Enter the Dragon- first published March 29, 2005
Posted by WARREN MOSLER on January 12th, 2011
March 2005 Article:
Kudlow’s Guest Commentary:
Enter the Dragon – New Dynamics in the Oil MarketBy Tom Nugent and Warren Mosler
Traditionally, the hedgers and speculators have ruled the commodity
markets. But now a new behemoth has stepped in- the institutional ‘long
only,’ ‘real money,’ fund manager, who has incorporated indirect ownership
of raw commodities as an ‘asset class.’ Yes, there are very large commercial
hedgers, and there are very large hedge funds who are speculators, but this
new entrant with $ trillions of assets under management is changing the
landscape.
In a recent Dow Jones Newswires article by Spencer Jakab, entitled
“US Pension Funds Dip Toe into Commodities, Roil Waters” the author
presents his research into the prospective impact of direct investor
involvement in commodities:
“…the advent of new funds that have allowed pension trustees to buy
a basket of commodities without dabbling in futures themselves, has
unleashed a torrent of money — an estimated $50 billion of flows into
indextracking funds in the last two years alone, with estimates of
another $50 billion on the way in 2005.”
What makes these funds qualitatively different is that they buy and,
for all practical purposes, never sell. In fact, most of them continue to net
buy an asset class as a percent of their total assets, which means as their
financial assets grow over time they buy and hold more and more
commodities. And this is exactly what the crude oil markets are telling us.
Even as inventories continue to grow well beyond commercial demand, the
price continues to rise, as pension funds continue to buy and hoard
inventory. And, if allowed to continue, this building inventory will grow
indefinitely and NEVER be used! Yes, price is still a matter of ‘supply and
demand,’ but in this case the demand is to hoard- continuously buy and
store, and NEVER sell.
At the macro level, our own pension funds are buying crude oil to put
away forever, by bidding up the price and depriving us FOREVER from using
the crude oil they purchase. This is truly a bizarre set of circumstances
at the macro level, while it makes perfect sense at the micro level. It is a
classic and colossal case of failure of institutional structure to serve a viable
public purpose.
To make matters worse, this monster has staggering geopolitical
consequences that are currently being played out. Hopefully essays on this
developing story will trigger more of the same that will enlighten our
leadership to these new forces in motion. But be prepared for things to get
much worse before they get better.
*Thomas E. Nugent is executive vice president and chief investment officer of
PlanMember Advisors, Inc. and chief investment officer for Victoria Capital
Management, Inc.
*Warren Mosler is a principal of Valance Co. and associate fellow at the Cambridge
Centre for Economic and Public Policy in the United Kingdom.
January 12th, 2011 at 6:25 pm
At least when I retire, my pension fund will keep my gas tank full.
Where are they taking delivery of all this stuff?
Time to go long warehouses.
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WARREN MOSLER Reply:
January 12th, 2011 at 8:44 pm
oil storage facilities are full as they have bid up the price of storage to accommodate all the net futures buying by the funds.
i’ve written about this over the years, including how it alters the term structure of futures contracts, etc
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January 12th, 2011 at 7:19 pm
A few years later I remember reading this article by Gene Epstein in Barrons that followed up on Warren’s theme here.
http://online.barrons.com/article/SB120674485506173053.html#articleTabs_panel_article%3D1
More depraved policy.
Resp,
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January 12th, 2011 at 7:44 pm
But doesn’t the price make some sense given the diminishing amount of oil in the ground, and the global appetite to burn it? I tend to think this is a good thing because it generates incentives for battery powered cars and nuclear energy; which is our future. …and also because I just bought me some stock in energy companies.
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WARREN MOSLER Reply:
January 12th, 2011 at 8:45 pm
right now there is excess supply. the saudis could pump an extra 4 million barrels per day if the demand was there.
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January 12th, 2011 at 7:57 pm
Albert Einstein argues that democracy and capitalism are incompatible.
Why Socialism?
And, no, Einstein was not a “Marxist.” He thought this through.
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Matt Franko Reply:
January 12th, 2011 at 8:26 pm
“The economic anarchy of capitalist society as it exists today is, in my opinion, the real source of the evil.”
Whoa. Smart guy this Einstein fellow. ;)
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Tom Hickey Reply:
January 12th, 2011 at 9:04 pm
Yeah, and that was in 1949. I wonder what he would say now.
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ESM Reply:
January 13th, 2011 at 11:58 am
Actually, I believe he would be more capitalist in his outlook. The socialist experiments since 1949 have been failures, and the capitalist experiments have been grand successes. There have even been side by side control experiments in the two Koreas, and controlled experiments in time (pre-1989 and post-1989 Warsaw Pact countries).
