Michael Martin is a proprietary commodity trader. He is a commodity instructor for the CFA Institute and a frequent lecturer on risk management. Until September 2008 he was an Associate Editor at Trader Monthly magazine. He blogs at http://martinkronicle.com and at www.huffingtonpost.com/michael-martin.
Victor Sperandeo is professional trader also known as Trader Vic — is generally considered an expert on commodities (particularly in the Energy and Metals sectors), where he has earned a reputation for profitably trading in declining markets. His market crash prediction during the September 1987 Barron’s interview earned him widespread recognition of his understanding of the financial markets.
Sitting On One’s Hands
There are several things that the Commodity Futures Trading Commission (CFTC) will be considering as they convene hearings. Hopefully they will hear well-researched, and well-thought out opinions, unlike that of Michael Masters – who’s testimony was slammed equally by the left and the right by the likes of Nobel Laureate Paul Krugman and Commodity trader Jim Rogers. Among the issues that the CFTC is looking at are transparency in the markets and the position reporting limits where they are not currently any Federal guidelines. A third issue is the stratification of the COT — the commitment of traders — which characterizes how the market participants are biased in the marketplace. Ultimately, these make for good talking points, however, regulation in these areas will not stamp out speculation nor insure Americans against high commodity prices.
That commodity futures contracts have position limits is not a new concept. The various exchanges set position limits, except for Agriculture futures which are set (Federally) by the CFTC. Each commodity has its own position limit and they tend to be very specific. NYMEX Crude oil, for example, has the position limit of 10,000 net futures in any one month and 20,000 net futures contracts for all months combined. You are limited to “only” 3,000 contracts in the last 3 days of the spot month, including any concurrent Call or Put Option positions on the same commodity. The question before the CFTC is how to account for the Over the Counter (OTC) market in aggregating position sizes. Also, the Intercontinental Exchange (the ICE), has evolved substantially since trading has become much more electronic. The ICE offers “look-alike” futures which are cash-settled and no physical commodity is ever involved by definition. The position limits for the ICE Crude Oil Futures are exactly the same as those set by the NYMEX on its crude oil contract. These are two different contracts on two different exchanges and their limits should be separate.
If Victor decides to sell 5,000 NYMEX crude oil contracts and Mike is buying 5,000 NYMEX crude oil contracts at the same time, there is no effect on crude oil itself. Neither of us is creating nor producing the physical oil – we are trading against one another. We are not impacting the consumer, unless the consumer happens to be a speculator and is taking part of the position. What we are doing, however, is providing valuable information to the marketplace on the outlook for Crude Oil. We already abide by the reporting levels. Further transparency will not annul volatility in commodity futures trading. Uncertainty causes volatility. Hedgers, real hedgers, are hedged oftentimes to the back of the board and they use several techniques beyond futures contracts.
Commodity investors, also called Indexers, invest in commodities for the long-term to assuage the effect of inflation on their traditional investments and “paper assets,” such as stocks and bonds. Through passive investments such as the US Oil Fund, LP (ticker:USO) discussed below, or through the asset class known as Managed Futures, they seek diversification along their investment frontier to enhance their returns while reducing risk. These indexers, which have billions and billions under management, are the large pensions (and in some cases Endowments) that have Defined Benefit plans that they are legally bound to pay out of to plan beneficiaries – retirees – in the future. It has been alleged that such indexers, due to their sheer size, are driving up the price of commodities. So far, there has been no evidence of fact to this regard. Regulating pensions and endowments out of the market or to the point where their participation would be meaningless, would be a great disservice to them and frankly, discriminatory because of their size. Such regulatory banishment would likely come back to haunt lawmakers and tax payers because if there was a shortfall in corpus that is due to be paid out, it would have to be made up. This would be a drama known as Social Security, Part II.
High prices are the best cure for high prices. Sound like a riddle? It could be. When prices rise to extremes, such as they did during Peak Oil, producers will run at full capacity to sell as much as they can into these high prices. The costs to produce oil is relatively static, so there is great profit potential. At the same time, consumers will consume less and less as prices rise. The confluence of the demand backing away and eventual supply glut drives prices down. There is no speculator or commodity indexer on the planet who can compete with the perfect production knowledge of Saudi Aramco or the National Iranian Oil Company (NIOC), the two largest oil producers in OPEC.
