An Open Letter to Congressional Speculation Ban Proponents

It’s that time of year again. The weather is warming up, people are back on the roads, and gas prices are going up. This is when we’ve learned to expect a fair amount of “blame the speculators” rhetoric going around. The recent New York Times op-ed by Joe Kennedy is a perfect example of this type of bad argument, but goes far outside the bounds of the typical calls for position limits or curbing influence. No, Mr. Kennedy wants an outright ban on speculation- specifically, in the oil markets.

Now, this, in contrast to what we normally see, seems a little extreme, and, in the past, we may have just chuckled at the notion while shaking our heads at the flow of logic that a high school debate student would annihilate in 30 seconds. Unfortunately, crazy seems to be catching. Senators Sanders, Blumenthal, Cardin, Franken, Klobuchar, and Bill Nelson have proposed legislation that would force the CFTC to take “emergency” action to stop “excessive speculation” in commodity markets with pressure to eliminate it altogether… within 14 days. Representative John Larsen took it a step further, publicly calling on the President to take action personally should the bill or CFTC fail. Then you have House Democrats holding a panel on the subject, where former CFTC official and law professor at the University of Maryland, Michael Greenberger, joined ranks with Gene Guilford, head of the Independent Connecticut Petroleum Marketers Association, to continue the crusade.

Suddenly, crazy has legs.

Sanders, in a public statement regarding his proposed legislation, likened the bill to a similar one that received support during the height of the oil spike in 2008, and that, unfortunately is exactly what has us on edge. As poorly supported as the arguments presented by speculation critics may be, and as much as the data may be on our side, the fervor that surrounded the oil spikes in 2008 eventually manifested as the ill-fated Dodd-Frank position limits we saw imposed late last year. We know that these emotionally driven policy crusades, however silly they may seem to those who know better, can and do become law… and this is one instance where we can’t let that go without comment.

To be clear- do we think the ban will pass? No- too many what-ifs, maybes, and election year dramas to play out. But on the off chance that it does become a consideration, this had to go out, and through conversations with financial professionals from across the board, what began as a 500 word retort became a behemoth of a smack down.

We, alongside many other economists, analysts, traders and financial experts, have addressed the speculator argument time and time again, but, apparently, numbers aren’t getting through. So here it is- our open letter to policy makers regarding futures speculation and the bottom line.

Dear Current and Former Policy Makers,

In the wake of 2008, it has become a popular choice to blame rising gas prices on evil oil speculators. The argument, essentially, has been that if it were not for individuals buying and selling oil in an attempt to generate profits, the price of oil would be far more reasonable.

We understand why the argument is used. In some ways, it’s intuitive. After all, what business does a trader have in setting the price of such a globally important commodity? It’s also rather convenient, as it deflects attention from the impact of other policies in place that may cause or exacerbate tensions on the global stage. Unfortunately, your argument is also completely false.

This red herring may be a go-to tactic for you, but the fact of the matter is that the story you weave with such gusto has no foundation in reality. It completely ignores the inherent structure of trading, history, and logic. It covers a portion of the plot, but not its entirety. And with these new proposals you seem so hell-bent on pushing through… well, we believe an epilogue may be in order.

While we have attempted to explain this with numbers and charts, the language of statistical proof seems to be a foreign one in your world. You do, however, seem to have a penchant for dramatic storytelling, so allow us, if you will, to regale you with the saga these numbers paint in narrative form. Don’t worry- even though it’s based on those boring things called data points and facts, it’s actually quite the epic.

See, the numbers tell a story of a group of leaders who are largely confused by what, exactly, speculation is. They render speculators as the monster under our nation’s financial bed, placing bets so risky that they wouldn’t be allowed in Vegas casinos. However, the sub-trundle horrors that these leaders are warning of are just as fictional as those childhood spectres that haunted our nightmares.

Let us put this as simply as we can: speculation, in its most basic form, involves assuming a certain amount of risk based on belief of future benefit. And it’s something we all do.