Sure, Albert Einstein was a scientific genius, but that doesn’t mean his essay is any more credible or persuasive. The arguments are laid out clearly, and they are too simplistic. He completely ignores the problem of worker motivation and incentive (not surprising for a theoretical physicist who worked hard simply to satisfy his own thirst for knowledge). He also recognizes that there could be a problem with the government becoming as oppressive as a capitalist oligarchy, without acknowledging the high likelihood of such a result given that the government must be staffed by human beings (just as the oligarchy is). In light of the events occurring in China, North Korea, and the Soviet Union and its satellites during the 40 years after he published this essay, I think he would revise his views sharply.
Tom Hickey Reply:
January 13th, 2011 at 12:45 pm
Einstein holds that capitalism and democracy are incompatible system because money and influence undermine the democratic process, which ends with state capture by capitalists.
“Private capital tends to become concentrated in few hands, partly because of competition among the capitalists, and partly because technological development and the increasing division of labor encourage the formation of larger units of production at the expense of smaller ones. The result of these developments is an oligarchy of private capital the enormous power of which cannot be effectively checked even by a democratically organized political society. This is true since the members of legislative bodies are selected by political parties, largely financed or otherwise influenced by private capitalists who, for all practical purposes, separate the electorate from the legislature. The consequence is that the representatives of the people do not in fact sufficiently protect the interests of the underprivileged sections of the population. Moreover, under existing conditions, private capitalists inevitably control, directly or indirectly, the main sources of information (press, radio, education). It is thus extremely difficult, and indeed in most cases quite impossible, for the individual citizen to come to objective conclusions and to make intelligent use of his political rights.”
Einstein also emphasizes that humans are social animals and operate effectively as groups based on cooperation and coordination rather than competition and control. This is basic biology, as Einstein (and Roger Erickson, and David Sloan Wilson, etc.) point out.
ESM Reply:
January 13th, 2011 at 1:10 pm
First, I think it was clearly wrong of Einstein to make such a definitive statement when certainty is clearly lacking: “… enormous power which CANNOT be effectively checked…” A great physicist should know better, although perhaps it was mistranslated or misedited. There are certainly problems with governments being influenced by money, although I actually think the problem is quite small, and history has shown that there are rich people on all sides of the political spectrum (i.e. not everybody is out to use government to make themselves richer, so the net effect in favor of capital concentration is diminished even further).
But neither Einstein nor you have examined the converse problem, which I actually think is much worse. Governmental power is used to create an oligarchy. At least in the US, almost anybody with charisma and overweening ambition has a chance to gain political power. Neither Bill Clinton nor Barack Obama started out rich, and neither one was beholden to moneyed interests as far as I can tell.
Yet, the power, money, and status that they can and do grant to their friends and toadies is astonishing. I don’t mean to pick only on Democrats by the way. The Republicans are almost as corrupt — slightly less so, though, because the media plays its watchdog role more diligently when Republicans are in power.
Tom Hickey Reply:
January 13th, 2011 at 2:44 pm
ESM, as long as there is a state it is up for grabs to capture. The notion of democracy is that the ballot box will keep power in the hands of the people. It doesn’t always work that way, especially in the case of representative democracy, designed to limite popular sovereignty in the first place, as limited parties, which limits the choice of voters.
This is an ongoing problem that has not been solved satisfactorily anywhere for long.
Of course, the question of whether the Democrats or Republicans are more corrupt is moot, since the system has been corrupted by moneyed interests and an elite with a geopolitical agenda that has been largely concealed from the public, as Ike warned wrt the military-industrial-governmental complex and the revolving door. Recall also that a coup was almost mounted against FDR when the political process failed them. It is called “the Business Plot.”
January 13th, 2011 at 3:46 am
I would be interested on any opinion why Brent continues to trade higher than WTI for the past 4 months. Is this also inventory related? Why isn’t there some sort of arbitrage? Last I checked Brent was trading over 98, while WTI is around 92.
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WARREN MOSLER Reply:
January 14th, 2011 at 9:35 pm
From Dennis Gartman letter:
I wholeheartedly agree that WTI / Brent is
“stunningly wide” but it is interesting to note the
LLS (Light Louisiana Sweet) is now trading at
WTI + $7 (from what was historically small
premium) and MARS is trading WTI + $2 (from
what was historically $4-5 discount). So while
the WTI has been falling into the abyss, the
premiums for the other physical grades on the
Gulf Coast have widened significantly. Hence
the LLS / Brent or MARS / Brent is not
materially changed. Just more confirmation
that WTI in Cushing becoming more
problematic and less useful as any sort of
marker
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Zaid Reply:
January 16th, 2011 at 3:36 am
Thanks. Also interesting: Out of curiosity, I searched for vehicles that allow shorting of the various crude benchmarks, and I haven’t been able to find easily accessible short ETFs on anything but WTI. So, this could be a case of the financial instruments placing downward pressure on WTI beyond what is warranted when compared with other benchmarks?
