Wednesday, June 17, 2009

CNN/Money: Obama v the Oil Bubble

This is an interesting development; I won't pretend to know what exactly all the causes are for this huge spike in oil while the largest user in the world (25% of all demand) has 10 year highs of inventory and Europe is in complete disarray. I am sure some is speculation but how much - who knows. But in a world where oil is... well, the oil that greases economies, I would assume 50-75% price swings, both up and down - in such short periods of time will catch the attention of any person. Supply and demand is simply not changing in that nature in 6 month periods...

I do believe in the stock market, ETFs are dominating the underlying stocks - as we pointed out last year many times the financial 2x, 3x ETFs were responsible for 30-40% of the trading in the underlying stocks. So as hedge funds roll into a financial ETF, all the stocks within it are bought in varying weights, regardless of their individual stories. Same when the ETF is sold. Some of the financial ETFs have been the 2nd, and 3rd most traded instruments on the exchanges in the past 18 months along with the S&P 500 ETF as #1. And the commodities market is much smaller than the equity market, so these ETFs that dominate oil, natural gas and the like are being (in my opinion) powered by an avalanche of money chasing a financial instrument, which to some degree is moving the underlying asset. So it is not fully based on supply and demand. If you are interested in the technical mumbo jumbo - FTAlphaville Blog had a good piece on how the Natural Gas ETF (UNG) is being overloaded by money and hence cannot do its job properly here.

One of the hottest investments on Wall Street may have gotten too big for its own good. With investors betting on rising gas prices, assets in the United States Natural Gas Fund (UNG) recently swelled to almost $3.7 billion from about $670 million in February, even sparking fears it could be disrupting the futures market.

Now the popular exchange-traded fund is days away from another potential problem: Funds that hold commodities typically face stiff restrictions on the number of shares they can issue to meet investor demand, and United States Natural Gas is running out fast.

Securities and Exchange Commission filings show managers want to increase the number of shares available nearly 10-fold. But such requests can take weeks and there is no telling when the SEC will act. If the fund can’t issue enough shares to meet investor demand, its shares could begin trading at prices higher than the underlying value of their holdings, breaking a key promise ETFs make to investors and possibly influencing prices in the natural-gas futures markets.

It is a very interesting world we have created - the stock market used to be a place to raise capital and value equities based on supply and demand for the stock. Valuation used to be the underlying determinant. That seems to be changing with all the new instruments we have created, especially of the ETF kind. I've been opining the past 18+ months that I believe that has changed the game... the ETFs and program trading have made this a very different world - now a casino where money flow is more important than actual things being bought and sold. It's now all about wondering which direction the student body will run, and what sectors they want to be in; the underlying securities in those sectors are many times meaningless as they are dominated by the ETFs that own them. Just my take, and I could be wrong - but after watching the market very closely over the past decade+ the behavior the past few years is very different to my eyes.

But let's look at what the regulators are considering specific to the energy commodites...
  • Can reinvigorated financial watchdogs take a bite out of surging oil prices? President Obama is scheduled to outline a regulatory reform program Wednesday that will, among other things, call for strong federal oversight of derivatives -- side bets on changes in asset values or interest rates.
  • But this year's surge in the price of oil is turning Washington's attention back to another derivatives debate: whether speculation in the futures markets is responsible for wild swings in the prices for crude oil and other commodities.
  • ... the price surge (in oil) has raised eyebrows because it comes at a time when economies around the globe remain weak. In the United States, oil supplies are at two-decade highs while demand is at a 10-year low.
  • Some observers blame the price rise on investment funds plowing money into commodity futures contracts. "What we're seeing is the assetization of commodities," said Dan Dicker, a longtime oil trader on the New York Mercantile Exchange who is writing a book about the phenomenon. "This isn't a nefarious group at work, but the oil market is following stocks almost in lockstep now."
  • Not everyone agrees that investors are so innocent. The concept got an airing last year, as oil headed toward its all-time high at $147 a barrel, after hedge fund manager Michael Masters testified before Congress on the role of these funds -- which he dubbed index speculators. Masters testified again earlier this month before the Senate Agriculture committee. He called for regulators to impose limits on futures-contract purchases by those not involved in the physical production or consumption of commodities. Any substantive changes in regulation will need congressional action.
  • Whatever is behind higher oil prices, it's easy to see how they could impede an economic recovery -- a turn of events that could draw much interest in Washington. Dicker said that should oil prices continue to rise, the drumbeat for action will continue to get louder. He said he could even envision regulators forcing all futures traders to liquidate their contracts when they expire, rather than rolling them over into the next month -- which is how regulators responded when the Hunt brothers tried to corner the silver market 30 years ago. "If the screaming gets loud enough," he said, "you could see some pretty draconian measures."

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