If we’re going to trade crude oil like a currency, we should regulate it like a currency, too.
I hold an apparently quaint and obsolete belief: “Not everything that can be traded should be traded. ” Specifically, there’s great danger in using long-term, long-only commodity futures positions as an investment asset class. The same is true of the derivative baskets of commodities that replicate such futures position. Please note that I’m not talking about futures funds (which trade both sides of the market and are generally in positions only for the short term), but rather the way that commodities are increasingly being used by pensions, endowments and hedge funds as investments rather than short term speculations; this has sometimes been called “index speculation,” to distinguish it from the traditional variety.
Investment flows into the futures market can distort the pricing that should instead be determined by producers and users of commodities. Price distortions of this type cause enormous economic inefficiencies, are deeply injurious to the world’s poorest, and create significant structural risk in the markets. The chart below is a good illustration of just how “financialized” energy prices have become, charting the trade-weight U.S. Dollar index (the dashed line) versus the DJ-UBSCI Energy Spot index (the solid line) since the beginning of the year:
Dollar vs Energy Prices
As emphasized by the arbitrarily drawn horizontal line, these plots are virtually mirror images of each other (running a regression results in a correlation of -0.88). This corresponds to the type of linked price action we saw during the buildup to the commodity frenzy last year. It’s interesting to note that commodities like gold show nowhere near the correlation (-0.177) with the dollar over this same period. Clearly, the pricing of crude oil and energy products have become dominated by financial, not commercial interests. Specifically, oil is being treated as a currency and not as a commodity. This is a terrible idea, but apparently a terrible idea whose time has come.
While using crude oil as a currency/asset class is a bad idea, there are some good (or at least interesting) ideas on how to address the associated risks. I have been a fan of applying speculative position limits to energy contracts, importantly including the OTC swaps market. This approach has some downsides: a) it may be ineffective since the problem is really that all the positions in aggregate are dangerously large, but perhaps not on the individual basis constrained by position limits, and 2) it may simply migrate investment interest away from futures and into hoarding physical oil. In some ways this has already happened, as the speculative interest in crude oil (“virtual hoarding”) has created a cotango market that has resulted in a massive, arbitrage-induced inventory buildup (physical hoarding).
Last July as crude was peaking, my friend, Tom Rooke, submitted an alternative idea to the House Committee on Agriculture, the Congressional committee which oversees the Commodity Futures Trading Commission. With the bust in crude prices in the latter half of 2008, this whole issue was put on the back-burner. With energy prices once again being pushed up by speculative forces, it’s worth reexamining Tom’s idea. By way of credentials, Rooke has extensive experience in the world of commodities, having served as the head of UBS PaineWebber’s futures division for many years. He is an expert in the term structure of futures contracts and in cash/futures arbitrage.
Rooke’s proposal, in essence, regulates crude oil much like some of the ways that money supply is regulated. In his creative structure, the U.S. would require that holders of crude be required to maintain a reserve requirement which would be controlled by a central governmental authority, much like the Federal Reserve can change reserve requirements for banks. This would raise the costs of hoarding crude (probably not a bad thing), represent a second, private strategic petroleum reserve in event of national emergency (definitely a good thing), and provide a stabilizing buffer in crude oil pricing (much like what OPEC used to do when it had more market power). In the proposal, the initial transition period and reserve buildup would be eased through using depository receipts issued by the Strategic Petroleum Reserve. Tom’s submission can be read here: TWR Letter. The specific proposal starts on page 10, although the earlier pages include a discussion of index speculation and the evidence that it was impacting crude oil prices. It’s worth noting, that at the time the crude oil futures were in clear backwardation and the impact of speculation was more muted (Tom estimated 10% of price increases, I guessed around 20%); with the cotango markets we’ve seen more recently, speculation plays a more direct and potentially greater role.
It is critical that this issue be addressed. Rooke’s proposal may not be the right way to go, but it deserves serious consideration. On the third page of his letter, Rooke outlines just one type of structural risks we could face. We’re flirting unnecessarily with danger. What’s truly amazing is that without greater regulation of the commodity swap market, we won’t even know how close to the precipice we are or how far the fall might be.