Friday, May 23, 2008

Congress Blames the Hedge Funds—Yeah, That’s It!



I got a call from a Congressman recently.

I’d met with his staff early last year after testifying before Barney Frank’s Financial Services Committee, which was looking into hedge funds and whether the presence of so many big hedge funds was a destabilizing influence on the American economy.

[Full disclosure: I once worked for Senator Ed Brooke of Massachusetts, then under a cloud over matters arising from the fallout of his divorce—a divorce that was, as America now knows, triggered by the Senator’s affair with Barbara Walters. Barney Frank back then was the only politician with enough guts to stand by Brooke. I still like him for that.]

My colleagues and I told Frank’s committee, in essence, “No, hedge funds aren’t destabilizing—in fact they help provide liquidity.” And that’s pretty much how it worked in the ensuing credit crisis that began about three months later, although it was clear at the time that a few on the committee weren’t convinced.

Now, this particular Congressman I spoke with recently was in no way the least intelligent of the bunch asking questions in that room. (Carolyn Maloney was what might politely be termed the “least value-add,” from what we saw: she read a statement that basically indicated she wasn’t going to listen to a word of what we said, asked a question that indicated she wouldn’t know a hedge fund from a tomato, and then headed out the door for something else.)

This particular guy seemed bright and interested in what we had to say, and his call this week wasn’t completely out of the blue (I’d made friends with a staffer, who was working on energy policy). He sincerely wanted to know what I thought was driving oil prices higher.

I explained the fact that a) world oil demand is up 12 million barrels a day since 2000, and non-OPEC oil supply is up only 4 million barrels a day since 2000, and b) America decided to convert food into ethanol at the very moment that c) China's demand exploded.


That’s pretty much the whole story, but the Congressman wasn’t buying it.

What about hedge funds, he wanted to know. What about all these traders carrying all these contracts?

I asked him how they had anything to do with it.

“Well there’s so much more oil traded than really exists,” he said. “Isn’t that driving up the price?”


I explained that's pretty much the way it is with anything...stocks, bonds, oil, you name it.

He didn't believe it. Then he said Congress is considering reducing the amount of oil contracts traders can buy and sell. “Won’t that reduce the price of oil?”

I explained that maybe if Congress had taxed gasoline and funded mass transit instead of giving tax breaks for SUVs and ethanol we wouldn’t be forced to go begging the Saudis for more oil.

It went downhill from there.

I figure maybe he’s been having coffee with Carolyn Maloney.

Let's hope my Congressman isn't.

Jeff Matthews
I Am Not Making This Up


© 2008 Not Making This Up LLC

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews' recommendations. The commentary in this blog in no way constitutes a solicitation of business or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author.

22 comments:

Kevin said...

But the answer to the Congressman's question - “Well there’s so much more oil traded than really exists, isn’t that driving up the price?” - is YES, Right? It doesn't matter if that is the way with stocks or bonds (which, by the way, are qualitatively different in that stocks and bonds do not represent physical commodities used in the real world). I'm surprised that you wouldn't be more forthright about this, given your view of the housing bubble. The housing bubble and the oil bubble are the same thing, really. Easy credit allows speculators to bid up prices of real estate - if folks only have to put down 5%, 1% or 0% on a house, of course prices are going to go up. With oil, I can open an account and buy the right to control $70,000 worth of it for $3,000. So the margin requirement on oil contracts is closer to 5% (stocks are at 50%). Before mortgage originators and their financiers got greedy, it was 20% for a house. Once that dropped to 5% and below, look what happened. From your previous posts, it sounds to me like you think it's pretty reasonable for a bank to require 20% down before they make a loan. And given the fallout from the housing bubble, it might even be reasonable for the government to REQUIRE that 20% down (or some other mechanism to keep the market stable). Why is the market for oil or any other commodity different? Why shouldn't the government put margin requirements in place to prevent rampant speculation that drives up the price of an absolutely critical commodity (to both the consumer and national defense)? I hope your answer isn't as lame as the NYMEX's - "if you do that, all our business will go to London...oh my!" (Please - like nobody trades stock in the US because the margin requirements are too high.) But my guess is that the real answer is "if you do that, you're going to seriously cut into hedgies' profits - cause that's how they make money. Leveraged bets."

