Is Wall Street to blame for the 2008 'Oil Bubble'?

I didn’t get a chance to write about this when I first spotted it last week (h/t The Moderate Voice):

CBS News “60 Minutes”: Did Speculation Fuel Oil Price Swings?

As the president of the Petroleum Marketers Association, [Dan Gilligan] represents more than 8,000 retail and wholesale suppliers, everyone from home heating oil companies to gas station owners.

When 60 Minutes talked to him last summer, his members were getting blamed for gouging the public, even though their costs had also gone through the roof. He told Kroft the problem was in the commodities markets, which had been invaded by a new breed of investor.

“Approximately 60 to 70 percent of the oil contracts in the futures markets are now held by speculative entities. Not by companies that need oil, not by the airlines, not by the oil companies. But by investors that are looking to make money from their speculative positions,” Gilligan explained.

Gilligan said these investors don’t actually take delivery of the oil. “All they do is buy the paper, and hope that they can sell it for more than they paid for it. Before they have to take delivery.”

“They’re trying to make money on the market for oil?” Kroft asked.

“Absolutely,” Gilligan replied. “On the volatility that exists in the market. They make it going up and down.”

In market-speak that’s called “arbitrage“; essentially it’s the art of finding bargains and buying into them early, before the market catches on. When other investors discover the same opportunity and try to buy, the increased demand causes the price to rise. Then the early buyers can sell their investments (shares, option, or futures) at a profit. Much of the arbitrage trading business involves intraday bargain-hunting and short-term buy and sell trading between the stock and futures markets. Because the profit on individual trades is small, arbitrage traders make up for it by buying and selling large numbers of shares. When a lot of high-volume activity occurs in the markets, prices can go up or down erratically.

About the same time, hedge fund manager Michael Masters reached the same conclusion. Masters’ expertise is in tracking the flow of investments into and out of financial markets and he noticed huge amounts of money leaving stocks for commodities and oil futures, most of it going into index funds, betting the price of oil was going to go up.

Asked who was buying this “paper oil,” Masters told Kroft, “The California pension fund. Harvard Endowment. Lots of large institutional investors. And, by the way, other investors, hedge funds, Wall Street trading desks were following right behind them, putting money – sovereign wealth funds were putting money in the futures markets as well. So you had all these investors putting money in the futures markets. And that was driving the price up.”

In a five year period, Masters said the amount of money institutional investors, hedge funds, and the big Wall Street banks had placed in the commodities markets went from $13 billion to $300 billion. Last year, 27 barrels of crude were being traded every day on the New York Mercantile Exchange for every one barrel of oil that was actually being consumed in the United States.

So who was responsible for convincing investors to put their money in futures-based index funds?

Surprise, surprise …

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Masters believes the investor demand for commodities, and oil futures in particular, was created on Wall Street by hedge funds and the big Wall Street investment banks like Morgan Stanley, Goldman Sachs, Barclays, and J.P. Morgan, who made billions investing hundreds of billions of dollars of their clients’ money.

“The investment banks facilitated it,” Masters said. “You know, they found folks to write papers espousing the benefits of investing in commodities. And then they promoted commodities as a, quote/unquote, ‘asset class.’ Like, you could invest in commodities just like you could in stocks or bonds or anything else, like they were suitable for long-term investment.”

Dan Gilligan of the Petroleum Marketers Association agreed.

“Are you saying that companies like Goldman Sachs and Morgan Stanley and Barclays have as much to do with the price of oil going up as Exxon? Or…Shell?” Kroft asked.

“Yes,” Gilligan said. “I tease people sometimes that, you know, people say, ‘Well, who’s the largest oil company in America?’ And they’ll always say, ‘Well, Exxon Mobil or Chevron, or BP.’ But I’ll say, ‘No. Morgan Stanley.'”

Morgan Stanley isn’t an oil company in the traditional sense of the word – it doesn’t own or control oil wells or refineries, or gas stations. But according to documents filed with the Securities and Exchange Commission, Morgan Stanley is a significant player in the wholesale market through various entities controlled by the corporation.

It not only buys and sells the physical product through subsidiaries and companies that it controls, Morgan Stanley has the capacity to store and hold 20 million barrels. For example, some storage tanks in New Haven, Conn. hold Morgan Stanley heating oil bound for homes in New England, where it controls nearly 15 percent of the market.

The Wall Street bank Goldman Sachs also has huge stakes in companies that own a refinery in Coffeyville, Kan., and control 43,000 miles of pipeline and more than 150 storage terminals.

Yikes. Now we probably know why President Bush, a former oil man, was so eager to put the TARP bailout program together. Poorly managed though it was, it probably provided a lifeline that kept the US oil industry from tanking along with the mortgage and banking sectors. On top of the current recession I can’t imagine how disastrous an oil market collapse would have been.