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January 13th, 2011 at 6:03 am
Do they buy phisical commodities instead of future contracts? They could burn, right? They have to pay for storing the stuff.
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WARREN MOSLER Reply:
January 13th, 2011 at 7:53 am
some do. and store it.
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Matt Franko Reply:
January 13th, 2011 at 8:53 am
Warren reported on one of these companies biting the dust back in 2008 in this post just before the GFC:
http://moslereconomics.com/2008/08/20/bloomberg-vitol-reclassified-by-cftc-as-non-commercial-trader-wsj-says/
But I would point out it took a change in policy to get them kicked out of the marketplace. The Fed probably bailed out their bankers.
btw ‘comments’ in this one are also interesting. Resp,
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January 13th, 2011 at 9:45 am
warren wrote: “right now there is excess supply. the saudis could pump an extra 4 million barrels per day if the demand was there.”
I take it you don’t lose any sleep over “peak oil” but what’s your take on battery technogology? How close are we to lowering our oil dependency via electric cars?
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WARREN MOSLER Reply:
January 13th, 2011 at 1:26 pm
happening very slowly
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ESM Reply:
January 13th, 2011 at 2:37 pm
I may as well take this opportunity to plug one of my investments:
http://www.scuderigroup.com/
I think the Scuderi engine is more promising in the short-term than any electric car technology.
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WARREN MOSLER Reply:
January 13th, 2011 at 2:56 pm
looks like a super charged 2 stroke to me?
one piston compresses the air and feeds it into the 2 stroke engine/cylinder that takes in the air and adds fuel and fires on the way down and exhausts it on the way up.
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ESM Reply:
January 13th, 2011 at 5:09 pm
Yes, although apparently the real boost in efficiency comes from storing braking energy as compressed air in a reservoir in much the same way that a hybrid car stores the energy from braking as electrical energy in a battery.
I’m surprised that it hasn’t gotten more press. Some of the world’s best automotive engineers are taking it quite seriously apparently.
January 13th, 2011 at 9:47 am
The passive commodity funds also expose the bankruptcy of modern portfolio theory. Pension funds are buying-to-hold non-productive “assets” with no real return over time (just more volatility vs. rolling t-bills). But hey, they get “diversification”.
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Tom Hickey Reply:
January 13th, 2011 at 12:51 pm
Right. The problem is valuation in the absence of capitalization, cash flow, earnings, etc. It’s all momo. And look what happens when money runs for the door. Is that where you want your retirement funds sitting? Disregarding the social and economic costs of hoarding.
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WARREN MOSLER Reply:
January 13th, 2011 at 1:27 pm
and they get slammed on storage charges, particularly the front month contangos in the futures markets.
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January 13th, 2011 at 10:58 am
Remember, the pension funds have advisors that put together these schemes. Just like investing in MBS with CDO insurance. No possibility for loss, right?
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January 13th, 2011 at 12:50 pm
OK I may be a bit dense here but I don’t quite get all the concern. Sitting on large quantities of commodities to never use them is indeed odd. But frankly, on my bizarreness meter this doesn’t rate very highly. How about countries that maintain vast armies overseas in murderous pointless wars at a cost that could provide everyone in the country with a decent job and standard of living? How about, in the case of the US, having by far the most inefficient health care system in the developed world yet being unable to even BEGIN to change it? How about the stupendous financial rewards doted on financial operatives who do nothing useful while wages for the average person who does all the grunt work and keeps the economy running are declining. And the grunt workers accept it!!?? Now that’s bizarre!
In the case of oil, daily consumption is about 85 million barrels per day. At $90 per barrel that’s almost 8 billion dollars per day consumed. If half of the funds Epstein discusses are invested in oil, say $100 billion, that’s only 12.5 days consumption. So what? If all of it is in oil that’s 25 days. Again so what?
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Tom Hickey Reply:
January 13th, 2011 at 1:01 pm
Keith, I think is probably does count. I remember during the 70′s gas crisis that part of the problem was that everyone was keeping their tanks topped up, whereas before the national average was, say, a half tank. That extra supply sitting in the aggregated tanks was putting a strain on refineries to keep up with the extra demand.