PS, how much liquidity does a hedge fund provide when it goes belly up because it was levered 20 or 30 times? I don't doubt that hedge funds provide liquidity. But they do so because they are using borrowed money.

natsfan said...

I guess that I would have added that the dollar's decline has also impacted the problem. If he is so worried about the issue of people entering into financial contracts for commodities like oil, then it is because they are likely seeking a greater return than a negative real rate. If real rates go up, then I would expect that "speculation" might lessen. If you look at the recent history of oil priced in euros or gold, the increase is not nearly as much. So he might want to direct his attention to the Fed/Administration and our "strong dollar" policy. I would expect, though, that hedge funds or investors have come to realize the value of allocating a portion of their portfolio to commodities and so there will likely be a sustained involvement of such participants above what may have been seen 5 or so years ago.

However, I still am somewhat confused. While all the points you raise are correct in my opinion, they were correct a year ago. So why this spike? Is it countries hoarding inventory? Iran is putting produced crude in tankers, but I can't believe that is economic for long. China is a wild card with the stockpiling they are doing for the Olympics and the issue with producing power after the earthquake impacted their coal production. But is that short term? Bloomberg did report, though, that there were investors that had taken uncovered short positions and are now in a purchasing crunch. As they seek to acquire, though, I would have thought that would drive up the spot and not the futures price. This trend has happened a couple of times this year as you have seen a backwardation for a short period.

Ultimately, in the end, you have to deal with the physical inventory. An investor is left having to sell their position to someone that is going to consume it. So while there may be some impact of increased investment flowing into oil, it seems to me that fundamentals and not speculation drive the price.

Tahoe Kid said...

I think the problem is politicans are looking for THE single source for higher commodity prices when the reality is there are many factors driving commodity prices higher. Yes, I beleive in my heart that there are some hedge funds that are helping push prices higher, but demand from countries such as China and India are having a more profound impact. Many of the EM countries keep prices below market rates through subsidies which only spurs more demand as prices rise (and contribute to governement budget imbalances). We can't ignore the reality that many investors are involved in the commodity craze as speculators and commodities have been sold to investors as an alternative asset class. And investors have responded. Take a look at the Pimco Commodity Real Return Fund. It ended its first year (2002)with a modest $31 million in AUM. It ended 2007 with $14 billion in AUM.

http://www.allianzinvestors.com/mutualFunds/profile/PMCR/performance_A.jsp

drfinn said...

Kevin you are wrong. It doesn't matter that you can buy it on leverage in the future. Once you have to take delivery of the commodity you have to pay for it in full. Its the difference between signing a contract to buy a home and put down 10% and buying the home at closing when the full price is due.

The Nymex and the clearing members aren't lending you money at a huge leverage to buy the oil, they are letting you buy the futures, they are letting you put a downpayment on the oil.

When the future contracts expires you better be able to find someone to get out of the contract or be able to deliver (or take delivery) of that contract or you are in trouble.

Sure speculators can move the price for a while but very shortly they will have to deal with the true price that comes from the cash markets.

Brian Hunter and Amaranth learned that lesson the hard way.

Kevin said...

Drfinn - so the futures you buy on Nymex are not cash settled? You have to take delivery of the oil? I doubt that. And are you really saying that futures prices do not affect spot prices? They don't affect the prices OPEC countries charge for physical delivery of a barrel of oil? Hmmmmm.... This is from OPEC's website:

"The most recent upward movement has occurred in parallel with a sharp slide in the value of the US dollar and, in turn, a move by many investors into crude futures contracts. It is a basic substitution of rising assets for those in decline. This has significantly influenced the short-term oil price, and this dynamic has also lifted the prices of other commodities."

