The FT reports on Wednesday that:
An unsigned paper opposing trading limits circulating in Houston’s natural gas hedge fund community warns that “domestic liquidity will suffer terribly” as CFTC rules grow more onerous. “While the US natural gas market could very well die, the other commodities, like oil and copper, would certainly find homes in foreign markets,” the paper says.
The above comes out on the day Britain’s financial watchdog and the UK Treasury meet oil industry representatives to discuss the US CFTC potential measures on speculators and position limits.
What the unsigned paper points out is very true: the direct consequences of excessive controls on speculators will be on liquidity, irrespective of whether investors take their business to foreign markets or not.
What some forget is that the oil markets are still relatively young. The development of the Brent and WTI benchmarks only came in the early 1980s and even then the contracts didn’t become actively traded until the onset of the first Gulf war — Brent being the most popular then:
The development of the futures market, meanwhile, was largely a response to the 1970s oil shock, which was itself a response to the collapse of Bretton Woods and Opec’s attempt to reprice oil in terms of gold. Until that time prices had been stable as the market was controlled by a cartel of western oil companies known as the Seven Sisters.
The oil shock not only presented the makings of a viable secondary market, it presented the opportunity to hedge the volatility that stemmed from that fragmentation, and via that the development of a futures industry.
But it wasn’t until speculators entered the market in a sizable way – during the first Gulf War – that the market really became efficient at providing that sort of hedging service.
More importantly, one could argue, it wasn’t until speculators actively entered the market this century that futures further down the curve really became the liquid hedging instruments they are today for both producers and consumers.
Until that time, the pricing of curve contracts was a simple function of the cost of production, the cost of storage and the time value of money. If the spot market was tight – meaning there were more buyers than sellers – the futures price was usually lower than the spot price. The curve, more often than not, was backwardated. Mostly, though, the pricing of the curve was theoretical.
The speculator effect
The entry of speculators on a mass level, meanwhile, brought an element of real price discovery into the long-term futures curve. Speculators — not being interested in physical delivery — naturally wanted to sit in contracts much further down the curve. Accordingly, speculator influence, if anywhere, came on the curve not on the outright spot price. One can argue the adjustment of the curve into a contango structure might therefore be due to speculators’ more sophisticated understanding of other asset classes, money markets and inflation – as well as their view on the oil price.
And while their entry may have provided much-appreciated liquidity for hedgers, it had one critical side-effect.
By taking the market into contango speculators found themselves, during the credit crisis specifically, being a source of cheap financing to the physical industry. The contango trade, after all, is nothing more than being able to buy physical oil now and sell it into the future for more than it costs to store it over the period. If speculators are willing to step in to provide the premium needed to make that happen, the industry will take advantage.
Of course the trick usually only lasts until storage becomes full. At that point storage prices rise and the economics become untenable.
Alternative financing
Crucially, though, this hasn’t happened this time round. This is largely to do with the appearance of an almost unlimited source of cheap storage for physical intermediaries: offshore tankers. Producers, meanwhile, have had the ability to curb production to avoid storage costs altogether, and still receive funding by riding the contango wave.
In effect, the emergence of the contango was the industry’s natural solution to the credit crunch — a way to finance itself as traditional financing seized up. The liquidity and premium provided by speculators along the curve was very important in allowing that to happen. By doing so speculators directly supported the industry’s exploration and production activities over the crunch. Physical intermediaries capable of sourcing cheap storage, meanwhile, just rode the wave for profit.
So what happens if speculators are driven out completely? Well, firstly a potential source of cheap financing to the industry may disappear — and arguably, this could have a much greater impact on driving spot prices higher than speculators themselves. Secondly, liquidity on the curve might suffer immensely, a fact that would only hurt the so-called bona fide hedgers currently seen as disadvantaged by the presence of speculators. Thirdly, it would bring pricing control increasingly into the hands of the physical intermediaries whose main interests remain spot price volatility.
Last, and not least, it would allow a small handful of investment banks and financial institutions — with actual physical enterprises — to tighten their grip on the market itself.
Related links:
Presenting, the ‘physical loophole’ – FT Alphaville
GLG goes physical – FT Alphaville
Evil commodities speculators in the dock - FT Alphaville