‘Crude mania’ creates oil price bubbles
A veteran dealer explains why oil markets are prone to price bubbles
Traders for the speculators are in it for the short profits they can make. They are generally lined up in a large, open room with many overhead video display monitors giving the latest prices, volume of trading, latest world news and a range of other news. They buy and sell contracts, or derivatives such as options, on a second-by-second basis. They have the latest in software, trends and analysis tools to help them buy low and sell high. They are the ones who pay a lot of money to obtain a seat on NYMEX which allows them quicker execution of positions. They are the ones who make forecasts of future oil prices. Others listen to these forecasts and rush to throw their money at more contracts, and so it becomes a self-fulfilling forecast.
This self-fulfilling prophecy is one of the reasons the crude oil price went so much higher than it should have. The main reason, however, is the ease with which the paper barrel market allowed entry into trading of crude oil futures and derivatives and the minimum financial obligation it took to do so.
The U.S. Commodity Futures Trading Commission (CFTC) requires buyers and sellers of crude on NYMEX to deposit a margin which they call a performance bond. It is not a partial payment for the crude purchase. It amounts to five to seven per cent of the total. In our earlier example of 300,000 barrels, the rule would require from $1.875 to $2.625 million upfront.
The U.S. Democratic Party’s policy committee on May 7, 2008, proposed legislation that called for a substantial increase in the margin requirement on crude oil future trades within 90 days. The avowed purpose was “to limit excessive speculation and protect consumers.” Crude oil traders retorted that the proposal would only cause market participants to take their trading to the Intercontinental Exchange (ICE) in London. The Democrats, in the same bill, vowed to “prevent traders of U.S. crude oil from routing their transactions through offshore markets in order to evade speculation limits and also impose reporting requirements.”
Increasing the margin requirement to 50 per cent would make trading much more difficult and take a number of speculators out of the market. It might not deter the largest traders but it might cool down the frenzy.
Better yet, the U.S. and Britain should legislate a requirement for traders to have physical possession and needs for crude oil. This would take the speculators out of those markets. Unfortunately, there are other world exchanges that would love to have their business. The end result is that not much can be done to control the speculators. We end up paying the price.
Where do we go from here? We know the price of crude oil and all the products derived from it went ridiculously high and had no justification in logic. All the people, companies, governments who greedily want the gravy train to keep rolling will find all kinds of reasons why nothing should be done about the status quo. They will say the market is open and transparent and based on long-term supply and demand. Besides, the price should be high to deter the wasting of our resources. While we’re at it, why not open up national parks and forest reserves and offshore areas for drilling so we can explore and find oil there and make even more money?
The crowd that blew up the oil price bubble want to keep their money and feel quite justified in continuing to let the consumer pay if the same thing happens again. What recourse do the rest of us have? We can hope the market worked as well as the traders claim it does. I hope they didn’t get out of the way too soon when the price plummeted.
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