Editorial comment

	Vol. 229 No.8
PERRY A. FISCHER, EDITOR

The end is nigh, capitulation, and feckless wimps

The Wall Street Journal ran an article in early July that touched off a firestorm of contention, especially among folks that would normally treat anything in the WSJ as gospel. The article was a simple analysis of the change in the number of futures market speculators versus non-speculators. The conclusion was that in 2000, 37% of traders were speculators, and 63% were non-speculators (physical commodity hedgers). By 2008, speculators comprised 71% of the market. They used the US’s CFTC data, but with a reclassification of the number of swaps traders, as per a congressional subcommittee.

The CFTC-the commodities watchdog-said that this probably wasn’t correct, but that they were still working on the measurement problem and might make some changes. At issue is the definition of speculators (defined as Non-commercial by the CFTC) versus non-speculators (defined as Commercial). Almost all Index Speculators now use a vehicle called “swaps,” which allows a speculator to bypass CFTC’s position size limits. If you want to buy $400 million in oil futures-which is far beyond position limits-you simply enter into a swap with a bank and presto, now you are not speculating!

Most institutional investors are now Index Speculators (401K’s, pensions, various similar funds), none of whom have the ability to take possession of a barrel of anything. Funds in these index trades have gone from $13 billion in 2003, to $260 billion by March 2008-a 1,900% increase.

Many commercial traders bear no resemblance to Huckleberry Airlines or Farmer Finn, who use a hedge to lock in the price of fuel or beans. Classifying all Commercial traders as non-speculative seems ridiculous. But that’s how the CFTC classifies these traders so far, though I suspect that will change.

Subsequent press releases from the agency have made the situation so strange that it appears the CFTC is acting as an apologist for something; exactly what and why I’m not sure-maybe they were all members of the Skull and Bones club. But it is clearly doing all that it can to ensure that the trading status quo is preserved.

To prove that speculation plays no part in commodities or oil prices, those with an obvious ideology-bankers, brokers, traders and peakers-use cryptic ratios to prove that there is no increase in speculation, while ignoring a sea of “hockey sticks”-you know, those graphs that run mostly horizontal for decades, and then suddenly exponentially increase. Merrill Lynch wrote a marvelous editorial in the Financial Times that said speculation is not to blame because the ratio of commodities derivatives to all OTC financial derivatives is only 1.8%. It’s like arguing that the world’s population was not increasing due to more procreation, because the ratio of men to women is still 50/50!

Trading volume on the Atlanta-based ICE, an American firm operating under UK regulation, tripled from 2005 to 2008, representing 47% of global oil futures trading-another hockey stick. An editorial by the head of London’s ICE (which stands to lose the most), gave a warning-actually, a threat-that any attempt to change the rules would result in traders taking most of their NYMEX business offshore. (It’s worth noting that, to a large extent, this is a competition between New York and London, to see if London can dethrone NYMEX as the leader in oil trading.)

The really amazing thing is that those who say that dramatically high commodity prices have nothing to do with speculation-that it’s all supply and demand fundamentals-must logically be saying that rolling back the trading rules to, say, 1999, would have no effect; even if it is scapegoating, it would be superfluous, harmless, a waste of time. Yet, the threat of any such rollback evokes the hue and cry of all those who benefit from the recent enormous rise in trading volumes and money flows, even the CFTC. It’s as if any attempt to restore trading to pre-2000 rules would end life as we know it. And that behavior should make anyone skeptical.

Rather than engage in the argument of how to measure speculators, I’ll just say that the markets have dramatically changed. Who could argue with that? Hockey sticks abound. During the past five years, there’s been a 2,000% increase in capital flowing into commodity futures, and it’s growing at a rate of $1 billion in contracts per day-quite a hockey stick.

In early July, Standard & Poor’s Chief Economist David Wyss said, “Speculation is raising oil futures prices.” Charles Biderman, CEO of TrimTabs Investment Research, said that raising the margin requirement to 25% would result in a 50% drop in oil prices. Congressional changes in commodities law could:

1. Eliminate a CFTC exemption to banks from speculative position limits in OTC swaps transactions; and require the reporting of all positions held by the same party across every exchange

2. Close the Enron/London OTC “blackbox” blind spot that eliminated CFTC oversight in the Commodities Futures Modernization Act of 2000

3. Increase the margin from the current 7-8%

4. Repeal the 1999 repeal of the Glass-Steagall Act, which, for 66 years, discouraged excessive leverage and wisely prevented insurance, banks and brokerage houses from being the same thing.

Realize that these are the same shysters who sold billions in junk mortgages and then, before the ink was dry, packaged and sold them as “enhanced securities” around the world, where they still sit in bank vaults in places like Liechtenstein. When they saw that con was running its course and could no longer be bilked, they moved their money into the futures markets. Where do you think the billions of new dollars in these markets come from? Sweat?

These hockey sticks will not last. We will look back and see mountains in the historic price charts of oil and other commodities. But it will not be a symmetric peak: The right side of the mountain will exit higher than the left side began. Various experts-the president of Shell Oil, an executive vice president of ExxonMobil, hedge-fund managers and others, say that $50 to $80 a barrel is the new sustainable price (€31 to €50), given finding and developing costs and the weak dollar.

The Republicans in Congress say they want to open offshore areas in which drilling is now prohibited by allowing individual states to decide. President Bush waited 7½ years to decide that he’s in favor of offshore drilling, after his party lost control of Congress, and after he and his brother, ex-Florida governor Jeb Bush, put offshore Florida off limits.