Easy credit, or the ability to borrow money at low interest rates, is a lot harder to regulate. It is the availability of easy money that may have had a greater cause for the volatility in commodity futures prices. Excess credit fuels speculation as we’ve seen in real estate, and for that you can look back to Chairman Greenspan. But speculation has nothing to do with the physical cash prices of commodities or what commuters pay for gasoline at the pump. In fact, if speculators were removed, it’s likely certain that price volatility for commodity futures contract prices would be greater. There has been greater volatility in onion prices, for example, where no futures market exists than in corn or wheat, where there are futures contracts. Onion speculating has been banned since 1958 thanks to a bill by then-Congressman Gerald Ford (R-MI). No futures markets exist for cobalt and molybdenum and they too suffer from drastically wild prices in the cash market. Speculators can help smooth out the price if involved in a centralized meeting place – an exchange – and take on the risk that producers and consumers cannot handle. The London Metal Exchange (LME) is introducing cobalt and molybdenum contracts in the next year. Go figure…
The price action in the cash market leads futures market prices, not the other way around. When we purchase gasoline at the pump, price is determined by the people buying and selling the gasoline – not by the trading of gasoline futures contracts. While it’s true gasoline retailers may be hedging their exposure, purchase and sales of commodity contracts is separate from the purchase and sale of gasoline in the cash or spot market. What occurs at the pump is between those companies that supply gasoline and the demand from those who drive. That is between consumer and your gas retailer. Speculators are not involved.
And about the alleged crude oil hoarding? There are several market players who have access to cheap money and storage, and thus, can earn profits on trading the physical commodity. If a market participant can store or finance the purchase of the physical commodity cheaper than the embedded storage and finance costs represented in the calendar spreads, the participant is encouraged to store the physical. It is not uncommon for Futures Commission Merchants (FCMs) to trade the physical commodity concurrent with their brokerage operations. It also diversifies their business operations. FCMs storing several barges full of crude oil is not hoarding – it is lawful, legal, and profitable in carry-charge (contango) markets. The spreads in carry-charge markets, in fact, dictate what to do: either store it (in barges) or deliver it immediately. They can’t store it for too long though. Unlike crude oil’s derivative products gasoline and heating oil, crude oil does not store particularly well.
Sensational articles tend to name these FCMs as also having received TARP money (which was force-fed so as to protect to protect the really sick banks, such as Citi) and therefore very greedily using taxpayer money to profit from commodities trading. Most, if not all, of these FCMs have been trading cash commodities long before the authors of such articles could spell CDO (Collateralized Debt Obligation), which is neither a commodity nor a derivative. The banks could not refuse the TARP funds. The recent SIGTARP report delineated that out of the 360 institutions receiving support, 31% disclosed that they made investments with some of the TARP funds. It did not list specifically what those investments were, although 26% reported buying Mortgage Backed Securities (MBS). Seeking profits from commodity trading – in either the cash or the futures markets – is not a form of greed, it is in business to seek profits! And, since when is it presumed that all the market participants always win or make money? Usually in tough financial times when it feels good to blame others. FCMs are in the business of making money and the CFTC should remember this while the hearings are on.
Almost all commodity futures contracts are offset well before they expire. Open Interest is the number of contracts that have been entered into by all speculators and hedgers. As time transpires in the contracts expiration draws nearer, you typically see a steady decrease in open interest, which means contracts that have been entered into are being closed. Purchasers are selling, and those who have sold short are buying them back or “covering.” All this activity is beyond the physical cash market for gasoline and the information is publicly available and readily accessible. Historically, less than 2% of all contracts are delivered against. An exception to this might have been an “unintended consequence” when in the early 1970s President Nixon put a price ceiling on plywood when he tried to curtail inflation. Producers lacked incentive to create more product thereby creating a shortage — a shortage so great that the commodity futures market for plywood became the supplier of last resort.
For every buyer there has to be a seller, so for every large index commodity investor there needs to be a willing person or several of them on the other side of the trade who are willing to sell. We’ve all heard of the “Goldman Roll” and we know when it’s coming. This does not create an imbalance in the commodity futures market.
During the most recent run up in spot Crude Oil prices, the International Energy Agency (IEA) determined that demand for crude oil did decrease, however, production fell at a greater rate thereby causing a rise in prices. The dramatic fall in the US dollar (USD) exacerbated the move. IEA and the CFTC found only “inconclusive evidence” (that means no evidence) that speculators had any effect on the cash prices for energy.