(BTW, I agree with natsfan (even though he's a nats fan) about the impact that the failing dollar has on oil prices). But the point I am making is that lower margin requirements make it easier for people to enter the market and speculate. I wasn't around at the time, but I think they put a law in place in 1934 to prevent just the kind of behavior we've seen in the housing market and now in the commodities markets. At the time, the country was trying to dig itself out of a depression that was in large part brought on by rampant speculation in equity markets fueled by easy credit. Margin requirements were introduced to prevent that from happening again (and, by the way, commercial banks were prohibited from acting as investment banks as well - another systemic protection that has gone the way of the dodo bird with the repeal of Glass Steagall). I think it has become widely accepted that margin requirements are effective instruments in dampening the level and volatility of prices by influencing investors' demand for the asset in question. The question I am asking, and the one I haven't heard a satisfactory answer to, is why margin requirements are not proper for commodities markets? Today's investors have easy access to commodities markets and can easily create bubbles that are harmful in so many ways. Why not have the CFTC impose stricter margin requirements?

Richard said...

The questions from your Congressman friend may have come as a result of this-

http://hsgac.senate.gov/public/_files/052008Masters.pdf


FWIW, if Calpers and other state pension funds are buying commodities via index futures, and keep buying because they are performing well, it sure as hell is going to have an effect on the price. The correct solution is position limits per commodity, and not allowing them to be circumvented by OTC derivatives. Higher cash margins on commodity futures, and some restrictions on bank funding of spec. commodity longs, such as the restrictions that occurred during the Hunt Brothers attempted corner on silver, should also be done NOW.
The financial regulatory authorities seem to be perpetually blind to incipient bubbles. If this one is allowed to go into full flower, commodity “investors” will be bidding against the buyers who need the product to eat. What are the moral implications of that?

Jeff Matthews said...

Speculation is a symptom, not a cause. Speculators can't keep a commodity up if it doesn't want to stay up: Just ask the Hunt Brothers.

The disease is this: America has no energy policy, never has.

The human capacity for self-delusion is staggering, especially in Washington DC.

JM

Aaron said...

Jeff:

A) Is your congressman in question Edward Markey from MA? Just wondering...

B) I agree with the other posters here that today's oil prices are a multi-factor problem: greater demand from countries such as China + lower oil output from non-OPEC countries such as Norway + suppy constraints in countries like Nigeria + weak USD (we import oil at higher prices) = what we're paying today at the pump.

C) One thought though - I think the government already has a tax (federal excise) on gas and has used those funds in the past for mass transit. I could be wrong...

Andy Tabbo said...

Good comments. I read this blog regularly and I'm a little disappointed with Jeff Matthews simple response to the Congressman. It's true demands is higher than supply last several years, but he fails to address the 100's of millions of barrels STUFFED into various SPRs around the world over the same time.

Also, I would question the relevance of non-opec supply v. opec supply. Who cares where the supply is coming from? The OPEC cartel is NOT retstraining supply. Just because they have a lot of cash doesn't mean they want even more.

They hit every bid. If they have a tanker with a buyer, they load it. Period. It's always humorous to me when they report that OPEC shipments have increased or decreased. It's an irrelevant stat and it means nothing. If they have buyers, the fill em up. If they can't find buyers, they store it. Period.

To completely dismiss the hundreds and hundreds of billions of dollars of LONG ONLY funds into the commodity markets is disingenous, especially considering that these markets previously had very little LONG ONLY investment.

If Congress/CFTC merely decided to enforce the position limits on both the OTC and futures markets for the oil markets, it would bring about a decline in oil prices immediately. If they actually reduced the postion limits, then say GOOD NIGHT...oil prices would go limit down until about 50-60 bucks.

I'm not suggesting that's the best thing to do. Extremely high oil prices today will actually create dramatically lower prices a few years now....disruptive technology is being developed to address the parabolic rise of oil this century.
And that's a good thing.

AT

Jeff Matthews said...

Aaron: Yes, the US already taxes gasoline. But it is ridiculously low relative to the true cost of our oil dependance, and does not discourage consumption.