Asked if there is price manipulation going on, Dan Gilligan told Kroft, “I can’t say. And the reason I can’t say it, is because nobody knows. Our federal regulators don’t have access to the data. They don’t know who holds what positions.”


It’s impossible to tell exactly who was buying and selling all those oil contracts because most of the trading is now conducted in secret, with no public scrutiny or government oversight. Over time, the big Wall Street banks were allowed to buy and sell as many oil contracts as they wanted for their clients, circumventing regulations intended to limit speculation. And in 2000, Congress effectively deregulated the futures market, granting exemptions for complicated derivative investments called oil swaps, as well as electronic trading on private exchanges.

“Who was responsible for deregulating the oil future market?” Kroft asked Michael Greenberger.

“You’d have to say Enron,” he replied. “This was something they desperately wanted, and they got.”

Greenberger, who wanted more regulation while he was at the Commodity Futures Trading Commission, not less, says it all happened when Enron was the seventh largest corporation in the United States. “This was when Enron was riding high. And what Enron wanted, Enron got.”

Asked why they wanted a deregulated market in oil futures, Greenberger said, “Because they wanted to establish their own little energy futures exchange through computerized trading. They knew that if they could get this trading engine established without the controls that had been placed on speculators, they would have the ability to drive the price of energy products in any way they wanted to take it.”

“When Enron failed, we learned that Enron, and its conspirators who used their trading engine, were able to drive the price of electricity up, some say, by as much as 300 percent on the West Coast,” he added.

“Is the same thing going on right now in the oil business?” Kroft asked.

Every Enron trader, who knew how to do these manipulations, became the most valuable employee on Wall Street,” Greenberger said.

So there was really more to it than just arbitrage trading. It appears that the big investment banks were actually trying to corner the US oil market, taking advantage of Clinton-era deregulation to control the lion’s share of domestic oil trading, then using commodities swapping to lock in low to moderate oil delivery prices while encouraging investor enthusiasm that pumped billions of dollars into the oil futures market and allowed speculators to wildly increase futures prices. If you’re sitting on reserves swapped at $65/bbl that could sell in six months for $145/bbl, that’s some serious money.

The whole thing fell apart, it seems, when the real estate meltdown robbed the banks of their cash supply and they could no longer afford to engage in large-scale oil futures trading. When their futures-indexed investment funds started failing, investors yanked their cash, and normal supply/demand economics pulled the price of oil back down to a level that more accurately reflected the abundant supply on the market and the reduced demand brought on by the unreasonably high prices.

So who is to blame politically? Some of the responsibility certainly rests on the Clinton administration, which repeatedly ignored Enron’s financial irregularities while enlisting its Commerce and Energy Departments to aid Enron in one sweetheart energy deal after another. But we should also ask why the Bush Administration, which repeatedly expressed concerns about the runaway subprime mortgage market, seemed either ill-informed or indifferent about the runaway price of crude oil.

The long-term sustainability of the free market is based in part on its ability to shake out irrational trends. The market did indeed work in this case, because the rapid spike in crude oil futures pricing was unsustainable and not based on true supply and demand. But the price that we all paid — and will keep paying in the form of long-term debt — for that brief period of market irrationality was very high. Let’s hope that next time the market can dampen irrational price increases before they do so much collateral damage.


ADDED: Here is a good write-up on the subject of “cornering the market,” specifically about why it is usually a bad idea. The Hunt Brothers tried to corner the silver market in the late 1970’s. Originally they intended to invest in silver as a hedge against inflation. But they got greedy and began to buy more and more silver on leveraged (that is, borrowed) money until they owned more silver on paper than could be physically delivered. The result was a huge spike in the price of silver, since the market supply was virtually depleted. The banks that loaned money to the Hunt brothers suddenly found themselves with debt liabilities that could have ruined them. The article explains, in depth, how the banks, commodity markets, and the Federal Reserve conspired to change the rules for silver trading so that they bailed themselves out, recovered all of their debts, and in the process, bankrupted the Hunt brothers.

Fast-forward to 2008. In the case of oil speculation, it was the banks who were reaping enormous profits (as opposed to holding debts). Their profits were paid by all of us on everything tied to the price of oil, which is … well … virtually everything. But the banks had no way to absorb the enormous losses triggered by the simultaneous collapse of their mortgage and oil derivatives. They bankrupted themselves. This time, they couldn’t “change the rules.” The government had to bail them out. So we the people, through the US Treasury, have become the debt holders for the financial damaged created by oil speculators. Thanks a lot, guys.

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