[DEBATE] : Oil, "Speculation," and Regulation

[Yoshie Furuhashi]

<http://www.cnbc.com/id/25070763/>
Tuesday, 10 Jun 2008
Bubble, Bubble, Oil Is Trouble …
Posted By:Daryl Guppy
Topics:Commodities | Energy | Asia
Sectors:Oil and Gas

Is the world running out of oil? Or gold, or rice, or wheat, or almost
any other commodity you care to name? Despite some usual shortages
that have been offset by a surplus in other areas, there has been no
significant change in the fundamentals of supply of most commodities.

Nor has there been a dramatic unexpected increase in demand from
China, or India, or elsewhere for products in the commodity markets.
The most likely culprit for the persistent and strong growth trend in
commodities – speculators.

"Since the price hit $105, everything above $105 is speculation.
Something like 50 – 100 billion dollars has poured into the market the
last 2 months", says Dr. Fereidun Fesharaki, CEO of FACTS Global
Energy Group.

The disconnect between oil prices and fundamentals is a disturbing
bubble. In Asia we have bubble tea. In the oil market we have bubble
swaps.

In analysing oil markets, we first look at current price activity to
project potential target levels relevant to the existing trend
behaviour. We also look at potential pullback levels in the current
parabolic trend, and signs for when the trend changes.

The most important feature on the weekly oil chart, is the development
of a parabolic trend. The trend is defined by a specific type of
exponential acceleration in the market. The two most important
features of this trend – a known calculated date for the end of the
trend and, the way the trend collapses.

CHART:
<http://www.cnbc.com/id/25071495/site/14081545/>

As the parabolic curve moves towards vertical, it sets the maximum
date for the end of the trend. The trend may end earlier, but it has a
low probability of continuing beyond the calculated date. As the price
continues to rise, it also moves to the right of the chart as each new
price candle is added. A move to the right of the parabolic trend line
is an exit signal.

When parabolic bubbles collapse, it's a rapid drop that takes out
support levels. The upside targets, and the downside targets, are
established by applying the standard trend and trading analysis to the
oil market. And this is a classic bubble situation.

Despite the headlines, oil moves in a tightly defined range bound
pattern. Breakouts behave consistently. The breakout from $113 had an
upside target of $126. The move above this has a projected target of
$140. Using the same trading band projection methods, the next upside
target is $152. This trading behavior can lift oil prices to an upper
resistance level near $163.

So, what is creating this disconnection between fundamentals and
pricing? The commodity futures market is an efficient mechanism that
allows buyers and sellers to lock in prices for forward delivery.
Professional futures market speculators take the risk by actively
trading futures contracts. Their activity is the liquidity that oils
the wheels of price discovery, risk management, and effective accurate
pricing. There will always be short periods where price runs away from
fundamentals due to political upheaval, hurricanes, or drought. But
these excesses soon return to the underlying trend.

The difference in today's market behavior may be due to the changing
nature of open interest in many commodity markets. Open interest is a
measure of the number of trades that have been opened, but not yet
closed. Once open interest was short term, and largely the preserve of
traders who were actively buying and selling. These traditional
speculators provided futures liquidity for buying and selling.

A recent submission to a U.S. Congressional subcommittee by Michael
Masters [LINK: <http://www.guppytraders.com/Michael-Masters-Written-Testimony%20(2).pdf>],
a portfolio manager for Master Capital Management LLC, suggests this
is changing. Pension funds and other long term institutional investors
have been attracted to the commodity markets. These markets have
become attractive high yielding investments. Institutional investors
do not want to buy and sell in the short term, so they roll their
positions with calendar spreads. They never sell. The average time
holding period for open interest in commodity markets has been
growing.

CHART:
<http://www.cnbc.com/id/25071526/site/14081545/>

These investors provide capital, but they consume market liquidity
because their positions reduce the number of contracts available for
trading. This is demand for financial contacts, not the physical
product. Futures pricing is the benchmark for physical pricing. This
demand creates an artificial shortage in the instruments essential for
the efficient operation of the futures markets. Their activity has
zero benefit for the mechanism of futures markets.

Commodity investment distorts the market by removing liquidity and
making it more difficult for genuine speculative risk management to
proceed. Capital allocation is not related to fundamental
supply/demand market factors. It's related to the financial
opportunity inherent in the market. The net effect is to make prices
higher than they ought to be.

