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The misguided witch-hunt for oil speculators
Vaughn Cordle, CFA / July 14, 2008
The Airline Transportation Association’s (ATA) current claim that speculators are driving oil prices higher is based on the naive
assumption that speculators do not respond to prices and when they do, they respond incorrectly buying at ever higher prices.
(Exhibit # 1) In reality, the commodities market is working as it is supposed to work. As intended, when the market expects
commodity prices to move higher and communicates that message swiftly and clearly, investors do shift more capital into those
rising commodities.
With the assistance of AirlineForecasts researchers, I examined dozens of studies and the forecasts, opinions, and analyses of
over 70 oil experts. As expected we found no/little evidence that speculators are responsible for today’s high oil prices. Most experts
and interest groups, such as the International Energy Agency (IEA), tend to dismiss or discount the impact of speculation on the
price of oil. The IEA’s most recent report offers the following scenario: “Like alchemists looking for a way to turn basic elements into
gold, everyone wants a simplistic explanation for higher prices. Often it is a case of political expediency to find a scapegoat for
higher prices rather than undertake serious analysis or perhaps confront difficult decisions.” People naturally look for popular
political solutions and politicians reflect and respond to whatever their constituents want, especially in an election year.
Unfortunately politicians are too quick to pass laws that produce short-term political benefits, but longer-term market distortions and
economic pain.
There are a great many oil bears, including a number of prominent analysts and economists who offer a too simplistic and incorrect
rationale for why oil prices should be lower. The bulls have the more compelling argument in my view. The International Energy
Agency believes that the gap between supply and demand could widen by as much as 12.5 million barrels a day by 2015 and as
long as the dollar remains weak, the price of oil will remain high. When those assumptions of the applicable fundamentals change,
investment flow into the spot and futures markets will also change. As an example, and based on AirlineForecasts' analysis, if the
dollar appreciated 10%, the price of oil should fall by $30 to $40 per barrel. However, as long as short-term interest rates in the U.S.
remain below the rate of inflation, and interest rates in other countries, it will take more dollars to buy a barrel of oil. Moreover, as
long as the U.S. has a large current account deficient, the dollar will remain weak.
Using these findings, AirlineForecasts concludes that record high oil prices are being driven by three primary influences: (1)
restricted and limited supplies, (2) strong demand, and (3) a weak dollar. Structural demand growth in developing countries and
ongoing supply constraints have produce a tight market for oil, which is based on inventories below 5-year average and strong
global demand. Additionally, poor supply growth since 2004 because of under investment in non-OPEC countries, combined with
strong demand from developing countries and a significant depreciation of the dollar has acted worldwide to force oil prices up
sharply. Oil prices averaged $111 per barrel in the first half of 2008, up 54% from 2007's $72 per barrel average. Oil prices
averaged $123 in June and rose to an historic high of $147 in early July. AirlineForecasts is estimating that oil prices will range
between $130 and $140 in 2008 and around $135 in 2009. This is the current base-case, but these prices are a moving target
which must be updated constantly to take into account changes in the fundamentals.
Michael Masters, ATA's key expert and fund manager, makes the case that oil prices will fall as much as 50% or $30 to $70 per
barrel if new regulations are passed that prevents speculators (non-commercial investors) in futures market. In essence, he
argues that speculators are driving oil prices higher than the levels justified by the fundamentals. That above-market price increase
is based on an artificial demand that simply adds to normal commercial demand. In other words, higher prices will result when
commercial demand is further supplemented by speculative demand. Except for the strategic petroleum reserves held by
governments, all of the oil produced in the last several years has been purchased and used by consumers, not speculators.
This growth in commercial use of oil is evidence that high oil prices are driven by real-world fundamentals and not by speculators,
as defined by the Commodities Futures Trading Commission (CFTC).
Wall Street’s definition of a speculator is different then the definition provided by the CFTC, but is the definition Masters is using to
make his case. The CFTC defines speculators as investors in the futures markets who do not take physical delivery of the
underlying commodity. The word as it relates to Wall Street's view of what rational investors do is best interpreted by Benjamin
Graham, the author of Security Analysis. "An investment operation is one which, upon through analysis, promises safety of principal
and a satisfactory return. Operations not meeting these requirements are speculative."
