Streetwise Professor

June 25, 2011

Will the CFTC Prosecute Obama and the IEA for Manipulation?

The IEA and the United States have announced plans to release over the next month 60 million barrels of crude oil from strategic stockpiles, including the US’s Strategic Petroleum Reserve.   Oil prices plunged, by about $5/barrel.  Initially, I was reluctant to attribute most of the price drop to the announcement, because the stock market and virtually all other commodities were down hard too, and the dollar rallied.  These broad changes were plausibly due to bad US job numbers and continued angst about Greece, and given the recent correlations between oil and stocks and the dollar, it was likely that a good part of the oil sell-off was related to these factors.  But when the stock market rebounded later in the day, recovering about 3/4ths of its previous losses, and oil only recovered slightly, it was evident that the oil stockpile release had caused a substantial drop in prices.

To understand the implications of the release, assume initially that the release is considered a one-off, with no implications for the future. In that case, it is like a sudden increase in initial availability of oil. Here is a figure based on a dynamic model of a storage economy that relates the amount of inventory carried out (on the vertical axis) to the amount of the commodity initially available (on the horizontal axis).*

A surprise increase in initial availability is a move along the horizontal axis. Since carry-out is an increasing function of initial availability, some of that new supply released from the reserve is added to private inventories. This would tend to dampen the effect of the release on prices, but some of the increased supply would be consumed, prices would fall. Here is a figure of price as a function of initial availability, which shows that as availability rises price falls. But this curve is flatter–more elastic–than the flow demand curve, because of the fact that some increases of initial supply are put into inventory which buffers the impact on price.

But the key thing here is that you can’t assume that the market believes that this will be a one-off, with no implications for the future. The availability-carry-out function depends crucially on the beliefs of market participants about how the SPR will be used going forward. The current use is unprecedented: previously, the reserve was used in extraordinary circumstances, like supply disruptions resulting from the 2005 hurricanes. Now it is being used to micromanage world oil prices–and to micromanage Obama’s political future. This dramatic change in the employment of the SPR will inevitably affect beliefs, and hence (a) the relation between carry-out and initial availability, and (b) price and initial availability.

In my opinion, the most likely outcome is for the change to affect beliefs in a way that leads to a bigger price response than implied by the two earlier figures. The reasoning goes like this. Those making decisions on how much oil to store do so in anticipation of earning a profit by selling out of those inventories when demand spikes up or supplies spike down. These private storers will now reason that there is a higher likelihood that supplies will be released from SPR under those circumstances. This reduces the amount of money they make on selling out of inventory during those condition. This makes holding private inventories less profitable, so they will hold smaller stocks, all else equal. Put differently, market participants will now view the SPR as a competitor for private storage under a wider range of economic circumstances than was previously the case, and this increased competition from public storage will drive out some private storage.

In terms of the graph, this shift in beliefs about the way the SPR will be used shifts the relation between availability and carry-out. In particular, it shifts it down, from the green curve to the blue one.

This shift moves exacerbates the price impact of the release. It means that a smaller amount of the release will be absorbed into private storage, more of it will be consumed, and hence prices will fall by a larger amount.

Going forward, private inventories will be smaller. This will make the market more reliant on public storage to smooth supply and demand shocks. That’s not comforting, because public storage decisions are not driven by commercial and market realities, but political ones, and by decision makers with poorer information and weaker incentives than commercial market participants.

Ironically, one hypothesis advanced to explain the decision is that it is designed to punish long speculators. Well, the government and the IEA have now just provided much speculative fodder: now market participants have to speculate about how SPR management policy has changed, and how it will change going forward. That is very complicated, given that it will be buffeted by numerous factors. These include how OPEC countries react, how the US reacts to the OPEC countries’ decisions, how it plays politically in the US, and on and on.

This uncertainty, the flow of information relevant to deciphering the policy shift, and the feedback mechanism among traders (e.g., the Bayesian learning dynamic mentioned in the Singleton paper) will all contribute to price volatility. In short, by attempting to punish speculation, the administration has only stoked speculation. The “constructive ambiguity” surrounding the release, and future reserve policies, will only further fuel such speculation. SPR policy will now attract the same kind of scrutiny as Federal Reserve policy, where market participants try to interpret Delphic announcements and actions in order to discern the future course of policy. They will try to infer how external events–say, Obama’s political standing–will drive policy: just what is the function that relates SPR releases to Obama’s poll numbers? All of this interpretation and inference will generate trading that will in turn generate price movements, just as is the case with respect to Fed policy. Alleged concern about volatility has led to a policy that will create volatility.

