Option Investor

Not Nice To Fool The CFTC

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Bulls were unable to capitalize on the monster drop in crude inventories on fears that the CFTC was about to change the rules on futures trading. The weekly crude inventory report showed that crude levels fell by -8.9 million barrels for the week ended May-23rd. Gasoline inventories fell by -3.3 million barrels. On any other week that would probably have been worth a $5 move higher in crude prices. There was a $4 spike but it was immediately sold when the CFTC announcement hit the wires.

Oil Inventory Table

The CFTC announced on Thursday it launched an investigation in December into possible price manipulation of the crude futures markets. The CFTC said it was probing a wide range of activities including storage, transportations and trading of crude oil and related derivatives. Speculative pressure has been blamed for adding as much as $20-$30 to the price of oil.

The CFTC said it was taking steps to improve the transparency of the complex energy futures market. The crude futures market is huge but it is nowhere near as large as the stock market. On April 22nd the total value of all open interest in crude futures for all months and strikes was $174 billion. That is up by a factor of 10 from the $17 billion in April 2003. Is it realistic to think that the value of open contracts increased 1000% in only five years? To start with crude was only $25 in April 2003 and there were approximately 500,000 open contracts. At today's $125 level that is a 400% increase in the price of crude alone. A 400% increase in the contract value would only be $85 billion if the number of contracts stayed the same. Today there are nearly 400,000 contracts in the July contract alone.

How easy would it be to manipulate the price of the July contract? With open interest of 370,883 contracts and initial margin of $8,525 per contract that would equate to only $3.2 billion in margin for all open contracts. Obviously there are plenty of individuals, institutions, pension funds and sovereign funds that could easily manipulate the price. They would not need anything near the $3 billion since they only need to juice the market not own it. Volume on Friday was only 287,382 contracts. Yes, you read correctly. 77% of the entire open interest changed hands on Friday. Since there is a position limit of 20,000 contracts it would take several players to really jack up the price.

Here is the key to the puzzle. Not only do we have hundreds of major players all wanting to juice the market on their own but the really big players can get around the position limits through swaps. What we have is a monster game of poker here that runs continuously 24/7 five days a week. Everybody is placing bets, raising, calling and folding all day long with very little oversight.

The CFTC announcement suddenly had the impact of Matt Dillon (James Arness) walking up to a crooked poker game in Miss Kitty's saloon. Suddenly all the players with something to hide decided to take a break. With everyone leaving at the same time the value of the pot took a sharp dive. Those gamblers have not left the bar but continue to circulate on the fringes while they wait on the new rules.

The CFTC said their already vigorous surveillance activity would be enhanced immediately. They announced an agreement with the FSA in Europe to increase surveillance on the ICE Europe exchange where 25% of the U.S. crude futures are traded. The FSA agreed to expand information sharing to provide the CFTC with daily large trader position reports in the UK WTI contract. They are also going to provide large trader position data for all contract months not just the current month. They are going to provide more detailed information on the identification of traders. ICE also agreed to notify the CFTC whenever traders exceed position accountability levels. Previously the FSA provided a weekly summary and daily information only in expiration weeks.

The CFTC also said it was going to require more information on trader identification in the U.S. markets. They are going to require index funds to report their trading so the CFTC can determine their impact on the markets. They are going to require more identification from swaps dealers and index traders. They will decide if index traders are adversely impacting the market and decide if classifications should be changed and position limits should be imposed.

All of these rules together may have put a crimp in the gunslinger style of enough large traders to burst the oil bubble at least temporarily.

Over the last 5 years the number of commodity funds or index funds, ETFs, etc has expanded dramatically. The majority of these funds are long only funds. That means they never sell without rolling forward into the next month. As these funds grow in number and size the amount of contracts they control grow in number. With dozens of funds investing billions in the commodity boom there is a shortage of contracts. In order for a fund to buy 100 contracts somebody had to sell them short into the market to create that open interest. Since the funds never sell that means the person that opened the short eventually has to cover in an increasingly narrow market. As funds receive more money for investment the only way they can buy more contracts is by offering a higher price. Speculators decide the higher price makes the risk worth it and they sell short at what appears to be a high price at the time. This cycle is repeated daily and the constant shortage of contracts means the pressure on prices continues to build.

Now add in the news items like Venezuela, Nigeria, Iran, Mexico, Russia, OPEC, etc and there is plenty of fuel for the fire. As demand increases to a breakeven with supply the lack of enough oil to cover open contracts continues to escalate the situation.

The last several months have been like a huge Ponzi scheme. Commodity funds are receiving massive amounts of money from investors and their buying actually pushes the price higher and that attracts more investors. Eventually this is going to end badly. It will either come in the form of the arrival of peak oil and a real rather than artificial shortage pushing prices higher. Or it will end when some event or regulation changes the game and all the players rush to take profits all at once.

Because the underlying premise of peak oil will always return to push prices higher any commodity crash should be perceived as a buying opportunity for long-term holders. We are reaching a point where there will not be enough physical oil to go around. Based on the latest estimates of oil coming to market in late 2008 and 2009 the peak will probably be in 2010. That will make today's volatility events look like a Sunday picnic at a retirement home. There really will be a shortage of contracts and everything I described above will increase exponentially.

Until that happens we still need to be aware that the house of cards could collapse at any moment. The key event will be a reclassification of index traders by the CFTC as speculators rather than hedgers. The margin requirements will increase dramatically and position limits will apply. When this happens, and most analysts believe it is imminent, there will be a monster flush of positions. One analyst said it could be in 2-weeks or 2-months but when it happens it will be dramatic. The other change will be the identification and regulation of the swaps dealers. Swaps are normally treated as hedgers with lower margins and no position limits. If they are reclassified as speculators then margins go up and position limits come into being. That will make it a lot harder for the big money guys to move the market. It is estimated that 60% of the open interest is held by institutional investors.

The testimony of Michael Masters to the U.S. Senate on May 20th fueled the fires for the CFTC to take action. While many analysts disagree with some of his numbers almost all agree with the points he brought up in his testimony. Basically he spelled out in great detail the impact of index traders on the crude futures market. You can read it here: http://tinyurl.com/45l8r3

Obviously if we ever get that announcement by the CFTC there will be a monster flush in the crude markets. Our positions will be stopped out and we will need to start over at a lower level. Because I believe this will happen I am going to tighten the stops.

Sunday is the first day of hurricane season and the forecasters are predicting 8-9 major storms in 2008. They also predicted that in 2006 and 2007 and there were no major storms. Our luck is eventually going to run out and we are going to take another hit in the oil patch. As storms begin to form you can bet prices will rocket higher only to crater again if the storm misses the oil fields. The first named storm of the season appeared a day early. Arthur formed off the coast of Belize and should move into the Gulf by Monday. The current track takes it into Mexico, not the U.S. This is the fun time of year to be long energy with an expected exit date in late August. The CFTC changes could spoil the party but we will continue to play until they take away the punch bowl.

Jim Brown

July Crude Futures Chart - Daily

June Natural Gas Futures Chart - Daily

June Gasoline Futures Chart - RBOB Daily


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