Masters makes the case that speculators will invest in the futures market, regardless of price, an idea that corresponds with
Benjamin Graham’s definition of speculator -- an investor who does not do a thorough analysis before investing. The flaw in Master’
s argument, however, is that hedge funds, institutional investors, and even small investors are shifting capital into commodities and
futures markets as a rational, financial approach to hedging their risks, inflation concerns, in addition to the pursuit of a profit. Any
investment is based on market fundamentals, not simply because prices are rising, as Masters claims in his analysis. Moreover,
no hedge or mutual fund manager would ever invest in the commodities market without matching that investment with a negatively
correlated asset or employing other hedging methods. This type of risk management is the essence of modern portfolio
management and is required to lower risk and improve return for the entire portfolio of assets.
Speculators are not the cause or the driver of high oil prices.
If unsophisticated speculators or manipulators did push oil prices in the futures market above a level that balances supply with
commercial demand, an oil glut would occur, then causing the commodity to be hoarded for future sale. Indeed, if speculators have
succeeded today in driving the price of oil above the level justified by its true fundamentals, it would follow that current global output
should exceed world consumption. If this unlikely scenario were the case, however, then commercial and financial investors would
now be hoarding tremendous amounts of oil. The produced oil would be going somewhere as non-commercial investors in the
futures markets would not need to take physical delivery. If there were no hoarding, a situation that implies that commercial
consumers are purchasing every barrel produced, then the world price of oil would be justified, again based on fundamentals.
It is very clear after examining US oil inventory data that there has been no physical accumulation of oil during the dramatic doubling
in price over 2007’s average. Clearly, speculators are not "hoarding" oil and keeping it off the market with the intention of driving up
prices. Rational investors and hedgers don’t “hoard” oil in warehouses; they try to predict where prices will be in the future and
make money off the change in price. Again, it’s important here to clarify that the very word "speculator" is a misnomer as it relates to
investors and hedgers in the futures market. The technical definition is used instead to reference the CFTC definition of non-
commercial investors, those who never take actual physical delivery of the underlying commodity. A speculator, as traditionally
defined by Wall Street, refers to an unsophisticated investor who does not do a thorough analysis of risk and return.
Masters claims that "index speculators have now “stockpiled,” via the futures market, the equivalent of 1.1 billion of barrels of
petroleum." (Exhibit # 2) He bases this misleading statement on the market prices of contracts and oil. Large investors buy futures
contracts in oil, but then roll them over before taking actual delivery. When futures contracts for July, for example, near maturity, the
investor will sell the contracts to a commercial user and then apply the money they receive to August contracts. The non-commercial
investor is thus just an intermediary who succeeds or fails based on the direction prices do take. Regardless of that direction,
however, the sold oil is ultimately delivered to the consumer who then uses it.
Contrary to the position advanced by Masters, non-commercial investors [i.e., CTFC speculators] in oil futures provide stability in the
markets. By buying low and selling high, these investors can help pull up lower prices and push down higher prices. Their actions
reduced price volatility, an effect that in turn reduces prices over time. Masters, however, argues that the same benefit is not the case
with index speculators: “Speculative investing explains the accelerating rate at which commodity futures prices (and actual
commodity prices) are increasing. Rising prices attract more Index Speculators, whose tendency is to increase their allocation as
prices rise. So their profit-motivated demand for futures is the inverse of what you would expect from price-sensitive consumer
behavior.” (Exhibit #3 )
Reality, however, is markedly/quite different. CalPERS invested $1.3 billion in energy because fund managers believe that
commodity prices, and their volatilities, provide an attractive investment relative to stocks and bonds. This is exactly what rational
investors are supposed to do when increased demand for commodities combined with tight supplies result in higher future prices.
As long as the market continues to believe that oil prices are headed higher, investors who push up spot prices provide a valuable
and necessary benefit, which will eventually result in greater production and less consumption and down the road lower prices for
oil. CalPERs does not meet the Wall Street definition of a speculator because its fund managers do a through analysis of risk and
return on the investment. Speculators do not.