A recent paper by Professor Scott Erwin of the University of Illinois took on the argument that speculators were behind the recent price moves in wheat. Professor Irwin demonstrated that speculators were not the cause of increased prices and weak but the relationship between the cash and the futures prices. His research found that they were there were two causes that led to higher wheat prices: “The first factor is the tendency for spreads in the futures market to reflect a relatively high percent of full carry (contango) since 2006. The second factor is long-term structural deficiencies in the delivery system for CBOT wheat.”
Lastly, not all speculators are in the markets at all times. One of the tool that a speculator has is the right to not participate. A hedger has to be in the marketplace to offset risk – a speculator does not – they can sit on their hands. When markets become very volatile, or choppy, many commodity investors head for the sidelines. Volatile and directionless markets can wreak havoc on a manager’s equity and investors usually enjoy stability more than anything.
We find that there is a lot of inference in media reports about commodity prices, especially when they are high. We investigated one recent, albeit short, blog post on a large commodity index that originally appeared in Reuters Blog called Commodity Corner:
Exchange traded funds like U.S. Oil Fund LP hold an increasing share of outstanding NYMEX energy contracts. The funds allow retail investors to bet on a rise in crude oil prices, but looming U.S. CFTC regulations aimed at curbing speculation could limit their positions in the future.
Seemingly, harmless enough, yet with a little digging we found (on Yahoo! Finance) that the price of US Oil Fund LP (ticker: USO) fell from $57.38 to a intra-month low of $22.86 during the acquisition of the July NYMEX Crude Oil contracts.
During that same time, the price of NYMEX July Crude Oil futures dropped from approximately $76 to a low of $42. USO was buying July Crude in a falling market.
We also found that USO purchases ICE Crude Oil contracts alongside their NYMEX contracts. In fact, according to Yahoo! Finance, only 50% of the corpus USO manages is invested. About 23% of all corpus is invested in NYMEX contracts and the other 26% is ICE Crude Oil – the one that is cash-settled. “WTI” stands for “West Texas Intermediate” – the type of crude oil that underlies the commodity futures contract.
We used Yahoo! Finance because it is public and free. You don’t need a 2-year contract and $2,000 per month to get this information like you would if you needed a Bloomberg terminal to get this data for example. This is just one blog post, but you’d be surprised how many of them are written in this manner.
Commitment of Traders
One thing that effects the COT is the physical trading desks of the large oil producers. In our opinion, it would be quite easy for a producer to speculate under their hedging activities. If a producer had production set at some factor X, they could sell X + K futures as a hedge, with K being excess contracts that do not represent the hedge. Currently, all such trading would be considered hedging.
Speculators can also enter into a long-term OTC swap arrangement and “hedge it” using futures. Although they’d be “hedging” a core position, they are in fact still speculating since that is their main business. In this scenario, they have entered into a type of spread trade with futures against an OTC position and would be looking for the spread to narrow or widen.
Indexers, such as USO above, will continue to be included in the Commitment of Traders.
Regulation gives one a false sense of security. One cannot legislate behavior, no more than religion can “legislate” morality. Parties that are invited to testify have agendas and their allegations should be vetted thoroughly. It is important for the CFTC not to over react so as to drive trading to foreign markets. We have already know that the more regulation (and tax) you add to the system, the less the output for a nation. Virtually all securities known as “structured notes” are sold in the UK and Asia due to the too stringent regulations and tax rules on such in the US. Too stringent rules on commodity exchanges, contract position limits, and regulations on participants, and you’re likely to see business heading offshore along with the jobs…and that means taxes – tax revenue that will eventually need to be made-up. One alternative that exists right now, is our ability to trade Crude Oil from our desktops in the US through the Dubai Mercantile Exhange (DME).
US commodity traders on regulated US exchanges do not pose any counter-party risk to one another and there has never been a financial failure in the commodity markets. There is no way to lower volatility in commodity futures prices through regulation because no one can regulate uncertainty. Speculation poses no risk to cash commodity prices for US consumers. Despite the lawmakers’ need to “do something,” the markets will take care of themselves. High prices fix high prices and therefore the CFTC should sit on its hands.
Onions in Fortune Magazine
NYMEX Crude Position limits data
IEA Energy data
slide #3 of 17
ICE WTI Crude Oil Futures Data
Reuters Commodity Corner
Price History of USO
Price History of NYMEX July 2009 Contract (Ticker: CLN9)