as a reason to not purchase her book. Once again, there's good information within that tells an interesting economic story.
Arguably most useful from an economic point of view is reporting that shows a 1970s style revival of commodity trading in the 2000s. Kelly writes that it "became the new fad" in the 21st century, that the total value of commodity trades spiked from "$800 billion [in 2002] to more than $13 trillion" by 2008. Kelly further reveals that "Until the mid-2000s, most investors had never seriously considered adding commodities to their individual portfolios," but amid a tripling in value of the Goldman Sachs Commodity Index (GSCI - the S&P 500 equivalent for commodities), commodities suddenly had the attention of investors; most notably sophisticated investors of the hedge-fund variety.
To Kelly, and this is where the book falls incomplete, soaring commodities were largely a function of "the torrid pace of demand in India and China." That the latter informed her basic thesis severely weakened the book overall. That's the case not just because Chinese and Indian demand could never move markets in the way she presumes, but because implicit in such an assertion is the view that markets themselves are unequal to the task of meeting consumer and industrial demand for that which is "easily found." Ok, so televisions, smartphones, computers and long-distance calling continue to fall in price despite rising consumerism in India and China, but somehow an oil industry that dates back to the mid-19th century (agriculture quite a bit older) hasn't been able to keep up with demand for oil byproducts? Not very likely, and of course, not true.
Missed by Kelly, and the miss very much diminished her book, was just about any mention of the dollar in which commodities are priced. And since the dollar didn't factor into Kelly's analysis, a merely good or interesting book can't be described as essential. To leave the dollar's direction out of a book about commodities is the equivalent of a vintner omitting grapes from his discussion of wine.
Interesting about all of this is that while the background to Kelly's book is the frenzied atmosphere surrounding commodities and nosebleed prices since the early 2000s, she did not report that in the seven years leading up to July of 2008 when crude hit a nominal all-time high, the price of oil in euros rose 198 percent, in Swiss francs 216 percent, but in dollars crude had spiked 459 percent. What this unquestionably tells us is that the commodity story of modern times is almost wholly a dollar story, yet despite this tautology, Kelly never tied the two together other than with an occasional allusion to "easy money."
What makes this even more puzzling is that since the 2000s began, major advances in the area of energy exploration have come to the forefront; "fracking" the most famous for this admittedly old technology unlocking access to abundant oil previously thought unattainable. But even with all this new oil reaching the market, consumers have so far not been able to enjoy low prices at the pump.
On the surface, the above truth seems odd until we bring the dollar back into the oil discussion. Once we do, we find that oil has never been expensive in modern times; rather the dollar in which it is priced has been cheap. Measured in gold - gold the most objective measure of money's value through the centuries - the price of oil is in fact quite cheap today. Indeed, in 1971, right before President Nixon's decision to delink the dollar from gold, a gold ounce at $35 bought 15 barrels of oil at $2.30. In 1981, after a decade of dollar devaluation, a gold ounce at $480 still bought 15 barrels of oil. As of May 2010, gold at $1176/ounce still bought 15 barrels at $79. Right now gold at $1262 buys roughly 12 barrels of oil, which, if history is any guide, signals a looming decline in the price of a barrel.
Looked at from an economic growth perspective, mentioned earlier was that commodity "booms" (think 1970s, the 2000s) always and everywhere take place when the dollar is weak; gold the best measure of its weakness. The economy limps in these periods simply because growth is a function of investment in new ideas, investors are buying future dollar income streams when they invest, but when the dollar is in decline, investors are naturally less likely to commit capital to ideas that, if they generate returns, will come back in weakened dollars. Kelly left all of this out of an important commodity story, and her book once again suffered.
Still, whether on purpose or not, she has provided readers with valuable economic clues about the horrors of weak and floating money; horrors that distract businesses all the while frequently robbing them of profits. As Kelly explained, businesses were and are "paralyzingly dependent on aluminum, sugar, coffee, and jet fuel for survival," but "with the prices of many commodities climbing, the companies couldn't accommodate the price shocks." What Kelly really meant without knowing it was that businesses suffer mightily a dollar that floats in value; its gyrations rendering commodity prices intensely volatile such that it's difficult for businesses to plan for the present and future with any kind of comfort.