On his part, Masters again misjudges how the markets actually work by asserting that "Index Speculators buy futures and then roll
their positions by buying calendar spreads. They never sell. Therefore, they consume liquidity and provide zero benefits to the
futures markets." (Exhibit # 4) This is simply not the case. For example, if CalPERS determines that 1% of its funds in oil futures is
a smart investment strategy and prices do rise, then the total value of those funds also increases. However, if the share of oil futures
rises disproportionately, then that same allocation will be higher than 1%. If the price increase fails to change the CalPERS views of
the future, then during the next rebalancing, the fund will reduce its holdings in oil futures. In other words, this so-called speculator
will become a net seller. Quite the opposite will hold true of course if oil prices fall since the fund will then buy additional futures
contracts to restore its desired 1% allocation.
Masters appears to dismiss the benefits of the liquidity provided by investors and misleads or misunderstands how non-
commercial investors rebalance their portfolios as prices change. Without institutional investors such as CalPERS, refineries and
other oil consumers would have no alternative but to find another physical consumer willing to buy the futures contract at the precise
time the refinery chose to sell them. If it couldn’t find these buyers, the refinery would have to sell small contract quantities to other
consumers. Here, non-consumers act as middlemen who relieve the refinery of the burden of searching for consumers to buy or
sell their contracts. In other words, institutional investors and financiers provide significant value to the function of market supply and
demand. They do this by buying and selling excess contracts at various prices before the delivery date.
Masters’s core argument that "index speculators" are to blame for rising commodity prices does not hold up in the real world. Prices
for commodities without any active futures markets are rising faster than prices with active markets. Steel is a key example, but rice
and dozens of other commodities strengthen this point as well.
Masters, the ATA, and a smattering of Congressmen, including Senator Obama, are busy claiming that institutional investors and
big Wall Street firms are manipulating the markets through "excess" speculation. Demagoguery and misunderstanding of how the
commodities markets actually work then unite to create a political/convenient scapegoat, which succeeds in shifting the real blame
for high oil prices. In large measure the real blame can be linked to Government monetary policies and the lack of a national energy
plan. Without a doubt, the US has had no specific energy policy for decades, and this failure in reality may be the heart of "excess"
energy consumption in the U.S. It also explains the current inadequate oil production, which has now declined substantially in
recent years. In today’s global economy, the absence of a national energy policy is a lack of Government leadership, which has not
yet been able to forge a political compromise to allow it to create with a coherent set of practical solutions to meet both excessive
energy consumption and inadequate supply.
Financial investors in futures markets who intend to make profits but not take physical delivery of the actual commodity provide
liquidity; but they certainly are not the cause of high oil prices. By my estimates, US policies that have succeeded in allowing the
dollar to weaken considerably accounts for approximately $50 or 35% of the current price of oil. Additionally, between $10 to $20 or
around 10% is an appropriate "risk premium" for the high probability of supply disruption risk. This risk premium should be
considered an appropriate component of the spot and forward curve in the futures market. Why you ask? As long as the risk of
geopolitical and supply disruption remains high, the market must account for this 10% risk with a higher price because supply
disruptions always increase price volatility. The distinction, however, is that this risk premium is not based on speculation but on a
greater uncertainty of future oil prices when/if supplies actually do disrupt.
Taken together, the risk premium and the weak dollar are approximately $65, or nearly 50% of the current price of oil. This
combination exchange rate and risk premium provides clear evidence that high oil prices are not simply a function of "excess"
speculation or market manipulation as claimed by Masters and the ATA. Rather, it is simply a pure function of oil market
fundamentals. The difference in price, from $21 average over the years between 1985 and 2003 to the $72 average in 2007 was
driven by the perception and reality that the gap between supply and demand was widening. It follows logically then that ATA's
political push to restrict non-commercial investors from the futures market today is definitely the wrong solution to bring down the
price of oil form its current $130 to $140 range. In fact, any government restrictions that are intent on preventing non-commercial
investors from investing in futures markets will do nothing to ease oil prices in the long run and to the contrary, may cause them to
rise even further. Such restrictions will hurt consumers even more by making the oil market even less efficient.
