The "Enron Loophole"

From Marketplace:

Deflating the oil bubble, by Michael Greenberger: ...Host Kai Ryssdal talks with former commodity regulator Michael Greenberger about ways to keep tabs on speculation.

Kai Ryssdal: ...The [Commodity Futures Trading Commission is] in charge of regulating oil markets in this country and Congress has been after the agency to do something -- to do anything -- about oil and gas prices, what lawmakers perceive to be speculation, in particular.

Michael Greenberger used to run the ... [Division of Trading and Markets for the Commodities Futures Trading Commission. He now teaches law at the University of Maryland.]

Ryssdal: Why is it so hard to figure out what's going on in commodities markets -- oil specifically?

Greenberger: Well, the reason it's hard to figure out is about 30 percent of our crude oil energy futures are traded in what is called a dark market -- that is a market that was deregulated in December of 2000 at the behest of Enron. Prior to that legislation..., all energy futures traded in the United States or affecting the United States in a significant fashion were regulated ... under a very careful regime that had been perfected over about 78 years and many observers believe that because those markets are not being policed, malpractices are being committed and traders are able to boost the price virtually at their will.

Ryssdal: You're not really telling me that seven years on, we're still paying the price for Enron, are you?

Greenberger: Well, this has been called the "Enron Loophole" and there are many legislators working very hard to close that loophole ...[and] bring the speculation under the kind of time-tested controls that were used until Enron had its way and amended the law...

Ryssdal: So what's Congress going to do?...

Greenberger: Well, there are several proposals..., but the bottom line is the speculators will, in the end, be policed. We will know who they are, what they're doing, what their controls are, what effect they're having on the market. Maybe we'll find out that there's nothing there.

Ryssdal: So just to be clear, you do think that we're in a bubble, then?

Greenberger: I believe it and I'm certainly not alone in my belief. If you talk to anybody who trades in these markets on a regular basis, they will tell you that the markets are completely dysfunctional and out of control because of speculative activity.

Ryssdal: How long is it going to take then if we are, as you say, in a bubble, for it to work its way through and us to get back to something more realistic for the price of a barrel of oil, whether its 50 bucks or 80 bucks?

Greenberger: From my own experience as a commodity regulator, I believe that if the Bush Administration were serious about its regulation, we could begin seeing prices drop within a month. If we don't get the kind of regulation that has been done for decades and the market proceeds along the pace its proceeding, we will have to go through a very, very serious recession. The question is do you want to deflate the bubble by that kind of suffering or do you want to deflate the bubble by applying tight U.S. regulatory controls? ...

Comments

[a reader]

To what extent is all this discussion about speculators pushing up the price just a way to avoid the harsh possibility that high commodity prices are here to stay?

There are undeniable fundamental developments at play here: stagnant supply and a demand that continues to grow at a rapid rate (though US demand has finally started to come down). Some analysts suggest we won't stop until we hit $150-$200 for *fundamental* reasons, and certainly there is no way to expect $50-80 prices any time soon, as suggested in the piece, since boosting supply will take a while..

Moreover, if there were indeed speculation in the futures market, wouldn't the spot price ultimately 'catch up' to these speculators and push the price down? We are talking about futures prices, but it's a physical commodity at the end of the day... Unless we're saying that someone's hiding ships of oil somewhere in the middle of the Altantic, I don't see how speculating in the futures market could hold up for months on end...

[James Killus]

I understand how a housing bubble can cause a recession. I'm a little unclear on how a speculative bubble in oil can do that. Could someone describe the mechanism?

[Mark Thoma]

Good question. I can see how the oil price run-up could cause problems, but a story involving the bubble popping and causing a recession is harder to tell. I was mostly interested in the regulation aspects and whether that has anything to do with the price run up so I missed that.

Interesting how the commentary is changing. Initially most said there was no bubble, but increasingly people are arguing that there is. We shall see.

[Andrew]

I imagine he means that proper regulation could slowly let the air out starting now, rather than allowing speculation to spiral the price upwards until the bubble bursts and billions (trillions?)of dollars evaporate into thin air.
The .com bubble may be an appropriate comparison.

In fact, it has been posited that the speculative frenzy from the dot-com bubble simply shifted to the housing market, and now it is shifting to commodities.

[Gerard MacDonell]

Umm, when everybody says it is a bubble, that is when it is not a bubble.