Thinking about the above, it's a worthwhile excercise for readers to Google "Oil Price History." If so, a chart will pop up that tells a very important story. When the dollar was stable thanks to its gold definition up until 1971, the price of oil was largely flat. But once the dollar lost its price anchor in '71, and ever since, oil and other commodities have moved up and down to the substantial detriment of businesses reliant on commodities for their daily operations.
The logical response to the impact of dollar volatility on the price of commodities is that companies can hedge it; essentially locking in a price of jet fuel for the coming year in order to smooth out the constant changes. No doubt they can, Kelly features prominently the decision of Delta Airlines to hire trader Jon Ruggles to do just that, but as she correctly notes, efforts to properly hedge fuel volatility were "maddeningly difficult," and as Ruggles' eventual departure (for a number of reasons) from Delta revealed, not always successful.
After that, we must consider the economic waste involved. George Gilder has written extensively about high and low entropy economics, and Gilder's point is that economic progress is a function of high entropy information reaching the marketplace; essentially businesses and entrepreneurs "leap" toward new concepts all the time such that the markets gain knowledge about what works, what consumers want, and what isn't profitable.
Important within all of this is that money is meant to be a low entropy input much like a foot and minute are. Homebuilders and cooks don't spend their days, or pay others to spend their days hedging constant changes in the length of the foot and minute; rather both are constants. The sole purpose of money is as a reliable measure meant to facilitate the exchange of goods and investment in new ideas, money has historically had a stable gold-based definition with its sole purpose as a measure in mind, but since 1971 money itself has become a high entropy input that has robbed us of all sorts of economic advancement. Rather than curing cancer, designing the mode of transport that would render the airplane prosaic, and writing software code for the next generation of the internet, countless great minds have migrated to the financial world in order to make money trading the chaos that, if it existed with a foot and minute, would lead to all manner of asymmetric houses and burnt soufflés.
None of this is meant to bash Wall Street or hedge funds, both are essential, but it is to say that we must consider what Kelly's narrative about the economic result of unstable inputs means for commerce. Businesses are reliant on commodities, but with the dollar very weak and unstable since 2001, a la the ‘70s, commodities have gone on a volatile tear wrought by a weak dollar illusion. Businesses have logically struggled under this, and worse, they've been forced to waste enormous energy and financial capital to try and at least mitigate the chaos. Imagine where Delta and all sorts of other businesses would be if money were like a foot or minute such that they could focus on serving shareholders and customers over wasting so much time divining the direction of fuel prices. As she notes, jet fuel is the "single biggest expense for many carriers."
Notable within all of this was Kelly's point that prior to the 1970s, "Physical barrels [of oil] were often secured months and even years ahead of time." Kelly didn't discuss it in the book, but before 1971 the commodity exchanges were rather sleepy. They were because with the dollar stable, so were commodity prices, and the need to hedge access to future supplies was much less urgent. Thinking about this in light of the rise of the late Marc Rich's company Glencore, the latter prominently featured in The Secret Club, it's no mistake that the importance of commodity traders took off after Nixon's fateful decision in August of '71, and it's similarly no surprise that traders of commodities have once again risen in prominence since 2001 when the dollar began its long and ugly decline.
Not surprisingly, Kelly spends a lot of time in the book addressing the role of "speculators" when it comes to high or low commodity prices. Here her conscious or unwitting decision to leave the dollar out of her reporting similarly set the book back. She alluded to a Senate report which presumed that "speculation" had added $20 to each barrel of oil, reported on a few regulators who suggested much the same, but got it half right (only half for her once again ignoring the dollar's seminal role) when she concluded that "there was scarce hard evidence to show who, exactly, was responsible for the astonishingly high prices." And then happily she finally, albeit on page 91, acknowledged the logic of an unnamed analyst who made the correct point that "for every buyer there was a seller." Absolutely, but the latter truth raises the question of why Kelly danced around what is a non-issue so much to begin with.