The technical analysis of the oil chart shows strong trend behavior.
It also highlights the potential for a bubble and a subsequent bubble
collapse. Analysis of the duration of open interest by fund managers
'investing' in the commodity market suggests this is the gas inflating
the bubble.

The commodity bubble will likely burst when the CFTC (Commodity
Futures trading Commission) closes the "swaps loophole" – which grants
the banks an exemption from speculative position limits when banks
hedge over the counter swap transactions.

<http://www.washingtonpost.com/wp-dyn/content/article/2008/07/06/AR2008070601833.html>
Pension Funds Boosted By Oil
While Stocks Fall, Commodity Bets Are Paying Off

By David Cho
Washington Post Staff Writer
Monday, July 7, 2008; A01

Soaring fuel prices that are burning a hole in the wallets of
consumers are not only benefiting oil companies and Middle Eastern
producers. They are also lighting up the investment returns of
pensions funds, which millions of ordinary Americans are counting on
for their retirement.

California's public employees' pension fund, the world's largest, made
its first investment of $1.1 billion into oil and other commodities
early last year, and since then, Calpers has seen it soar 68 percent.
Fairfax County pension managers have enjoyed a 61 percent return from
a similar move over the past 12 months, far outpacing any other
segment of the fund's portfolio.

"Our commodity investment has really helped," said Robert L. Mears,
executive director of Fairfax County's Retirement Administration
Agency. "This year would have been a lot worse."

Other pension funds are rushing to get in on the action as the prices
of oil, precious metals, corn, uranium and other vital goods continue
to reach record highs. Montgomery County officials are in the process
of shifting 5 percent of their $2.7 billion pension fund away from
stocks and into commodities.

These funds are part of a tidal wave of investment dollars that has
flooded commodity markets in recent years and, critics say,
contributed to the run-up in prices.

Investors, including pension funds and Wall Street speculators, have
sharply increased their commodity allocations since 2003, from $13
billion to $260 billion, making financial actors an even larger force
on these markets than farmers, airlines, trucking firms and companies
that buy and sell the physical goods to run their businesses.

Pension funds are among the biggest of these financial investors,
according to industry analysts, but the extent of their involvement
has not been tallied.

These funds and similar investors buy futures contracts, which
determine the price goods will fetch on a particular date in the
future. Unlike commercial businesses, speculators have little interest
in actually taking delivery of oil or other commodities. Instead,
these investors trade the contracts like stocks.

The investments can be very attractive because there are only light
restrictions on whether they can be bought and sold using borrowed
money. While risky, this can produce enormous returns.

For decades, trading commodity contracts was considered taboo by most
pension funds because the market is so volatile and risky. Most fund
managers relied on their stock and bond investments to enlarge their
pools of retirement money.

That changed after the stock market crashed in 2001. Fund managers
realized they needed more diversified portfolios that would perform
well regardless of whether stocks did. At the same time, new financial
products simplified trading by allowing big funds to buy into
commodity indexes, which work like mutual funds, that were run by Wall
Street firms, mainly Goldman Sachs and Morgan Stanley.

Other investors also began buying commodities, including university
endowments, hedge funds and big banks. But their investment strategy
has been different than that of pensions funds. Many of these
investors use trading techniques to make money when commodity prices
both rise and fall, while pension funds mostly try to maximize their
return over the long term by betting that oil and other commodities
will increase in price well into the future. The approach adopted by
pension funds has been a concern for some lawmakers because it pushes
up prices by increasing demand for futures contracts.

The increase in commodity prices has been so sharp that some pension
managers are worried about a possible crash. Partly for that reason,
the Virginia Retirement System has decided to stay away.

"It's hard to know which commodities are in a bubble and which
aren't," said Bob Schultze, director of the Virginia Retirement
System.

Whether pension funds and other investors are behind the rise in food
and fuel prices has sparked a heated debate on Capitol Hill and pitted
powerful interest groups against one another. The airlines and other
industry associations say the influx of investment money is creating a
bidding war for commodity contracts and contributing to higher gas and
food prices, hindering companies that need the goods for their
businesses.

"The financial health and security of the United States depends, in
part, on a commodities market that is stable, rational and
predictable," Douglas Streenland, chief executive of Northwest
Airlines told a House oversight subcommittee recently. "If the current
pricing dynamic does not change, our industry will be severely
challenged and will continue shrinking -- to the detriment of
customers and the communities we serve."