(Western Europe, which has extremely high excise taxes on gasoline consumes far less per capita. In fact, oil demand there did not increase from 2000 to 2007, even though the rise in the Dollar price of oil was muted by the strong Euro).

Andy: When Congress recently took the bold move of suspending additions to the Strategic Petroleum Reserve, they freed up the staggering amount of 70,000 barrels per day of oil for you and me.

Unfortunately, we import about 12,000,000 barrels per day.

While the SPR does hold a lot of crude (700 million barrels), it has been around since 1975. We have had two oil gluts and two oil shocks since we began filling it.

The SPR is the least consequential item on the agenda here.


As for who the Congressman was, the conversation was not a public discussion, and I will leave it that way.

JM

Andy Tabbo said...

JM:

This is going to be a little lengthy..

Let me first say, that I agree with you. Our energy policy is an unmitigated disaster. Emerging countries policies may be worse. My earlier point was that there other factors that have led to this perfect storm than the simplistic "supply cannot meet demand ...china...india...yada yada yada."

In 2000, the U.S. demand for ALL oil products was 19.5 mm/day. Refinery demand for crude was 15.2 mm/day. In 2007, that number peaked near 21.0 mm/day for an anemic 1% annualized growth, or about 200,000 bbls/day growth every year. (Demand is actually down this year) Refinery demand for crude is FLAT throughout the last several years at 15.2 mm/day--ZERO growth in crude demand this decade.

The U.S. alone has stuffed in 170mm barrels into its own SPR over the same time, at a rate of about 70k/day. In other words, SPR demand has been the only growth driver to U.S. demands on crude oil this century. Who knows how much other volume has been stuffed into various other SPRs around the world over the same period?

Enough on the SPR. It's nowhere close to being the BIG issue, but given the DOE-based data above, and given the fact that it is the "marginal barrels of supply and demand" that set price, I hope you can realize that hoarding 170mm extra barrels in the last several years "may" have been one of several factors.

The killing of MTBE in favor of ethanol was a disaster. Simply putting aside the obvious issues of burning food in our fuel tanks and dramatically raising the price of ag products, ethanol is also a huge energy drain. It is a very inefficient energy product to transport. It must be moved on trucks/rails/ships as opposed to pipelines. The only growth in energy demand in the U.S. is in diesel....ya think the ethanol boondoggle is a contributing factor? Of course it is. A repeal of the ethanol mandate would DRAMATICALLY improve our energy situation. It would reduce diesel demand and lower grain prices. Remember, it's the last few bushels of corn that set the price for the entire crop, similar to the last few barrels of diesel setting the price for all the diesel.

Although our energy/food policy is a disaster, I think the emerging countries contiued subsidization of energy prices is perhaps an even greater disaster. The economists behind that policy should be shot. To subsidize a scarce, globally priced resource, is crazy. The government would be much better off giving direct money to its people and letting them decide how to allocate the scarce resouces.

If I were to craft a cure to what ails I would

1) repeal the ethanol mandate and ethanol tariffs
2a) create huge tax incentives to upgrade refinery kit to handle heavy/sour crude
2b) offer a 200mm barrel sweet/sour crude exchange from the SPR at same time as offering 2a)
3) massive and enduring tax incentives for other energy like nuke/wind/solar
4) harmonize the gasoline and diesel spec in the U.S. to more closely match the global specs.
5) reduce the national speed limit to 55 mph
6) enforce futures limit positions to the OTC and futures markets for ALL participants--level the playing the field.
7) after cleaning our own house, go to chindia and convince them of the pitfalls of subisdizing energy consumption.

-AT

jest said...

Kevin-

The cash market is really what drives the price. All futures contracts converge towards the cash price.

As an example, when funds roll one contract to the next month they have to SELL the old contract to purchase the new one. If the delivery price is lower, then the futures would be sold at the lower price. It's a zero-sum game.

In other words, physical demand is the final influence on futures curves, not speculators.

