Oil Speculation Revisited
An unusual and disturbing pattern with oil prices started to develop as we moved into the new millennium. Price volatility, always an issue to some extent, became frequent and pronounced. And oil prices, which had been depressed the previous decade, started a gradual but continuous climb. These developments were hard to miss, and while the causes were obviously upstream they called for investigation and eventually action.
‘It’s been a decade since we first engaged in trying to figure out what had changed in commodities,” said Sean Cota, a partner at the industry consultancy Lake Rudd Capital Partners. He is formerly the co-owner and president of Cota and Cota Heating Fuels of Bellows Falls, Vt. ‘You [previously] could look at the supply and demand of products and determine within a rough parameter what was likely going to occur from a hedging standpoint. Although you had volatility in certain emergency situations, outside of that there really was not a lot of volatility in the market. What I saw in 2004 was that nothing made sense anymore.”
Cota, an active leader in the industry involved with both the New England Fuel Institute and Petroleum Marketers Association of America, has been a key player in the battle explore address the upheavals in the commodity markets. He has appeared on ’60 Minutes” discussing the issue and at one point he was being pushed as a potential commissioner candidate for the Commodity Futures Trading Commission. He has severed as a member of the CFTC Energy and Environmental Markets Advisory Committee.
A variety of issues were being cited for this fundamental change in the markets, with the primary one being a tight crude oil market where a ‘peak oil” component was butting heads with the actual and/or projected increase in demand for oil among rapidly developing countries like China and India. This was seen as impacting price generally and enhancing the volatility when any potential or real supply disruption occurred.
Also cited was a devalued U.S. dollar, the trading currency for commodities like oil, where a declining dollar would naturally increase the price of oil purchased with dollars in a global market.
Speculation in the commodity markets was also cited as a possible driver (and not just for oil, but for similar spikes in a range of commodities). There was plenty of opposition to this view, particularly in the financial and business media and financial institutions like Goldman Sachs that were pushing their index funds. The Energy Information Administration also downplayed this aspect.
Economists also cited academic explanations for why speculation could not be occurring’often overlooking real world distinctions in specific markets like crude oil. For example, in June 2008, Paul Krugman wrote in The New York Times: ‘A futures contract is a bet about the future price. It has no, zero, nada direct effect on the spot price. And that’s true no matter how many Joe Shmoes there are’that is, no matter how big the positions are.”
Academically that is a fair statement. But, Krugman’s ignorance of the real-world crude market overlooked the fact that nearly 30 years ago the decision was made (ironically enough to reduce manipulation and increase price stability) to base long-term physical oil contracts on ‘formula pricing” linked to a premium/discount benchmark relative to a benchmark futures contract such as West Texas Intermediate or Brent (depending upon the region).
Similarly, oil’s inventory/storage behavior was not seen as being in line with traditional academic speculation models. However, oil is again not a typical commodity and in the western world ramping up oil storage (as might be expected with speculators) is hardly a simple matter given environmental pressures and regulatory hurdles. In the non-western world, storage activities are said to be opaque at best, and there is the ability to store oil by leaving it in the ground by producers.
But, why should speculation suddenly be an issue? There was an explanation’the passage of the Commodity Futures Modernization Act of 2000; which was developed during the final days of the Clinton administration. Quite a bit had actually changed in commodity trading in just a few years.
CFMA, among other things, effectively created the ‘Enron Loophole,” so named because Enron pushed for it, which allowed the option of trading energy commodities on deregulated exchanges such as the Intercontinental Exchange, a ‘foreign” over-the-counter swaps market.
An additional result was that Wall Street banks were exempt from speculative position limits when those banks hedged over-the-counter swaps transactions, as the CFTC’s classification scheme counts all speculators accessing the futures markets through the Enron Loophole as commercial rather than non-commercial. This resulted in two notable impacts: it distorted the analysis of what is and is not a commercial participant when analyzing the impact of potential speculation on the market, and it allowed for highly-leveraged trading that created a ‘casino” atmosphere.