[anne]

http://www.earthpolicy.org/Updates/2008/Update72_data.htm#table4

January 11, 2008

World Grain Production, Consumption, and Balance, 2000-2007

(Million Metric Tons)

2000 1,843 1,857 -15
2001 1,875 1,902 -28
2002 1,822 1,909 -88
2003 1,862 1,934 -72
2004 2,043 1,990 53

2005 2,017 2,019 -2
2006 1,992 2,043 -51
2007 2,075 2,098 -22

[Bubble?]

[anne]

http://www.earthpolicy.org/Updates/2008/Update72_data.htm#table14

January 23, 2008

U.S. Fuel Ethanol Use, Grain Production

(Million Tons)

2000 16 of 340
2001 18 of 321
2002 25 of 294
2003 30 of 345

2004 34 of 386
2005 41 of 363
2006 54 of 336
2007 81 of 414

2008 114 of 400 * Projection

* Too high

[anne]

http://www.earthpolicy.org/Updates/2008/Update72_data.htm#table13

April 9, 2008

World Grain Yield Annual Increase by Decade, 1950-2007

1950-1960 2.0%
1960-1970 2.5
1970-1980 1.9
1980-1990 2.1
1990-2000 1.2
2000-2007 1.2 *

* Annual increase over eight years.

[Where is the commodities bubble?]

[JeffF]

Re: oil bubble burst causing a recession

I think that might not be quite what is being said. I think he may be suggesting that regulation could burst the bubble and a recession avoided or the oil bubble will cause a recession and that will burst the bubble.

[JeffF]

Demangle my words a bit and I suppose rather than avoiding recession he thinks we might avoid the "very, very serious recession" which he thinks will otherwise burst the oil bubble, assuming I am reading him correctly.

[JeffF]

BTW I don't necessarily believe he is correct. I find the inventory argument rather persuasive.

[Donald A. Coffin]

If the futures market for oil is in in a speculative bubble, then a lot of speculators are going to lose a lot of money. Unless the fundamentals of the market for oil ultimately support those higher prices, then those who have paid high speculative prices for oil futures will be stuck looking for (in J.K. Galbraith's phrase) "greater fools" than themselves to sell to. When those fools don't appear...pop! goes the bubble, and the speculators crash and burn...and oil prices fall...

[BrotherMaynard]

Commodities (i.e. oil) are strategic assets. The least we can do is make sure the markets (that are run by humans) are working correctly. The ICE has next to nothing when it comes to regulation.

While economic theory aptly explains futures markets etc...it doesn't do a very good job explaining if 90% of the people trading have little to no interest in the underlying -- all these 90% of people care about are expectations and expectations of expectations.

[Jim Harrison]

Back at the time of the California power crisis some people blamed market manipulators while others pointed to insufficient power production. In fact, as we found out later, Enron and other companies did create brownouts and blackouts to make money. Thing was, though, it was the underlying tightness of supply that made their skulduggery possible. I think something similar may be happening now. The imbalance between ever rising demand and stagnant or declining growth in supply is the basic fact, but that doesn't mean that a host of stinkers aren't exploiting it. Unfortunately, policing the markets, hard as it may be, is orders of magnitude easier than scaring up more petroleum while drastically cutting back on consumption.

[Richard H. Serlin]

Paul Krugman has asked many times, if speculation is pushing up oil prices, why is there no evidence he can find of hoarding, of increased inventories?

Some have argued that the records of inventories are not that accurate; that it's still possible to hide a substantial amount of hoarded oil. I have little expertise on oil inventory recording, so I don't want to offer an opinion.

But a point I would like to add is that if the supply and demand curves for oil in the short run (or very short run) are very inelastic, then you wouldn't have to hoard much to push the price of oil up a lot. And if you only have to hoard a relatively small amount of oil, then it might not be that hard to have it not detected in the inventory records.

Imagine (or draw) supply and demand curves that are almost straight lines (Again, I'm thinking in the short run, or very short run. In the long run, the demand curve at least is very elastic). In that case, if you move the quantity that gets to the market back just a little bit, by putting it in storage, the price jumps a lot.

[prostratedragon]

Oil bubble being popped by the recession (that it helped to cause or worsen in the first place) is what I think Greenberger meant.

[Michael McKinlay]

Bubble or Peak ... ? Both ?

In case you have missed it crude oil production actually peaked in 2005 and has been on a plateau according to the IEA and the EIA ... The commonly used phrase 'liquids' has been going up a bit, but it counts biofuel so many barrels are actually being counted twice as biofuels use much oil.

