Gas Prices: Speculators Have Cornered Market. It's That Simple.

Due to the Enron loophole, which deregulated the commodities exchanges in 2000, first Enron was able to bilk California energy consumers for a couple years and now large commodity speculators are able to bilk the entire world's consumers at the gas pump, and, in addition, at the grocery store. Although much has been said about the need to reregulate the market, (the Farm Bill on Bush's desk contains a provision to eliminate the Enron loophole), it may not be so easy to do so since commodity exchanges are in the process of moving offshore out of the reach of congressional legislators. Therefore, the world's consumers might just suffer the ultimate effect of globalization: paying outrageous prices for basic necessities in order to enrich the very few.

At one time when futures contracts were limited to farming, they served a rational purpose: they guranteed the farmer a certain price for his product regardless of market conditions. It worked like this. Say a farmer was prepared to plant and harvest 10,000 bushels of wheat. He would calculate his costs, figure in a profit and, for example, conclude that he would need to get $3.50 a bushel to make it worth his while to even get out of bed in the morning and plant his crop. So he would sell a future contract to someone to deliver 10,000 bushels of wheat at $3.50 a bushel on a certain date, say three months in the future after his crop was harvested. Now if the market price at that time was $3.00 a bushel, the farmer would still get $3.50, and he would be happy. If the market price was $4.00, the farmer would not be quite as happy, but he still would get his $3.50 making his efforts worthwhile if not quite as profitable as they would have been had he taken his chances in the marketplace.

A further refinement would allow the farmer to get the market price if the market had risen but still get the contract price if the market had fallen. When the farmer sold his contract for 10,000 bushels of wheat at $3.50 a bushel, he would purchase an option contract to buy 10,000 bushels of wheat at $3.50 a bushel. Then if the price in three months had fallen, he would let the option expire and be satisfied with $3.50 a bushel. If, on the other hand, the price had risen to $4.00 a bushel, the farmer would exercise his option to buy 10,000 bushels at $3.50, use those bushels to fulfill his contract to sell 10,000 bushels at $3.50 a bushel and sell the 10,000 bushels he himself had produced on the spot market at $4.00 a bushel thus picking up an additional $.50 a bushel.

All this was well and good when it applied to farming, but soon other commodities such as oil and metals started to be traded on the commodities exchanges. Now no one thinks that the oil producers are so economically marginal that they need to lock in a contract in the future to deliver so many barrels of oil. It's just ridiculous, but the futures market for oil works the same way as it does for farm products. A producer will sign a futures contract to sell so many barrels of light sweet crude, for example, at some date in the future. The buyer puts up some money, typically 6% of the contract price, and he owns the oil as of that future date. As that date gets closer, naturally, the price gets bid up since the original buyer of the contract tied up his money for a period of time; think of the interest he might have gotten had he invested otherwise. Since the buyer buys the oil on margin, he can control a lot of barrels of oil by putting up only a relatively small amount of capital or, in other words, he has a lot of leverage. Oil speculators or investors have no intention of taking delivery of the oil they have purchased at some future date. Instead they sell the contract to another investor (making a profit, supposedly), and that investor sells to another etc. until finally someone sells the contract to an actual consumer of oil. That would be the oil company who then refines it and sells it to consumers at the gas station.

