Farm Bill's Bid to Stop Oil Speculation

The Commodity Futures Trading Commission says it launched a nationwide investigation last December into possible manipulation of the oil-markets.

The probe comes during an election year that has the country on high alert over record oil prices, now boomeranging over $130, a price that has doubled in the last year.

With voters taking to the roads this summer driving season, expect complaints to soar as average gas prices in a growing number of states surpass $4 a gallon. The spike in diesel costs has pounded the trucking industry and contributed to soaring food prices.

However, the $300b farm bill has some legislative fixes that could help stop oil speculation--a pipe dream as oil speculation will never be stopped given how large the market is. President George W. Bush may veto the bill due to pork and other concerns.

The farm bill would close a loophole oil traders have driven a Mack Truck through. It would hike margin requirements on oil trades and end the so-called Enron loophole that lets traders buy oil electronically outside of the United States.

Though market watchers say high oil prices are really a supply and demand issue, the bill aims to stop speculators thought to be artificially inflating the price of oil in order to cash in, which Sen. Carl Levin (D-Mich.) estimates adds as much as $35 to the price of a barrel of oil.

Senate Democrats want to increase the amount of money traders would have to put down when buying oil futures. Specifically, they want to jack up the margin requirement for energy futures trades, now ranging between a teensy 5% and 7% of the cost of a new position, versus 50% for stocks.

However, the bill apparently doesn't give an upper bound limit to that margin requirement, as it only orders the CFTC to hike the margin requirement by a "substantial" amount.

Would increasing the margin suck liquidity out of the market, leading to volatility and higher prices, as critics cahrge? Debatable, given that central banks around the globe have been gunning the printing presses, and sovereign wealth funds, pension funds, private equity funds are chasing the next hot trade.

Next, Senate Democrats want to shut the so-called "Enron loophole" which lets traders purchase oil contracts electronically outside of the US. Bringing the trades onto the CFTC would stop oil traders from trying to get around the new margin limits by fleeing to electronic markets offshore.

The "Enron loophole" has been around since 2000, when the Commodity Futures Modernization Act was passed. It lets oil traders buy and sell oil futures contracts electronically in markets outside of the CFTC's jurisdiction, such as the commodities exchange in London.

Essentially what's going on here is oil traders of U.S. crude now can make electronic trades in offshore markets. US "computer terminals will be governed by US regulation, because the computer terminal is located in the United States," Sen. Carl Levin (D-Mich) has noted.

For now, the CFTC says it struck a deal with the Intercontintental Exchange along with Britain's Financial Services Authority to get more daily trading data on large trader positions in oil futures made on the ICE Futures Europe platform. ICE oil futures are traded electronically on computer terminals across the US, using prices linked to oil futures trades on the New York Mercantile Exchange. However, they are not subject to the same CFTC reporting requirements.

Whether any of this legislation will lower oil prices is unclear at this moment, as China and India suck up oil at record amounts and OPEC refuses to ramp up production (don't you wonder whether OPEC members are saying to themselves, why invest in Citigroup or Merrill Lynch when we can let oil sit in the ground as oil will continue to rise?)

A stronger dollar would help, too, as the debasement of the US dollar has caused oil, traded in dollars, to rise. A rising dollar may have helped push oil prices lower Thursday, as crude futures for July delivery fell $4.41 to $126.62 a barrel in New York futures trading.

However, the CFTC's dragnet could even sweep up large institutional funds, including pension funds, thought to be pumping up oil prices as their buying of futures contracts for oil and other commodities has moved apace.

Check out this testimony recently given by Michael Masters, a hedge fund portfolio manager, to Congress. He says the huge number of investor dollars flooding into the commodities markets has skewed the relationship between oil supply and demand.

Specifically he said that only $13b was traded in commodities indexes in 2003, soaring to $260b in March 2008. A longer version of his testimony is provided below, from a recent report:

Masters asserted that institutional investors such as corporate and government pension funds, sovereign wealth funds,and university endowments now account for a larger share of outstanding commodities futures contracts than any other market participant, after holding a miniscule position prior to 2003.

The severe bear market in equities from 2000 to 2002 led these investors to commodities, which historically trade inversely to fixed income and stock portfolios.

The result was a sharp jump in assets allocated to commodity index trading strategies, jumping from $13b at the end of 2003 to $260b as of March 2008.  Over that time span, the prices of the 25 commodities that make up these indices surged by an average of 183%, Masters says.

During that five-year period, speculators' demand for petroleum futures has increased by 848m barrels, almost equal to the 920m barrel increase in demand from China, according to US Department of Energy figures.  While funds never take physical delivery of the oil, Masters said these amassed contracts are undoubtedly a factor in demand and the single largest force in the market today.

"The huge growth in demand has gone virtually undetected by classically trained economists who almost never analyze demand in futures markets," he said. 

By his count, speculators have now stockpiled, via the futures market, the equivalent of 1.1b barrels of petroleum, or eight times as much as the US has physically added to its Strategic Petroleum Reserve in the last five years.

These investors do not care what the price of oil or any other commodity is, Masters noted. If they decide to allocate 2% of their portfolio to commodities, they will buy as many contracts as they need at whatever price necessary. Because commodity markets are much smaller than capital markets, these investments can have a far greater impact on prices.

In 2004, for instance, the total value of futures contracts outstanding for all 25 index commodities amounted to $180b, compared to the $44t value of worldwide equity markets. Speculators pumped in $25b into commodities in that year, equal to about 14% of the total market, Masters says.

Moreover, rising prices tend to attract more speculative activity. 

During the sharp run up in crude oil prices in the first quarter of this year, index speculators flooded the markets with $55b in the first 52 trading days alone.

"Doesn't it seem likely that an increase in demand of this magnitude in the commodities futures markets could go a long way in explaining the extraordinary commodities price increases in the beginning of 2008?"  Masters asked.

He said refiners have told him that the price of oil, excluding the impact of speculation, would be in the $65 to $70 range.