And note that even though this action has hurt some speculators–those who are long–it has been a huge windfall to others.

The numbers are pretty staggering. Based on Commitment of Trader Reports for 21 June, and just looking at NYMEX and ICE WTI and Brent crude oil futures, given a price impact of about $4/barrel, the announcement led to a shift of wealth from longs to shorts of about $17 billion in crude futures and futures options alone. Add in refined products and you’ll increase that more. Add in swaps and other OTC instruments, you will increase that number substantially. Very substantially.

Within categories, again assuming a $4 price impact and looking only at crude futures and futures options, long swap dealers lost $1.9 billion, short swap dealers made $1.7 billion; long managed money lost $1.5 million and short managed money made $460 million, other reporting long speculators lost $556 million and other reporting shorts made $380 million. Again this overlooks the transfers between longs and shorts in the swap market. And also the capital losses on unhedged private inventories; at the end of May, OECD commercial crude and product stocks totaled about 2.7 million billion barrels. US commercial stocks of crude are about 360 million barrels, and crude and product stocks (ex SPR) about 1 billion barrels. Thus, the value of inventories in private hands in the OECD fell by about $10 billion, and in the US about $4 billion–who knows how much inventories fell in value in China. (And by the way, the value of oil in the SPR fell by about $280 million$2.8 billion.)

A lot of money changing hands. A lot.

Earlier this year, I blogged about potential economic justifications for a strategic petroleum reserve, and how the reserve should be used based on such justifications. In brief, something like the SPR can be justified to correct some other market failure that would depress private storage below its optimal level: the most likely candidate for such a market failure would in fact be a government failure, such as the threat of price controls or other interventions during a crisis.

Suffice it to say that the current action cannot be justified in this way. There is no demonstrable market failure being ameliorated here. This use of public storage is not correcting some deficiency in private storage arising from some market failure or government failure. Indeed, perversely, this use of the SPR’s public storage will, as noted above, discourage private storage.

In US law, there are three elements to proving manipulation: causation, intent, and artificial price. It is clear logically and empirically that the SPR release did cause prices to move. It is also abundantly clear that the administration and the IEA had the specific intent to cause price changes: indeed, they are both boasting about the purpose and effect of the policy. Artificial price is somewhat more ambiguous here. No market failure is being corrected, so a colorable case can be made that the price movement is not moving price closer to where it should be in the absence of such a market failure. That supports a claim of artificiality. But given that the SPR might have distorted price in the first place, it is arguable that perhaps prices are now closer to where they “should” be–but that only means that the price was artificial before because the SPR was inefficiently holding oil off the market.

Causation and particularly intent are often the hardest thing to show in a manipulation case: here, in contrast, they are easily proven. Artificiality is not so clear cut here, but I think it is beyond cavil that the impact of the policy will be to enhance volatility in oil prices and lead to fluctuations based on conjectures about the future course of government policy. That interferes with the operation of these markets and will lead to misallocations of resources, which is what artificial prices do, and what the manipulation laws are intended to combat.

This leads me to conclude that there is a strong prima facie case of manipulation: certainly a stronger case than some others the CFTC has filed in the past. I therefore expect that the agency will move swiftly to file a manipulation action.

That was all tongue in cheek, for those slow on the uptake. I of course know that no such action will be forthcoming; the government has vast discretion in use of the SPR. But if you look at the perverse effects of manipulation by commercial and speculative players–massive transfers of wealth between market participants, distortions of consumption and production decisions by private players, unnecessary price volatility–all of them are present in spades here. Indeed, the effects here are huge, far larger than any private manipulation case that I am familiar with (and I am familiar with all of them, I think).

It is especially ironic that this move came during the same week that the Federal Trade Commission announced that it was launching the most recent in a continuing series of investigations of manipulation by oil companies. This happens every time prices are high, with the same result: the FTC finds nothing. It’s one of the longest running farces in Washington.

If it wants to find manipulation, it should restrict its investigation to the 202 area code.

This is not the first time, certainly, that the US government has attempted to intervene in commodity markets to control prices in order to achieve a political objective. The Hoover administration–you know, that laissez faire bunch (not!)–did so with abandon in the grain markets with the onset of the Depression. That turned out badly. I don’t expect this to turn out much better.

* This is the same model as I analyze extensively in my forthcoming book. Just received the galleys, so the end is in sight!

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15 Comments »

  1. Professor, it’s been a while since I’ve visited your blog. I think at the time I departed it was because of the constant Putin “pilot fish” responses in the comments fatigue. Glad to see you are in good health and as sharp as ever. Having eaten my loses after the 3/09 market crash and gone to cash thereafter, hey, and not the richer for it, my life got focused on other things. I know I’m going somewhere with this…..