If you go to the store around the middle of November, and you see a popular children’s toy is in stock when it’s been hard to find, and you decide to buy three of them now, knowing that you have friends and family with kids who will want it come Christmas, you are taking on the risk of overpaying for the items when you could have gotten them on sale during a Black Friday sale in exchange for the potential benefit of avoiding a potential stocking issue. That’s taking a calculated risk. That’s risking something as a result of your beliefs about the future. You don’t have hard numbers on what the supply and demand for the toy will be on Black Friday, you don’t know if you’re doing yourself a favor by buying today, and there is certainly sufficient supply for the demand at the time of that purchase, but you’re willing to spend and sacrifice that money now as a sign of belief in your projections.

These are the same principles exercised in financial speculation. An individual or institution, based on beliefs about the future of supply and demand in a given market, will take on a calculated risk (known as a trade) in an effort to preserve or expand capital.

The numbers tell a story where the innocent bystanders- commercial hedgers and producers- are just as guilty of the purported crime as the villain. The market participants that are considered hedgers are attempting to mitigate the risk of a price shock on their business by taking specific positions in markets. On face, this seems like legitimate business, right? That’s because it is- but it is also executed via speculation. Hedging is taking on a financial risk based on the belief of avoiding a greater risk in the future (read: deriving benefit). In order for someone to feel the need to hedge, they must speculate on future conditions and determine that a hedge is necessary. Innocent by your standards? Not so much.

We will grant that you are fiercely dedicated to your story. We often hear you often attempt to separate the “evil” speculators from these innocent hedgers through a false distinction of intended ownership. When a futures contract is traded, it is merely a piece of paper representing a commodity or instrument’s value at a future date. In the original version of this story, the good guys (or hedgers) are always looking to take physical possession on that future date, while the bad guys (speculators) are just greedy and looking for money. In fact, Mr. Kennedy explicitly points to them for blame, distinguishing them as,” “pure” speculators — investors who buy and sell oil futures but never take physical possession of actual barrels of oil.”

This black and white view of the markets is not only comically trite in terms of storytelling, but also wholly inaccurate. Mr. Kennedy allows that strategic hedging may be acceptable, and even necessary. However, those who are “hedging” are not looking to receive or deliver the underlying commodities of the contracts they trade. The idea behind hedging is to take on a position that is the opposite of what you are already in (typically in a physical sense)- providing a financial buffer in case things don’t go your way.

The numbers tell a story where policy makers have no comprehension of how supply and demand factor into market movements, but are quick to assert that the markets don’t rely on them anymore. We understand that these basic principles are very complex, so we’ll start by using pictures to guide you through this story.  Take a look at the chart below. You should be familiar with it; we see you pointing to a similar chart each time you reference the all too fresh pain experienced in 2008 and the years preceding, where oil prices jumped an astounding 526%.

Source: US Energy Information Administration

This chart gives you the statistical enumeration of the pain at the pump that so many consumers- including ourselves- have felt. But since we’re such fans of artistic storytelling, we can obviously agree that a line chart doesn’t tell the whole story. Let’s blow this up and take another look, shall we? Go ahead and click the chart to see the bigger version- it won’t bite.

Source: US Energy Information Administration

Now that’s more like it! You’ve got violence, suspense, trauma, and disaster- all the makings of a summer blockbuster. Coincidentally, they are also the spitting image of the types of macro events that would cause oil prices to spike- trends and incidents that called into question global demand, production capacity, and transportation security. But, that couldn’t be, could it? After all, that would mean the market is responding to supply and demand elements, and that… well, that’s just crazy talk.

When you look at that second chart, the assertions you put forward regarding the market’s disregard for supply and demand seem a little silly, but they seem even more foolish when looking at the way in which the public conversation is framed, as it highlights an incomplete grasp of these all important concepts.

There are two general ways in which supply and demand is misunderstood by you. The first is in terms of cost of commodity purchase versus cost of collection. Mr. Kennedy states, “Because of speculation, today’s oil prices of about $100 a barrel have become disconnected from the costs of extraction, which average $11 a barrel worldwide.”