Chinese demand was increasing, oil production (at that time) seemed to be plateauing or declining and the dollar was decreasing in value. But the changes in the market seemed beyond what the hard data on supply and demand might suggest for those causes, to the point that traditional analysts like the late Peter Beutel were at a loss to explain it. You could also look at the declining dollar and moving beyond the direct inflationary impact on oil prices and see that major investors were increasingly looking at commodities as a hedge.
A lot of money was moving into the markets. Michael Masters, managing member and portfolio manager at Masters Capital Management, LLC., noted in testimony before the CFTC on March 25, 2010: ‘In 1998, the average commodity market was about 25% speculative as a percentage of open interest. By 2008, speculators comprised about 65% of open interest. Bona fide physical hedgers once outnumbered speculators 3 to 1; now speculators outnumber hedgers 2 to 1. The positions of bona fide physical hedgers doubled during this ten-year period, while the positions of speculators rose by 1,200%.”
With billions of new dollars coming in chasing a limited number of barrels, and paper contracts rolling over prices in the futures markets kept moving up. And the volume of trades had more than tripled since 2000 from 483,000 thousand contracts in the first quarter of 2001 to 1,397,000 in the first quarter of 2008, according to EIA data.
Overwhelmingly the action was on the ‘long” side of things with these new investors, which was the plan of the index funds driving the action.
Masters cited a Goldman Sachs Report from 2008 on the subject: Commodity indices were designed to be long-only investment vehicles in order to create a stable supply of passive buyers to balance the commercial selling. Put simply, the index investors are the buyers of the commodity futures positions that the commercials want to sell in order to hedge their natural exposure to commodity.
The Goldman Sachs report also indicated that traditional supply and demand concerns were not that important with these index funds: The buying and selling of index investors is driven by asset allocation decisions, portfolio rebalancing and the shape of the commodity forward curve during the ‘roll” period, not views on the supply and demand fundamentals.
Crude oil prices had been comfortably perched under $25 per barrel from the mid-1980s until 2000. They then began a steady and significant rise and practically doubled from $54 to $93 in 2007. In July of 2008 they topped at $145. By the end of the year, as the recession hit, they collapsed to $40. Obviously, the recession created demand destruction, but the world economy while severely shaken hardly ground to a halt.
TAKING ACTION
The fight to address commodity speculation was well underway by the time the recession arrived. In fact, the impact of financial deregulation relative to housing was barely on the radar at the time.
It’s not surprising that heating oil dealers pushed for the fight to reregulate commodities (with critical assistance from similarly impacted players not only in oil but other commodities). The massively increased price of heating oil was a critical threat to business. What is surprising is that such an outgunned force achieved so much and so quickly.
NEFI and PMAA were the foundational leaders in the push to look at the role speculation was playing in the markets. Jim Collura, NEFI vice president for government affairs, noted that the former NEFI President and CEO Jack Sullivan wanted to make sure the organization had an understanding of what was driving the excessive price volatility. The institute hired Lexicon, a firm in Texas, to analyze the markets and to see what role speculation might be playing.
‘Lexicon came back, and I believe it was December 2005 or January 2006, with a preliminary report stating that they couldn’t tell us what role speculation was playing with commodity futures because of two major problems,” said Collura. ‘First, the markets are completely opaque and most of the information wasn’t even available to regulators. Many trades were occurring over-the-counter and some of what was occurring on designated contract markets like NYMEX was actually speculation disguised as hedging. Second, Wall Street had secured some loopholes that allowed certain activities to be classified as hedging even though they were speculative. So in terms of aggregating commercial versus noncommercial transactions, it was difficult to decipher between the two. I remember sitting in the room and my jaw was on the floor.”