    …..my not formally educated economist take on this not so surprising SPR reserve release is captured in a good thread at IV: http://www.investorvillage.com/mbthread.asp?mb=4288&nhValue=74200&nmValue=74240&dValue=1&tid=10647335&showall=1 – one on the best on-going investor oil and gas boards.

    So far our Socialist overlords have killed/are killing off the middle class, fear based stock market investing seniors thanks to zero interest rates, the small business class, now commodities “speculators” whoever and whatever that means, I could go on. Whole business sectors and non-public union workers appear to be vulnerable by design. But, then wasn’t it FDR’s great feat not to have remedied the Great Depression, but to have solidified the Democrat party as the entitlement entity in American life. In my humble opinion, Obama’s crowd has rigged the markets in collusion with Bernanke and their WS insider cabal. They’ve gone after Toyota(union owned GM needed a more rigged playing field), the oil companies, etc, now Google, their always shifting corporate targets are endless.

    If the 2012 elections don’t rebuke this rot then we are pretty much goners.

    Comment by penny (aka onecent) — June 25, 2011 @ 8:31 pm

  2. Hi, Penny–welcome back! Yes, we are in the era of gangster government. I was just telling my mother today, in response to her question about the debt ceiling showdown, that all that matters is 2012. Like you say, our future hinges on its outcome.

    Look forward to hearing more from you.

    The ProfessorComment by The Professor — June 25, 2011 @ 8:38 pm

  3. Professor, you were right that the war in Lybia could go on for a long time. Probably US administration got it finally as well and the understanding of this fact led to SPR intervention.

    Comment by a.russian — June 26, 2011 @ 3:30 am

  4. Professor, sir! Any good books you can recommend for a young man interested in Economics and Finance to educate himself? I enjoy the blog, your style and reasoning, but must admit that I’m able to understand only half of it, mostly about Russia (ironically, because I happen to live there), and the uni courses here are expensive and laughable. Any answer will be appreciated.

    Comment by azzkel — June 26, 2011 @ 9:24 am

  5. @azzkel–thanks for the comment, and for reading. Let me give some thought to a few good books on economics and finance that would be good to start with. Ping me in a week or two in case I turn into the Absentmindedstreetwise Professor:)

    One suggestion off the top of my head re economics is Thomas Sowell’s books Basic Economics and Applied Economics. Sowell writes clearly and intuitively. I can’t think of anything comparable re finance–I’ll see what I can come up with.

    Hope this helps . . . should be some more Russian material this week.

    The ProfessorComment by The Professor — June 26, 2011 @ 3:34 pm

  6. […] – Oil, the IEA and manipulation. […]

    Pingback by FT Alphaville » Further reading — June 27, 2011 @ 1:15 am

  7. Thanks, Professor, always a good read from the smartest commenter on regulatory matters there is.

    But I think you are missing the elephant in the room here, which is the role of ‘inflation hedging’ and ‘financial oil leasing’.

    My view of ‘speculation’ is that it is financial investment undertaken with a view to transaction profit, and it is bi-directional, ie the sale may also precede the purchase.

    But the inflation hedging which has been around since Goldman invented the meme (in 1992?) is the complete opposite. It is long only financial investment undertaken to avoid loss – ie the motivation is fear not greed. These investors are off-loading dollar risk in favour of taking on commodity risk.

    It was the smartest kids in the block – Goldman Sachs – who first cottoned on to this in 1995, and I reckon that their joined-at-the-head relationship with BP for 12 very successful years thereafter was based upon the ability of BP
    to lean on the structurally long position of the GSCI fund all that time. It was a goldmine for Goldman and BP.

    Shell opened it up in 2005 in their transparent relationship with ETF Securities when they realised they could monetise their oil in tank (or even in the ground) without being subject to the exchange casino’s greedy take, although investors still have market risk, and the risk of having Shell as a counterpart (which personally I’d prefer to any bank).

    I think that the run up since then – apart from a genuine speculative spike which eventually pricked the bubble – was caused by a flow of financial purchases, a large part of it OTC.

    Once the spike occurred, it was the outflow of inflation hedgers which was the market over-correct to $30. But for as long as $ interest rates are zero, it’s always going to inflate again, and so it did.

    My thesis is that it was in the first half of 2009 that the Saudis caught on to the potential of monetising their reserves, and through distinctly un-open market operations on the Brent?BFOE market

    Comment by Chris Cook — June 27, 2011 @ 3:29 am

  8. …..they were able to support the Brent/BFOE price at a level which they must have agreed with the US government. It’s not dissimilar to the way that the ITC cartel was able to keep the tin price supported for years via the LME.

