Tuesday, July 28, 2009

Oil: the Market is the Manipulation

A very smart post via The Oil Drum. When news of the CFTC declaration that speculation was the cause of last year's run-up in oil prices I thought about writing an "I told you so" post. We've done at least twenty posts on speculation in the oil markets in the last fifteen months.
Instead I confined myself to a single comment at Henry Blodget's GreenSheet:

CFTC Blames Oil Speculators For Price Spike

Sounds ridiculous. Look forward to reading. And I must say I don't understand why it seems so imperative to demonstrate that the cause was anything other than supply and demand.

... Climateer (URL) said:
I know you're skeptical but both Paul Tudor Jones and Wilbur Ross said last year that oil was a speculative bubble.
Ross went so far as to make the most leveraged bet on lower prices he could find, the decrepit Indian airline, SpiceJet.
If you remember the spike on 6Jun08, it was a machination to crush the shorts.
Although he was talking his book, Masters was right in pointing the finger at long-only index "investors".
The place where the CNBC talking heads go really askew is confusing "speculators" (who do a societal good" with the "investors" who were buying swaps from the friendly neighborhood derivatives salesman and whom GS threw under the bus* last November when it appeared their prop trading was being threatened.
Never forget that Blankfein came up via J. Aron"", the crown jewel.
*...Now Goldman is left with the ignomy of summarily abandoning the investors who listen to its research calls, telling them effectively that they’re on their own. On Thursday, Goldman said it was ”closing” its recommendations for oil trades. Meaning that in a perilous time when the traders who pay attention to Goldman’s recommendations could use some guidance the most, Goldman has opted to give them the least. And some traders are furious about it, comparing the maneuver to then-strategist Abby Cohen’s decision to abandon her targets for equity indexes in the fall 2001, citing the uncertainties abounding in the market.

Goldman specifically talked about four trade recommendations it previously issued, and said clients shouldn’t put any stock in them any longer. One particular trade, a Nymex-WTI swap on the 2012 contract, issued in September, when crude already had declined to below $70, suggested that the contract would reflate to a range of $120 to $140. Obviously, that hasn’t happened...
-Barron's, Nov. 20, 2008
**"When Blankfein asked about his title, a boss at J. Aron said,
'You can call yourself contessa if you want.'"
-Fortune, January, 2006
Here's Chris Cook at TOD:

...When I joined the International Petroleum Exchange as Head of Compliance and Market Regulation in 1990, the growing market in oil derivative contracts (futures and options contracts the purpose of which is to manage oil price risk) took off dramatically with the first Gulf War, and the IPE never looked back.

During my time at IPE major investment banks were completing a transformation into “Wall Street Refiners” who provided liquidity to the end user producers of oil and consumers of oil products who use derivative markets to “hedge” the risk that prices may fall, or rise, respectively. Indeed, I unwittingly facilitated their emergence by introducing new trading tools such as “Exchange of Futures for Swaps”, “Volatility Trades” and “Settlement Trades” which became hugely successful.

When I left IPE in 1996 the pieces on the present day oil market chessboard were pretty much set, and the game was commencing. It was already clear that the trend towards screen trading was unstoppable, despite the wishful thinking of the traders on IPE's open outcry trading floor. Moreover, market participation of investors through funds was already visible in embryonic form.

A Partnership made in Heaven?

There are probably few more influential people than Peter Sutherland. An Irishman with a high level legal and political background, he became a non-executive director of BP as early as 1990, and after a brief but successful period to 1995 as head of the World Trade Organisation he has been on the BP board ever since, from 1997 as chairman. He has also chaired Goldman Sachs International since 1995.

Lord Browne of Madingley was a career BP man who ascended to the top in 1995 and eventually fell from grace in May 2007 shortly before he was due to retire. He was on the Board of Goldman Sachs from May 1999 until May 2007.

BP have always been natural traders. Unlike Exxon, who are vertically integrated and produce & refine oil and distribute products, BP sell the oil they produce on the market, and buy the oil they refine. In the years since 1995, BP has made phenomenal profits by trading oil, and oil derivatives.

So have Goldman Sachs. You don't rise to the top in Goldman Sachs unless you are responsible for making a great deal of money: and their energy trading operations have made immense amounts.

The key player in Goldman Sachs is the current CEO Lloyd Blankfein, who rose to the top through Goldman's commodity trading arm J Aron, and indeed he started his career at J Aron before Goldman Sachs bought J Aron over 25 years ago. With his colleague Gary Cohn, Blankfein oversaw the key energy trading portfolio.