NEFI made the decision to adapt its public-policy agenda to focus on speculation as main concern. The association identified organizations that were potentially impacted by this and formed what was to become the Commodities Market Oversight Coalition. CMOC is an independent, non-partisan and non-profit alliance of groups that represents commodity-dependent industries, businesses and end-users. The coalition advocates in favor of government policies that promote stability and confidence in the commodities markets, that seek to prevent fraud, manipulation and excessive speculation and that preserve the interests of bona fide hedgers and consumers.
The true reality of the scope of the situation sank in for Sean Cota when he was set to testify before the Senate Energy & Natural Resources Committee on behalf of PMAA and NEFI on April 3, 2008.
‘When I tried to figure out what was going on’we didn’t realize that at the time most of the market was no longer being traded on the traditional platforms,” said Cota. ‘We did not know what the term was at the time, but the swaps market was essentially invented with the CFMA. It became clearer when I was testifying in front of the Senate and I was listening to George Soros who explained’before the housing market collapsed’ the problems with securitization in the housing market. How people are incentivized just to move stuff into the market and pawn off these trades onto Fannie and Freddie. He went into some detail about how the money flows into this market. A cold sweat ran down my back as I realized that it’s not just housing, it’s everything. I realized that the only way we could even address the issues with oil was to tackle the entire financial structure and derivatives and futures markets. And you look at that task and say is there any way that a handful of folks doing the right thing for the right reason can even have an impact?”
DODD-FRANK
On Sept. 15, 2008, the fourth-largest investment bank in the United States filed Chapter 11. Lehman Brothers’ demise marked the general collapse of a bubble economy fueled by subprime mortgages. Fortunately, the industry had made its case in foresight instead of hindsight that the related deregulation was also impacting commodity prices.
‘Having the industry pool together in communicating with legislators that the financial industry was corrupted, and the fact that it happened before the collapse got us credibility. When the collapse happened they actually listened to us,” Cota said. ‘We are some of the few folks that use these markets for the actual physical purposes. Most people utilizing the markets were doing it for financial reasons. When you securitize the market you’re doing it for making returns on investment and your investment doesn’t need to relate to things like supply and demand and things like that. It only relates to ‘the trend is my friend.’ If you push enough money into it you can make a lot of money because there are always chumps in the market, and, unfortunately, we were some of the chumps.”
Something had to be done and there was finally real will to do what was a very difficult political task. The industry had already pushed for and enjoyed several successes to build upon.
The ‘Close the Enron Loophole Act” had been passed as part of the 2008 Farm Bill which represented a narrow fix, because it only addressed the electronic market concerns raised by the Enron natural gas fiasco. It only required transactions to be regulated if they were declared by the CFTC to be price discovery contracts.
‘That was very limited,” said Collura, ‘But we fought very hard just to get that passed. And CFTC had formed the Energy and Environmental Markets Advisory Committee. Those were significant but then everything changed when the market collapsed in September 2008.”
Collura noted that going into the collapse Congress was already debating law to regulate commodities derivatives. That law passed the House in July 2008 with broad bipartisan support, but stalled in the Senate. After the collapse, the full extent of the issues with derivatives was realized and the need to look at far more than just commodities. That led into the debate in 2009 – 2010 over a much broader bill.
‘It was Jim Collura heading up CMOC that paired up with a group called Americans for Financial Reform that gave us the political power to draft large chunks of Dodd Frank,” Cota said. ‘We made a lot of shrewd decisions leading up to that. Because the markets were all coming unwound at the time there were serious concerns about who was going to be running CFTC and who is going to be making an impact on these markets. The incoming chairman of CFTC was a guy named Gary Gensler who was from Goldman Sachs, and we insisted on meeting with Gary early in the process before he went to any confirmation hearing. Our concerns were that here’s a guy that helped deregulate, along with Robert Rubin and Larry Summers, large chunks of this market.”
Cota noted that Gensler had experienced a change in his life and saw the damage that had been done by the deregulation. He realized and learned from the mistakes that had been made and knew the minutia of how these markets worked.