Is there speculation in the oil markets? Of course, that's what markets are. Is there illegal trading going on ? We'll see, but the overriding factor in the price of crude is stagnant supply with increasing demand.

[hari]

Finally some professional confirmation by insider-info that market is being manipulated. By whom? I suggest consider (1)traditional traders in crude and (2)speculators who are creating the bubble due to Fed action on liquidity and rate cutting (since Aug).

Traders in commodities are both *buyers* and *sellers* of positions. However entry of hedge funds and investment banks suggests they're *holders* of large positions - not sellers (as known to market professionals). They are heavily leveraged and speculative positions facilitated by credits from like of Citi and Merrill.

So, if the latter are accumulating volume and hoarding it due to Feds actions, they must have insiders who are helping them with this type of transactions. Transparency of transactions are difficult to see because speculators are not selling when market trends up - which suggests there is some sort of manipulation going-on here. The Enron loophole may not be the culprit - the real culprit is CFTCs inability to monitor how bundels of commodities are being controlled at *strike price* level.

This *cabal* involved in commodity bubble will finally be exposed...but after inflicting great damage to global growth and development. Libertarian economic philosophy is centre of this anamoly which only a regulatory regime can bring to order and control.

[hari]

Goldman & Sachs have been speculating on crude for sometime now and their current futures report has crude @ 200/barrel. Where do they come up with that futures price from? It can't be based on supply constraint...Saudi's are now calling a business meeting with suppliers and traders (including Goldman and Co) to find out exactly how crude market is being manipulated...and maybe expose it finally.

Is it possible hedge funds and investment banks are part of Galdman's *cabal* trying to corner the crude market with its specualtive bubble - like Hunt Bros (Texas) did with Silver futures market a few decades ago?!

[mark ii]

If (when) this bubble pops are we going to have another round of IB's / HF's going to the fed to ask for support in the name of 'stability of the financial markets?'

Interesting times.

[BrotherMaynard]

Keep in mind, the CFTC found nothing wrong with markets when Amaranth happened.

[BrotherMaynard]

btw, an egregious assumption that fundamental economics makes is that arb/specs have "unlimited capital" to bring prices into equilibrium. Given that oil producers couldn't possibly deliver the amount of oil that is traded on a daily basis, there is no way they could bring the market down.

So arbs/specs have to do the dirty work. But arbs/specs are tapped out...either from macro events, or by the fact that indexers have more capital.

So, until someone figures this out, massive amounts of capital will continue to accrue on oil producers' balance sheets (aka wasted capital).

As a side note, this market is clearly broken, how anyone could make any long-term decision (policy, or otherwise) based upon these markets is just downright foolish.

[macburger]

As a side note, this market is clearly broken, how anyone could make any long-term decision (policy, or otherwise) based upon these markets is just downright foolish.

Economics starts off withe assumption that everything is perfect. And then they go on to argue the markets wl solve everything.

The pie-in-the-sky dilettantes are all jumping up and down - where is the inventory? where is the inventory? There is no bubble! There is no bubble!

What did they do during the housing bubble?

Since their models and assumptions could never account for a housing bubble, they cooked up more and more incredulous research for justifying the bubble prices.

Go to the Fed web site, and do a search on "housing bubble" and read the research papers. And that's just the Fed. Academia was full of the same - Gary Smith [HAHAHA], Delong, JD Hamilton - except for a few like Shiller, Roubini,and Baker who are still treated like eccentrics and heretics.

And now there is no oil bubble!

In front of their bleeding eyes, electricity which is the toughest thing to put in storage, got into a bubble [courtesy Enron]. But not so for oil. NO SIR! No inventory, no bubble.

Who are you going to believe? Your lying eyes? Or my imaginary economic models?

[James Killus]

Krugman assumes first, that increases in oil inventories would be in the usual places (i.e. oil storage facilities). But oil can be stored at any point in the supply chain, including the fuel tanks of automobiles (which, in fact, contributed to the early 1970s oil shock), or kept in the ground.

Krugman also assumes that the data is not being jiggered. I'm not sure that I trust the oil states and the oil companies to give accurate information about inventories.

[hari]

IHT (Paris) says *oil futures regulators reached deal on trade limits*.

