Wednesday, June 25, 2008

Speculators Driving Up Oil Prices?

Congress says yes. Wall Street MSM consensus, however, is "Naaah!" Since Luther's on an oil roll, I figured I'd join the fun and throw in another piece of the puzzle.

The short answer to the above conundrum is that for once, Congress, even the Idiotarian Democrats on the left, are actually right here. But, of course, since they don't understand capitalism, they're right for precisely the wrong reasons.

[Fair warning. Long post incoming. But you'll never read the truth on this topic anywhere else.]

Speculators are a convenient target for the Dems because they think that the oil speculators in this case are all the evil white dudes up on Wall Street who spin the trades that are impoverishing you and me. And in one sense they're right. But again for the wrong reason.

Back when Wonker was a stockbroker, the futures traders in a brokerage house were a breed apart. Where I worked, they'd sit in a back room they had all to themselves with several proprietary TV futures screens running constantly in foreground tracking the ongoing trades. (This was in the early 1980s before you could actually get this stuff on your own computer.)

True gunslingers, they'd be on the phone to their customers constantly. When things were working, they'd all make a fortune. When they weren't, the futures traders and their clients all went bust (seriously). The shattered and sometimes chastened traders would have to be staked by the manager for a couple of months of draw until they could rebuild their their clientele with fresh blood and replace those huge lost commisions. And then the cycle would begin anew.

Lest you feel there was anything rotten about this, keep in mind that the futures traders were required to screen their customers very carefully, vetting them for net worth, assets, suitability of trades, etc. Essentially, your average lay futures trader was an older rich guy with plenty of time and money, enabling him to play in the futures market. Which, as any futures trader will tell you, is a contact sport requiring constant phone interaction and presence.

One important practical rule of thumb was, the client had better not put on a few contracts, then fly off for an extended vacation in a wilderness area where there were no phones. (And again, in those days, there were no cells. Without a landline, you were hosed, brother!) You can get wiped out in an instant in futures, what with only having to put up 10% of each contract in cash. The rest was margin--basically money loaned by the house. With a volatile market run on that kind of leverage, you had no business being out of contact range or you deserved whatever happened to you. Yet guys would do this all the time which is often why they got wiped out.

But my main point is, these were rich guys who usually had plenty more in their piggy banks and had been carefully vetted and qualified by the house as suitable customers for this kind of investment mayhem. So when their accounts disappeared down the rat-hole of fate, they were generally capable of recovering. Since, after a raft of cuss words and half a bottle of scotch, they still had enough resources in another bank account to get back in action.

That, folks, is speculation. Buying futures contracts for which you'll never take delivery of the commodity. And trading them rapidly for fractional gains vastly magnified by the enormous amount of leverage brought to bear. The leverage, pure and simple, was key to making, and losing, fortunes quite quickly. Not a game for the faint at heart. Or for the average Joe. It's a game that's still best played by the professionals, however insane they may be.

Which starts moving us to our point. A new generation of computer-savvy but still rich, greedy guys on Wall Street invented, a few years back, something called the "ETF," or exchange-traded fund. These are essentially good old-fashioned mutual funds except they trade just like stocks on the exchanges. Unlike a broad-based mutual fund, however, most ETFs are closely targeted to meet this or that average or marketbasket of stocks. You have biotech ETFs, ETFs that track the S&P 500, ETFs that track baskets of stocks in a single country (Brazil, Malaysia, Thailand ETFs). Etc.

ETFs turned out to be massively popular, so new ones come out every month as the firms who package these mutual-funds-turned-floating-crap-games are in hot competition to move this kind of popular merchandise since it's quite profitable for them. And in theory, it's really good stuff, enabling you to, say, track a whole basket of risky biotech stocks, thereby smoothing out the kind of extreme risk you'd take if you invested in just one of them and guessed wrong. I mean, who know much about Brazilian stocks anyway? But the country is on a winning streak. So why not invest in a Brazilian stock ETF, even out your risk in that country, and not worry too much about needing to know each and every stock you're sort of into.

But as I said, the brokerage firms and investment banks who invented these things were going nuts trying to create new products. So they hit upon a great new idea. Why limit ourselves to boring old stocks. Been there, done that. Let's make futures ETFs too!

So they started inventing precious metals ETFs that invested in mining stocks AND the raw metal. And, ta-da, ENERGY ETFs that did the same kind of combos, a little drilling stock here, a few actual barrels of oil there. Or sometimes, only the commodity, as in United States Natural Gas Fund LP (symbol: UNG, traded on the Amex). The blurb on my current brokerage's info page (no link) describes UNG as follows:
The investment seeks to replicate the performance, net of expenses, of natural gas. The trust will invest in futures contracts on natural gas traded on the NYMEX that is the near month contract to expire. It is nondiversified.
Now we're getting there. You're saying, why, (splutter), that means that little jerks like me and Wonker can invest in futures contracts without qualifying, without documenting net worth, and without any experience at all! And if that's really what you're saying, well right you are.

The energy ETFs are hugely, hugely popular right now. Guys (and gals) like you and me are plunking massive amounts of money into them because we think that oil (and gas, and gold, and God knows what else) are going to make us a lot of money since currency, particularly the dollar, is worthless, and since we're upside-down on our mortgages.

And for now, a lot of average investors, little and big, ARE making good money in energy future-centric ETFs. But now it gets more interesting. As the little investors pile into these ETFs, just like mutual funds, the guys who own the EFTs are getting more and more and more cash, which means they have buy more and more and more futures contract to issue more and more and more ETF shares so we can all make more and more and more money forever, right? What a game. Like Jay Leno used to say on that old Frito commercial: Eat all you want. We'll make more!

