Leveraging Markets & the Price of Oil

The concept of leverage is interesting.  In physics, we use levers and fulcrums to increase lifting power.  In relationships, we use (unfortunately) leverage to get what we want.  In politics, we use leverage to manipulate the levers of power. 

And in economic markets, we use leverage as well.  But in this case, the practice can have very delitirious impacts.

In economic markets, leverage is the use of a small amount of principle to purchase a larger position in the markets.  We call this "buying on margin". This problem reared its head in ugly ways through the late 19th and early 20th century.  The impact of the crash of 1929 was amplified by the fact that so many investors had bought on margin -- borrowed money to stake their positions. When the market began to collapse, brokerages issued "margin calls".  When investors couldn't pay the value owed, brokerages began to shutter, and along with them, the banks which had backed these loans.

Sound familiar?

It should, because the same thing has been happening with the sub-prime loan "crisis".  I put crisis in quotes because frankly, it's hard to call something a crisis which was caused by sheer stupidity and fraud.  The same thing happened over the last decade or so with home values.  As the value of homes rose exponentially, the markets and the banks were willing to allow more and more investors to "buy on margin"-- essentially borrowing more than they could afford to pay back reasonably, and putting less principle down.  Thereby buying a large stake in the real estate market.

Until the loan rates began to reset, that is... and at precisely the same time when the cost of housing was so high that the market was naturally beginning to slow.  The market was over-leveraged, and began to collapse.

And now we are heading in the same direction with energy, but only this time, the problem is much worse.  Why?  Because Congress is the largest group of single-mindedly stupid Americans gathered in a single location.  During the days of Enron, when "energy trading" was going to be the "next big thing", Congress essentially de-regulated the energy futures market.    Typically, I am hugely in favor of de-regulation, but only when all market actors have equal power.

Some points should be noted here before we proceed.  First, the Chairman of Enron, the late Ken Lay, was a huge Democratic contributor.  Second, he was also the progenitor of cap-and-trade schemes and carbon credits.  Why?  Because Enron was building its empire on the foundation of two principles:  a) by limiting the power choices available, they could corner the market on energy reserves and b) by de-regulating the energy futures market, they could arbitrage the very market they were planning to corner.

See the picture?  Energy futures market deregulation was the flip-side of the cap-and-trade scheme coin.  A coin that both Bill Clinton and Al Gore loved to have in their pocket.  A coin that would have grown tremendously in value had the US Senate voted to ratify the Kyoto Treaty (which was never submitted to the Senate by President Clinton, by the way).

Here is my point:  Enron and Ken Lay and their buddies in Congress (which included a fair number of Republicans, like Senator Phil Gramm)  were not de-regulating the market to create a level playing field.  They were manipulating the market to achieve policy goals -- and removing equal power from all market actors.
So what does this have to do with leverage?  Well, unlike the stock market, energy futures markets only require a 5% margin requirement.  That is, only 5% in principal needs to be paid to secure a 100% stake in a market position.  The other 95% can be secured through debt.  So hedge fund managers can go out and start purchasing oil futures -- contracts for future purchases of oil that they will never see delivery on -- through borrowing 95% of the amount to be invested.

This has two distinct impacts on the market.  First, it wildly distorts the supply and demand equation, because the purchases have little to do with demand and they are backed not by actual currency, but by debt.  Second, should the price of oil take an unexpected decline, a lot of bankers -- and eventually, US taxpayers -- are going to be left holding the bag.  Just like in the housing mess.

It should be clear by now -- 200 years after The Wealth of Nations -- that regulation OR deregulation that creates or protects market disortions is bad.  The energy deregulation of 1999 here in Maryland is a perfect example.  And the market deregulation foisted on us by a crooked Enron and its corporate leadership -- in cahoots with the political chattering class of stupid neanderthals in Congress -- is proving it again.

So what is the solution?  Well, at this point any sudden shift would be dangerously destabilizing.  But, it is clear that we need to slowly start raising the margin requirements on futures purchases, demanding that contracts are purchased with hard currency and not debt instruments.  This will slowly start forcing the most radical speculators out of the market -- those who have no interest in being in the oil business and are not part of the supply chain -- and restore an equilibrium to the market.

More importantly, we need Congress to unseat its head from its ass and start allowing exploration and exploitation of our own natural resources in an environmentally sound manner.  Adding these extra resources to the mix will lower the cost of energy, lower the cost of energy delivery, and disincentivize radical market speculation and price inflation.
And it will let the American people begin to use a little of their own leverage against out of control markets and politicians.