The principles of economics should teach us that tight markets keep prices high. Therefore, as long as the dollar continues to
weaken against foreign currencies, or those currencies strengthen, US consumers will remain the weaker bidder with little choice
but to pay the highest price for increasingly scarce commodities. The other economic [policy] choice, however, is to increase
domestic production because we can then buy out own energy, and at the some time bring down the price of oil. Another positive
economic result of increasing domestic production is increasing domestic employment. The third positive result if that by
increasing our own production, we can reduce our over $700 billion a year trade deficit and thus over time reduce that negative
impact on value of the dollar. It appears that both the politicos in Washington and the ATA have not caught up with this "crude"
reality, or have been mislead by some who are misinformed or sadly have a vested interest in the outcome of their political
“solution.”
Business Week (Exhibit # 5) has reported that Masters has 20% of his fund in airline and auto call options, stocks that could
increase significantly in value if oil prices did fall as a result of new Government rules restricting non-commercial investors in
futures markets. Typical funds invest no more than 3% to 7% in commodities so one would have to assume that Masters has
chosen to take exceptionally large and focused bet via his investments that oil prices are headed lower. This bet is a major conflict
of interest in terms of his present advocacy of new rules that he believes would have a major impact on oil prices and thus fuel
costs.
The current economic storm that encourages politicians to shift the blame for high oil prices may well yield short-term political
benefits, but it will not change the basic fundamentals of supply and demand, which will continue to play out as always. Nor will a
political “blame game” change the price of oil on the world market. To the contrary, any new rules that restrict financial investors in
the futures markets will produce greater volatility, less liquidity, and probably even higher oil prices over time. Moreover, investors
will simply find other ways to invest in oil. Regardless of the Congressional actions ultimately taken in Washington and forced upon
the CTFC as a result of the ATA initiative, such tactics that attempt to halt valid and appropriate investments and curtail positive risk
management by investors large and small (i.e., hedge strategies using futures) represents political expediency that will likely have
unintended longer-term negative consequences.
The political push by ATA is simply the wrong strategy. While it may sound good on the surface and for the short term, it is an
unsupported notion that claims that neither basic market fundamentals nor the weak dollar are responsible for the dramatic run-up
in oil prices. ATA's campaign to quickly "educate" and encourage the public to write their Congressional representatives in a
grassroots effort to change Government policy is a valuable lesson in how politics works in the United States today. Certainly, the
ATA deserves an "A" for political savvy as its efforts have resulted in a flood of emails and letters to Congressmen. However, the
ATA is communicating flawed logic by associating the actions of speculators too simplistically with higher oil price, and
broadcasting the implication that it will take new rules to reduce those prices substantially. For this effort, ATA gets a well-deserved
“F.” Unlike Masters’s claim that the high price of oil is driven by unsophisticated speculators who disregard price, risk and
underlying fundamentals, the truth about what’s driving oil prices higher is not so difficult to understand.
The ATA and Mr. Masters are chasing the wrong boogeyman. They falsely claim that 50% of the price of oil is driven by speculators.
Their bizarre logic is motivating a political push to regulate the futures market, but it is not based on sound economic principles. In
reality, the involvement of large financial investors provides the needed stability and liquidity to price oil and other commodities in
world markets. Regulations that are simply enacted to choke such investment will only succeed in creating less liquidity and higher
volatility in the futures market. The even more damaging result of blaming excess speculation for high oil prices will be a shift of
Government efforts away from identifying the real problems behind high oil prices and generating practical solutions and climbing
on the bandwagon of false hopes.
Washington's recent politically expedient efforts to constantly bail out industries, consumers, and Wall Street banks, is a primary
reason the dollar has been debased and US consumers pay dearly for oil. The lack of leadership in regards to an effective national
energy policy have resulted in a country ill-equipped and prepared to handle significantly higher energy costs. Short-term fixes that
focus on the effects of this inactivity and irresponsibility can only cause even more damage in the long term and more disruption.
The country needs a coherent and effective energy policy that will result in less dependence on foreign oil and less energy
consumption. Priority Number One should be to lift the restrictions on land access and offshore and onshore drilling, efforts that
require both President Bush's signature and Congressional approval. President Bush has done his part with his Executive order
lifting the restrictions, now it’s time for Congress to do its part. The oil futures price curve would fall immediately if Congress lifted
the restrictions, which in turn would bring down the spot price of oil. This would occur even as it takes 5 to 10 years before oil could
be produced. Why? Because oil prices are in large measure a function of future supply and demand.
