There's been a big argument since gas passed $3 a gallon over just how much of the soaring price is due to speculation. News has just come out from the Commodities Futures Trading Commission (which is like the Securities and Exchange Commission but responsible for futures contracts on things like oil, wheat and frozen concentrated orange juice) that gives us a pretty good idea. Around 81% of NYMEX contracts are held by financial institutions for their own accounts or those of their clients. That's a heck of a lot of extra demand in a market with tight supply. The only conclusion is that we're sitting on an oil bubble.
I tried to find the report on the CFTC website, but they're two days behind. The story comes from David Cho of the Washington Post. The situation looks like it has gotten well beyond the regulators. Vitol, a Swiss entity, had been considered a broker of sorts, helping industrial firms get the oil they needed to run their business. The facts are different. Mr Cho says
. . .when the Commodity Futures Trading Commission examined Vitol's books last month, it found that the firm was in fact more of a speculator, holding oil contracts as a profit-making investment rather than a means of lining up the actual delivery of fuel. Even more surprising to the commodities markets was the massive size of Vitol's portfolio -- at one point in July, the firm held 11 percent of all the oil contracts on the regulated New York Mercantile Exchange.
The discovery revealed how an individual financial player had gained enormous sway over the oil market without the knowledge of regulators. Other CFTC data showed that a significant amount of trading activity was concentrated in the hands of just a few speculators.
Now, if you remember your Econ 101 class, an efficient market doesn't exist when one player has 11% of the market tied up. Inefficient markets result in price spikes, gouging and manipulation. That's what we have here. Let me scare you a bit more with the Vitol situation before making things worse.
CFTC documents show Vitol was one of the most active traders of oil on NYMEX as prices reached record levels. By June 6, for instance, Vitol had acquired a huge holding in oil contracts, betting prices would rise. The contracts were equal to 57.7 million barrels of oil -- about three times the amount the United States consumes daily. That day, the price of oil spiked $11 to settle at $138.54. Oil prices eventually peaked at $147.27 a barrel on July 11 before falling back to settle at $114.98 yesterday.
The documents do not say how much Vitol put down to acquire this position, but under NYMEX rules, the down payment could have been as little as $1 billion, with the company borrowing the rest.
Borrowing the rest is the truly scary part here. Borrowing to control assets is how we got the Great Depression, the real estate bubble that is still popping, and the dotcom mess of a few years ago. Leverage, or gearing as the Brits call it, can greatly increase your profits, or your losses.
So, let's make it even worse, shall we? In the markets, there are guys called "swap dealers," sort of the 800-pound gorillas in the business. They manage the commodity trading for commercial firms as well as invest for hedge funds and the like. For them, business has been amazing -- since the stock market is tanking, bonds stink and real estate is the worst of the bunch, money managers have been sticking cash in commodities, $13 billion in 2003 to an estimated $260 billion now. That's a lot to play with, and play the swap dealers have been doing. Mr. Cho says:
Some swap dealers have maneuvered behind the scenes, exploiting their political influence and gaps in oversight to gain exemptions from regulatory limits and permission to set up new, unregulated markets. Many big traders are active not only on NYMEX but also on private and overseas markets beyond the CFTC's purview. These openings have given the firms nearly unfettered access to the trading of vital goods, including oil, cotton and corn.
In the case of the oil market, Mr. Cho reported "CFTC data show that at the end of July, just four swap dealers held one-third of all NYMEX oil contracts that bet prices would increase." Four dealers held 33% of the action on one side. The ability to manipulate is terrifying, and if you believe the swap dealers didn't, please come visit me in New York where I have some lovely bridges for sale.
It wasn't always this way. Unlimited purchases of commodities used to be restricted to those who were going to consume them or to their agents. US Steel could buy up all the iron it wanted, but Joe Speculator was limited. The J. Aron wing of the Goldman Sachs empire changed this in 1991 when it whined to the CFTC that when it bought a commodity for an investor/speculator that was the same as US Steel's agent buying it up. I can only conclude that the CFTC couldn't find an intelligent 6-year-old to help it understand the difference. Instead, J. Aron got an exemption,and so did the rest of Wall Street. When private electronic trading platforms showed up, the law was relaxed even further -- the so-called "Enron loophole" resulted in regulators being unable to act in the interests of the economy as a whole.
Here's where it gets political. In a rational, decent, pro-market society, the CFTC would start regulating and enforcing to the extent of the law and probably go to Congress to ask for more powers. That isn't what is happening.
Mr. Cho says, "In the coming months, swap dealers expect to have yet another venue for oil speculation. The CFTC has stated it would not stand in the way of trading in US oil contracts overseas in Dubai. Goldman Sachs and Vitol are among the major investors in this new exchange."
I believe in markets and, for the record, I used to be a foreign exchange trader (I'm getting better, thanks for asking). Yet I know enough about the world to know Adam Smith was right when he wrote, "Businessmen seldom gather together except to conspire against the public interest."
But I think the situation is worse than any conspiracy. There doesn't need to be one. The guys who run the Republican administration have the exact same worldview as the swap dealers, the Vitols and the Goldmans. They agree on what they want to do without discussing it because their interests coincide.
Obama '08 or God Help Us.