‘We talked to Gary at some length about whether he had the ability to do it and his interests in pushing this forward,” said Cota. ‘Our interest was having a functional market that serves the commodity end-users and he was with us and we took a gamble’and some heat at the time’for supporting a guy in the nomination process looked like he was in the pocket of the banks. In reality it turned out to be just the opposite.”
The legislative vehicle was to be the Dodd’Frank Wall Street Reform and Consumer Protection Act. The portion developed with industry involvement was Title VII, which covered futures and derivatives. The act was signed into law on July 21, 2010.
‘People to this day do not have an understanding of how big that market is,” Cota said. ‘In comparison, at the point of collapse the federal discretionary budget was like $1.2 trillion; the total budget was $3.5 trillion; total U.S. GDP was $14 trillion; world GDP was $70 trillion; the world stock market value was $44 trillion; the world bond market was $82 trillion; but the unregulated derivative market at that time was $605 trillion, of which the US was half of that total market. And it was leveraged an average of 35 times. You are talking about more money, just in this area that we were attempting to regulate, than it would take to buy everything in the world.”
Collura noted that the legislative process for Dodd-Frank involved six long, hard months to develop the Senate bill that was ultimately enacted into law. Virtually every priority was included such as across-the-board transparency in derivatives, mandatory clearing requirements for nonstandard contracts and mandatory exchange clearing requirements for standard contracts. It also required that offshore trading entities wanting to do business in the United States have to have comparable regulations, including position limits.
‘It basically closed the Enron loophole in its entirety, including swaps, and closed the offshore trading loophole,” said Collura. ‘It required across-the-board transparency, it strengthened anti-manipulation and anti-disruptive trading laws and made it easier for the CFTC to prosecute those laws’it was an amazing accomplishment. The problem, though, is that it didn’t fill in a lot of the details. For example, it required position limits but did not give CFTC guidance as to what level.”
Collura noted that various similar ambiguities left opponents in the financial industry with wiggle room. ‘It was clear to us that Congress, in enacting the Dodd-Frank, meant for mandatory speculative position limits on all commodities,” he said. ‘Under the previous law passed in 1936, Congress said that was basically at CFTC’s option and was only required as appropriate. Dodd-Frank said CFTC shall establish position limits but failed to remove the ‘as appropriate” language. There is significant legislative history about what Congress intended, but unfortunately this left some room for our opponents and Wall Street made the argument that position limits were optional.”
RULEMAKING BATTLE
The rulemaking process has been a very complex task, spread among a range of agencies and with a highly funded financial industry pounding the pavement in Washington to roll-back any reforms.
‘Wall Street looked at it and said; well, now this is law. We’ve got these rules and there are three things we can do,” Collura said. ‘Number one, we can push really hard against the regulations through our meetings with CFTC commissioners and their staffs and through the comment letters we submit. And make those comment letters as lengthy and complicated as possible. We have to question everything. This drew out the rulemaking process tremendously. The second thing Wall Street said was that if we lose and the rules are finalized’let’s sue them. And they’ve done that with the speculative position limits, for example. And then the third thing was let’s tell members of Congress, particularly in a newly Republican-controlled House, just how horrible this bill is and how it’s going to harm our ability to remain innovative and competitive globally and how it is going to prevent us from pushing the economic recovery.”
Legislation was introduced to try to repeal Dodd-Frank, or to intervene in the rulemaking process and force the CFTC to change its rules. The industry was able to counter any effort of consequence. Attempts have also been mounted to cut CFTC funding, and thereby cut its efforts to enforce the rules. The industry was successful in fighting off the proposed cuts but unsuccessful in attempts to increase funding.
Opponents of Dodd-Frank were perhaps most successful in influencing the rule on position limits.
‘The first version of the position limits rule that we had a huge influence on was struck down, and new position limits have been proposed that are going to be more resistant to court challenge,” Cota said. ‘It’s not what we want, but it’s better than the alternative.”
