Who Benefits From Bogus Oil Prices?

Regular readers know that I am disturbed by the influence of speculative trading (paper barrels) on the price paid for actual oil (aka. wet barrels). If you could watch only one video on the subject, I recommend Aaron Task's interview with Duquesne University's Kent Moors (below). Duquesne is a small Catholic university here in Pittsburgh. I will be doing my biweekly Saturday Oil Report tomorrow, so I will postpone any discussion of the current state of the oil markets until then.

I would like to bring to your attention the Wall Street Journal's Big Banks Cash In on Commodities. I have skipped part of the text to remove Wall Street Journal propaganda. Read it and weep.

Wall Street is tapping a real gusher in 2011, as heightened volatility and higher prices of oil and other raw materials boost banks' profits.

A group of 10 large banks—including Goldman Sachs Group Inc., Morgan Stanley, J.P. Morgan Chase & Co., Citigroup Inc., Bank of America Corp. and Barclays PLC—saw their commodities revenues increase by 55% in the first quarter, according to Coalition, a firm that analyzes the performance of investment banks. After a disappointing 2010, commodities was the fastest-growing segment in banks' fixed-income businesses in the first three months of this year, even though it still accounts for just 7% of banks' total fixed-income revenues, Coalition said...

J.P. Morgan has emerged as one of the biggest beneficiaries of the commodities boom sweeping Wall Street. The bank's commodities unit—which employs about 1,800 people, more than any of its rivals—made more money during the first quarter than through all of last year, according to people familiar with the matter. So far this year, the unit has earned roughly $750 million and is on course to beat its 2011 internal target of $1.2 billion, these people added. The J.P. Morgan unit earned just $514 million for all of 2010, falling far short of its goals.

The banks extract cash from the commodities markets by taking advantage of the volatility in those markets. If that volatility is all in one direction, which is to say UP, as it was from February to early May, the big banks (and other traders) are essentially effecting a wealth transfer from you to them. This is so because the banks are not simply cashing in on volatility; they are creating it, too.

J.P. Morgan Chase (or Goldman Sachs ...) benefits from bogus oil prices, or bogus food prices, or bogus metals prices. Jaime Dimon & Co. have extracted about $750 million from the commodities markets so far this year, and they expect to reap a $1. 2 billion windfall by year's end. You might ask yourself: why doesn't the CFTC properly regulate the oil markets? Now you know why. See below.

As Kent Moors points out, oil "has an unusual position in that it is both a commodity [wet barrels] and it is also a financial asset in its own right [paper barrels in the futures market]." This ambiguity has wreaked havoc with the price, as Moors will explain in the video.

"If you look only at oil prices, all of the basic indicators I look at are going up and just about anybody in the industry will tell you that," Moors says, citing currency considerations, supply/demand, inventories, geopolitical uncertainty and other traditional fundamental metrics.

In addition, "the speculation is running the market," he says. That's not necessarily a news flash and Moors recommends many of the same remedies to dampen speculation as prior guests, including:

• Higher margin requirements
• Position limits on crude contracts
• Regulation of over-the-counter derivatives.

Where Moors' work differs is an accompanying focus on what he calls "disconcerting" anomalies in crude trading, as detailed in his new book The Vega Factor.

Increasingly, Moors sees "deviations in the trading of oil futures and options on oil futures [that are] much greater in either direction than formulas on which the options are based would specify."

In other words, the oil market is not behaving in ways in which the models used by professional traders say it is 'supposed' to behave. As a result, "an entire new generation of synthetic derivatives are being introduced to make the [trading of] paper and wet barrels fit,"

Moors says. "I like to tell people, 'if you like the subprime mortgage crisis problem, just wait until you see this bubble.'"

In other words, the oil (and other commodities) markets do not "clear" properly to make the trading of paper and wet barrels fit together by arbitrage at contract expiration. Academic economists (like Paul Krugman) will tell you ad nauseum that speculation can not be driving the price because that is simply impossible in properly functioning markets. It has never occurred to these professors to leave their office, roll up their sleeves and trade some oil to find out how things really work. And it never will.

Here's the video.

 

Comments

[John D]

Pretty scary stuff. Oil at $150 a barrel- even based on speculation- combined with all other factors in the ponzi scheme we call an economy, could bring it all down. Not to worry though, trade all your assets for GS shares and you just may survive.