Skyhigh Oil

Andrew Horowitz, the Disciplined Investor, writes about the parabolic rise of crude oil prices and the precipitous drop.

Skyhigh Oil: We have been screwed.

If you have been a regular reader of MSN TopStocks over the past several months, I have been talking, writing, yelling and ranting about the obvious and rather incredible speculation that has occurred within the energy futures markets. It is remarkable how during that time, there has been a never ending stream of naysayers who have been confident that supply and demand is the only rationale for the parabolic rise of crude oil.

Now mind you, this comes from some pretty smart people who have been certain that in the short span of only a few months the world’s supply was being outstripped due to the massive industrialized growth within China and India. Then, just as fast, that all changed because (as the tale goes) the price escalation actually dampened global consumption. Come on fellas, do we really look that stupid?

Sure, we knew that something was odd and that there was much more than met the eye with this. All along, the notion that a few major investment banks were involved and held financial stakes in the Intercontinental Commodity Exchange (ICE) was more than enough to raise our collective eyebrows. Of course, we now know that the ICE is the very center of the problem as it is the exchange that has been targeted as speculation-central because it has been operating without certain U.S. regulatory oversight for years. 

(Listen to TDI Podcast 63: OIL-OIL-Enron Loophole-OIL-OIL for the amazing story of the Enron Loophole)

Over the past few days, there has been a growing interest in this and all of a sudden the media is in a frenzy. Why? Perhaps it is because it is finally shaping up to be to a great story with an even greater opportunity to move up a few notches in the ratings. (Cynical, who me?)

In my last TopStocks article on this subject, a few comments came in about the questionable lag between the passage of the Farm Bill, that had embedded in it the Energy Act of 2008, and the drop of crude oil prices. Some of the reason is that there was a 120-day compliance period after the approval date – which may have had something to do with the lag and….

The punch line: The fine print on the story and to get right down to the reason for the precipitous drop is simply this: On July 18, the CTFC had, "reclassified certain positions in the energy futures and options markets from the Commercial category to the Noncommercial category." Up until then, only commercial operations, such as airlines, manufacturers, farms, and their brokers who handled their futures trading activities had permission to trade almost without limits. Before the enactment, they were allowed as it was necessary for the stability of their business to reduce the effect of price fluctuations.

In addition, according to a Bloomberg report:

Commodity index investors, blamed for record oil prices, sold $39 billion worth of oil futures between a July record and Sept. 2, causing crude to plunge, according to a report released today.

The work by Michael Masters, president of the Masters Capital Management hedge fund, blames investors who buy and hold an index of commodities for driving prices to records and for their subsequent drop. It comes a day before the U.S. Commodity Futures Trading Commission is set to discuss its own study of energy trading with a congressional committee.

Masters testified three times before Congress this year, arguing that limits on traders would cut oil prices to $65 to $70 a barrel. He has been cited by lawmakers who introduced at least 20 measures to curb speculation. Congressional pressure on the CFTC to step up enforcement and restrict anonymous trades has pushed index traders out of their positions, Masters said.

“I don’t think it’s just coincidence that the money came out after the pressure was put on these folks," Masters, who wants legislation that would set limits on index commodity holdings, said in an interview.

Details and additions of the included components of the June 17 announcement from the ICE, these specific conditions that have been added to ICE Futures Europe’s no-action letter:

1. ICE Futures Europe will impose on IFE Linked Contracts, by rule or otherwise, position limits or position accountability levels (including related hedge exemption provisions) that are comparable to the existing position limits or position accountability levels (including related hedge exemption provisions) as adopted by: (i) the DCM, DTEF or ECM for the contract against which the IFE Linked Contract settles or (ii) the DCM, DTEF or ECM for a financially-settled equivalent of such contract;

2. ICE Futures Europe will inform the Commission in a quarterly report of any member that had positions in an IFE Linked Contract above the applicable ICE Futures Europe position limit, whether a hedge exemption was granted, and if not, whether a disciplinary action was taken;

3. ICE Futures Europe will publish daily trading information (e.g., settlement prices, volume, open interest, and opening and closing ranges) that is comparable to the daily trading information published by the DCM, DTEF or ECM for the contract against which the ICE Futures Europe contract settles: and

4. ICE Futures Europe will provide to the CFTC, through the Financial Services Authority (FSA), a daily report of large trader positions in each IFE Linked Contract for all contract months in a form and manner that: * can be fully integrated into the CFTC’s market surveillance systems, including full identification of each position’s beneficial owner comparable to the reporting that is provided by the DCM, DTEF, or ECM; * can, subject to the Memorandum of Understanding between the CFTC and FSA, be fully integrated into the CFTC’s Commitments of Traders Report, including appropriate categorization of traders and their positions.

So, what’s next? Another bailout?