©Copyright 2008 AirlineForecasts, LLC All Rights Reserved
Vaughn Cordle, CFA / July 14, 2008
The Airline Transportation Association’s (ATA) current claim that speculators are driving oil prices higher is based on the naive
assumption that speculators do not respond to prices and when they do, they respond incorrectly buying at ever higher prices.
(Exhibit # 1) In reality, the commodities market is working as it is supposed to work. As intended, when the market expects
commodity prices to move higher and communicates that message swiftly and clearly, investors do shift more capital into those
rising commodities.
With the assistance of AirlineForecasts researchers, I examined dozens of studies and the forecasts, opinions, and analyses of
over 70 oil experts. As expected we found no/little evidence that speculators are responsible for today’s high oil prices. Most experts
and interest groups, such as the International Energy Agency (IEA), tend to dismiss or discount the impact of speculation on the
price of oil. The IEA’s most recent report offers the following scenario: “Like alchemists looking for a way to turn basic elements into
gold, everyone wants a simplistic explanation for higher prices. Often it is a case of political expediency to find a scapegoat for
higher prices rather than undertake serious analysis or perhaps confront difficult decisions.” People naturally look for popular
political solutions and politicians reflect and respond to whatever their constituents want, especially in an election year.
Unfortunately politicians are too quick to pass laws that produce short-term political benefits, but longer-term market distortions and
economic pain.
There are a great many oil bears, including a number of prominent analysts and economists who offer a too simplistic and incorrect
rationale for why oil prices should be lower. The bulls have the more compelling argument in my view. The International Energy
Agency believes that the gap between supply and demand could widen by as much as 12.5 million barrels a day by 2015 and as
long as the dollar remains weak, the price of oil will remain high. When those assumptions of the applicable fundamentals change,
investment flow into the spot and futures markets will also change. As an example, and based on AirlineForecasts' analysis, if the
dollar appreciated 10%, the price of oil should fall by $30 to $40 per barrel. However, as long as short-term interest rates in the U.S.
remain below the rate of inflation, and interest rates in other countries, it will take more dollars to buy a barrel of oil. Moreover, as
long as the U.S. has a large current account deficient, the dollar will remain weak.
Using these findings, AirlineForecasts concludes that record high oil prices are being driven by three primary influences: (1)
restricted and limited supplies, (2) strong demand, and (3) a weak dollar. Structural demand growth in developing countries and
ongoing supply constraints have produce a tight market for oil, which is based on inventories below 5-year average and strong
global demand. Additionally, poor supply growth since 2004 because of under investment in non-OPEC countries, combined with
strong demand from developing countries and a significant depreciation of the dollar has acted worldwide to force oil prices up
sharply. Oil prices averaged $111 per barrel in the first half of 2008, up 54% from 2007's $72 per barrel average. Oil prices
averaged $123 in June and rose to an historic high of $147 in early July. AirlineForecasts is estimating that oil prices will range
between $130 and $140 in 2008 and around $135 in 2009. This is the current base-case, but these prices are a moving target
which must be updated constantly to take into account changes in the fundamentals.
Michael Masters, ATA's key expert and fund manager, makes the case that oil prices will fall as much as 50% or $30 to $70 per
barrel if new regulations are passed that prevents speculators (non-commercial investors) in futures market. In essence, he
argues that speculators are driving oil prices higher than the levels justified by the fundamentals. That above-market price increase
is based on an artificial demand that simply adds to normal commercial demand. In other words, higher prices will result when
commercial demand is further supplemented by speculative demand. Except for the strategic petroleum reserves held by
governments, all of the oil produced in the last several years has been purchased and used by consumers, not speculators.
This growth in commercial use of oil is evidence that high oil prices are driven by real-world fundamentals and not by speculators,
as defined by the Commodities Futures Trading Commission (CFTC).
Wall Street’s definition of a speculator is different then the definition provided by the CFTC, but is the definition Masters is using to
make his case. The CFTC defines speculators as investors in the futures markets who do not take physical delivery of the
underlying commodity. The word as it relates to Wall Street's view of what rational investors do is best interpreted by Benjamin
Graham, the author of Security Analysis. "An investment operation is one which, upon through analysis, promises safety of principal
and a satisfactory return. Operations not meeting these requirements are speculative."
