Speculators & Scapegoats

If you're like most people, then you could use a little brief on how the futures markets function and, ultimately, the extent to which a futures market can actually affect current spot prices. I found this article quite good for that purpose.

The article makes the connection that most articles and media reporters do not: inventory. Inventories are the key to affecting any market's spot price. Put simply, or put otherwise, the spot price does not is not affected by volume fluctuations, but rather actual changes in demand and supply. To affect the spot price for a commodity, be that oil or wheat, there must be a change in the amount supplied or the amount demanded. If you look at futures traders as shoppers in a store, then the number of shoppers really should have no affect on the prices listed on the shelves. Instead, only those actually at the checkout are having an affect - the ones taking delivery of their orders. So how do inventories come into play?

Use your own logic; if you wanted to corner a market on a particular good, then what would you do? You would try to buy-up as much of the supply as possible and then be able to set your own price; right? Right! Essentially, you would be driving-up demand and causing a shrinking supply in that good. This is exactly the counter-argument against blaming speculators for the rising oil prices because the vast majority of participants in the futures markets never take delivery, but rather roll-over their contracts days before they expire; they are not taking deliver and are not hoarding those barrels of oil in secret warehouses until they can sell it at a higher price that they set themselves. The number of barrels available has actually increased.

So, then, how do you explain the very apparent bubble in the oil price? Well, we should start by considering not the U.S. market, but the global market as a whole. As much as American's (and Canadians, for that matter) don't want to hear it, the rest of the world (the Middle East excepted) pay far higher prices than we do. One could argue, then, that the North American market prices are simply adjusting to the global prices. The question I'm sure you will ask then, of course, is why now and why so dramatically. The argument there will likely involve a lot of pointing at China and India as their economies continue to grow at near-double-digits. Unfortunately, there's a counter-argument to that as well given that the growth of those economies is not high enough to fully justify the growth in the price of oil. So, then, we've come full circle without really answering any question.

Is speculation affecting the market price of oil? Yes, probably. Are the growing economies in China and India causing an oil price spike? Yes, probably. Can either be blamed exclusively for the rising cost of oil? No. In today's global economy there is never one reason for anything; it is the interaction of many forces that results in what we see reported at the end of a trading day. The headlines will try to point to one cause or another, but the wise investor will look at all the headlines over a period of time and apply a weight to each factor to form a more comprehensive picture of what may actually be occurring and then plan accordingly. We all want a silver bullet solution, but we all also, for the most part, recognize that that's rarely the right solution.

The Grass is Always Greener

This is a funny story about how the ban against futures trading in the market for onions, introduced in the late 50's, may finally be repealed to help stabilize the volatility in prices... yes, I said stabilize. All this, while the news is rife with talk about how futures traders (a.k.a. so-called speculators) are blamed for the persistently climbing oil prices. So where's the truth? Do traders help stabilize or do they increase volatility in the markets?

The price of onions, apparently, has soared as much as 400% between October 2006 and April 2007; that puts the rise in oil prices to shame. This happened, of course, with no futures market at all so analysts have no choice but to put the blame on the good ol' forces of supply and demand. All that volatility came on the back of swings in the weather; as the supply of onions dried-up, the prices soared. It's just that simple. So why, then, can it not be the same for the oil market?

As with a lot of things in life, it's more than likely that the truth lies somewhere in the middle. You must recall that a futures market was introduced primarily for the purpose of stabilizing the commodities markets by providing producers, farmers for example, with a way to hedge against changing weather conditions and ensure themselves of a more predictable revenue stream against which they could plan their businesses. Again, as with many things in life, there's a downside. Just as the futures markets can stabilize prices, they can also exacerbate fluctuations.

There are two fundamental forces: demand and supply. Weather affects only one side: supply. Similarly the arguments about how much oil is in the ground are all arguments about supply. The futures market makes it easier for people to speculate on the future price of good and this, simply, drives greater demand for that product. Without a futures market, the only people who are buying a commodity are those who can take delivery - just as you would at a grocery store. The futures market allows you to place an order for, let's say oil, with the option of canceling your order before it comes time to pick-up your order. That's what people have labeled speculation. It's nothing more than higher demand with a fancy name. So, then, what does this all mean?

The introduction of a futures market in the market for onions or, similarly, the legislation against speculation in the oil futures market will not really resolve anything in the long-term. In each case, market participants are responding to the current market conditions without much consideration for how the market outlook six-months or six-years from now. A futures market does stabilize the prices in a market during times of turbulent weather and may actually increase volatility in times of stable market climates. The futures market is a synthetic market introduced by laws and regulations; whenever you introduce such legislation you have to take the good with the bad. For any benefit that comes from a law, there's bound to be some negative externality that balances the scales. The grass is not actually that much greener on the other side of the fence. Sorry.

12 times $625 million equals $7.5 billion

That's the total, potential, exposure that State Street faces in light of a law suits already filed against it by several insurance companies for whom they managed retirement funds. No one believes that the verdict will be that high, of course, but that's the maximum as calculated based on the losses suffered by the funds under management as a result of the sub-prime mortgage investments. $625 million, on the other hand, is what State Street set aside late last year in anticipation of these lawsuits. See a discrepancy? Me too.

The lawsuits, under review for class action status, appear to have more than one leg to stand on. The reason is that the suits are filed under the Employee Retirement Income Securities Act (ERISA); why is that important? Well, funds registered under ERISA are designed to be relatively low-risk so as to appeal to individuals looking for retirement-oriented investments. As it turns-out, of course, sub-prime lending isn't all that safe and a lot of people are now faced with the loss of as much as half of their retirement savings. How would you feel or react if that were you? Yea, me too.

State Street, of course, isn't the only one in this position and there will be others hitting the headlines in the coming months. The issue is really the extent to which these fund managers owe a fiduciary responsibility to the individual investors whose money they are ultimately investing. Were these investors properly informed of the risks being taken? Did the fund managers even appreciate the risks themselves? If you're interested in corporate finance, then the next year will certainly be an interesting one to observe. 

Just as in we had Sorbanes Oxley come-about as a result of the scandals earlier this decade, I'm sure that we'll have new legislation and regulation written to avoid such events in the future. It's easy to view this as just a cycle - one that will repeat again, just in a different form with a different name and with different acronyms. What makes this a little more real is the thought of the millions of people whose life savings have been so detrimentally affected by the decisions of so few.