The Oil Bubble

Will it burst or can we deflate it?
by Jerry Gordon
(June 2008)


"I can calculate the motions of the heavenly bodies,
but not the madness of people"
          ---Sir Isaac Newton, comment on the South Seas Bubble of 1720

Many Americans this Memorial Day experienced sticker shock on steroids at the gas pump. It now costs $4.00 a gallon for regular unleaded gas in many areas of the country. Here in Florida’s Panhandle, even with our economical four cylinder family car, it now costs $60.00 to fill up our gas tank weekly. By contrast in January, 2007, with an average price of $2.21 a gallon, according to the Energy Information Administration, it cost $33.15 a tank full. This is almost a doubling of gasoline costs in 18 months.  The price of the US crude oil futures on the New York Mercantile Exchange (NYMEX) more than doubled over the period from May 1, 2007 to May 23, 2008: $60.00 versus $132.19.



Texas oil patch billionaire hedge fund manager T. Boone Pickens says that oil futures could soon hit $150 a barrel based on his estimates that daily worldwide demand of 87 million barrels per day (mbd) exceeds current capacity of 85 mbd.  Goldman Sachs energy analyst, Arjun N Murti whose earlier prognostications have been on track, suggested that crude oil prices might easily reach $200.  In many parts of the US, this spike in oil prices has caused major adjustments in family budgets and for the first time significantly curtailing driving and holiday vacation plans this summer. Clearly an oil bubble has rapidly emerged to rival that of the dot.com stock bubble of 1999-2000, and the housing bubble and subprime mortgage credit crisis of 2007-2008.

We got a peek at the emerging oil commodity bubble during a luncheon club talk by Walker Todd here in the Florida panhandle. Todd has been a consultant to both the Cleveland and New York Federal Reserve Banks and has done consulting for the World Bank. He writes periodically for the American Institute of Economic Research in Great Barrington, Massachusetts. Todd’s  topic was “Oil, Gold and Commodities.”

Todd drew the luncheon audience’s attention to two indices: oil future prices using the US oil futures benchmark of West Texas Intermediate (WTI) and the exchange traded dollar index. He noted that the WTI crude oil futures had spiked over 35% in less than five months since the beginning of the year. While the exchange traded dollar index, which had depreciated in five years from a high of 120 to less than 74% at the beginning of 2008 had dropped less than one percent to 73%. The inference was that something other than basic Economic 101 supply and demand dynamics was at play. My wife a former university professor in international economics commented: “looks like speculation.” 

She was not alone. AAA spokesman Geoff Sundstrom told CNN: “We have to wonder if the foundation behind these very high prices is nothing more than speculation.”

But there is something more afoot: the return of possible “stagflation.” This is a term we haven’t heard in years since the oil spike in 1979 to 1980 produced in the wake of the revolt in Iran that established the Islamic Republic with its rising nuclear terrorist threat to the West.

Amatole Kaletsky, the London Times economics columnist commented:

Instead of just causing a brief recession, the oil and commodity boom threatens a prolonged period of global ‘stagflation’, the lethal combination of high inflation and economic stagnation last seen in the 1970’s and 1980’s. It would be a disaster far more momentous than the repossession of a few million homes and collapse of a couple of banks. It is more lethal than the credit crunch for two reasons. It prevents central banks in advanced economies from cutting interest rates to keep their economies growing. Even worse, it encourages the governments of developing countries to turn their backs on global markets, resorting instead to price controls, trade restrictions and currency manipulations to protect their citizens from the rising costs of energy and food.

Kaletsky went on to suggest that so-called fundamental market dynamics such as global peak oil reserves, China’s insatiable demand, global warming, Middle East conflicts, terrorist attacks on oil tankers off the horn of Africa and in the Nigerian estuary oil fields weren’t the only culprits. He noted that none of these factors had changed the supply/demand dynamics in the past year, especially with regard to China:

China’s ‘insatiable’ demand growth has decelerated. In 2004 it was consuming an extra 0.9 million barrels a day; in 2007 it was consuming just an extra 0.3mbd. In the same period global demand growth has slowed from 3.6 mbd to 0.7mbd. As a result, the increase in global demand growth is now well below last year’s increase of 0.8 mbd in non-OPEC production.

If  market fundamentals aren’t driving the oil bubble, what is? Furthermore, what are possible remedies to deflate the oil bubble before it bursts?  The answers may both surprise and anger you.

The  Congress and the White House target the wrong culprit: OPEC

On May 20th, the US House of Representatives passed by a vote of 324 to 84 legislation that permitted the Justice Department “to sue OPEC members for limiting oil supplies and working together to set crude prices.”  In the words of Wisconsin Democratic sponsor, Rep. Steven Kagen the bill would:

“Guarantee that oil prices will reflect supply and demand economic rules, instead of wildly speculative and perhaps illegal activities.” 

