Beware of what you wish for…
As Yogi would say (Berra not Bear), you can observe a lot by watching. Apropos the rally in equities and commodities from the first quarter, the common refrain amongst traders and analysts at the time on CNBC went something like this… I don’t believe in this market’s strength, but I want to “participate” while it lasts.
In other words, traders were so desperate that they started buying, not on fundamentals, but rather on fear of missing out before this market headed back into the toilet. Thus, large upstairs traders and their flying monkeys on the floors of the NYSE, NYMEX, et al. just decided the recession was over. They were tired of the market going lower, they were bored with giving the same story day in, day out to Mark Haynes and Sharon Epperson, they needed some excitement in their lives… not to mention larger commission checks. So, based on nothing more than some non-customary stock picking advice from the White House, they started buying.
And, given that the economic view was so dire, their buying was met with little resistance. Then, as more and more money was encouraged to participate, the market began to snowball. Thus, what started out as a bear market rally was all of sudden being spoken of in terms of V-shapes and second derivatives. In other words, the market was convincing itself that initial signs, i.e. green shoots – suggesting the worst of the recession was over were instead, actual signs the recession was over. What proof did they have? The market was going higher… and therefore they went on a buying spree because once again, high prices were the justification for high prices.
The rationale for speculators bidding crude oil to $75, $85… $147.27 amidst the greatest contraction of global economic activity since the Great Depression was never questioned. Thus, as headlines began to roll in April and May… only 345,000 Americans lost their jobsin May, U.S. consumer confidence in April bounced 13.9 points off of the two lowest readings ever recorded (since 1967). Other key indicators, industrial production, housing starts… etc were all bouncing around historic lows… but, they were not falling anymore. These headlines were met with absolute glee amongst the cognoscenti because the numbers were not falling anymore… so less bad news was thought to be good and that was good enough to buy.
But, last week’s headlines suggest that could be changing. For starters, the outlook amongst U.S. consumers took an “unexpected” [sic] downturn in June. However, our analysts here at The Schork Reportwanted to know… what was so unexpected about this event? Since February, when the confidence index bottomed, 2.6 million Americans have lost their jobs and gasoline at the pump rallied 40%.
More importantly, according to last Thursday’s Jobs report, the number of hours worked fell to the lowest level, 33.0 hours, since records began in 1964. That’s an ominous sign. Whereas the unemployment rate and payroll data are lagging indicators… and therefore easily pooh-poohed by bullish speculators… the hours worked data is more of a coincident indicator. After all, if those much vaunted green shoots were really sprouting last month, the work week would have increased. Instead, it contracted.
Bottom line, this recession is the longest and deepest since the Great Depression. And, the latest employment numbers suggest it is going to be around a lot longer than the bulls, at least publicly, will admit to.
Accordingly, we are in the midst of a large speculative correction in the oil markets. In this vein, this year’s mini bubble, on the heels of last summer’s massive bubble is of course leading to calls from Washington to rein in “speculation”.
That all sounds politically correct, but is it economically sensible? After all, Washington’s stated goal is to lower market volatility. But, who is to say imposing greater controls on speculation will achieve this.
We fully accept the notion that increased speculation has increased the ante, as it were, when it comes to volatility. But, you have to ask yourself, what would volatility in this market look like without the speculators?
It is not as obvious as you think. The point of a healthy futures market is to provide hedgers, producers and consumers alike, to mitigate their price exposure by selling that risk to speculators.
Consider what happened last September in the oil markets. Crude oil supplies to the Midwest, the second largest concentration of refineries in the United States, were cutoff following the disruption to Gulf of Mexico tanker traffic and the attendant shut-ins to pipelines in the wake of Hurricanes Gustav and Ike.
Nevertheless, these refineries had the option to go to the futures market (NYMEX) to secure their supply requirements. Who sold them this oil? Speculators, naturally. Their rationale for selling went like this… with all of those refineries in the Gulf Coast shut-in, the demand for crude oil will fall. Therefore, this demand destruction will lead to further price declines… just like it did in 2005 following Hurricanes Katrina and Rita.
However, what a lot of speculators failed to appreciate last September is that sometimes the guy who buys that oil from you really wants it. Thus, when it came time for the speculators to buy back their contracts to deliver oil, they found out there were less sellers than normal in the market. As such, bearish speculators squeezed themselves and the contract for October 2008 delivery surged more than $25 a barrel or $25,000 per contract on the day of its expiration as the speculators had to keep bidding up prices to get out of their obligations.
In this case, the market got its oil and the speculators took a bath. Hooray… sometimes the good guys win.
In this light, if Washington succeeds in “reining in” speculation, then Washington succeeds in increasing, not decreasing, volatility. After all, what would those refineries in the Midwest do last September had they not had speculators guarantee them their oil?
If the goal of Washington is to simply reduce the role of the speculator than we here at The Schork Reportsuppose this can be achieved vis-à-vis margins. That is, raise the price of poker by increasing margin requirements. You will raise the cost for the speculator and probably limit their role in the market as a result. However, margin requirements are a double-edged sword. If you raise the cost for the speculator, you also obviously raise the cost for the hedger as well. Thus, you create a template that will ultimately discourage hedging.
And, we just have to look at the pathetic state the U.S. airline industry is in to see what a bad idea that is.
Bottom line, futures markets, speculation aside, do ultimately revert to the fundamentals. It may take some time, but the mechanism does work. In this vein, we prefer the devil we know, to the devil we don’t. Decreasing speculation sounds great in theory, but the law of unintended consequences suggests in could lead to even greater volatility.
After all, you cannot legislate risk. It will always be there. Therefore, it is preferable to have someone there to buy it than face it alone.
Stephen Schork is the Editor of, "The Schork Report"and has more than 17 years experience in physical commodity and derivatives trading, risk systems modeling and structured commodity finance.