It appears clear that BP and Goldman Sachs have been working collaboratively – at least at a strategic level - for maybe 15 years now. Their trading strategy has evolved over time as the global market has developed and become ever more financialised. Moreover, they have been well placed to steer the development of the key global energy market trading platform, and the legal and regulatory framework within which it operates....

...Market Strategy

If you are an end user, then market volatility is your enemy – indeed, that is why end users began to use derivatives in the first place. But if you are a middleman, then volatility is your friend, and the only bad news is no news. Likewise, good access to market data is essential to end users – whereas privileged or “asymmetric” access to market data is beneficial for intermediaries.

The temptation is therefore always there for intermediaries to create artificial volatility through “hyping” or even creating news, and to move the market around. Whether or not BP and Goldman Sachs trading arm J Aron were involved in such collaborative behaviour during the late 90s is an interesting point, since they were uniquely well placed, but if they did, they wouldn't have been the only ones.

Certainly by 2000 manipulation of settlement prices – for the purpose of making profits “off exchange” - was rife on the IPE to the extent that the opportunity for profit to which it gave rise was affectionately known by IPE locals as “Grab a Grand”. When I discovered it by chance, and blew the whistle on it, my allegations were buried by the UK's Treasury, FSA and IPE between them, and so was I, personally and professionally.

Meanwhile, in 1999, Goldman Sachs managed to convince the US regulators, the CFTC, that they were entitled to the same regulatory “hedge” exemptions as those market participants who were genuinely hedging their physical requirements. This, combined with the collapse of Enron in December 2001, cleared the way for the complete takeover of the global energy marketplace which has followed in trading on (and off) the ICE platform, and prepared the ground for making money out of the growing constituency of financial investors.

Financial Investors

Through the1990s two new breeds of financial investors in the energy markets began to evolve
Firstly, the inaptly named hedge funds, which recruited, or were set up by, some of the top energy traders, who preferred to make money for themselves rather than their employer oil firms or investment banks. These traders began to take large bets in the oil and energy markets, using investors' money as risk capital, using both on and off exchange contracts, and as much “leverage” as they could command, either through derivatives, borrowing, or both.

This was good business for the “prime brokers” who acted as counter-parties to hedge funds and benefited both from commission and fee income, but also from privileged knowledge of order flow, superior knowledge of the physical market, and “front running” of customers wherever possible.

The lion's share of this prime brokerage business went to the ICE founders, Goldman Sachs and Morgan Stanley, who took different approaches to their necessary relationship with the physical market. Morgan Stanley acquired energy market infrastructure, particularly storage, whereas Goldman appear to have relied more upon their close relationship with BP. In the years from around 2002 until the Credit Crunch neutered the hedge funds, BP, Goldman and other prime brokers prospered mightily.

The advent of the Goldman Sachs Commodity Index (GSCI) fund in 1995 was one of the earliest examples of a fund investing in commodities for the long term as a “hedge against inflation”. To do so the fund ran increasingly significant positions in all commodity markets, but weighted towards energy. These positions were held over time, and had to be “rolled over” from month to month in the futures markets either directly, or through the intermediation of J Aron. This resulted in the phenomenon of what John Dizard documented as “Date Rape” and which I had observed – and pointed out to the FSA - several years earlier.

In the last few years, and particularly in the aftermath of the Credit Crunch, a massive wave of money has washed into a new breed of Exchange Traded Funds (ETFs) some of which exist solely to invest in commodity markets (ETCs). By mid 2008 it was estimated that some $260 billion of such money was invested in the energy markets. Compare that to the value of the oil actually coming out of the North Sea each month, at maybe $4 to $5 billion at most.

No one is in any doubt that this tidal wave of fund money caused a Bubble in oil prices culminating in a “spike” to $147.00 per barrel on 11 July 2008. But there appears to be a complete misconception – particularly in the US - as to how this Bubble occurred, and who was responsible. There is no consensus, and many conflicting theories, as to why it occurred and also why the oil price appears to be held at levels apparently unjustified by supply and demand....MUCH, MUCH MORE including this dénouement(or is it a J’accuse...!):

...The manipulation in the oil market is taking place at a different “meta” level to the Leesons and Hamanakas. The Goldman Sachs and J P Morgan Chase's of this world do not break rules: if rules are inconvenient to their purpose they have them changed....