Even as rising prices translate into staggering increases at the
grocery store and at the pump, some regulators, including Treasury
Secretary Henry M. Paulson Jr., say investors are not to blame. He has
argued that the markets need them because they expand trading volume,
allowing goods to change hands more easily.

Walter Lukken, acting chairman of the Commodity Futures Trading
Commission, said the price of oil and other goods is going up simply
because demand is outstripping supply. "It's our proposition that
strong fundamentals are at play, driving higher commodity prices
across the board," he said. "There are obviously powerful economic
forces in play here: the falling dollar, political unrest in the
Middle East, flat global production, rising demand from emerging world
economies."

Lukken said his agency would study the issue nonetheless. He said he
has formed a task force involving staff from the CFTC, Treasury and
the Federal Reserve. Its report will be out in mid-September, he said.

But critics question whether long-term investors such as pension funds
should bet on oil and other critical commodities.

"They were never designed for that. When you are buying food and
energy commodities, it's affecting people's lives. There are
social-justice issues," said Michael Masters, a hedge fund manager who
has testified before Congress on the subject several times.

Pension managers counter that the public also has a stake in making
sure retirement accounts are healthy. Commodities are one of the few
investments that can perform well when inflation is rising.

In Fairfax County's case, no other investment came close to the
returns of its commodity investment. Overall, its pension fund, which
has about $5 billion in assets and serves 18,400 active county
employees and 7,000 retirees, may show a very slight gain for the
fiscal year ended June 1, officials said.

"Our job is to minimize our risks on the taxpayer," said Mears, the
county's pension executive director. "If you can do that, why wouldn't
you?"

<http://www.ft.com/cms/s/0/45da56b6-4c89-11dd-96bb-000077b07658.html>
The usual suspects
By Javier Blas and Joanna Chung
Published: July 8 2008 03:00 | Last updated: July 8 2008 03:00

Prices were outrageously volatile. While traders attributed the sharp
market movements to supply and demand, most politicians in Washington
were sure that speculation was the culprit. The US public became
incensed.

The year was 1958, the commodity in question onions. Congress held
long and sometimes tumultuous hearings in which Everette Harris, then
president of the Chicago Mercantile Exchange, tried to convince
lawmakers that the futures market for onions was not the cause of the
volatility. "We merely furnish the hall for trading . . . we are like
a thermometer, which registers temperatures," Mr Harris told a
hearing. "You would not want to pass a law against thermometers just
because we had a short spell of zero weather." But such arguments were
ignored and in August of that year the Onion Futures Act was passed,
banning futures trading in the commodity.

Fast-forward 50 years and it seems that little has changed. The recent
surge in commodity prices has sparked an intense and politically
charged debate on whether financial investments - to some, plain
speculation - are affecting the markets. Pension funds and other big
institutions today hold about $250bn in commodities, mostly invested
through indices such as the S&P GSCI, a widely accepted industry
benchmark. This compares with just $10bn in 2000, although part of the
increase represents the rise in prices rather than fresh flows of
money.

Surging prices for energy and food have caused a political storm in
Washington, where US politicians from both parties have been
scrambling to come up with solutions to appease voters and both
presidential candidates have pledged action on the issue. In recent
months, at least 10 legislative proposals have been fielded and a
similar number of congressional hearings have been held into some
aspect of the oil markets and speculation. George Soros, the
billionaire investor, spoke of "a bubble in the making" in oil and
other commodities in testimony to Congress, adding that the ability of
investment institutions to invest in the futures market through index
funds was exaggerating price rises.

Many politicians blame "excessive speculation" and various regulatory
"loopholes" for the market situation. Joe Lieberman, an independent
Democratic senator from Connecticut, is among lawmakers who say that
speculative demand - particularly through commodity index funds - is
one of the main forces behind surging energy and food costs. "My own
conclusion is that index speculators are responsible for a big part of
the commodity price increases," says Mr Lieberman, who chairs the
Senate committee on homeland security and governmental affairs, among
the committees to hold hearings.

Some regulators are uncertain about the impact of speculation and have
called for further investigation. "I don't know absolutely if
speculative money is causing price rises or not but what I do know is
that there are hundreds of billions of dollars that did not exist in
these markets a few years ago," says Bart Chilton, a commissioner at
the Commodity Futures Trading Commission, the US commodities and
futures watchdog.