At that time there was not only rationing by price, i.e., prices climbed a lot higher, but also rationing by supply, in that not all stations had petrol all the time. One had to hunt around for a pump that worked. I was traveling interstate at the time and carried not only a full tank as much as I could but also a couple of 5 gallon fuel cans in case I couldn’t find gas out in nowhere, which happened. If that happened to you, you just had to sit until the replenishment truck came, hoping they didn’t run out of beer, too. Bummer.
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WARREN MOSLER Reply:
January 13th, 2011 at 1:38 pm
agreed, there are worse things happening.
and it’s more like 4% of pension assets going to these ‘passive commodity strategies’ so maybe $1 trillion or more world wide worth of stuff people are digging up, refining, etc. to pile up somewhere never to be used, disrupting lives and prices and markets that further disrupt lives etc. etc. etc.
but yes, there are worse things going on.
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Matt Franko Reply:
January 13th, 2011 at 2:30 pm
Keith,
Here’s a link from testimony from Michael Masters who I believe Warren knows. From back in 2008 near the last speculative crescendo.
http://hsgac.senate.gov/public/_files/052008Masters.pdf
He goes into some detail. Maybe the point he makes is that the 12.5 days would be almost half of the global monthly (30 days) consumption, and these funds apparently use the monthly futures market as the investment vehicle, keep rolling them over and providing huge monthly demand for futures, etc…
It could be debatable I guess, but I would like to see the regs ban the practice and see what happens. One of the retorts is “for every buyer there is a seller”, and that one I think is BS for sure. Resp,
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January 13th, 2011 at 1:36 pm
I read in the NY times about half a year ago that the creation of new storage facilities are underway. I’ve heard from a friend who monitors this stuff that the funds have found a way to pay producers to keep their oil stored for them.. in the ground by not pumping it.
Not quite sure there is zero social value in this though. If one takes the long view, it’s good that some oil is saved for future generations. Or that less CO2 goes into the atmosphere.
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Tom Hickey Reply:
January 13th, 2011 at 3:05 pm
Whatever raises the price of petroleum, I am for it. Only cost-effectiveness is going to spur requisite market-driven investment in alternatives, since governments don’t seem to be able to coordinate it for public purpose.
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WARREN MOSLER Reply:
January 14th, 2011 at 7:55 pm
true, but rationing by price in this manner is highly regressive
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beowulf Reply:
January 14th, 2011 at 2:15 am
I’ve heard from a friend who monitors this stuff that the funds have found a way to pay producers to keep their oil stored for them.
That’s odd. Reminds me of the Steven Wright joke, “I have a large seashell collection which I keep scattered on the beaches all over the world. Maybe you’ve seen it”.
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Tom Hickey Reply:
January 14th, 2011 at 12:38 pm
Not a joke, really. That is exactly the way the ruling elite thinks.
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January 13th, 2011 at 4:46 pm
Warren,
Apparently the CFTC may be taking their lead from your blog! This just out today.
Excerpt: “The Commodity Futures Trading Commission proposed limiting the volume of futures contracts that financial investors can trade for 28 commodities. The panel voted 4-1 to advance the rule, which opens it to public comment………….The growing role of hedge funds, financial traders, and long-term passive investors in energy and other commodity markets has had devastating consequences for the average American,” the senators wrote. “These speculators have contributed to rising volatility and periodic price spikes in the cost of gasoline and food.”
http://finance.yahoo.com/news/Govt-moves-to-limit-apf-4112081129.html?x=0&sec=topStories&pos=8&asset=&ccode=
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Tom Hickey Reply:
January 13th, 2011 at 8:01 pm
“The growing role of hedge funds, financial traders, and long-term passive investors in energy and other commodity markets has had devastating consequences for the average American.”
And what about the ROW? The developing world is already getting hit hard by rising food prices.
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WARREN MOSLER Reply:
January 14th, 2011 at 7:56 pm
yes, thanks to Mike Masters and his efforts
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January 13th, 2011 at 6:05 pm
I’ve been wondering, what’s to keep the Saudis, etc. from investing in such hedge funds?
They’ve got the supply side under control, and this seems like a good way to manipulate demand, or at least apparent demand, if/when the need arises.
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January 13th, 2011 at 6:53 pm
Matt, thanks for the link.The paper was informative and allows me to illustrate my point about oil.