Indeed, speculation is a two-way street, by definition. For one trader to transact on his bullish view about the oil price, he must find another trader who has the opposite view, and who is willing to transact. Implicit in the laughable belief that speculators were behind nosebleed oil prices was and is the absurd fantasy that markets are comprised solely of buyers.
Taking this further, those who presume that speculation has driven oil upward put the cart before the horse. They correlate increased trading (Kelly mentions other reports that tie the two together) in a certain commodity amid a higher price for that same commodity as a sign of something sinister, but the joke is on them. Indeed, it's only natural that as a commodity's price increases that trading in that commodity will increase. As Kelly makes plain throughout her book, rising commodity prices were and are a huge problem for businesses reliant on them, so with commodities spiking amid the dollar's decline since 2001, trading has as mentioned skyrocketed as businesses have sought to minimize the damage through sometimes well-timed hedges.
Kelly herself seems to buy into the view that large funds can move commodities like oil, and this may help explain a book title that makes little sense. Early on she wrote about estimates inside BlueGold that their large trades "moved the Brent futures market down an additional $2 or $3," but the gargantuan size of what is a global oil market wholly mocks such an estimate. BlueGold couldn't on its own, or even in concert with numerous other large funds move the price of oil; rather oil trading by hedge funds naturally increases when oil-price volatility increases. First the price of the commodity changes, then the trading picks up. Implicit in Kelly's reporting is that BlueGold or even OPEC controls the price of oil. Nothing could be further from the truth.
If this is doubted, Kelly and others would have to explain why oil plummeted in the ‘80s and ‘90s after spiking in the ‘70s, only for oil to once again rise in the 2000s. Were the OPEC countries and other "speculators" feeling generous in the ‘80s and ‘90s? Not very likely. The mystery about oil and commodity prices is that there's really no mystery. Allowing for occasional unique circumstances, commodities rise in a nominal sense when the dollar is weak, and then they decline when the greenback increases in value as it did in the ‘80s and ‘90s.
Happily for readers, Kelly's book prominently features the droolings of regulators throughout; CFTC commissioner Bart Chilton most notably. This is a happy circumstance simply because it reminds readers to look very skeptically on politicians telling them that regulators are the fix to alleged problems in the marketplace. With regulators we're almost always talking about those who can't; as in those like Chilton who would never rate a job on Wall Street. About him, Kelly wrote that he "had never traded commodities himself," but had "spent time at cattle auctions" and was seemingly bothered when he witnessed "a couple of guys whispering to each other at auction" on the way to an agreement about the price of cattle. Yes, it's those who could never get a job trading anything who presume to oversee those who can, and that's why regulation never works.
In the case of CFTC Chairman Gary Gensler, he actually did work at Goldman Sachs, but his insights about commodity markets weren't much better than Chilton's. Commenting on the non-role of "speculators" in the price of commodities, Gensler defaulted to emotion over hard data, or better yet, simple logic. His basis for fingering speculators as the source of high prices was "It's what I feel." You can't make this up.
There's value in all reading, and applied to Kate Kelly's book, she brings more than basic value. Indeed, there's quality information within that, if paired with simple knowledge of monetary policy and trading, makes the book a more than worthy buy.
Still, it's disappointing for its incomplete nature; the latter rooted in Kelly's lack of firsthand understanding of money or the simplicity of trade. Late in the book Kelly references an e-mail from a trader who asserted that there's "a shitload of money to be made shorting" crude. No doubt there is at times a ton of money to be made betting against the price of crude, particularly if the U.S. Treasury is leaning toward protecting the dollar, but seemingly missed by Kelly at every turn is that there's only money to be made shorting oil if there's a contrarian who thinks there's a "shitload" of money to be made from being long oil.
Kelly's main thesis is once again that the fraternity of commodity traders is the most powerful in the world. That she believes what is plainly false means the book ultimately misses for her analysis having missed. Traders of any kind are ultimately rather weak; always a change in dollar policy away from having their "face ripped off" and utterly reliant on someone else in possession of a view wholly different from their own. Had Kelly embraced this essential truth, what is an informative book and one worth buying would be an excellent book, and one that would be a must-have for readers.
