Artorius Castus

Why Can’t Our Media and Politicians Get The Oil Story Right?

Posted in Uncategorized by Patrick Truax on June 11, 2008

Of course the answer is quite simple! Our pathetic media and politicians can’t get it right because they don’t know how to analyze a market. After all, how many of them have actual experience in managing a client’s portfolio or traded a futures market?

The problem is that their ignorance is having an outlandish impact on our lives as their ineptitude to understand and present the facts might very well lead to policies that will substantially hurt this country’s economy for a long time to come.

We have precedence for this; just look at how they handled the S&L bailout in the 1990’s, where the misguided decisions of Congressional Committees and Government Regulators led to a $10 billion dollar bailout exploding to at least 10 times that amount.

Back then, the political whipping boy was the financial product High-Yield Debt, euphemistically called ‘Junk Bonds’. A market built mostly by the investment firm Drexel Burnham Lambert and it’s powerful investment banker Michael Milken had grown to about a $200 billion market in issuance. As with any financial innovation that takes off, other Wall Street firms piled into the market, and supply grew to levels that were not easy to absorb into the market. Instead of only being used to finance companies that were not able to get bank financing, which was the original purpose of the market, the instruments were used to initiate a number of takeover bids and management-led leveraged buyouts.

As with so many other financial boom periods, as the size of the market grew along with the profitability to the investment bankers, some shortcuts and lax lending standards started to appear, because the potential monetary rewards were so great that ethics standards started to slide. Names like Ivan Boesky, Dennis Levine and Marty Siegel become national symbols of the ‘Greed Generation’. Oliver Stone’s movie ‘Wall Street’, was an actual amalgam of some of these stories (although some of it was absurd – a Bud Fox would never have been trusted by a Gordon Gekko so easily in that time period).

This made easy pickings for the politicians, many of which had constituents who suffered job cuts when the downsizing of leveraged companies hit full speed. Pour on top of that the fact that a few high-profile S&L’s and 6 life insurers ended up going broke because they happened to buy more High Yield debt than what was prudent to do so.

This is when the fun started.

In order to clean up the mess of the failed institutions the estimated needed infusion of capital would have been approximately $10 billion. That would have covered the costs of liquidating and/or merging the failed institutions into healthier firms. But the government decided it needed to try to ensure this would not happen again. So they took policy initiatives that ended up having much further repercussions than expected.

James R. Barth, a senior fellow at the Milken Institute, who served as chief economist at the Federal Home Loan Bank Board and its successor, the Office of Thrift Supervision, from 1987 to 1989, laid out these policies in a speech delivered in September, 1999:

“In 1989, Congress shuffled regulatory bureaucracies, raised capital requirements and, ironically, required S&Ls to retreat to home lending, where they had first gotten into trouble. Compounding the damage, they forced institutions into a fire sale of their relatively modest portfolios of high-yield bonds, which had performed well throughout the decade. Last, but hardly least, Congress eliminated ‘goodwill’ as an asset in S&L portfolios, pulling the rug out from under many institutions and adding a potential $50-billion of taxpayer liability, when the Supreme Court agreed that the government could be sued for reneging on what amounted to contracts.”

All of a sudden, a number of institutions that held High-Yield Debt were forced to sell those holdings into a market that did not have the liquidity to absorb these assets. The overwhelming majority of these holdings were financially sound and paying their principal and interest on time. But when a huge percentage of the market is put up for sale at the same time, and you have a limited timeframe to sell those assets, the natural tendency of the market to discount the value of those assets took its toll. Large write-offs were artificially created by the sale of those bonds at levels well below true value. A number of the former Drexel Burnham investment bankers and salesman led syndicates that bought these assets for 60 cents on the dollar and ended up very wealthy a few years later when liquidity returned to the market.

Meanwhile, many other institutions ended up being busted because these losses on their sales had to be written off immediately and their capital bases reduced at a time when the regulators had ruled they had to increase their capital. A perfect storm of government bungling.

Which brings us to the present. In some instances, history seems poised to repeat itself if we are not careful. Not necessarily in the danger to the banking system but to a number of investment institutions like pension plans, college endowments and hedge funds that have fueled the rapid rise in commodities.

Yes that’s right, the rapid increase in commodities in the last 18 months is more caused by the influx of this money than the imbalances of supply and demand. That is not to say imbalances haven’t caused some price rise, but that happened three and four years ago. The extra rise in the last 18 months was not accompanied by any physical shortages for the most part.

You can still go to any gas station in this country and get a full tank of gas for your car. There are no gas lines, rationing or odd/even license plate sale days. The oil is available, and over the last month we have started to see reduced demand for oil and gas both here and in China. Yet prices have continued to rise. There is only one reason for that: artificial demand for these commodities that have had new financial instruments created for them.

This is where my personal experience comes to bear. About three years ago, as a Financial Representative for Northwestern Mutual, I started to read in the financial planning magazines articles talking about the need to find a way to more fully diversify the investment portfolios of clients. Traditionally, a diversified portfolio might have been: US stocks of all sizes, International Stocks, Bonds and Real Estate Investment Trusts. At the time that was considered sufficient for most investors of modest means.

Larger institutions had started to utilize other asset classes, such as private equity, hedge fund strategies, bank debt and even commodities to further smooth out their returns on investment. For the average investor options were limited for commodity investments. Most brokers would not pitch futures contracts to their clients, as they were deemed to risky and not suitable for use. The braver ones might have talked about gold and gold stocks but most investors were not interested, particularly since gold had fallen in price for almost 20 years.

Even the larger institutions would limit commodity involvement due to a lack of ways to invest in them that would be okay to regulators and their portfolio managers. So what changed?