Mr. Kennedy, you are a business man, and a busy one at that, so we will forgive you your confusion. The relationship you are referencing is a function of computing cost relative to return on business operations. This is not the same as supply and demand. Just for your reference.

The second mishap is a more common one, and it relates to the idea of calculating only physical supply and demand versus a holistic approach to supply and demand metrics. Senator Sanders falls victim to this classic error, arguing, “The supply of oil and gasoline is higher today than it was three years ago, when the national average price for a gallon of gasoline was just $1.94.”

The first half of the misstep is that these supply metrics are being calculated based off of physical supply. While this is obviously an important element on the supply side, the Senator’s leading statements ignored the other factors at play. With gas, in particular, prices are only partially based on the price of oil- things like taxes, refining costs, refining capacity, costs of complying with environmental regulation and so forth are what get you from a $100 barrel to a $4 gallon of gas.

The second half is that this presentation ignores the forward looking nature of supply and demand analysis in the futures markets. If trading a futures contract is assuming risk based on what you think might benefit you in the future, then the physical supply and demand of today is not always as important as the projected supply and demand of tomorrow. That is why physical supply and demand metrics are not always exactly in sync with price movements. We’ve already covered how even the commercial hedgers are acting under these same impulses, so we won’t bore you with repetition.

The numbers tell a story where people regulating markets do not understand how they operate. Our leaders proclaim that speculators are responsible for nominal amounts of price changes, citing reports in the same vein, which they claim enumerate the role of the speculator in the cost of oil. Unfortunately, they interpret these numbers without understanding the context in which they are calculated. We wish it was one simple mistake being made, but it tends to vary by report, so we’ll break down the big issues.

First, let’s take a look at the popular Goldman report from earlier this year, referenced by Senator Sanders as proof positive of the speculative impact. The Goldman report posits that there is essentially a $10 premium added to the cost of a barrel of oil by speculative trading. The way they reference speculation, however, is in the more general sense; they’re talking about people trading based on supply and demand expectations instead of physical stores and consumption. They refer to this as “risk premium”- meaning that it is based on perceived risks that supply could drop or demand could spike in the future. Given that this type of speculation is not based on the distinction drawn by you regarding commercial traders and your evil speculators, this is a reflection of market fear for the future, and not a particular class of traders. The same is true of the metrics reported on during last year’s Congressional testimony from Exxon.

Then you have statistics derived with even less context. Usually, we see leaders citing CFTC or CME reports, and drawing conclusions from those numbers. The reason these conclusions are typically inaccurate is because they are viewing the numbers here in the same way that they would view stock transactions. They equate the world of futures trading to the world of stocks, where purchasing stock is, in many ways, the purchase of an asset. It’s yours, it stores value, and you can do with it as you please. Here’s the problem- futures trading is not like stock trading. The nature of futures trading is perhaps best simplified through the name of instrument that is traded- a futures contract. It is a promise to buy and sell between two entities, and cannot exist without someone on the other side. A contract without two or more parties wouldn’t do much of anything.

What does this have to do with the speculator’s impact on oil and the reports that add it up? It has to do with how you’re calculating it.

It may be argued by some that the bulk of your evil speculators are on the buy side at the moment, but it ignores that “it takes two to tango” element involved in a futures contract, mistakenly likening the process to buying and selling stock. In order for these evil speculators to buy, there has to be someone on the other side willing to sell- which is presumably where all of the sainted commercial hedgers reside. This isn’t necessarily true; you will, on occasion see hedgers on opposite sides. Maybe they’re over or under supplied relative to the general hedging population in a market- doesn’t matter. There can and will be differences. But even when they’re not, because they are participating in those trades each and every time, on one side or another, the hedgers contribute to the price movements, as well. However, with Mr. Kennedy claiming that only 30% of market participants are actual members of the oil industry, speculators cannot be completely to blame anyway.  It is statistically impossible for there not to be evil speculators on the sell side of the futures contract trade- selling oil in the belief that prices will go down.