Masters makes the case that speculators will invest in the futures market, regardless of price, an idea that corresponds with
Benjamin Graham’s definition of speculator -- an investor who does not do a thorough analysis before investing. The flaw in Master’
s argument, however, is that hedge funds, institutional investors, and even small investors are shifting capital into commodities and
futures markets as a rational, financial approach to hedging their risks, inflation concerns, in addition to the pursuit of a profit. Any
investment is based on market fundamentals, not simply because prices are rising, as Masters claims in his analysis. Moreover,
no hedge or mutual fund manager would ever invest in the commodities market without matching that investment with a negatively
correlated asset or employing other hedging methods. This type of risk management is the essence of modern portfolio
management and is required to lower risk and improve return for the entire portfolio of assets.
Speculators are not the cause or the driver of high oil prices.
If unsophisticated speculators or manipulators did push oil prices in the futures market above a level that balances supply with
commercial demand, an oil glut would occur, then causing the commodity to be hoarded for future sale. Indeed, if speculators have
succeeded today in driving the price of oil above the level justified by its true fundamentals, it would follow that current global output
should exceed world consumption. If this unlikely scenario were the case, however, then commercial and financial investors would
now be hoarding tremendous amounts of oil. The produced oil would be going somewhere as non-commercial investors in the
futures markets would not need to take physical delivery. If there were no hoarding, a situation that implies that commercial
consumers are purchasing every barrel produced, then the world price of oil would be justified, again based on fundamentals.
It is very clear after examining US oil inventory data that there has been no physical accumulation of oil during the dramatic doubling
in price over 2007’s average. Clearly, speculators are not "hoarding" oil and keeping it off the market with the intention of driving up
prices. Rational investors and hedgers don’t “hoard” oil in warehouses; they try to predict where prices will be in the future and
make money off the change in price. Again, it’s important here to clarify that the very word "speculator" is a misnomer as it relates to
investors and hedgers in the futures market. The technical definition is used instead to reference the CFTC definition of non-
commercial investors, those who never take actual physical delivery of the underlying commodity. A speculator, as traditionally
defined by Wall Street, refers to an unsophisticated investor who does not do a thorough analysis of risk and return.
Masters claims that "index speculators have now “stockpiled,” via the futures market, the equivalent of 1.1 billion of barrels of
petroleum." (Exhibit # 2) He bases this misleading statement on the market prices of contracts and oil. Large investors buy futures
contracts in oil, but then roll them over before taking actual delivery. When futures contracts for July, for example, near maturity, the
investor will sell the contracts to a commercial user and then apply the money they receive to August contracts. The non-commercial
investor is thus just an intermediary who succeeds or fails based on the direction prices do take. Regardless of that direction,
however, the sold oil is ultimately delivered to the consumer who then uses it.
Contrary to the position advanced by Masters, non-commercial investors [i.e., CTFC speculators] in oil futures provide stability in the
markets. By buying low and selling high, these investors can help pull up lower prices and push down higher prices. Their actions
reduced price volatility, an effect that in turn reduces prices over time. Masters, however, argues that the same benefit is not the case
with index speculators: “Speculative investing explains the accelerating rate at which commodity futures prices (and actual
commodity prices) are increasing. Rising prices attract more Index Speculators, whose tendency is to increase their allocation as
prices rise. So their profit-motivated demand for futures is the inverse of what you would expect from price-sensitive consumer
behavior.” (Exhibit #3 )
Reality, however, is markedly/quite different. CalPERS invested $1.3 billion in energy because fund managers believe that
commodity prices, and their volatilities, provide an attractive investment relative to stocks and bonds. This is exactly what rational
investors are supposed to do when increased demand for commodities combined with tight supplies result in higher future prices.
As long as the market continues to believe that oil prices are headed higher, investors who push up spot prices provide a valuable
and necessary benefit, which will eventually result in greater production and less consumption and down the road lower prices for
oil. CalPERs does not meet the Wall Street definition of a speculator because its fund managers do a through analysis of risk and
return on the investment. Speculators do not.