This week, the House committee on agriculture is to hold three
consecutive days of hearings to examine the various legislative
proposals, some of which address whether the CFTC has sufficient
resources to oversee the burgeoning futures market. The agency's
staffing levels are at near-record lows, having fallen about 12 per
cent since it first opened 33 years ago, even as the volume on futures
exchanges alone has grown 8,000 per cent, according to Walter Lukken,
acting chairman of the CFTC. He told Congress that the agency needed
"immediate additional resources" to do its job and could not carry out
additional tasks at its current resources and personnel level.

Political pressure is also mounting outside the US. Italy is calling
on the Group of Eight leading economies to tackle commodities
speculators, while last week a UK parliamentary committee said it
would hold its first hearing into regulation of oil markets amid
concern over the possible role of speculators in driving record crude
oil prices.

But lawmakers could end up disappointed if they enact restrictions or
outright bans on the trading of commodity futures. Indeed, a number of
governments, regulators, central banks, investors and multilateral
organisations have argued that such moves would be unlikely to either
damp volatility or stem the increase in prices.

The US regulator says there is little evidence to link price rises to
institutional investors. It has maintained its stance that fundamental
supply-and-demand factors combined with a depreciating US dollar -
which is used to price and trade commodities - are mainly behind the
recent market movements.

There is, moreover, a significant difference between speculation and
manipulation or illegal activity. In response to a question at one of
the hearings last month, Mr Lukken of the CFTC, said: "Speculators . .
. provide a healthy mix of participants in the market to ensure there
is a buyer for every seller and a seller for every buyer. That has
been the case for the 150 years that these markets have been around."

He added: "We are taking steps to ensure that markets are not being
overrun by speculative interests. But, to date, we have not seen
evidence of that . . . [Speculators] are not all on the long side of
the market, betting it will go up. So it is difficult to say there is
a smoking gun there but we continue to look."

The agency, for instance, is collecting more detailed information on
index funds and other transactions being conducted through so-called
"swap dealers" and plans to provide recommendations to lawmakers in
September.

Some go further. The International Energy Agency, the western
countries' oil watchdog, recently accused politicians of looking for
"an easy solution" that avoids taking the necessary steps to improve
supply and curtail demand. Michael Lewis, head of commodities research
at Deutsche Bank, says: "When regulators turn the lights on these
'dark markets', they will find no monsters in the room - rather
underlying fundamentals driving prices higher."

The Onion Futures Act is a perfect case study. When economists studied
the market, they discovered that volatility and prices were higher in
the period after the ban than they were before. Frédéric Lasserre,
head of commodities research at Société Générale in Paris - who has
studied the onion example - says today's context is very similar. "The
politicians are leading the debate pressured by the people," Mr
Lasserre says.

The onions market is not the only example. India last year banned
financial trading in most agricultural commodities but prices
continued to rise. "[Banning financial trading] is irrelevant," says a
senior Indian official. "When a commodity is scarce, its price rises,
whether it is traded on an exchange or not."

That is exactly the argument of those who say that high prices merely
reflect robust demand growth - boosted by the industrialisation of
populous emerging economies such as China, India and Brazil or new
policies such as biofuels - against sluggish supply increases
following years of underinvestment.

Moreover, record commodity prices are being seen across the board, not
just in raw materials with developed futures markets but also in those
without significant speculative investments such as iron ore and rice,
up 96.5 per cent and 120 per cent respectively this year. Research by
Lehman Brothers shows that prices for metals that are not traded in
exchanges, such as chromium, molybdenum or steel, have risen faster
than prices for metals traded in exchanges, such as copper or
aluminium. In addition, some of the commodities markets in which
pension funds hold the largest share of outstanding contracts, such as
hogs, have seen price drops.

Equally important is that price rises across the commodity spectrum
are not in line. This shows that different markets are responding to
their own supply-and-demand fundamentals rather than to financial
investors' money flows, analysts say. The base metals market is a good
example: while aluminium and copper prices have risen by about 30 per
cent since January, nickel, zinc and lead have fallen between 20 and
40 per cent. Tin, the only metal in which pension funds had little
exposure, has jumped almost 40 per cent.

In another sign that supply and demand is the main driver, inventories
for most commodities - including crude oil - have fallen since
January. Many analysts echo Mr Lukken in pointing out that financial
investors in commodities are no longer betting only that prices would
rise, as at the beginning of the boom in 2000-2001. Today, many funds
are betting on lower prices.

