Friday, January 15, 2010

Wrongheaded, shortsighted commodities law to also be meaningless

The CFTC (Commodities Futures Trading Commission) yesterday unveiled a proposal that would, if enacted, put limits on the numbers of oil and gas futures contracts speculators could control. This rule is currently in a "90-Day Comment Period". (The WSJ reports on it here.)
Here's a choice quote from Washington Senator Maria Cantwell's camp, pulled from a Reuters article on the proposal:
"While yesterday's proposal is a step in the right direction, we are concerned that the proposed limits may be too high to rein in damaging speculation in oil and gas markets," John Diamond, a spokesman for Senator Maria Cantwell, said.
Cantwell, a Democrat, has been a vocal proponent of increased energy market oversight and introduced legislation that would have forced CFTC to set position limits.
"The CFTC must set the limits at a level that does not allow excessively high speculative positions that ultimately harm energy consumers," her spokesman said.
The question as to what, specifically, is damaging about oil speculation remains to be answered by Ms. Cantwell. So let me help you out. The answer is nothing. Nothing is damaging about speculation in it's own right. What is damaging, however, is leverage. As I discussed in a recent post, the amount of leverage extended to commodities investors (in the form of margin) is absolutely insane. If you think about who the market is supposed to serve (producers and consumers of commodities) that kind of margin makes sense; if you're an oat farmer, you probably can't afford to buy or sell 5000 bushels of oats as a hedge against your own crop that has yet to be harvested, but an exchange can be pretty certain that that oat farmer will either have liquidated his position or else deliver on his contract once trading ceases. The man is an oat farmer for God's sake. He shouldn't have much trouble finding some oats. If you think about it as credit, and if the currency of your credit is oats, then I'll be damned if you can find a better candidate to whom to extend that credit than an oat farmer.
You might think, then, that the easy solution is to remove speculators from the commodities markets entirely. Sounds fine at first, but that really ends up screwing over the actual producers and consumers of the goods. These folks NEED speculators in the market to provide liquidity and ensure no one can unfairly corner the market. Think of it as market transparency taken to its utmost extreme.
No, the real problem is that there is no reason at all why speculators should be extended equivalent amounts of credit with which to move contracts around. You think some hedge fund manager in New York plans to drive a semi up to the NYMEX warehouse to pick up his 1000 barrels of West Texas Intermediate? No of course not, he'd probably get his suit dirty, and that suit cost more money than his margin on the oil contract.
If a firm (a hedge fund, index fund, etf, etc.) has say, $1 milllion to deploy on oil contracts, they can effectively buy or sell about 200 contracts, the equivalent of between $15 and $16 million worth of oil (assuming oil is at $75 - $80 / barrel). It's this kind of margin insanity that encourages wild and irresponsible speculation. Limits on the number of contracts you control are meaningless unless you make people accountable for the costs of those contracts.
What's that? Oh right. The actual limit. This law would set the maximum amount of contracts a trader could control at ~98,000, which works out to be about $7.5 billion worth of oil. So, look for that to affect, I don't know, Scrooge McDuck.

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