On his part, Masters again misjudges how the markets actually work by asserting that "Index Speculators buy futures and then roll
their positions by buying calendar spreads. They never sell. Therefore, they consume liquidity and provide zero benefits to the
futures markets." (Exhibit # 4) This is simply not the case. For example, if CalPERS determines that 1% of its funds in oil futures is
a smart investment strategy and prices do rise, then the total value of those funds also increases. However, if the share of oil futures
rises disproportionately, then that same allocation will be higher than 1%. If the price increase fails to change the CalPERS views of
the future, then during the next rebalancing, the fund will reduce its holdings in oil futures. In other words, this so-called speculator
will become a net seller. Quite the opposite will hold true of course if oil prices fall since the fund will then buy additional futures
contracts to restore its desired 1% allocation.
Masters appears to dismiss the benefits of the liquidity provided by investors and misleads or misunderstands how non-
commercial investors rebalance their portfolios as prices change. Without institutional investors such as CalPERS, refineries and
other oil consumers would have no alternative but to find another physical consumer willing to buy the futures contract at the precise
time the refinery chose to sell them. If it couldn’t find these buyers, the refinery would have to sell small contract quantities to other
consumers. Here, non-consumers act as middlemen who relieve the refinery of the burden of searching for consumers to buy or
sell their contracts. In other words, institutional investors and financiers provide significant value to the function of market supply and
demand. They do this by buying and selling excess contracts at various prices before the delivery date.
Masters’s core argument that "index speculators" are to blame for rising commodity prices does not hold up in the real world. Prices
for commodities without any active futures markets are rising faster than prices with active markets. Steel is a key example, but rice
and dozens of other commodities strengthen this point as well.
Masters, the ATA, and a smattering of Congressmen, including Senator Obama, are busy claiming that institutional investors and
big Wall Street firms are manipulating the markets through "excess" speculation. Demagoguery and misunderstanding of how the
commodities markets actually work then unite to create a political/convenient scapegoat, which succeeds in shifting the real blame
for high oil prices. In large measure the real blame can be linked to Government monetary policies and the lack of a national energy
plan. Without a doubt, the US has had no specific energy policy for decades, and this failure in reality may be the heart of "excess"
energy consumption in the U.S. It also explains the current inadequate oil production, which has now declined substantially in
recent years. In today’s global economy, the absence of a national energy policy is a lack of Government leadership, which has not
yet been able to forge a political compromise to allow it to create with a coherent set of practical solutions to meet both excessive
energy consumption and inadequate supply.
Financial investors in futures markets who intend to make profits but not take physical delivery of the actual commodity provide
liquidity; but they certainly are not the cause of high oil prices. By my estimates, US policies that have succeeded in allowing the
dollar to weaken considerably accounts for approximately $50 or 35% of the current price of oil. Additionally, between $10 to $20 or
around 10% is an appropriate "risk premium" for the high probability of supply disruption risk. This risk premium should be
considered an appropriate component of the spot and forward curve in the futures market. Why you ask? As long as the risk of
geopolitical and supply disruption remains high, the market must account for this 10% risk with a higher price because supply
disruptions always increase price volatility. The distinction, however, is that this risk premium is not based on speculation but on a
greater uncertainty of future oil prices when/if supplies actually do disrupt.
Taken together, the risk premium and the weak dollar are approximately $65, or nearly 50% of the current price of oil. This
combination exchange rate and risk premium provides clear evidence that high oil prices are not simply a function of "excess"
speculation or market manipulation as claimed by Masters and the ATA. Rather, it is simply a pure function of oil market
fundamentals. The difference in price, from $21 average over the years between 1985 and 2003 to the $72 average in 2007 was
driven by the perception and reality that the gap between supply and demand was widening. It follows logically then that ATA's
political push to restrict non-commercial investors from the futures market today is definitely the wrong solution to bring down the
price of oil form its current $130 to $140 range. In fact, any government restrictions that are intent on preventing non-commercial
investors from investing in futures markets will do nothing to ease oil prices in the long run and to the contrary, may cause them to
rise even further. Such restrictions will hurt consumers even more by making the oil market even less efficient.