As far as margin, yes there is some effect on prices, but I think the biggest effect is on volatility, not the overall price trend.

Richard said...

Jeff,

With all due respect, the Hunt brothers got the price of silver up from ~$2. to $50. They believed the dollar was trash, and backed the belief with an oil fortune. Then Henry Jarecki at Mocatta Metals got the Comex to change margin requirements, the govt. changed the rules severely restricting loans for holding spec. commodity positions, and only then did the accumulated weight of millions of families sending in the family silver to be melted for bullion crash the price. It was a crisis, and I was personally able to set up cash and carry silver positions at over 20% per annum because money was so tight. The dollar was BS then, as it is now. Yes, the Hunt Brothers were eventually killed by the market turning. No, it DIDN’T happen without intervention. But nobody starved because silver went up. Mexican silver miners were happy for about a year.


There is always a fundamental reason for bull markets to start. The dotcom nonsense had some initial truth to it, but went horribly wrong when dumb money thought all tech was good, irrespective of price. Commodities likewise have reason to rise, but their rise is magnified by the application of TONS of spec index money. With the current speculation in foodstuffs, the index buyer is bidding against people who need the product to eat. Do you really think it is morally defensible to stand aside and let the market do it’s work to destroy the commodity specs of Calpers and such, while third world grain eaters are carried along for the ride? See the latest Economist article-

http://www.economist.com/opinion/displaystory.cfm?story_id=11402856&CFID=7082392&CFTOKEN=53995051

Food constitutes 60% of India’s average consumer price basket, to cite an extreme example. Is it really OK to let specs double the price of food for these people? That math equates to human starvation. It isn’t earth shaking for the average US person, but the world is made up of a lot of poor people who are directly affected by this stupid game.

PS- the link that I attempted to post earlier is-

http://hsgac.senate.gov/public/_files/052008Masters.pdf

whydibuy said...

Of course there is no mention by either the comittee members or the politically correct green guy Jeff Matthews on opening up U.S. areas for new drilling. No drlling in alaska, the coastal waters ( other than the gulf ) and nearly every state now off limits Perhaps is having a effect. But, no, Lets sue opec. Yeah, thats a way to deflect from responsibility in choking off any new domestic supply. Its their fault opec won't produce more and not ours for not utilizing the vast resources still on U.S. lands. Good one.

ward said...

Drfinn - so the futures you buy on Nymex are not cash settled? You have to take delivery of the oil? I doubt that.

WTI futures, ticker symbol CL, are PHYSICALLY DELIVERABLE. See the NYMEX website: http://www.nymex.com/lsco_fut_descri.aspx

And to pre-empt a possible question, the volume in the physically-deliverable contract is orders of magnitude greater than that of the financially-settled contract (ticker symbol WS).

Jeff Matthews said...

WhydIBuy:

My point to the Congressman, which neither you nor he, gets, is: deal with demand. Price will take care of itself very quickly.

Drilling deals with supply (very slowly, too, given the time-frame of bringing new production onstream), ethanol deals with supply, new refineries deal with supply.

Deal with demand instead. Much faster, much longer-lasting. Much healthier in the long run for the economy.

But, of course, that won't happen, which is why the market clearing price will have to do it instead--as it did in 1980 and 1974.

Also, your comments are less effective when you toss around Yahoo message-board labels like "politically correct green guy." Whatever you are is fine with me; just leave out the name-calling for the benefit of our readers.

Next time you or anybody else does it, whatever your take on the oil supply/demand situation...'No post for you!'

JM

Mark said...

It's obvious to me (me, who knows next-to-nothing about the oil business, which is a very good reason to view anything that's "obvious to me" with great skepticism), that the high price of oil has very little to do with "speculation" and everything to do with the inelasticity of both demand (Vroom! Vroom! We LIKE driving in Chindia, and we're willing to PAY for it!) and supply ("More production, Engineer Scotty! I like these prices"... "She's giving me all she's got, Sheik; I can't crank things up any higher!"

drfinn said...