The UK Treasury, in a report published last month, suggests that
investors are not driving price increases. "Although there is
insufficient evidence to conclusively rule out any impact, it is
likely to be only small and transitory relative to fundamental trends
in demand and supply for the physical commodities," it says.

Wall Street banks acknowledge that investor flows could influence
day-to-day movements, pushing prices to overshoot or undershoot their
fundamental level for a few days. But they state that investors are
unable to shape the long-term trend.

Such arguments, however, seem to have proved less persuasive for US
lawmakers than those of other experts testifying before Congress.
Michael Masters, a manager of a long-short equities hedge fund with a
large stake in oil-hit airlines shares, told legislators that gasoline
prices could fall as low as $2 a gallon - half today's price - with
legislation barring commodity index funds. Fadel Gheit, an equity
analyst at Oppenheimer, claimed that current record oil prices in
excess of $135 per barrel were inflated. "I believe, based on supply
and demand fundamentals, crude oil prices should not be above $60 per
barrel," he said.

In response, lawmakers are preparing new legislation aimed at quickly
fixing the problem of record high oil and food prices - or, as one
committee staffer put it, to "help American families right now". The
proposals - several backed by political heavyweights - range from a
ban on some kinds of speculation in commodities and energy futures
markets, to higher margin requirements, to effectively extending the
jurisdiction of the CFTC overseas. For instance, the "Close the London
Loophole Act" aims to stop traders from manipulating prices and
speculating excessively by routing oil trades through foreign
exchanges. The "End Oil Speculation Act" proposes to increase the
money, or margin, that speculators would have to put up to trade oil
futures to 25 per cent of the value of the underlying commodity
compared with 7 per cent now.

Some sceptics dismiss the various proposals as political posturing.
But amid the growing political pressure, the CFTC has already taken
the step of imposing position limits on the crude oil contract traded
on London's ICE Futures Europe exchange and a similar contract to be
traded on the Dubai Mercantile Exchange, bringing limits for crude oil
traders overseas in to line with limits on domestic markets. Congress
recently approved legislation closing the co-called "Enron loophole"
and giving greater authority to the CFTC to oversee over-the-counter
derivatives markets.

Some observers of Capitol Hill suggest that lawmakers could try to
consolidate the different proposals. But it is unclear what laws, if
any, will emanate from Congress, not least given that the White House
- which has the power to veto legislation - has taken the view that
supply and demand are behind the price surges. President George W.
Bush recently threw his support behind proposals - forwarded by John
McCain, Republican presidential candidate - to lift the ban on fresh
oil drilling off the US coast to help reduce dependence on foreign
energy sources.

A White House veto could be overridden if enough Republicans join the
Democratic majority as they did last month, when the House voted by a
huge margin - 402 to 19 - to require the CFTC to "utilise all its
authority, including emergency powers, to take steps to curb excessive
speculation in the energy futures markets". However, it is unclear
whether the Senate will take up the same bill.

Political pressure is so high that some think that congressional
action is possible before the summer recess in August. One
congressional insider says: "The truth is that it is going to be very
difficult to get anything done before the presidential election . . .
But this is so much a primary issue facing everyone, there is
momentum." One of the bills that could have some traction is the
so-called "Increasing Transparency and Accountability in Oil Markets
Act", introduced by Democratic senators Dick Durbin, the Senate
majority whip, and co-sponsored by 15 other senators. The bill would
authorise new resources for the CFTC, including 100 extra employees,
and close the "London Loophole".

Some of the more extreme proposals have already been shelved, such as
one idea from Mr Lieberman's committee that suggested limiting certain
institutional investors from investing in the commodities futures
market. "After hearing from experts, the public, and holding numerous
hearings on excessive speculation, our third draft proposal to limit
certain institutional investors from commodity markets does not appear
to be viable at this time. It doesn't look like it would have the
support in the Senate," says one Lieberman committee staffer.

But industry executives, analysts and some lawmakers warn that in a US
election year, there is a danger of over-regulation. "If we reach
September and gasoline prices or food prices are setting new highs, no
one knows what Congress would do," one says. That means there is also
a risk of long-term damage to the commodity futures industry.

Today, the Onion Futures Act remains in effect. But that has not
stopped the price of onions from shooting up an eye-watering 420 per
cent since 2000.