WASHINGTON, DC, June 20 -- Citing the harmful impacts record high crude oil prices are having on consumers, US Rep. Bart Stupak (D-Mich.) introduced a bill to close regulatory loopholes that he said have allowed commodity speculators to push oil prices upward and profit from the increase. ... Stupak and Inslee both said that recently soaring crude oil prices reminded them of dramatic increases in Western US wholesale electricity prices in 2001 that were later traced to manipulation by traders at Enron Corp. "I've seen this bad movie before. It's the Enron movie, which hit the West Coast power markets like a bomb because the federal government was asleep at the switch. It has happened again with oil prices," Inslee said. Numbers back this up Stupak said that while Treasury Sec. Henry M. Paulson and the CFTC won't acknowledge that excessive speculation is part of the high oil price problem, others from the International Monetary Fund to Saudi Arabia's oil minister have said that it is. "The numbers back this up: Between Sept. 30, 2003, and May 6, 2008, contracts held by traders jumped from 714,000 to more than 3 million, a 425% increase. Since 2003, commodity index speculation has increased 1,900% from an estimated $13 billion to $260 billion invested," the House member said. He said CFTC data show that in 2000, physical hedges that airlines and other businesses use to ensure a stable price for fuel in coming months and actually imply delivery, accounted for an estimated 63% of the total futures market, while speculators represented about 37%. "By April 2008, physical hedgers only controlled 29% and speculators had taken over a whopping 71% of the oil futures market," Stupak said. He said 85% of the futures purchases tied to commodity index speculation comes through swap dealers—investment banks that serve as intermediaries for their pension fund and sovereign wealth fund customers. One report found that $55 billion of total worldwide commodity trading over 55 days came in as swaps, according to Stupak. "The CFTC has allowed 117 exceptions to swaps. When that many exceptions are allowed, they are not really subject to oversight. We have a CFTC that's supposed to be doing its job. I'm not certain that it is," he said. ... Inslee said many energy commodity trades take place beyond the CFTC's oversight. "If you don't have transparency, you have excessive speculation. We learned from Enron that if you don't have transparency, you have the potential for manipulation," he said. Asked if he still intends to press his legislation if crude oil prices start to drop, Stupak said that he does. "We have not spent 3 years looking at this not to. Rep. Inslee and I were here for the Enron debacle and we're tired of seeing it happen. There's clearly a bubble here that's about to burst. This bill will do more to make it happen than anything the Chinese government could do," he said, referring to China's announcement the previous day that it would raise domestic fuel prices by as much as 18%.

Although much has been written about the need to raise the margins on futures contracts (currently 6% in the commodities market compared with 50% in the stock market) and to limit the amount large scale investors such as hedge funds can invest, no one it seems quite understands how the process that has caused oil to increase by 100% in two years works. No one disputes the fact that, as oil has gone from $60. a barrel to $130. a barrel in two years, gas has gone from roughly $2.00 a gallon to $4.00 a gallon . That's a direct correlation. But what are the mechanisms by which world commodity prices have risen so drastically. The answer is actually very simple: cornering the market. If one entity or several entities working independently but along the same lines own all or a large percentage of a necessary resource, they can set the price at will. In particular if a few very large scale investors such as hedge funds own, say, 90% of the oil futures contracts, they will be able to set the price of oil instead of the price being set by the laws of supply and demand just taking into account producers and consumers. Commodity speculators are middle men who deal in "paper oil." They have no intention of taking delivery of oil. They just buy and sell contracts for oil. Now perhaps I should say quasi-cornering of the market since unlike the Hunt brothers who almost cornered the market for silver in 1979 or the hedge fund Amaranth which attempted to corner the market in natural gas in 2007, the oil market is not being cornered by one individual or entity but by several entites working quasi-independently. There does not necessarily need be any overt collusion among them as they all know what effect they're trying to achieve so they can work in concert without "manipulating" the market, without colluding, but the ultimate effect is the same. Anyway, it's not a question of market manipulation, but what is legal versus illegal manipulation. Whatever is legal that will maximize profits will be done whether someone considers it manipulation or not.

The "spot" market for oil is the market for physical oil as it exists today; that is, if you were going to go out and buy some today. The futures market for oil is the market for contracts for oil to be delivered sometime in the future. Since demand for oil is only going to rise, speculators can take long positions knowing they can't lose. The demand for oil is not going to go down what with the growing demands of the Indian and Chinese markets. After several rounds of buying and selling oil contracts, the price of oil gets bid up, and, because of the large number of contracts involved representing a huge volume of oil, the spot market price, instead of being set by the law of physical supply and demand, actually gets set by the price of future contracts on the last day of trading. The experts will tell you that the futures price and the spot market price will converge and this is how the price of physical oil is determined. However, whether the convergence is upward to the futures price or downward to the spot price never gets mentioned. I contend that the spot market price is being set by the futures price and, therefore, speculators are determining that price and not the law of supply and demand for physical oil. Rather price is being determined by the law of supply and demand for future contracts. If oil were sold directly by the producers to the consumers, then the OPEC cartel would be setting the price, but, since it's being sold by the holders of futures contracts, then they determine the price especially if they've quasi-cornered the market, that is, if most of the oil has been bought up by speculators. If, on the other hand, the amount of oil held in future contracts is relatively small compared to the total amount available for sale, then the price of oil would be determined by the OPEC cartel who would set the price for oil on the spot market. So OPEC has lost control of the price setting mechanism, and prices are being set by the value of a futures contract on the last day of trading. And for this scenario to be valid, demand need only be increasing slowly and gradually not rapidly.