The truth is that, in the zero sum game of futures trading, if you’re going to blame speculators for high prices (which they’re trading based on those beloved supply and demand numbers and projections), you’ve got to blame them for the downside, too. And yet, where was the jubilation on March 29th this year, when oil plunged nearly $2 in a day? Where was the celebration from July through October of last year, when prices fell around 30%? Where was the parade for these speculating heroes when prices plummeted over 70% in the last half of 2008- undoing in a price buildup of 5 years in six months? Has anyone seen Natural Gas lately?

You can’t have it both ways. If speculators are responsible for jumps in price, they are also responsible for downturns.

The numbers tell a story in which the evil speculators facilitate risk management for producers and refiners. Russ Rausch, COO at Emil Van Essen, LLC and veteran of the oil futures trading game, explains it rather concisely. These markets were developed to create a venue for producers to hedge the risk of a price movement in a specific direction. But risk doesn’t go away- it is shifted, and someone has to be willing to take it on. Futures markets create a pool of willing participants in this world of shifting risk, and eliminating this pool would leave producers exposed to the full blast of a potential price shock.

The numbers also tell a story where the added volume improves liquidity and limits the probability of sharp price shocks that would send consumers reeling. The body of academic literature on this subject is vast enough to fill a never-ending literature review, but we will spare you that list. Instead, since you are so fond of the narrative approach to policy making though, perhaps we can arrange for you to listen to the thoughts of the thousands of commodity trading advisors we work with. They would be happy to tell you why, as professional money managers, they do not participate in markets with limited liquidity. They could probably go on for hours about the risks associated with the severe movements seen in under-populated markets like Lumber and Orange Juice. True, Mr. Kennedy, you may be able to replace your orange juice with apple juice, but its market dynamics present a cautionary tale that you should be listening to- and we can arrange for that, should you like. It may put a crimp in your campaigning schedule, but if it’s in the name of better policy development, it’s worth it…  right?

Senator Sanders points to the fact that 80% of the oil futures market is now comprised of speculators. While conversations with the CME and reference of the CFTC’s Commitment of Traders report negate these figures (not to mention Mr. Kennedy’s assertions), in a world where we assume them to be accurate, what happens to the remaining 20% of traders when the ban takes hold? Forgetting for a moment that there will no longer be anyone available and willing to take the other side of these risk-mitigating trades, do you truly believe that having 80% fewer participants vetting the price discovery of a market is going to protect us from larger price shocks?

Without the structurally essential transparency that a liquid futures market provides, you limit the amount of eyes watching the trades that set these prices. As the recently more popular saying goes, corruption is authority plus monopoly minus transparency. Again, we understand that Congress is not especially partial to things like data and statistics, but is that equation simple enough to follow?

We know it sounds a bit harsh to say that this data is ignored, but it is the only way to describe the means in which it has been handled. While we, and others, have taken the time to deconstruct the arguments and data points you and your statisticians have provided, you have yet to directly refute the data or logic behind these benefits speculators provide to the markets. For instance, Mr. Kennedy directly acknowledges these benefits, and in response, repeats his assertion that speculators are increasing price. Even in a world where this was accurate (and at this point, we know it’s not), it doesn’t respond to the benefits of liquidity, transparency and protection from price shocks. Mr. Sanders is more explicit of his subjective dismissal, stating he simply “believes” the high impact numbers are accurate.

This is a willful ignorance of the facts by those who are charged with determining policy in the best interest of the country. That’s scary.

But it’s also demonstrative of an unwillingness to take responsibility for the consequences policymakers have created. It is exceedingly easy to weave a story based on misconstrued data. It is far more difficult to own up to the impact that your policy decisions have had on your constituents. We won’t waste your time with a laundry list of U.S. policy decisions that have exacerbated global geo-political tensions, but to ignore the impact of those decisions on the uncertainty that drives up oil prices is naive at best and delusional at worst.