But realistically, Washington, Oregon and the entire Eastern Seaboard are not very prospective, and I would be surprised if oil companies bid high for those drilling rights. That leaves California and Florida, whose citizens will likely never vote to allow offshore drilling. So in reality, it’s symbolic political posturing, proving that they are pandering feckless wimps.

Will the Democrats in Congress make sweeping changes in the commodities rules and energy legislation? Will they allow drilling on 0.01% of Alaska’s wildlife refuge? No. Will they raise the futures margin? Require limits on swaps? Re-separate banks and brokers? No. They know the hand that feeds them. They’ll finesse the situation and do very little, such as close the Enron loophole halfway or require traders to file a new form. But they’ll do it with a lot of bluster.

Over various timeframes and using congressional “fuzzy math,” Congress will spend $2,000 billion on a war of choice; $90 billion for ethanol vote-buying; $300 billion to bail out shyster bankers, on the doctrine that “they are too big to allow to fail”; but only spend $5 billion directly on energy programs. Feckless wimps indeed.

A large number of folks-especially in TV sound bites-say that the quadrupling of oil prices is simply due to demand outstripping supply, without offering any convincing data. But the data doesn’t show anything extraordinary.

During the last OPEC Summit, I was on Saudi television (obviously, someone cancelled) being asked why oil prices were high. I said that, inadvertently, Saudi Arabia is contributing to high prices by not demonstrating that it indeed has the spare capacity that it claims. This emboldens the “peak oil” community and affects the traders’ mentality that a permanent decline in oil production is near. Matt Simmons, arguably the most active leader in the “peak movement,” said during a speech at OTC 2008 that “oil will go through $200 like a hot knife through butter.”

Even if it were to reach that level, it would fall back quickly. Biderman says that “$200 oil won’t happen because the US economy would crash. At $200 per barrel, America’s oil bill would be equal to a staggering 23% of the after-tax income of all Americans who pay taxes.”

Simmons also showed a table of “oil” production that clearly indicated production had been decreasing slightly since 2005, declaring unequivocally that global oil production had peaked in 2005. Of course, like most peakers and those who want to show the lousiest possible production figures, he was only talking about the crude and condensate component of “oil” production, which is roughly 72 million barrels a day.

There’s another 14 million barrels a day of other “oil” production, generally of higher quality, that has been growing to keep up with the world’s 86 million barrels a day of demand. Eight out of the last ten years of IEA’s demand growth forecasts have all been high. Most of its forecasts have been more than double the actual growth, even though they were made just six months before the forecast year. IEA just published its five-year forecast revised downward, of course. It calls for normal yearly growth, equal to the past 20-year average of 1.6%. Falling demand in the rich countries will displace rising demand in emerging growth nations.

EIA’s International Petroleum Monthly, published July 10, shows that during the 12-month period from March 2007 to March 2008, US “oil production” (all liquids plus refinery gain) was up 2.5%, OPEC up 5.1%, and total non-OECD up 3.2%. Global “oil” supply increased 1.8%, easily outpacing world demand, which increased a pathetic 0.1%.

So, what does this mean? Well, it could mean that high oil prices increase supply and decrease demand. (Duh!) Or it could mean that OPEC (a.k.a. Saudi) can easily control prices in times of balance. But if I shift the 12-month timeframe to just three months earlier, I get nearly the opposite picture. So realize that the data are noisy. Nevertheless, if you graph world oil demand, it looks like another hockey stick, only upside-down. Even so, there is cause for supply-side worry, since two major producing regions-the North Sea and Mexico, have indeed peaked in production and are in somewhat steep (6 to 9%?) decline.

If markets are looking for a ledge, they have found it: Simply put, demand has crashed, supply is adequate, projects are coming online, and there are just too many hockey sticks. If you are an investor, you know it’s usually best to follow the crowd up to the point that things get extreme; then it’s best to be a contrarian. Relative to today’s $140 oil price, I expect capitulation, followed by normal growth and much lower prices. But like any good soothsayer, I’ll hedge my prediction and say within two years, although I strongly suspect that it will be sooner rather than later. It usually starts in the fall.

An odd thing that could ruin this forecast: Governments are starting to rethink their ethanol subsidies. In the US, Kay Bailey Hutchison and Nancy Pelosi-a leading Republican and Democrat-have both recently said that the massive ethanol subsidy has had “unintended consequences.” What if this subsidy juggernaut were to end? World production of ethanol is just over 1 million bpd. Even after compensating for its one-third lower energy content, that works out to the equivalent of 2 million bpd of good quality crude. Simply put, we’ve become dependent on ethanol supply. Without it, we would be in a world of hurt. (How odd for me to say this, given my strong opposition to ethanol from food.)

My perennial three reasons as to why oil prices are high remain (but don’t ask me how much each one contributes-I have no idea):

1. Dramatic changes in commodities markets, brought on by changes in the laws and rules under which they operate

2. Peak fears (fear-not actual shortage, yet)

3. The crummy dollar (lousy fiscal and monetary policies).

It’s on this last point that I think the greatest change in the price of oil is likely to occur. A weak dollar comes from exporting too many dollars, and governmental policies that ensure even more dollars will outflow. In 2000, the US debt was $5.8 trillion; now it’s nearing $10 trillion.

I’m a firm believer that economics has a great deal to do with faith. And faith in the present US government’s leadership has been in a downward spiral for years. It’s a part of our lousy status on the world stage, as well as the weak dollar. But the upcoming presidential election will change that, and it won’t matter which one of the candidates wins-relatively speaking, they both look like leaders, statesman-like even and, dare I say, competent. And with that, the US will slowly regain its stature as it rejoins the world. Some of the goodwill squandered after 9/11 will come back, and as the faith and goodwill return, the dollar will strengthen.