Kagen went on to say that Americans “are at the mercy of OPEC for how much they pay for gasoline.” The Bush Administration commented that targeting OPEC investment in the US for payment of damage awards under the bill’s provisions “would likely spur retaliatory action against American interest in those countries and lead to reduction in oil available to U.S. refiners.”

President Bush during his recent Middle East trip met with Saudi King Abdullah to prod the Saudis to convince OPEC to pump more oil. He got rebuffed when the Saudi said they wouldn't pump less than an additional 300,000 barrels a day, when something akin to an additional 1.5 million barrels might moderate price spikes.  Bush then countered criticisms about his failure to get Saudi support by suggesting the US might pump more oil in areas previously untapped like the estimated reserves of 10 billion barrels in the Alaskan National Wildlife Refuge or the federal waters of the Gulf of Mexico with an estimated reserve potential of 15 billion barrels, near an area that China and Cuban are developing in the Straits of Florida. All that takes time and billions in new investments to extract relatively high cost oil.

Both the House and President Bush didn’t see the 800 pound gorilla in the room, the oil bubble.

 What caused the Oil Bubble?

F. William Engdahl, economist and author, in Global Research on May 2, 2008 put the blame squarely on oil speculation. In an article entitled: “Perhaps 60% of Today’s Oil Price is pure speculation,” he noted:

The price of crude oil today is not made according to any traditional relation of supply to demand. It’s controlled by an elaborate financial market system as well as by the four major Anglo-American oil companies. As much as 60% of today’s crude oil price is pure speculation driven by large trader banks and hedge funds. It has nothing to do with the convenient myths of Peak Oil. It has to do with control of oil and its price. How?

First, the role of the international oil exchanges in London and New York is crucial to the game. Nymex in New York and the ICE Futures in London today control global benchmark oil prices which in turn set most of the freely traded oil cargo [prices]. They do so via oil futures contracts on two grades of crude oil—West Texas Intermediate and North Sea Brent.

All this is well and official. But how today’s oil prices are really determined is done by a process so opaque only a handful of major oil trading banks such as Goldman Sachs or Morgan Stanley have any idea who is buying and who selling oil futures or derivative contracts that set physical oil prices in this strange new world of “paper oil.”

With the development of unregulated international derivatives trading in oil futures over the past decade or more, the way has opened for the present speculative bubble in oil prices.

Since the advent of oil futures trading and the two major London and New York oil futures contracts, control of oil prices has left OPEC and gone to Wall Street. It is a classic case of the “tail that wags the dog.”

A June 2006 US Senate Permanent Subcommittee on Investigations report on “The Role of Market Speculation in rising oil and gas prices,” noted, “…there is substantial evidence supporting the conclusion that the large amount of speculation in the current market has significantly increased prices.”

What the Senate committee staff documented in the report was a gaping loophole in US Government regulation of oil derivatives trading so huge a herd of elephants could walk through it. That seems precisely what they have been doing in ramping oil prices through the roof in recent months. 

The Oil bubble is largely the product of uncontrolled speculation by hedge funds, US pension funds and oil patch principals like T. Boone Pickens in the oil commodity futures and derivative markets. It has been fostered by two exemptions granted by the chief regulator of the US commodity markets, the Commodity Futures Trading Commission created by the Commodity Exchange Act of 1974 (CEA).  The first exemption was, ironically, that granted to Enron in 2000 that enabled Over The Counter (OTC) energy derivatives trading. The second occurred in 2006 when, according to Business Week, the CFTC allowed ”unlimited speculation through a swaps loophole that exempted Wall Street investment banks like Goldman Sachs and Merrill Lynch from reporting requirements and limits on trading positions that are required of other investors to the oil derivative traders on Wall Street vis a vis the ‘swaps’ exemption.”  According to the Treasury Department, the top five Investment banks who dominate swap dealing in oil futures include: Bank of America, Citigroup, JPMorgan Chase, HSBC America Holdings and Wachovia.

Who and what is behind the Oil bubble?

Senator Joseph Lieberman (I-CT) chair of the U.S. Senate Homeland Security and Government Affairs Committee (HSGAC) along  with Senator Susan Collins (R-ME) held an important hearing on May 20th on “Financial Speculation in Commodity Markets: Are institutional Investors and hedge funds Contributing to the food and Energy Price Inflation?” In his introductory remarks he noted:

This unbridled growth raises justifiable concerns that speculative demand-divorced from market realities – is driving …energy price inflation and causing a lot of human suffering.