    In support of my thesis:

    (a) the fact that the natural gas price and oil price have diverged since then – ask Gazprom! – because the former market is or was at the lower bound clearing level where production gets locked in, while the latter is at the upper bound where demand gets destroyed (NB the tin market demonstrated an overnight collapse between the two levels in 1985).

    (b) the Saudis switched from WTI to Brent as a benchmark that summer, probably because of friction costs;

    (c) the Saudis routinely declared themselves ‘comfortable’ with the price level at OPEC meetings which became a byword for boredom;

    (d) the Saudis not long since declared that there was $40/bbl of speculative premium in the price – ask yourself where this number comes from?

    Anyway, Obama’s number one priority is to get the oil price down, because he knows going into the election with gasoline prices at 2008 bubble levels would finish his re-election chances. The US and Saudis couldn’t agree an oil swap – on price – so now we see what I might call Quantitative Greasing, using the SPR as a quasi-monetary reserve.

    I think it might work in the short term, through the threat of intervention, but in the medium and long term it’s up against global supply and demand, and you need a crystal ball for that. But the point is that if it really looks like working for a while, then the inflation hedgers – who are ironically responsible for causing the very inflation they seek to avoid – will pull out again, and the market will collapse, until it once more starts up the hill…..rinse and repeat.

    In my view we need to completely reconfigure both the market, and market instruments, but I’m not holding my breath.

    Comment by Chris Cook — June 27, 2011 @ 3:49 am

  9. With respect, isn’t everyone missing the elephant in the room? There’s a roughly 2mn b/d demand increase coming up in just about everyone’s global supply-demand balance projections in the third and fourth quarters, and Opec appears to be doing nothing about it. It’s not yet clear if the Saudis are willing to increase production by enough to meet this shortfall (or even able to, but that’s a whole other story). The market will balance, of course. It has to. But it will now do it at a lower price than if there hadn’t been a strategic stocks release.

    It strikes me that the IEA is finally doing something correct on behalf of its members — which, after all, are mostly net oil importers — instead of suppinely seeking producer-consumer dialogue. There is disruption to supply in the global market: 1.5mn b/d of light sweet crude, which on a quality basis Opec can’t really replace, even if it wants to. This is what strategic stocks were designed to address.

    @Chris Cook: The Saudis did not switch to Brent from WTI. They changed their official formula price *for sales to the US* to include an index called “ASCI” which is based on the US Gulf sour crude market, instead of WTI. (And while we’re going off the pedantic end of the scale, they also don’t actually use Ice Brent futures in their formula prices. For sales to the Mediterranean and northwest European markets, they use a price called Ice B-wave, which is a weighted average of Brent futures settlements that the Ice supplies as a separate price.)

    Comment by Down with this sort of thing — June 27, 2011 @ 4:57 am

  10. […] Will the CFTC Prosecute Obama and the IEA for Manipulation? Craig Pirrong, The Streetwise Professor, 26 June 2011 […]

    Pingback by Energy and Environment News — June 27, 2011 @ 9:17 am

  11. @The Professor: Thanks a lot! Time to do some book shopping. I’ll ping you back in a week or so.

    Comment by azzkel — June 28, 2011 @ 1:20 am

  12. @Down

    You’re right re the Saudi switch: I was in a hurry.

    Re B-Wave though, being pedantic back at you, the price is calculated as a weighted average of all Brent Futures prices traded (in the front month as I recall) in a particular trading day. It’s not an average of settlement prices, which is a different trading tool.

    Comment by Chris Cook — June 28, 2011 @ 5:04 pm

  13. […] – Oil, the IEA and manipulation. […]

    Pingback by Further reading « b2bville — June 28, 2011 @ 9:16 pm

  14. […] the oil being sold out of the Strategic Petroleum Reserve is being put right into private storage. Which is exactly what the figures in this post showed would happen.  Indeed, the only thing that is preventing more oil from moving into private storage is the fact […]

    Pingback by Streetwise Professor » If the Decision Makers Didn’t Expect This, They Shouldn’t Be Making the Decisions — July 1, 2011 @ 8:50 pm

  15. […] Pirrong explores this angle in a long post at Streetwise Professor, suggesting that politicized management of the SPR will at the margin tend […]

    Pingback by Oil markets appear unfazed by announced release of oil from strategic reserves « Knowledge Problem — July 5, 2011 @ 1:45 pm

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