Oil Limits are Political Grandstanding, Not a Solution

Kyle Hartman's picture

Thursday, July 9, 2009 - 3:17pm

by Kyle Hartman

Regulators seeking to stave off a return to $140 crude want to crack down on oil-market "speculation" by putting limits on some big trades. Any new rules along these lines wouldn't affect individual investors.

The Washington-based Commodity Futures Trading Commission is the equivalent of the Securities and Exchange Commission. It regulates the trading of contracts for things like gold, wheat, pork and crude. Chairman Gary Gensler is proposing a limit on the role of speculators in the oil market.

Officially, the commission is supposed to ensure that excessive speculation doesn't put an undue burden on interstate commerce. To that end, it's not announcing new rules but opening a public-comment period to hear what industry participants, traders, financiers and investors think about new regulation.

I think it's cheap populism.

I think trading limits would detract from the valuable role speculators play in the market. I think the whole idea belies a shocking ignorance on the part of the politicians supporting limits. And -- after all that -- I don't think limits would do any good.

I'll make my case, but first, let me explain a little about how the system works.

Speculators, conventional wisdom holds, "provide liquidity to hedgers." That's what the textbooks say, anyway. But what does that mean?

First we have to be clear about what a hedge is. A hedge is simply an insurance policy that a big commodity user would take out. A bakery, for instance, might try to "hedge" against an increase in the cost of flour. When you hear "hedge," think "insurance."

Insurance, of course, costs money. But that bakery isn't going to pay premium to an insurance company. Instead, it's going to purchase another financial product known as a futures contract.

A futures contract is exactly what it sounds like. It's an agreement for delivery of a product on a certain date for a certain price. A bakery, to stick with our example, doesn't know what the price of flour will be next year. But it does know what the price of flour has been in the past, and it knows what flour costs now. If the current prices are favorable, then the baker might choose to lock in the price by arranging for future delivery now. Such a move would protect the bakery if flour prices suddenly shot upward. In other words, if flour costs $3 a pound today, it might be wise to pay 30 cents a pound to guarantee that price. Better to pay a certain $3.30 than to get stuck with $6.00, right? And the most flour you use, the more true that is!

But: Every bakery is going to be after the same hedge, right? None of them is going to try to engineer a higher input cost. They're all going to be betting on or against the same thing. So they need someone to take the opposite bet, or they don't have anyone to offer them protection from the risk. And big users need big speculators to bet against. That is part of the critical role speculators play.

The other part of the role speculators play is informative. Let's get back to oil. If a big player in the oil market starts betting against the price of oil when the price is high, then that's valuable information. It tells you that at least one well informed industry participant has information that suggests the prevailing trend is wrong. In fact, every commodity trader in the country works with one eye on the open-interest column, which shows the number of contracts for each ir. If those totals move, signifying that traders are positioning to take advantage of a price swing, then the odds are good that a price swing is imminent. Without speculators, without seeing whose betting against the hedgers, we lose information that the market has come to rely on.

Now, let's talk about ignorant politicians. Take Sen. Byron Dorgan, the Democrat from South Dakota who said the CFTC's action was a positive first step toward derailing oil speculators who are "looking for a quick buck at the expense of American consumers."

This is pure, unadulterated hogwash. Speculators don't give a hoot if the market goes up or down, only that it moves. They make money off volatility. It's just as easy for a speculator to bet on prices going down as on prices going up: Savvy traders do both, all the time.

Lastly, I mentioned that the proposal wouldn't work. That's because only the very largest traders would be affected. For 90% of the market, nothing would change.

And why would you want anything to change? If policymakers want to protect against a rise in the price of oil, they have tools they can use to do that. They simply chose not to, last time around. The president at the time said he wouldn't interfere with the market, he didn't, and prices normalized.

And let's not forget that rampant speculation is a self-correcting problem. If you make the wrong bet, you're done. The best way to make a small fortune in commodities, the adage goes, is to start with a large fortune.

If serious regulators seriously wanted to decrease speculation, they could do it in a heartbeat. Futures trading is done in margin accounts. The Federal Reserve's Reg T sets the margin requirement, currently 50%. It's the Fed's job, after all, to combat inflation. And if the Fed thought the oil market was out of control and that the country legitimately needed to be protected from surging oil prices, it could change the Reg T requirement tomorrow -- it's empowered to do so, and without Congressional approval.

The Fed isn't looking to score political points, only economic ones. When speculation is a problem, you can rest assured it will be addressed.

Eliminating each and every speculator from the futures market isn’t the answer. Yes, fewer speculators will lead to less volatility however the market will become far less liquid. But liquidity is key to free markets, and limiting that could do more damage than good

Kyle Hartman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.