Namely 30% of futures crude oil (Texas Intermediate Crude) is traded electronically on London Futures Market and there was no volume/ceiling control on contracts. That's how the speculative bubble got started (maybe) and CFTC and London Futures market have now agreed to limit TIC contracts/volume.

[anne]

There is simply no evidence that beyond the continual price problems in the wakes of warfare and treats of warfare there has been anything artificial about the price increases in fuel and food. There are all sorts of market issues, from continually increasing profits but a relative absence of investment in exploration for and research and development of primary and secondary fuels, but manipulation of commodity markets has been no more than an increasingly heard rumor.

[anne]

Grain markets are especially instructive to me, for productivity has declined since 1990 while production increases have been limited since 2000 and increasingly grain is being used for fuel. Where then is the mystery to rising prices, and why is there almost no mention of the use of grain for fuel even with what is turning to a difficult growing season?

What manipulation of markets there has been has been recent significant subsidization of fuel raised for fuel and long term subsidization of grain raised for animal feed. But, such subsidization is not hidden.

[anne]

http://krugman.blogs.nytimes.com/2008/06/18/concrete-evidence-of-chinas-importance/

June 18, 2008

Concrete Evidence of China’s Importance
By Paul Krugman

Cementing its place in the world economy

[Chart]

From The Oil Drum. *

* http://www.theoildrum.com/node/4162

[zinc]

The bubble (manipulation) is in financial paper. The price is set by the price of the paper contract, not the other way around. If PK wants to see hoarding, he might want to look at the stack of contracts, not the commodity.

[Movie Guy]

I've been waiting for someone to address this issue in an econ blog.

More fallout should occur...

---

[Real Person from the Real World]

I don't understand a bubble in oil, but I do think I understand speculative behavior. I also agree with Serlin, it probably doesn't take much "hoarding" to spike oil. As for who is doing what, take a look at where the money goes. First there was ranting about OPEC, now the story is we have to start drilling in the artic or on the ocean shelf. Seems to me, we are being manipulated by speculators in big oil, who want to do what they want to do.... drill elsewhere, where environmentalists' ranting kept them out.... not do anything somewhat more practical, like research batteries for hybrid or electric cars.

[Julio]

We're having a discussion about oil and grains, before that housing, before that tech stocks...

As a software guy, I'm looking at what is common to all these? Do we have a system that encourages these "bubbles"? E.g.

1) Technological support for worldwide transactions and "everyone's" participation,

2) Velocity/frequency of these trasactions, i.e. 10,000 transactions each representing a tiny fraction of the market buch each increasing the price by a tiny amount, and the price zooms,

3) A financial system where the real decision-makers, in each transaction, are never the "last fools" left holding the bag,

4) Said financial system penalizing said decision-makers only for NOT participating in bubbles,

5) and the like.

I keep getting the feeling (as Zinc says above) that the pricing is on pieces of paper, and the specific assets being supposedly traded are just used to fill in a blank in otherwise identical forms.

If this is all Econ101 I apologize -- I have no training in economics. I'd appreciate some feedback from someone who does.

[hmpierson]

The difference between the Enron type manipulation and the oil market is that electricity prices (to consumers) were capped in California, but in case of shortages, utilities were forced to buy on the spot market regardless of price. So this created 2 flavors of electricity that could be purchased, "California" and unlimited. Enron conspired to buy "California" electricity, effectively stealing it from the utility companies, "routing" it out of state, and then selling it back to the utilities at a higher price:

http://en.wikipedia.org/wiki/California_electricity_crisis

Instead, wholesalers such as Enron manipulated the market to force utility companies into daily spot markets for short term gain. For example, in a market technique known as megawatt laundering, wholesalers bought up electricity in California at below cap price to sell out of state, creating shortages. In some instances, wholesalers scheduled power transmission to create congestion and drive up prices.

*****

This is totally unrelated to the worldwide market for oil. It might be possible to manipulate the market for a few minutes, but it's a game of musical chairs, and whoever gets stuck holding the contracts when the "phony" incremental demand stops gets hammered. It's not enough that longs hold contracts to keep prices high - they have to CONSTANTLY account for part of the demand every day, otherwise supply and demand comes back into balance on a daily basis, and the price falls.

I can't believe anyone seriously thinks anyone is nuts enough to keep buying oil and accumulate what becomes several days to weeks worth. If prices head down, there would be no one to sell it to.

[Cynthia]

So Enron has come back to haunt us a bit, but I'm not particularly spooked by the ghost of Enron.