Collura agrees that the limits are still too high, and noted that under the new limits if the spot month or front month for commodities is 25% of deliverable supply, and you have, for example, 100 speculators, and each of them has 25% of deliverable supply at a maximum position for crude oil those 100 speculators would control 2,500% of the deliverable supply of crude oil. ‘We’ve argued that creates an artificial demand for the product and drives up the price,” he said. ‘We also argued strongly for an across-the-board limit on all speculation as a class of trade. The CFTC said that was much too heavy of a lift, and it would’ve guaranteed litigation and they were not comfortable with that. We would probably need an act of Congress to make it happen, which is not likely to happen anytime in the near future.”
The successes have been notable. ‘I think the Dodd Frank implementation has been reasonably good,” said NEFI President and CEO Michael Trunzo. ‘We’ve had a lot of input and the CFTC has been willing to listen. They do understand the importance of the constituents that CMOC represents, and while not every rule has been exactly as we would like it we think the market has taken a step in the right direction for transparency and we have a much better sense of who the players are in the marketplace.”
Cota sees the clearing function as the most important element that has been put in place to date. ‘Everyone made a big deal out of transparency so they created swap execution facilities which report what the deals are and, more importantly, guarantee the other side of the bet. If I, as Sean Cota Oil, wanted to buy heating oil contracts on the NYMEX exchange and the seller of those contracts was Fly-By-Night Oil Company, the exchange does two things. First, it reports the settlement price that we came up with through the exchange and it also guarantees that if Fly-By-Night Oil flies by night and disappears the exchange will deliver on that contract [for a margin fee]. So you’re going to take a look at the credit risk of the individual, the market and price it accordingly. That’s what the bank should be doing. So now they have a way of making money doing what they should be doing instead of betting against their accounts. And because it’s all going to be visible, if there’s manipulation in these markets and it’s going to be visible you might as well get out of it now before it comes to the light of day.”
This already seems to be having an impact on the market dynamics that developed post 2000.
‘Morgan Stanley was traditionally the biggest holder of oil in the world in a variety of businesses that they either owned or had a controlling interest in such as TransMontaigne,” Cota said. ‘They had Morgan Stanley Oil Company which they did a lot of their hedging with, there was Morgan Stanley Shipping and then their commodity trading unit. They put a lot of those things on the block. An exchange provides transparency so that you can see what’s going on. If people know who is making a bad bet, they will gang up against him’because it’s a ruthless market’and take him out. If it’s in an opaque market you can’t tell, don’t notice it and you can’t find out if there’s a rational or irrational reason.”
SO WHAT NOW?
As noted, there have been some significant regulatory successes and apparently those are already bearing fruit. However, challenges remain. After a struggle that has already lasted eight or more years in general, with five years of focused effort how much more is left to do and how much energy is there in the industry to continue the fight?
At this point, the struggle is focused on preventing a backslide on what has been accomplished; the push for the finalization of the position limits rule and increasing funding for the CFTC so that the current rules are enforced.
‘The fight now is on position limits,” said Dan Gilligan, PMAA president. ‘Chairman Gensler has resigned, but he had proposed a rule to follow up and get position limits in place. Of course, Wall Street with their battery of lawyers effectively tied it up in the courts, so right before he left Gensler issued a new proposed rule which is far less vulnerable to attack. You lose time because you have this other rule that was moving forward, but we just felt that the legal battles were going to be too severe and draw it out even farther. We think is headed in the right direction now and we are working to continue to fight for effective position limits.
‘It’s not perfect. And it’s not having as much of an effect as we would want but we do think it is causing people to be more careful and more aware of some of the things that overheat the market with excessive speculation. I think we have elevated the understanding of a lot of people about how vulnerable the crude oil market is to undue influence if people hold too many contracts. I think it has done some good but it’s hard to come up with statistics to specifically show that. But it is something we can see and believe in.”
Increasing CFTC funding is also a critical goal.