Problem is, the game is getting a little like the Y2K dot-bomb and the 2006- residential real estate crash--which still seems to be going on, BTW. Don't people ever learn? Guess not.

Back to our original question: is speculation driving up the price of oil catastrophically? You bet!

But, as I've just described, at least in part, we've met the enemy and he is us! (Hat tip to Pogo fans.) Sure, you can bet that the odd Russian hoodlum, Al Qaeda's investment bankers, and Communist-capitalist George Soros are also having fun at our expense. But it's John Q. Public, snapping up energy ETFs that invest wholly or partially in futures contracts, that have become, I think, a driving force behind the current oil price disaster. We ourselves are helping to massively drive up the price of the commodity we bitch about whenever we fill up the tank of the Hummer we wish GM hadn't made us buy.

So this is why Congress has it partially right. Rich guys created this EFT monster. But the ones really driving it now are you and me, and yes, I've been in and out of these bloody things with mixed results, mainly to learn how they work. And the way they work: They are sliced and diced FUTURES CONTRACTS that are just as volatile as they always were, and even more so now that they're being devoured by amateurs who have no clue what they're setting themselve up for.

Mark my words: in the terminology of technical traders, oil futures contracts have now gone "parabolic." That means that their charts have prices going up so fast that the composite direction of those charts is not up and down but STRAIGHT UP. When any investment goes parabolic, it's generally but a short period of time before something breaks the momentum. At which point a selling panic occurs, driving the investment down much faster than it went up. Which is usually known as a crash. Dot-bombs went parabolic in 1999-2000. Residential real estate went parabolic in 2004-2006. And now, even as we still reel from the still-ongoing real-estate bust, what are we doing but wiping ourselves out again by buying so many futures contracts via ETFs that we're going parabolic again. As the oil futures go, so will their ETFs.

Folks, I don't know when the swan dive is going to start. I just know that it will, and for folks on the long side of this trade, it won't be pretty. Right, Iran can do something wilfully stupid, Al Qaeda can bomb all the Saudi oil fields, or the idiots in Nigeria can keep wrecking their own facilities. Any of these plausible events will drive prices catastrophically HIGHER if any of these scenarios unfold. But in the end, that'll only increase the already perilous verticality of the oil futures parabola and make the inevitable dive-bombing crash all that more breathtaking. I think people have no clue what is coming. Particularly those who read the press which is so wilfully stupid in this area it takes my breath away.

My advice: remember what Paul Volcker's Fed did in another era to the Hunt Brothers, who'd succeeded in virtually cornering the market for silver bullion in the early 1980s and driving it up from, oh, about $5 an ounce to around $55 an ounce in fairly short order. Volcker simply sat down, talked to a few people, and one bright morning, Wall Street raised the margin requirement on silver from 10% to 50%. Since the Hunts had cornered nearly all the bullion silver in the world (seriously), they immediately had to raise cash to cover their position--more cash than you or I can count. And they had to raise it, as I say, immediately. Silver buyers figured this out and stepped aside. Hey, it's an auction market, right? With no one to sell to, the Hunts saw the value of their massive holdings drop like a waterfall as their brokers were forced to sell out their positions for whatever they could get.

It was awe-inspiring. People came in off the streets at our brokerage house to watch the tape. Stocks in nearly every sector gyrated crazily. The stock market itself took a massive dive. Yeah, there was panic in the streets, and I had visions of myself selling apples on the street corner the following morning--and I don't mean the Steve Jobs kind of apples.

Maybe about 2 days later, it was essentially over. The Hunt Brothers, the fabulously wealthy Hunt Brothers, were effectively wiped out. Silver settled down to normal trading. And it's never been anywhere near that stratospheric high to this day. Margin requirements were again "normalized." And, in those early Reagan years, that was probably about the end of the end of the Carter bear market as normal trading and prosperity finally returned to the market at last.

Yeah, this was a long post, but I haven't seen any Wall Street geniuses write about this anywhere. The speculators ARE driving the oil market today. But while there surely are some rich and villainous traders and rogue countries playing the game, more and more energy futures contracts are being driven up by hungry, unqualified amateurs thinking they've found unlimited value. And they have. For now.

Unfortunately, as in 2000 and again even now in real estate, the bottom will drop out and the amateurs will be crushed again. They never learn. (And the press never helps them, BTW, feeding them frenzied crap and lies every day as they cheer the price of oil up, probably hoping to screw the Republicans worse than they're screwing themselves this fall.)

My advice to Ben Bernanke is to call Paul Volcker and ask him how he got the machinery cranking against the Hunts. (The SEC and the brokerage houses actually play the major roles here, with the Fed doing the jawboning as I recall. The details are actually somewhat unimportant.) Then, one fine morning, we'll get an announcement that owners of oil futures contracts (including ETFs presumably) will need to put up 50% rather than 10%. Then we all step away. By afternoon, blood will be running in the streets. And the oil speculation problem will be history. For now.

This doesn't solve the energy problem per se, of course. But it will buy us a nice chunk of time to do that. Just like we had in the 1970s, and again in the 1980s when prices busted back, albeit settling at higher levels than earlier eras. Except that maybe this time, we'll smarten up and really solve the problem this time rather than just talk it to death and worry about the polar bears. Next time, there might not be a next time.

Last call.


Luther said...

This is so important that I've revised previous posts to reflect your amazing work here.


Wonker said...

Thanks, dude! Pleasure doing business with you!