Kevin,

Yes the NYMEX contract is a physical settled contact. You must deliver the physical crude oil.

"Settlement Type

Physical.

Delivery

F.O.B. seller's facility, Cushing, Oklahoma, at any pipeline or storage facility with pipeline access to TEPPCO, Cushing storage, or Equilon Pipeline Co., by in-tank transfer, in-line transfer, book-out, or inter-facility transfer (pumpover). "


And what I am saying is that over the medium to long run the futures price will go to the cash price. They MUST go towards it or people will deliver the oil to the NYMEX each month.

If this was a game of speculators then you would see large carries in the front month contract as it went into experation. We would all know that the indexs and long only fund had to roll and would wait for them. [Just like we did to Art Benson and MG].


As far as OPEC goes I wouldn't trust them. All the member states lie to each other, why in the world would they tell you the truth?

admin said...

I am glad I discovered this blog today. Lot's of good commenters here.

The one thing I have always wondered is why conservatives advocate for drilling in ANWAR and off the coast of some of our most popular beaches?

A realpolitik strategy would be to deplete the other guys reserves, leaving our reserves in tact for the period after the other guy is sucked dry.

So increasing domestic production, to me, does not make strategic sense. It also happens that I agree with JM on the importance of dealing with supply to address the impact on the domestic economy of shock and aw(e)ful oil prices.

Jeffrey Sykes in NC

Andy Tabbo said...

My previous comment suggested some practical and immediate solutions to the immediate issue of parabolically rising oil prices. While I believe addressing the supply-side of the ledger would be appropriate, I actually do not think it would be a good thing to bring prices down. I did not really address the demand-side solutions because they are too easy. We are currently killing demand in the U.S. with 3.50+ gas and 4.50+ diesel. Prices are currently killing enough demand to clear markets. The futures markets aren't there yet due to the mania....but it's happening on the ground right now. Oil prices are going to decline appreciably over the next several months. And that is actually NOT a good thing. The purest, most blunt form instrument, would be a $3.00/gallon Federal Tax on gasoline, up from $0.18/gallon currently. It would destroy the economy in the short run, but would bring about an extremely vibrant, strong, enduring country in the decades to come. But nobody has the guts to explain that to the public.

-AT

PhillipCharles said...

Exhausting.

This is ridiculously simple:

It has nothing to do with futures contracts or margin requirements or the SPR. I know there are really smart people who read this board and because current information sources are awash in news and commentary on "How high will be the price of gasoline before we are forced into a world recession and have to sell vital organs to afford a bushel of rice from the Nepalese?!?" you, as a result, feel like this is a complex subject in need of a complex answer; it's not and it isn't. Oil/gas is like anything else with a price tag.

Everyone knows that but we are too busy trying to outsmart the media, who loves to exploit the first sniff they get of anything they can paint with their 'class warfare' brush, i.e. fancy hedge-funders living in New York City and tony chateaus in CT are making you pay exorbitant sums to fill up your F150, costing YOU a chance at a well-deserved summer vaca, or... Big-Oil execs are lining their pockets while YOU are forced to get a 2nd job! Awful. But unfortunately our society buys that stuff and begs for more. I digress...

Reduce demand.

That's your solution if the problem is $4/gallon gas.

Supply is finite, if we don't reduce soon, nature will do it for us.

In the meantime, sell your television and subscribe to a literary journal.

CheddahYetti said...

JM:

While I agree this isn't a speculator-driven "bubble", I'm wondering why no one is bringing up the fact the US really has no control of the demand side of equation anymore. Our incremental growth the past 7 years is a rounding error on the world stage (just like Western Europe but without the insane taxes).

$US5/gal gas will destroy demand here. But unless the emerging economies are exposed to actual market prices instead of being sheilded by subsidies (China and India being the most important but by no means the only countries), our conservation will soon be overwhelmed by their additional growth.

I don't see how you get world demand destruction when the incremental consumer doesn't fel the higher prices. I'm afraid the only way that'll come about is an eventual super-spike that forces those governments to pass on the price hikes.