Now consider what would happen if demand were  to decrease. Then all available oil on any given day would not be sold. The price of oil on the spot market would come down, and those holding oil purchased on futures contracts at a higher price would be left holding the barrel, so to speak. If oil is bid up by multiple rounds of trading on the futures market and then demand slackens, the speculators would lose money. They'd be holding contracts they couldn't sell at the price they paid for them. But this will never happen as long as demand is increasing even slightly so they can effectively set the price wherever they want and, because of inelastic and increasing demand, get it. The combination of huge amounts of money invading the commodities market and rising demand for physical oil, food and other commodities is what's causing the price of these necessities to skyrocket. It's not rocket science to figure out why demand is rising. The world's population will have gone from 6 billion to 7 billion in just a few short years. As world population rises, globalization has led to the fact that nation states no longer have regulatory control over markets so that from a world perspective markets are effectively deregulated leading to large investor ability to set prices at exhorbitant levels in order to extract as much as possible financially from the world's population who need to eat and drive to work. The antidote to this malady, of course, is decentralized solar energy production, the last thing that large energy corporations want to happen. They want whatever form of energy production that is encouraged or subsidized to be one that is centralized so that they can meter, price and control it as well as trading it on the commodities markets which would lead to the same situation we're in today even if the entire world's energy needs were obtained through solar and not non-renewable resources such as oil, coal and natural gas.

Decentralized solar energy production by installing and subsidizing solar panels on each citizen's house rooftop and car rooftop will take energy production out of the hands of large corporations and commodities speculators. The same can be said for localized food production. Not only is it ecologically more copacetic to buy at farmer's markets because food need not be transported over huge distances, but is sold directly from producer to consumer, and, therefore, cannot be commodified and traded on the commodities market. It just makes sense that prices will be lower. In the meantime far wiser people than I have suggested that the commodities markets need to be reregulated so that large futures contracts can be limited so they can't dominate the market, and margin requirements need to be increased in order to decrease the leverage speculators now enjoy. The Commodity Futures Trading Commission is attempting to crack down on speculators but it just might be a case of too little too late. Like most government agencies under the Bush administration, the CFTC has been underfunded and staffed with personnel whose mission is to represent the interests of those they are supposed to regulate.

Persons within the United States seeking to trade key US energy commodities – US crude oil, gasoline, and heating oil futures – are able to avoid all US market oversight or reporting requirements by routing their trades through the ICE Futures exchange in London instead of the NYMEX in New York. Is that not elegant? The US Government energy futures regulator, CFTC opened the way to the present unregulated and highly opaque oil futures speculation. It may just be coincidence that the present CEO of NYMEX, James Newsome, who also sits on the Dubai Exchange, is a former chairman of the US CFTC. In Washington doors revolve quite smoothly between private and public posts.  A glance at the price for Brent and WTI futures prices since January 2006 indicates the remarkable correlation between skyrocketing oil prices and the unregulated trade in ICE oil futures in US markets. Keep in mind that ICE Futures in London is owned and controlled by a USA company based in Atlanta Georgia.  In January 2006 when the CFTC allowed the ICE Futures the gaping exception, oil prices were trading in the range of $59-60 a barrel. Today some two years later we see prices tapping $120 and trend upwards. This is not an OPEC problem, it is a US Government regulatory problem of malign neglect.

So the doubling of price of gas at the pump in the last two years is directly correlated with the inflow of money into oil futures by hedge funds. Hmmm. It doesn't take a rocket scientist ...