One witness at this Senate hearing Michael Masters, a hedge fund manager, noted:

“(Commodities) are experiencing demand shock from a new category of speculators: institutional investors like corporate and government pension funds, university endowments and sovereign wealth funds.  Index speculators trading strategies amount to virtual hoarding via the commodities futures markets. Institutional investors are buying up essential  items that exist in limited quantities for the sole purpose of reaping speculative profits.”   

Remember London Times economics columnist Kaletsky’s comment about China’s oil demands, well here was an interesting comparison by Masters about the relative impact of commodity index paper oil demands.

According to the DOE, annual Chinese demand for petroleum has increased over the last five years from 1.88 billion barrels to 2.8 billion barrels, an increase of 920 million barrels. Over the same five-year period, Index Speculators demand for petroleum futures has increased by 848 million barrels. The increase in demand from Index Speculators is almost equal to the increase in demand from China!

In one year alone in 2005, oil speculator and hedge fund manager Pickens earned  $1.4 billion in profits playing the oil futures markets, enabling him to purchase over 600 windmills for a wind farm  in the Texas panhandle to generate electricity, as an alternative energy play.

Masters further noted that over the five year period from 2003 to 2008, US pension funds increased investment in commodity index funds by more than 20 times from less than $13 billion to more than $260 billion. Financial speculators, according to Business Week grew from one-quarter to two thirds of the commodity market. One of those US pension funds active in commodity index futures is the giant California Public Employees Retirement System, CALPERS. That invested over $1.1 billion in commodity swaps through Goldman Sachs as an inflation hedge.  Clark McKinley, a CALPERS spokesperson commented: “We understand that there is of course some effect of investors on (Commodity) prices. But it’s a relatively small impact.”  Sure. 

In the same Senate hearing, Jeffrey Harris chief economist of the Commodity Futures Trading Commission shifted the blame to “the weak dollar, strong demand from emerging economies-the ‘new China syndrome,’ geo-political tensions, supply disruptions, unfavorable weather and increased production of ethanol.” Harris argued that the CFTC data showed no connection between commodity index fund investments and possible market manipulation. He noted in his testimony:

‘The absence of a link between fund positions and price changes suggest that global market fundamentals...provide a better explanation for the recent price increases.”

Another panelist at the Senate HSGAC hearing, Dr. Benn Steil of the Council of Foreign Relations and director of international economics told the panel that “no doubt” the oil and other commodity prices have been accompanied by a corresponding rise in interest from institutional investors. While noting the ‘fundamental factors’ that CFTC economist Harris testified to, Steil indicated that “these fundamental factors, as important as they are, cannot explain the magnitude of price rises in recent years”.  Steil put part of the blame for this shift on recent Federal Reserve monetary policy and indicated that this was “inducing people to buy commodities as a substitute for currency.”

The testimony of CFTC economist Harris so infuriated one Senator at the HSGAC hearing, Senator Clare McCaskill (D-MO), that she said:

“The people of America are about to pick up pitchforks. If I were Popeye, I’d give you a can of spinach to muscle up here.”

What is the expression of the cartoon character Pogo from the comic strip drawn by the late Walt Kelly? “We have met the enemy and they are us.”

The case of Amaranth Natural Gas bubble crash: Is the Enron loophole finally closed?

The Congressional Research Service released a recent report on CFTC Reauthorization. One of the topics addressed for consideration by the 110th Congress was Energy Derivatives. The author of the report, Mark Jickling noted the turmoil in the energy markets witness to underlying volatility, fraud and excessive speculation. The CRS report cited the California energy crisis of 2000, when a partially deregulated energy marketing system had been established. Enron had been among the energy trading firms found to have manipulated the California energy market. After Enron collapsed, fictitious trades and wash transactions were uncovered resulting in false accounting records. The CFTC had charged dozens of trading firms of manipulating natural gas pricing through such false and misleading information. Hedge funds and financial speculators were behind the natural gas bubble that exceeded supply and demand driven fundamentals. The CRS report noted a so-called regulatory gap “indicating that neither the CFTC nor the Federal energy regulatory Commission (FERC) has the requisite regulatory authorities to enforce “anti-fraud and manipulation rules.”  Of interest in particular was the OTC energy derivatives market of  which the CFTC has virtually no oversight.

In August of 2006, the Amaranth hedge fund cratered. It lost over $2 billion in natural gas derivatives and was forced to liquidate an $8 billion portfolio. The Senate Permanent Subcommittee on investigations of HSGAC in a June 2007 report found that the Amaranth hedge fund collapse triggered a steep decline in natural gas futures. To quote the Senate Committee report: “Amaranth’s large positions caused significant price movements in period before it failed.” The Report went on to conclude that:

Amaranth was able to evade limits on the size of speculative positions by shifting its trading from Nymex to exempt and unregulated markets. 

