Tuesday, January 19, 2010

Why Imposing Oil Position Limits is a Tremendous Mistake

As a follow up to my post on Friday about how the CFTC's proposed oil and gas position limits are ultimately wrongheaded, I wanted to talk a bit more about why position limits won't solve the problem, and why these regulations are ultimately bad for the markets they are supposedly trying to protect.
As I said in Friday's post, the problem is not position size, but leverage. And the reason leverage is a problem is that small market moves are amplified by virtue of the buying and selling that NECESSARILY must follow when positions are entered into via margin.
To understand this, first, consider that unlike a stock every futures contract is entered into by two individual parties. There is no corporate entity issuing these contracts to raise capital as is the case in the stock market. Further, the commodities do not necessarily have to even exist for the contract to be initiated. Today, I could "sell" you 5,000 bushels of oats to be delivered in September. Never mind that I live nowhere near an oat farm, let alone the Chicago warehouse to which those oats would be delivered. No, as an investor, I would be selling you those oats with the intention of buying the same amount of oats from someone else later to offset my position, hopefully at a lower price than the one I gave you. My bet is that the price oats will go down between now and September. Your bet is that the price of oats will go up. Thus, for every futures contract that exists, there is a bullish participant, and a bearish participant. The bullish participant (the buyer) expects the value of the underlying commodity to go up, or at the very least, to NOT go down. The bearish participant expects the price to go down, or at least to NOT go up. In every trade, someone is wrong and someone is right.
Now, back to the point at hand, by virtue of the fact that someone wins and someone loses on ANY price movement, the dramatic effects of leverage can work like a positive feedback loop. Commodities exchanges and financial institutions facilitating futures trading require that a certain amount of money be maintained in an account to maintain one's position. This is called the "maintenance margin" and adverse price movements can wipe you out, initiating a "margin call" where the exchange or brokerage requires you put up more money or else exit the position.
Let's take a concrete example with a fake commodity. Assume there are two speculators: Albert and Brian. Each of whom has $10,000 he'd like to invest in Widget futures, currently trading at $20 a box with one Widget contract equal to 500 boxes, making the total value of one Widget contract $10,000 (convenient, eh?). The exchange requires a minimum margin of $1000 per contract. Albert, the more risk averse of the two, buys exactly one contract. Brian, seeking to amplify his gains, buys ten contracts. Albert is not leveraged whatsoever, whereas Brian is as leveraged as possible. The next day, the price of Widgets falls from $20/box to $19/box. Albert is now down $500, whereas Brian is down $5000 (–$500 x 10 contracts = –$5000). Since Brian has fallen below the margin requirement of $1000 per contract, his broker tells him he must either add another $5000 to his account, or else exit his position. Having no more funds to allocate, Brian tries to sell his Widget contracts (all ten of them) to exit his position. However, because the price has gone down, many other investors are also trying to sell their Widget contracts, having received margin calls from their brokers. The flood of sell orders drives the price of widgets even lower. Eventually, some buyers enter the market at the deep discount of $18 / box, and this is the price at which Brian is forced to sell. Now, at $18 / box, Albert has lost a net of $1000, while Brian has lost every last penny. Incidentally, Albert (always patient) can wait for the price to go up, as he knows these sorts of market hiccups are to be expected. Brian, meanwhile, moves all of the rest of his money into T-Bills.
Now, what about oil? The above scenario is precisely what happened with oil futures in 2008. Take a look at this graph of oil prices from August 2007 through February 2009:
Oil was moving more or less sideways until February 2008. At which point, a perfect storm of geopolitical factors began driving oil prices up. As oil continued up, the bearish speculators (those who had sold oil) had to cover their positions as they were losing money. Some, certainly, received margin calls. Because they were leveraged they did not have the luxury to wait for prices to go back down to exit their positions. A flood of buy orders only served to drive prices higher until they reached the ludicrous peak of $140 / barrel, at which point, investors realized that was insane and began to sell crude like crazy. Those who had continued to buy oil all the way up to $140 now found themselves awash in sell orders and, because they too were incredibly leveraged, these folks were forced to cover their positions as oil went down, all the way through the public awareness of the credit crisis (how apropos) and into March of 2009, when sensibility and prudence (purely the product of fear) finally began to return to the market.
Would position limits have caused things to go any differently? Absolutely not. If anything, limiting the number of positions people or institutions can hold would have had an even worse effect by stifling the liquidity of the market. The problem is not position size, the problem is leverage. Now, admittedly, when large financial institutions take massive speculative positions in the market they somewhat amplify the problem. (Consider some hedge fund with 1000 Oil contracts all maximally leveraged suddenly getting a margin call; you now have 1000 more sell orders than you did five seconds ago.) But limiting leverage would in effect also limit position size. If your firm has $1,000,000 to deploy on oil contracts, and the margin requirements were $10,000 instead of $5000 per contract, the firm could buy only 100 contracts, rather than 200 under the lower margin. This would also give the firm much more breathing room, so to speak, when prices move against them. Margin calls would be fewer and further between for EVERYONE.
One last caveat, the margin problem is not so much with individual investors buying an oil contract here or there on margin, but with big firms buying hundreds of oil contracts on the smallest allowable margin.
Were I king of the CFTC, I'd impose a sliding margin requirement based on number of contracts. Something like, say, a 10% increase on minimum margin for each speculative position entered into past the 10th. Of course, lawmakers would rather their restrictions meet the populist demands than actually make sense from an economic point of view.
My advice? Stay the hell away from any index fund or ETF that tracks oil or gas. If these regulations go through, energy commodity funds are due for a liquidity shock, and some market maker will happily arbitrage your money right out of the fund.


spragus said...

Curiously, comparing a price chart of crude oil against the net number of long/short contracts of the non commercial big specs, shows no correlation whatsoever. So, what's the fuss? Showing this evidence to a class of stats 101 students would leave them scratching their heads.
There are markets that do have positive correlations, but not here.
Perhaps the issue is that the composition of the large non commercials is incomplete? If this has some baring on the matter, why can't someone show it?

Charles said...

Great point spragus. I actually suspected as much but didn't have the data on hand to verify. Do you have a link to where we might see such a plot?

Thanks for the input.

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