And before you begin to dismiss those explicit foreign policy issues as outside of your purview, remember that if you have voted, at any point in the past decade, for a bill that added to the national deficit, you are culpable. If you were in office during the debt debacle last summer that culminated in the downgrade of our credit rating, you are culpable. You have contributed, in a meaningful way, to the weakening of the U.S. dollar.

Not biting? 2008, your go to example for speculative malfeasance, was, in many ways, a product of this weakened Dollar. Oil at $140 a barrel was ugly, but had the currency maintained its value from 2001, let’s just say our pocket books wouldn’t have been hurting quite so much..

Source: US Energy Information Administration and U.S. Inflation Calculator

They say that pride goeth before the fall, and while we understand not wanting to claim your role in the rise of oil prices, please do not think that we, or anyone else, are unaware of the fall that concerns you. Election Day is mere months away, and the voting populous is displeased with the state of the economy.

John Highland is the CIO of United States Commodity Funds. They operate USO– the largest and most actively traded oil fund in the States. He was exactly on point when he stated, “This is not a fact-based discussion- it’s about election year politics. It sounds good to a certain part of the voter base to say that oil is where it is because of evil bogeymen, but [it doesn’t to say it’s because] of limited growth, or because China is sucking up the spare oil to stick it in their strategic reserve, or because everyone’s assuming that there’s going to be a war breaking out in the Persian Gulf. From a political stand point, it’s a good thing [to find] some scapegoat, and say that this has nothing to do with our policies.”

Let’s pause for a recap. Leaders who do not understand how futures trading works, what speculation is, or how supply and demand interact, are pushing for a ban on a type of trading they cannot nail down, for an impact they did not cause, while ignoring the benefits they provide to the marketplace, all as a part of an electoral play. What a story.

But let’s say we imagine a world where, despite the facts, we consider this ban on oil speculation anyway. The problem with this scheme is that, even in a world where evil speculators were a problem, your plan wouldn’t work.

For starters, you’re looking at the wrong people. Yes, the futures market is large, but look at the largest players in oil, and you’ll find that they play their games off the exchange by using over-the-counter (OTC) trading. Dodd-Frank regulation on swaps may address this to some extent, but the language of the swap requirements was more vague than it was constructive, and the bulk of these major players are not based in the U.S. or subject to our rules. Your concern is market manipulation? They’re the ones you’re looking for– not the futures traders already thoroughly regulated via position limits and the like. Even in a world where a ban eliminates the hedging exemption referenced by Senator Sanders, there’s no reason these financial institutions won’t continue their bids alongside these movers and shakers overseas.

And just because you stop futures speculation here does not mean that it will stop overseas. Peter Brandt, CEO of market research firm Factor, LLC, financial blogger, author, and 30 year commodity futures trading veteran, points to a recent global volume report highlighting the burgeoning futures markets abroad, underscoring the fact that the CME and ICE are not the only game in town. The oil market is too big and too important to too many of these evil speculators of yours, and there are too many foreign entities more than willing to fill the void presented by your regulations.

So what do you achieve? The transfer of trading revenue to other nations? A competitive loss for the U.S. during a period of economic strain? That, combined with your inability to actually impact oil prices through a speculation ban, will make a great campaign slogan: “Vote for me! I transferred sources of American revenue to our global competitors, and am powerless over your expenses at the gas pump, but hey- I care!”

But since we’re already playing pretend, let’s imagine what the world would look like if you did, somehow, totally ban all oil futures speculation across the world, period. Your goal was decreased oil prices and volatility, right? Highland thinks you’re dreaming.

“If taken to the extreme of banning all speculation, you’d shut down NYMEX. If there’s no speculative section of the market, you don’t have a futures market,” Highland postulates. “We go back to the 1970’s where OPEC posts the price of oil. You don’t like it? Tough. Maybe we go to a market like Iron Ore, where six private companies hold shadowy negotiations to set the price in an opaque manner. The third choice is that you have more participants involved, but because of the inability for players to hedge their positions, you’d be far more susceptible to higher price volatility, and, on average, higher prices.

