Streetwise Professor

More from Matt Leising at Bloomberg on yesterday’s oil squeeze:

“This sharp move reflected extreme tightness in the prompt physical market as participants that were short oil scrambled to find physical oil before expiration,” wrote the analysts, led by Jeffrey Currie. Record oil prices have made refiners rely on stocks of existing supply, the analysts wrote, creating “critically low” inventory levels.

Vulnerable to Spikes

“This tight inventory situation has left the oil market with very little cushion and therefore extremely vulnerable to price spikes,” the note said.

Trading was light on Nymex yesterday. About 41,000 crude contracts for October delivery changed hands, 85 percent less than the 15-day moving average volume of 280,000 contracts, according to Bloomberg data.

The traders who sold contracts short might have been betting on price declines due to less-than-expected damage to oil rigs and production from Hurricane Ike as it crossed the Gulf of Mexico.

“Ike did more damage than originally thought,” said Rick Mueller, director of oil markets at Energy Security Analysis Inc. in Wakefield, Massachusetts.

The most recent storm in the Gulf made landfall in Texas on Sept. 13, cutting off power and damaging some refineries. U.S. energy producers resumed output for about 23 percent of oil and 34 percent of natural-gas production in the Gulf after the storms, the Minerals Management Service said yesterday in a statement on its Web site.

This suggests that deliverable supplies were low due to Ike. Low deliverable supplies make the market more vulnerable to a squeeze. Put differently, somebody with a 10 million barrel futures position may not be able to squeeze the market profitably when deliverable supplies are 9 million, but may be able to do so when they are only 5 million or 4 million. Thus, Ike’s disruptions raised the likelihood of a squeeze.

One should not go the next step–as people often do–of concluding that Ike “caused” the price disruptions in the October contract. Just as a forest fire requires BOTH dry tinder AND a spark, a squeeze requires low deliverable supplies AND the affirmative action of a large long (or longs). A large long must demand excessive deliveries. The low deliverable supply only means that the long can get the same price effect–and a bigger profit–by demanding fewer deliveries and liquidating more contracts at an artificially high price. Put differently, the cost of manipulation is burying the corpse of deliveries. With low deliverable supplies, the corpse is small, and the manipulation is easier to carry out. To mix metaphors, and extend the forest fire example, the low deliverable supply is the dry timber, but the uneconomic demands for delivery by a large long or longs is the spark that is necessary for the fire to occur. Low deliverable supply is a precondition that makes the market vulnerable to a squeeze. But somebody has to do the squeezing. Smaller players can squeeze when deliverable supplies are small.

Since the FTC Report on the Grain Trade in 1920-1921, it has been common to label events like those of yesterday as “natural squeezes” because “natural” market conditions made the squeeze possible. The “natural” terminology has been used to excuse the opportunistic exercise of market power by those who exploit these conditions to distort prices. This “reasoning” is wrong, and highly injurious to the market. It essentially gives longs a manipulation option. Hold a large long position to expiration. If something happens to reduce deliverable supply–squeeze away, and make money. If nothing happens, just liquidate at the competitive price. When they come after you for squeezing, just say “Hey, it was a natural squeeze. And natural is good, right? That’s what they tell me at Whole Foods!” It’s worked. And it has undermined market efficiency. Regardless of whether exogenous events made a squeeze more profitable, a necessary condition for the squeeze to occur is for somebody to exercise market power opportunistically. These people should not be allowed to skate.

As commentor Scott Irwin noted, due to the fact the squeeze took place in a very short period of time, it is unlikely that it will have acute deadweight costs, although large amounts of money will change hands as a result. (The fact that the main price action took place in the last half-hour of trading that is used to determine settlement prices–and the final prices on swaps tied to NYMEX CL–suggests that somebody was long swaps as well as futures, and earned profits from the price distortion on a cash settled OTC swap position.)

The main deadweight cost is the effect that the episode will have on the speculation debate. People are already seizing on this as evidence that market manipulation is a serious problem that needs to be addressed by more draconian restrictions on market participants. My take is very different. The contrast between what happened on 9/22 and what happened in the last half of 2007 and the first 8 months or so of 2008 shows that the big price surge in oil that peaked in July was almost certainly NOT the result of manipulation.

Yesterday’s events bear all the hallmarks of a squeeze. It waddled like a squeeze, it quacked like a squeeze, it flew like a squeeze, and it swam like a squeeze, so . . . I would have a hard time arguing that what happened in the October CL price was normal and competitive.

So what yesterday shows is, yeah, manipulation can happen. What happened on 9/22 bears all the hallmarks of a manipulation—and look how different that was from what transpired over the first 7 or so months of 2008. The 9/22 event was intense, but limited to a very short period of time in a single market. It affected one price that moved a lot relative to other prices (e.g., the November price, the prices of heating oil and gasoline). It happened as the contract moved to expiration/delivery. That’s what happens during a squeeze, a manipulation.

In contrast, the runup in oil prices over 2007-July, 2008 was long, sustained, occurred in all markets, was not concentrated around contract expirations, and did not result in one price getting way out of line with all other prices.

Thus, in my view, by contrast, the squeeze of 9/22 shows that what happened in 2007 and the first 7 months of 2008 was NOT manipulative.

The events also showed that when a squeeze happens—people notice. Regulators notice. The subpoenas went out within hours of the event. People will sweat. People will pay. That’s the way to deal with it. By focusing on people who engage in demonstrable wrongdoing, and punishing them severely—not by clamping down on all speculative activity, virtually all of which is quite legitimate. Cut out the cancer—don’t shoot the patient in the head—a surefire cure, but not a very constructive one.

This episode also brings to mind a historical parallel. In May, 1921, the Senate was holding hearings on the regulation of futures trading. A representative of the Chicago Board of Trade, Julius Barnes, testified that there was no need to regulate futures trading because the exchange had the incentive and ability to prevent manipulation. The very moment he was speaking, a large grain trader named Field executed a huge squeeze of the expiring May wheat future. The price of May wheat rose $.17/bu–almost 10 percent–on the last day of trading, and the price of cash wheat fell $.20/bu the day after the contract expired. This spike and crash is symptomatic of a squeeze.

An exasperated Barnes wrote to his business partner: “nothing has embarrassed, in recent years, like the gyrations in Chicago May–the very day we were arguing before the Senate Committee that the governors of these exchanges were making some progress themselves in eliminating manipulation.” A month later, a chastened representative of the CBT, L.F. Gates, testified before the Senate that “The trade recognizes the manipulator as the enemy of the whole organization. We dislike him as much as any of you gentlemen do, and if we could find any way of shitting him out absolutely, we would do it. Maybe you can help us on some of these problems.” In other words, the CBT almost begged for regulation. The Congress obliged, passing the Futures Trading Act, the first major Federal regulation of the futures markets, and the progenitor of the Commodity Exchange Act that governs the markets to this day.

Thus, the actions of a squeezer–Mr. Field–on one day dramatically changed the political landscape, and forced a previously recalcitrant CBT to submit to Federal regulation. Sadly, whoever squeezed the October crude contract on 22 September, 2008 may have a similar legacy. Even though the October CL squeeze in no way validates the wild accusations leveled against oil speculators for causing the price runup to $147 in July, it may well become the “I rest my case” Perry Mason moment that will be used to justify wide ranging restrictions on energy trading. Restrictions that will do little if anything to prevent events like those that occurred on Monday; that will not prevent prices from rising to $147 or higher when fundamentals justify it; and that will impair the efficient operation of the market as a price discovery and risk management tool.

Thanks, buddy, WTF you are.