The principles of economics should teach us that tight markets keep prices high. Therefore, as long as the dollar continues to
weaken against foreign currencies, or those currencies strengthen, US consumers will remain the weaker bidder with little choice
but to pay the highest price for increasingly scarce commodities. The other economic [policy] choice, however, is to increase
domestic production because we can then buy out own energy, and at the some time bring down the price of oil. Another positive
economic result of increasing domestic production is increasing domestic employment. The third positive result if that by
increasing our own production, we can reduce our over $700 billion a year trade deficit and thus over time reduce that negative
impact on value of the dollar. It appears that both the politicos in Washington and the ATA have not caught up with this "crude"
reality, or have been mislead by some who are misinformed or sadly have a vested interest in the outcome of their political
“solution.”
Business Week (Exhibit # 5) has reported that Masters has 20% of his fund in airline and auto call options, stocks that could
increase significantly in value if oil prices did fall as a result of new Government rules restricting non-commercial investors in
futures markets. Typical funds invest no more than 3% to 7% in commodities so one would have to assume that Masters has
chosen to take exceptionally large and focused bet via his investments that oil prices are headed lower. This bet is a major conflict
of interest in terms of his present advocacy of new rules that he believes would have a major impact on oil prices and thus fuel
costs.
The current economic storm that encourages politicians to shift the blame for high oil prices may well yield short-term political
benefits, but it will not change the basic fundamentals of supply and demand, which will continue to play out as always. Nor will a
political “blame game” change the price of oil on the world market. To the contrary, any new rules that restrict financial investors in
the futures markets will produce greater volatility, less liquidity, and probably even higher oil prices over time. Moreover, investors
will simply find other ways to invest in oil. Regardless of the Congressional actions ultimately taken in Washington and forced upon
the CTFC as a result of the ATA initiative, such tactics that attempt to halt valid and appropriate investments and curtail positive risk
management by investors large and small (i.e., hedge strategies using futures) represents political expediency that will likely have
unintended longer-term negative consequences.
The political push by ATA is simply the wrong strategy. While it may sound good on the surface and for the short term, it is an
unsupported notion that claims that neither basic market fundamentals nor the weak dollar are responsible for the dramatic run-up
in oil prices. ATA's campaign to quickly "educate" and encourage the public to write their Congressional representatives in a
grassroots effort to change Government policy is a valuable lesson in how politics works in the United States today. Certainly, the
ATA deserves an "A" for political savvy as its efforts have resulted in a flood of emails and letters to Congressmen. However, the
ATA is communicating flawed logic by associating the actions of speculators too simplistically with higher oil price, and
broadcasting the implication that it will take new rules to reduce those prices substantially. For this effort, ATA gets a well-deserved
“F.” Unlike Masters’s claim that the high price of oil is driven by unsophisticated speculators who disregard price, risk and
underlying fundamentals, the truth about what’s driving oil prices higher is not so difficult to understand.
The ATA and Mr. Masters are chasing the wrong boogeyman. They falsely claim that 50% of the price of oil is driven by speculators.
Their bizarre logic is motivating a political push to regulate the futures market, but it is not based on sound economic principles. In
reality, the involvement of large financial investors provides the needed stability and liquidity to price oil and other commodities in
world markets. Regulations that are simply enacted to choke such investment will only succeed in creating less liquidity and higher
volatility in the futures market. The even more damaging result of blaming excess speculation for high oil prices will be a shift of
Government efforts away from identifying the real problems behind high oil prices and generating practical solutions and climbing
on the bandwagon of false hopes.
Washington's recent politically expedient efforts to constantly bail out industries, consumers, and Wall Street banks, is a primary
reason the dollar has been debased and US consumers pay dearly for oil. The lack of leadership in regards to an effective national
energy policy have resulted in a country ill-equipped and prepared to handle significantly higher energy costs. Short-term fixes that
focus on the effects of this inactivity and irresponsibility can only cause even more damage in the long term and more disruption.
The country needs a coherent and effective energy policy that will result in less dependence on foreign oil and less energy
consumption. Priority Number One should be to lift the restrictions on land access and offshore and onshore drilling, efforts that
require both President Bush's signature and Congressional approval. President Bush has done his part with his Executive order
lifting the restrictions, now it’s time for Congress to do its part. The oil futures price curve would fall immediately if Congress lifted
the restrictions, which in turn would bring down the spot price of oil. This would occur even as it takes 5 to 10 years before oil could
be produced. Why? Because oil prices are in large measure a function of future supply and demand.
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