Just like the early success of the High-Yield market led to more financial investors wanting in on the action, so did the early rise in commodity prices from depression-like levels (remember most commodities were selling for basically the same amount per unit than they were 20 years ago) due to supply and demand issues. For example, copper prices rose due to the demand in the emerging economies for basic construction needs like housing and infrastructure. Due to decades long increases in manufacturing productivity due to supply chain management, just in time delivery and similar techniques, stockpiles of readily available commodities were difficult to find without pricing power arising.

But how could investors participate in these movements without buying the physical material and without having to worry about transportation, storage, insurance, etc.?

Starting about three years ago, I started to think about paying heed to the diversification articles in the magazines and that led me to investigating how to put about 3% of my client’s portfolios into commodities, which was the approximate recommendation from these magazines. Now 3% doesn’t seem to be a big deal, but if you have a pool of about $25 trillion on invested assets in this country (and that doesn’t include non-USA investors), 3% is $750 billion dollars. The entire oil futures market was about $30 billion a few years ago, so even a mere fraction of the $750 billion is a lot for this market to absorb.

At the time of investment, the only real option I found for having direct commodity investment was the relatively new PIMCO Commodity Real Return Fund. When I started to place this mutual fund in my client’s portfolios my Compliance Department took a long look at this. It was only because I could point to the magazine articles to get them to allow this to be a suitable investment. I was probably among the first five Financial Representatives at Northwestern Mutual that went in this direction. But I was not to be the last.

Meanwhile, more and more institutions wanted a way to also invest in commodities. And just like in the High-Yield market new instruments were invented. Many of them were developed to mimic the price movements of certain commodities, particularly oil, natural gas, and gasoline. ETF’s (Exchange traded funds) were developed to give another method of investment.

And here is where the media and regulators are getting it wrong. There is a very lazy use of the term speculator to describe the onrush of investment capital into these markets. There is some speculation going on, but most of this price rise is PERMANENT investment capital being allocated into a commodity asset class that was not invested in previously in any great volume. The $30 billion market has become approximately a $150 billion market in the energy futures. Almost all of this increase has come from the permanent investment of large institutions and mutual funds.

In order to accommodate these investors the FORCED purchase of the energy futures by these investors is driving up ARTIFICIAL demand for these contracts, as they will NEVER take physical delivery of the product. The oil companies can only pre-sell so much production as they have the expense of drilling, marketing, refining and storing the actual product. So, there are far more buyers than sellers in a market that leads to real world difficulties like rapidly rising prices, even in the face of no lack of supply.

So, how does the government handle this?

Even though the greater good is to substantially cut down on the ability of certain institutions to hold these contracts is preferable to the smaller amount of people that can benefit from the profits on these contracts, we need to handle any changes to the regulations with finesse, not the typical heavy hammer that appeared during the S&L crisis.

The last thing this financial system needs is another round of write-offs and losses that will spook the economy, the public and other financial markets. It is easy to postulate an immediate reduction in position limits and increasing margin requirements but we need to get the timing right this time so that investors don’t get punished for doing nothing more than what they were encouraged to do by their advisors.

There has to be a way for the regulators to give a lengthy transition period where the holders of these contracts can be given the ability to unwind these positions. It might make sense for the oil companies and the futures contract holders to negotiate a swap of futures contracts for hedged oil company contracts. It might mean the government would need to spend some money to ease the transition but that would pale in comparison to this continuing, and eventually spiraling out of control, which we are on the path to do if the momentum play of rising prices starts to draw in even more of the $25 trillion in investment assets. All markets get to a point where a bubble occurs because value is disregarded in favor of momentum. Even OPEC’s producers don’t want this to continue; the last thing they want is for us to find alternatives completely removing the need for their product.

Spending money might take the form of a tax credit to the oil companies to take these contracts off the investor’s hands. The important thing to do is not to ARTIFICIALLY cause the same market reaction on the downside of price movement that we did on the upside. We do need to pay to reduce the level of investment to that which takes the artificiality out of them.

Another reason to make this market off limits as much as possible to investors is that it removes the possibility of price manipulation by the producing countries. How do we know that Iran, Venezuela and Russia aren’t recycling some of their windfall into the futures markets through intermediaries? Reduce the size of the market and the ability to hide this type of activity is reduced. Now that’s a congressional investigation I can live with.

And for those that think if we make changes that this market will just go overseas: Let it! When the day of reckoning comes it will be foreign investors that will lose their shirts, not us.

Let the oil companies go back to negotiating fixed, long-term price contracts for the oil. Producing countries will most likely find that arrangement better for long-term planning of their economies than the futures market. If they balk at that let them live with the consequences when we eventually reduce the ability of our investors to buy these contracts. Oil fell as low as $7 per barrel in the 1980’s, it can do so again if demand falls off substantially. And this time, America won’t forget the pain and won’t be so quick to become profligate again.

Only after these positions have been unwound can we re-think the levels of position limits and margin requirements for the contracts. To try to do so too early will only guarantee a similar market result to the S&L crisis.

Let’s hope that our regulators have learned the lesson of history before we repeat its mistakes.

A great article written by Freeper LRoggy. Rooted in common sense, a commodity sorely lacking in todays electorate, it explains what havoc Government intervention into economic downturns can wreak. He makes a lot of sense and offers a couple of pretty good solutions..


2 Responses

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  1. Anonymous said, on June 15, 2008 at 6:26 pm

    What WILL the dinosaurian big business and political structures – and the leeches that benefit from said structures – do when we finally embrace agricultural-based biofuel tech as the…. Oh, I forgot, I live in America.
    (this was meant to be vague, with the point being totally up to the
    view and intelligence of the reader)

  2. Anonymous said, on June 15, 2008 at 7:02 pm

    ….Oh, and, before your falling on the question, no, I am not a liberal….nor a conservative.

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