Monday, July 14, 2008

Gas at 3.99 a gallon? What fortune!

A few months ago I wrote in my post that the current economic condition would worsen over the next year. At the time, although the Dow Jones had dropped 1,000 points to around 13,000, it was holding against rising oil prices and a weakening dollar. Many experts proclaimed that we had reached the proverbial bottom and were on our way out. Today the Dow is holding just barely above 11,000 and is coming off the worst June in 20 years. There is also talk that Freddie Mac and Fannie Mae are insolvent (which I'll write about next). I'm not one to gloat, but I will say I told you so.

Maybe you noticed last week that oil leveled off a little bit. Did you wonder why? I'll explain in a moment. The other day I was forced to listen to a comment by a presidential candidate (who shall not be named since this is a bi-partisan blog, but, I'll just say he's the older of the two) regarding how nefarious "speculators" are to blame for the high oil prices. What?! It's painful for me to listen to someone who pretends to understand the drivers behind billions of dollars moving among billions of homo-sapiens the world over. Of course, it's my job to explain this (rather, why he is wrong) to the four readers of this blog. How can a system be right when people are making money and wrong when people are losing money? This smacks of public pandering! And how does this relate to oil prices taking a brief respite from their break-neck ascent last week? Read on.

What are "speculators?" It sounds like a dirty word that connotes greed and irresponsibility, but that could not be further from the truth. I'll explain in more detail shortly. This presidential candidate was blaming the derivatives markets, which is sometimes synonymous with "speculation." I'm not going to explain what a derivative is except that it is only an asset class, like a mutual fund, but could be defined further. Options, Swaps, and Futures are all "derivatives." In this case, the blame seems to be directed at the futures market.

I love the futures market! Here's how it works. Futures allow organizations/people to lock in future exchanges (backed by a contract) at future prices. If I'm an oil refinery, I can buy a futures contract committing to buy a certain amount of oil from a seller who agrees (in contract) to sell the oil at a specified price at a specified future date. By the way, this is exactly why Southwest airlines is whoppin' up on their competitors. They bought futures contracts years ago that allowed them to buy oil at $60/barrel today! They can lower fare prices without losing profit and they are killing their competition. Futures markets allow organizations to control some of the volatility behind prices. For example, say Southwest airlines wants to add a new route but it would only be profitable if oil stayed below $90/ barrel. At the same time, say an oil company wants to drill in a new oil field but this endeavor would only be profitable if oil stayed above $80/barrel. A futures contract can be negotiated at $85/barrel between the two parties. It's a win-win. The value of the contract itself is adjusted periodically depending on the price of oil relative to the negotiated price. But the contract now allows both the oil company and airline to move forward regardless of market outcomes. So, why the blame?

Here is where large institutional investors like Pension funds are involved. There are two types of speculators; traditional and index. Traditional speculators engage in active buying and selling. Index speculators usually have an investment policy that stipulates how much exposure the pension plan can have to derivatives instruments. If the policy designates an allocation of 2% of assets, then the plan purchases futures contracts to gain their 2% exposure. What this one presidential candidate claims is that these index speculators never sell their contracts and thus "remove" liquidity from the system, which increases demand and, subsequently, prices. But this conclusion is simply unacceptable.

If a large pension fund decides to allocate 2% to oil futures at, say, $120/barrel, then any rise above $120/barrel would increase the value of the overall contract, right? Therefore, instead of having a 2% exposure, a fund might find themselves with an exposure of 2.5% (of the overall portfolio) reflecting the increased value of the futures contract, especially if the rest of the economy is in the crapper (which it is) and other holdings are decreasing in value. At this point the pension fund must "rebalance" the portfolio, or bring the allocation back in compliance with the 2% mandate. This forces the fund to sell .5% of their futures contract. This could easily equal millions of dollars which would push the price of futures back down. So institutional investors actually help the market. What is the corollary to the recent fall in oil prices last week?

Many institutional investors have fiscal year-ends of June 30th. Many of them also have direct exposure to oil and oil futures. Every quarter or year-end these funds must "rebalance" their portfolios to bring them back into compliance, which means selling off oil futures as well as direct exposure in equities. Increasing the supply back into the market decreases the overall price of oil. Over the last two weeks, plans across the nation have been rebalancing portfolios thus bringing down he price of oil futures and energy stocks in the short-term. Futures contracts allow companies to continue focusing on core business strategies instead of worrying about commodity prices. And institutional investors bring much needed liquidity to the derivatives market and help to keep prices in check.

Banning institutional investors, like this candidate proposed, doesn't help anyone and only displays obvious ignorance.

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