Monday, July 7, 2008

Oil: Commodities Regulator Under Fire

Swaps, Swaps, Swaps!
In October 2007, the author of this piece, Ann Davis, had a story that knocked our socks off: "Where Has All The Oil Gone?"
From the Wall Street Journal:
...Still, even some Wall Street analysts whose firms benefit from the status quo contend that the investment influx has changed market dynamics and could be making raw-materials prices higher or more volatile.

"We are seeing the classic ingredients of an asset bubble," says Edward Morse, chief energy economist at Lehman Brothers. He says that for every $100 million in new investment since 2006, oil prices have risen 1.6%.

Plaguing both sides of this debate is a shortage of data about a thriving sector of the market: the customized market for derivatives known as swaps. Wall Street banks such as Morgan Stanley and Goldman Sachs have developed swaps to allow pension funds, hedge-fund traders and commodity companies to bet on prices among themselves, largely outside the regulatory surveillance of the CFTC.

Investors can make larger trades through swaps dealers than they could make directly on a futures exchange. Until this month, the CFTC has not required Wall Street swaps dealers to routinely provide more detail on who these customers are....

...Swaps have grown so popular that they are the primary means by which institutional investors have made massive bullish bets since 2002, totaling an estimated $260 billion in indexes linked to the price of a basket of commodities. At a hearing in early June, the CFTC said 85% of index investing is done outside of regulated futures exchanges.

The Bank for International Settlements, a global body that surveys central banks, puts the notional value of all over-the-counter commodity instruments at $9 trillion.

Because an estimated 50% or more of this market consists of instruments related to crude oil, a report from research company ISI Group says over-the-counter oil trading could be as much as 18½ times larger than the total oil bets outstanding on the main regulated energy-futures market, the New York Mercantile Exchange....

...But congressional witnesses, among others, say that the CFTC misses trends involving large trades by swaps dealers acting on behalf of index investors and hedge funds because it lumps what little data it gets from Wall Street swaps dealers into a "commercial trader" category also encompassing airlines and oil refiners.

A CFTC study released last year showed that while commercial traders as a whole are net sellers, swaps dealers were typically net buyers of the near-term futures contracts that are quoted as the Nymex benchmark....

In late May I had a comment back-and-forth at the WSJ's MarketBeat blog, reading it again, it is apparent that the other commenter and I were talking past each other, kind of a grade school/grad school kind of thing:

It was the swaps comments in Mr. Masters testimony that seemed to wake old Joe up, not the Index part.
The banks will ditch the fund business in a second if there is any hint that allowing an outside speculator to evade position limits by swapping, and thus showing up in the COT reports under the ‘large commercial [4 or less]’ umbrella, would lead to further regulation or even scrutiny of their business.
Citi broke out their smallish piece as worth $661 MM.
CalPERS may pay a lot of fees but not enough to get GS to risk the golden goose.

Comment by Climateer - May 31, 2008 at 8:43 pm

How many times do we have to endure this sort of conspiratorial idiocy in human history before it stops?!! How is it that so many people cannot see past their well-documented, primitive anti-market biases? If prices rise, blame the speculators! Of course, it’s so obvious! Those evil capitalists! This time, the twist is that it’s not just the evil oil companies and traders that are manipulating prices, it’s the pension and endowment funds!

Liberal environmentalists (like Climateer) are so fond of touting the supposed “consensus” of scientists that support their anti capitalistic bludgeon of anthropogenic global warming (despite the fact that many reputable climate scientists don’t support it), so it’s funny that on this issue not one reputable, trained economic scientist has supported this ridiculous witch hunt against commodity index investors. Funny too how no one, including Mr. Masters, has supplied anything other than naïve speculation that what he claims is true. In fact, all reputable economists who have opined on this notion dispute it....

Thanks for the econ lesson. Here’s one for you.
The use of force verbiage is short-hand for the evolution of economic thought in just the last 700 years. The economics of the 14th century was the econ of the Condottieri.
Force of arms trumped all.
In response societies developed rules of conduct, laws, to codify what constitutes acceptable (and unacceptable) commercial behavior.
Over and over again you will find proponents of “Laissez-faire” are the first to appeal to the power of the state to enforce their property rights.
So the question isn’t whether one believes in state intervention, it is to what extent and how duplicitous they are in their public pronouncements.
Voltaire nailed the concept with “Ils ne se servent de la pensée que pour autoriser leurs injustices, et emploient les paroles que pour déguiser leurs pensées” (Men use thought only to justify their wrong doings, and employ speech only to conceal their thoughts)
In the instant case, the commodity markets, there are so many shennaigans going on right now that even Enron would blush.
The recent failure of spot cotton prices to converge with the futures on settlement day is just one example of the dysfunction of the markets.
The CBOT’s turning a blind eye to the same phenomena in winter wheat is proof positive that participants will preach “Free-markets” as long as it suits their purposes.
Pension funds evading speculative position limits by entering into swaps agreements with commercials is another example of gaming the rules.
This one has the further anti-market effect of transforming a spec position into a “hedge’ in the COT reports, reducing transparency and conferring an anti-market advantage on those who know the true state of affairs.
Speaking of Enron, their behavior in the California electricity market was, simply, a fraud on the market.
The action of oil prices will give us an indication of where the truth lies. When functioning, the price discovery mechanism is admirable for its signaling ability. When manipulated, it is a fraud on society.
The real fun will come with the introduction of artificial markets in carbon.
I’m hearing the same B.S. about “market-based solutions”.
If the prognosticators are right, we are looking at $2 to 4 Trillion in activity with 15% slippage (bid /ask spreads, commissions, fees, bribes etc.)
I’ve got to go run a business now but feel free to respond it you have anything else to share.

Comment by Climateer - June 4, 2008 at 12:02 pm

This is like arguing with a parrot or a sugared-up kid with ADD. I could no doubt spend weeks countering one error of yours after another — such as explaining to you the difference between the initiation of force and a legitimate response to its initiation by a criminal; or how attempts by governments’ to control markets will always lead to unintended consequences and loss of efficiency, as it did in California’s energy markets, and with things like position limits in commodities markets (just ask a trained economist, who will likely agree that if position limits make any sense at all, they certainly make no sense for index investors like CalPERS who continuously roll their positions forward and clearly have no intent to corner any commodity market) — but then I don’t have that much time or interest....

There's more, if you care, here.