The author believes there is a problem with what amounts to 12.5 days of oil supply. To me that is not very significant. If the oil was being bought and sold in devious and manipulative ways to create volatility so the speculator could reap windfall profits then, despite the relatively small quantity involved, it would concern me. However the oil is being bought and held apparently indefinitely, or at least for a fairly long time. Where the oil is being held in storage this seems straightforward. In fact when it is sold it will cause an increase in supply and decrease in price, presumably a plus.
The odd case is where investors are able to do this ”virtually” by rolling over future contracts and never taking actual delivery. But still, every day, day in day out, 85 million barrels are produced and someone takes delivery. Holding a static hoard of a small percentage of a year’s production, doesn’t seem all that significant to me. Of course if the amount became a much larger percentage of yearly production I would be concerned. For instance the author notes that two year’s supply of wheat has been hoarded in this way. This is indeed worrisome and must have had a significant effect on prices.
Again, re oil, it still seems to me that the driving force behind the price run-up (excepting any short-term manipulative dealings)was the supply/demand balance. I recall at that time producers were going flat out and demand was very strong and there was very little, if any, spare capacity.
Below Tschäff notes that investors are now paying producers to keep the oil in the ground. Interesting observation. Is that speculation? It can be a fine line at times. Are the Saudis engaging in speculation by not pumping 4 million barrels per day? It is their oil after all. Or are they just conserving it for the future when they believe they can get more for it? Why should they undermine the price of their depleting resource? Maybe they want to conserve it for future generations (This contrasts with the point Warren often makes about the absurdity of prefunding future real benefits with current financial assets).
Despite what the author of the paper writes, oil is not a life and death commodity. If it were essential to life, like his pharmaceuticals example, or water in the desert, or food, OK. But oil to drive your car from a far-flung suburb to work?
Warren notes that at least $1 trillion worth of commodities are now in these hoards, representing 4% of pension funds. I certainly agree that if the stuff is being dug up and refined and stored that is a remarkable waste of effort and depending on the commodity, food for instance, is just plain wrong.
Perhaps that’s central point – all that effort for no purpose, for oil and minerals anyway. They could just be left in the ground.
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January 13th, 2011 at 9:12 pm
Keith,
See your point. And I have a tendency to agree w/ Warren that for oil, there is a monopolist in control these days and that is probably more influential on the price for oil, and then oil feeds into food for planting, harvesting, transportation.
But you have to give oil futures some consideration. Oil always goes up at the pump when a hurricane is going to strike, etc.. it’s immediate. That complex seems to be VERY sensitive to the futures price. As opposed to say lumber which hardly trades on the futures. When a hurricane is going to hit, you dont see Home Depot jacking up the plywood prices, if a sheet was $15 before the forecast, thats what it is when the storms turns toward the community. They just keep the price posted and sell till they run out.
Also when the GFC hit oil collapsed to like $33/bbl from above 100, why did that happen? Consumption didnt get hit that much. Or if you look at the portfolio theory, when prices dropped, these index specs just keep buying it up until their allocations level is reached (rebalance). So its sort of like the Feds QE2 for bonds in reverse. Only these funds are buying on a scale up, but like the Fed they dont care about price they only are concerned with quantity. These oil ‘investor’ index funds are trying to get the price up, the Fed wants to get bonds prices down, and both of these buyers have the deepest pockets of any buyer in the marketplace.
I think right now this oil price is holding everything up, if we can get that price to crack, look out below for a deflation scenario. Its going to take more conservation/substitution and maybe Iraq can get a few more Bpd out and then see if the cartel can hold these levels.
Anyway from another post it looks like the regs are finally on it now 2 years later. We’ll see. I noticed no GOPers signed that letter.
Resp,
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January 14th, 2011 at 12:53 am
Ahhhh, new and imaginative reasons for why oil is going up and to deny that the affordable and easily mined oil is getting scarce. Why, haven’t we all been told since 2005 and before that the US has lots of oil in the ground. And of course there is no environmental impact in burning it. That makes it abundantly clear that there is absolutely no reason at all for alternative energy sources. Let’s just stick with oil because the price will soon fall to $30/barrel and our economic problems will end forever. And our largest source of imported oil, Canada, can just damn well keep it. Ha!
And if anybody doesn’t accept that then they should also know that God is making it in the ground faster than we can burn it. Now how comforting is that?
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January 18th, 2011 at 5:32 pm
Very interesting interview:
Turmoil in Global Energy Markets
Part 1:
http://www.youtube.com/watch?v=m1jyGr-ueco&feature=related
Part 2:
http://www.youtube.com/watch?v=_4_rfiPm_Q0&feature=related
Part 3:
http://www.youtube.com/watch?v=BHsw2PkFC9E&feature=related
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