“No one will finance an oil company at the current rates in this scenario, but if we assume that they would, all the sudden, you can no longer [transparently evaluate the prices as collateral], so you either charge them more, which leads to higher prices [transferred to the consumer], or you loan them less, which will lead to less capacity coming on stream.”

So either we go to a dictated price, a shadowy oligarchy determined price, or a small market that’s rolling dice and exposed to maximum risk, all of which lend themselves to higher price volatility. Oh, and financing complications are going to ramp up prices no matter what. So, even if you win and your solution gets put into play, you lose.

But since we mentioned the idea of the NYMEX shutting down, let’s talk about what you’d do to jobs. IHS released a report which detailed the impact of trading limitations- not even an outright ban- in the energy sector. Their take? Severe limits alone would have such an impact on liquidity, price volatility and transparency that we’d be staring down massive costs to our economy- well beyond the bounds of these evil traders losing money.

Source: IHS

Again, this was just derived off of limits being put in place. So, assuming your ban actually works, odds are you’re looking at substantially higher losses in these arenas.

But IHS excluded the financial industry from its calculations in job losses, and while we know you revel in using us as blood sucking cretins in your cast of characters, whether you like it or not, we get calculated into the nation’s overall employment rate. In a world where that total ban goes into place, you just put every trader who has dedicated his or her life to oil trading; every oil broker; every oil analyst- out of a job. You just took a massive chunk out of FCM and exchange revenues. You just killed off dozens of fund and ETF products that rely on oil speculation- products that are responsible for employing countless analysts, traders, sales people, support staff and others on their own. So not only have you failed in achieving your goals, but you have added to overall unemployment when that rate is already high enough to hurt you in the polls.

The final, most chilling potential outcome is, we will admit, a bit extreme, but its punch is so powerful, it should be enough to make you think twice. Brandt put it concisely:

The problem is that ending oil speculation doesn’t just end futures trading in oil- it kills the entire futures industry.

You try to nuance this to banning oil speculation, but the text of the legislation you have proposed is not specific to oil- it is inclusive of all markets. You do not define what “excessive” speculation is. Mr. Kennedy tries to indicate that speculation in other markets, such as Orange Juice, wouldn’t matter or draw such ire because, essentially, people can switch over to apple juice. But what of corn? Or wheat? Or copper or gold or any other contract? Some of these do not have an interchangeable alternative, and by setting the precedent for banning speculation, you set us up for a similar death knell the next time food prices spike. We already heard such pleas a year ago. Given how reliable your data is, I’m sure you won’t be surprised that the U.S. agricultural stock data is questionable at best, and with increasing demand for food worldwide, the thought of “next time” being right around the corner for another spike is not so far-fetched.

These are not onion markets and this is not the 1950s. These are financial superhighways that people rely on, and that employ hundreds of thousands of people around the globe. Try explaining destroying an entire industry to your constituents- without any derived benefit AND higher prices for them– and let us know who you think is the REAL boogeyman in all of this.

Bottom line? You are playing with fire. Realistically, it’s more like a toddler playing with a flamethrower in the center of a gasoline-soaked wooden structure, built on the plains, in the middle of a drought.

We hope you have enjoyed story time with Attain. Were you paying close attention? We hope you were, because there is a moral to this story that is important to you and anyone else reading this letter.  You folks are artful storytellers, to be sure, but our concern is what story the history books will tell in 20 years. With the path you have us on, we don’t want to read the ending.

Please get your act together.





Further Reading:

IHS Report on Volcker Rule

EDHEC’s “Oil Prices:  the True Role of Speculation”

Foreign Affair’s “In Defense of Speculators”



One comment

  1. […] Highland, CIO of United States Commodity funds, explained in a post we put out on oil speculation several months ago, “We go back to the 1970′s where OPEC posts the price of oil. You don’t like it? Tough. Maybe […]

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