‘CFTC regulates 10 times what the SEC does, yet it essentially has no budget,” Cota said. ‘With SEC, for every security it gets 50 cents and CFTC doesn’t have any of that. It would take like 2 cents on a heating oil contract to fully fund the agency. What’s 2 cents on a fuel oil contract? Will that make a difference in whether or not a heating oil dealer would buy a contract? Probably not’that would practically be immeasurable. But the people who don’t want to see CFTC do its job will tell you that will break the market and you can’t do anything like that. That is one of the current battles that the industry needs to be engaged in.”
Unfortunately, the battle is one the heating oil industry has to lead. As Cota noted the heating oil market does a disproportionate amount of hedging for its products compared to other segments, including motor fuels. The trucking industry has a mechanism for passing along the costs with freight surcharges. The airlines, which have previously been a strong ally, have been impacted by mergers that have not paid off as well as expected. Publicly traded companies in impacted industries have to fear negative influences behind the scenes with the same entities that are handling their stocks. The major oil companies and a variety of intermediaries rely on repo agreements through these financial entities to subsidize product inventories (crude and refined) during shipment. Propane has tended to be less effected due to market dynamics, so speculation is less of an issue.
‘Oddly enough, and they don’t know it yet, the most likely allies are the agriculture guys,” Cota said. ‘They were never deregulated and never had these crazy swaps. As part of the new rule coming out there’s some uniformity in all of the hard commodities and oil is going to be re-regulated so that one person in the nearest traded month can’t hold more than 200% of all that’s available. As crazy as that sounds, that’s an improvement. In the agriculture markets today, with something like wheat, traditionally no person can hold more than 5% of the total available market. What impact is that change going to make on those markets?”
Nor can much of a push be expected from the Obama administration. While it is aggressively focused on healthcare and climate change initiatives, there seems to be little beyond lip service to follow through on the goals of Dodd-Frank.
Collura credits Obama with forcing out CFTC Commissioner Bart Chilton, an industry ally, in favor of Sharon Bowen a Wall Street securities lawyer whose outlook on the issues at hand is not yet clear. He further wonders if low oil prices are really a priority for an administration focused so aggressively on oil alternatives.
Also at CFTC, industry champion Gary Gensler has left, and Obama nominee Timothy Massad is another question mark as a replacement. J. Christopher Giancarlo has also been nominated on the Republican side and he has been critical of the CFTC’s recent swap rule reforms. As this article goes to press Bowen, Massad and Giancarlo have received Senate committee approval and are awaiting full Senate approval.
Scott O’Malley, the Republican commissioner, remains and is said to not be generally supportive of the industry’s viewpoint. Mark P. Wetjen, who is a Democrat, also remains but he has tended to vote more sympathetically to the Wall Street side.
‘The question for us now is do we continue to commit the time and resources necessary to maintain the cohesion among our allies and continue fighting this? Or do we say we’ve got as far as we can and it’s not as important spending resources on this issue compared to others that our industry is facing,” Collura said. ‘That is one of the debates we’re having internally. Not only us but the other partners involved in this fight. How much more time, money and personnel are we willing to dedicate to this? Especially given the amount of resources the other side has to bring to the fight. There’s a reason why the vast majority of our members have supported us spending so much time and money fighting this. It’s the right battle and we have gotten a lot out of it. And prior to that whenever prices were out of hand people fingered their dealer for price gouging. I think now the average consumer knows that these price swings have nothing to do with the person that sells them the product and they have a better understanding about the kind of factors that go into play further upstream.”
For all the challenges, the industry still has its most powerful weapon’heating oil dealers and marketers. ‘We cannot influence politicians through campaign donations, we cannot hire out armies of attorneys, we cannot pay for expansive PR campaigns through front groups to shove the messaging down the throats of the consumers but we have an army of hard-working, passionate, dedicated people who care about their consumers and want them to know what is really happening,” Collura said. ‘That is why we won last time, and if we are going to really make something happen here and preserve and strengthen our victory it’s only going to happen through doubling down on that approach. We have to redouble our efforts, get the industry fired up and get them to talk to their customers and then we will be successful.”