CFTC  chairpersons have repeatedly rejected that new legislative authority was required to eliminate this loophole. Acting CFTC chair Sharon Brown-Hruska in 2004 defended its record in enforcement against Enron and others engaged in false reporting of natural gas prices.

Congress didn’t fall for that after the Amarantha failure and the collapse of the natural gas bubble. The CRS Report noted that under amendments to the Farm Act HR 2419, awaiting enactment, a new regulatory agency regime would be created for energy derivatives subjecting them to ‘exchange-like regulation.’ Of particular interest would be multi-party transactions posted over electronic networks. The CFTC would be required to register these currently exempt markets thereby enabling it to enforce rules about disclosure, fraud and excessive speculation.”

Witness this comment from the Engdahl report about how trading on the London-based ICE compounded the Enron loophole:

In January 2006, the Bush Administration’s CFTC permitted the Intercontinental Exchange (ICE), the leading operator of electronic energy exchanges, to use its trading terminals in the United States for the trading of US crude oil futures on the ICE futures exchange in London – called “ICE Futures.”

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. 

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.

By not requiring the ICE to file daily reports of large trades of energy commodities, it is not able to detect and deter price manipulation. As the Senate report noted, “The CFTC's ability to detect and deter energy price manipulation is suffering from critical information gaps, because traders on OTC electronic exchanges and the London ICE Futures are currently exempt from CFTC reporting requirements. Large trader reporting is also essential to analyze the effect of speculation on energy prices.”

In a “Market Maker” column in the New York Times by Nelson Schwartz, he noted that Connecticut Democratic Congressman John Larson proposed legislation that would ban over-the-counter trading of energy futures by traders who do not intend to take delivery of the commodities.  NYMEX trading, subject to CFTC regulation would not be affected. But, as Schwartz notes: “billions of other trades could be brought to a halt.”  Larson has support from local suppliers of heating oil, gasoline and diesel who say that supply and demand is not determining pricing in the energy markets. There is also bi-partisan support for this action from Johan Barraso, (R-WY), who, while generally favoring less regulation, noted that “I think the price is higher than it should be, given supply and demand, and I’m looking at it to see if there’s manipulative speculation.”  So what does the Head of the Futures Industry association say about this:  “Election-year politics gives everybody an opportunity to feel the pain of the average consumer. Everybody would like to see prices go down, but limiting the (OTC Trading) activity in any market is a bad idea. Does Larson’s bill stand a chance? Probably not. 

Will the Farm Act amendments close the Enron Loophole given the London ICE OTC trading? We will have to wait and see if the Farm Act survives a Presidential Veto and is enacted with the new regulatory authorities for the CFTC.

What to do about the “swaps loophole.”

Senator Lieberman’s HSGAC hearing on oil and commodity future speculation identified the ‘swaps loophole’ as matters to be addressed.  Masters in his testimony at the Senate Committee hearings recommended that Congress move to close the swaps loophole "which speculators use to roll over monthly future contracts, allowing them to 'effectively circumvent position limits.'"

The CFTC issued proposed rules in November, 2007 to address so-called excessive speculation as defined under 7 U.S.C. sec 6a.

Excessive speculation in any commodity under contracts of sale of such commodity for future delivery made on or subject to the rules of contract markets or derivatives transaction execution facilitates causing sudden or unreasonable fluctuations of unwarranted changes in the price of such commodity.

Senator Lieberman’s Committee may hold hearing on this remaining loophole to gauge ideas and proposals for closing it. Some ideas as to how to address this are contained in the proposed Consumer First Energy Act of 2008 S. 2991, released on May 8th. Title V – Market Speculation has two provisions that endeavor to limit use of overseas OTC exchanges such as the London International Exchange (ICE) and limit the speculation by increasing margin requirements. The following is an excerpt from the legislative history of the proposed measure:

The Consumer-First Energy Act of 2008 would amend the Commodity Exchange Act to limit the price impacts of excessive speculation by preventing traders of U.S. crude oil from routing their transactions through off-shore markets in order to evade speculation limits and also impose reporting requirements.

Additionally, the bill would require the Commodities Futures Trading Commission to substantially increase the margin requirement on crude oil future trades within 90 days to limit excessive speculation and protect consumers. The current margin requirement varies between five and seven percent which essentially means that a commodity trader can control $10 million worth of future oil contracts by only putting $500,000 to $700,000 down.

 As Lieberman said at the May 20th Senate committee hearings:

At times it is in the public interest to limit the opportunity people have to maximize profits. A lot of the rest of us are paying through the nose as a result, including a lot of us who can’t afford to pay through the nose.


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