The big global banks have begun to warn clients that the blistering rally in oil and industrial commodities in recent weeks has run far ahead of economic reality, raising the risk of a fresh slump in prices over the summer.
Barclays, Morgan Stanley and Deutsche Bank have all issued reports advising investors to tread carefully as energy and base metals fall prey to unstable speculative flows in the derivatives markets.
Oil has jumped 40pc since January even as the US, China and the world economy as a whole have been sputtering, falling far short of expectations.
“Watch out: this rally may not last. The risks for a reversal in recent commodity price trends are growing,” said analysts at Barclays.
“There is a huge disconnect between the price action in physical markets where differentials are signalling over-supply and the futures markets where all looks rosy.”
Miswin Mahesh, the bank’s oil strategist, said a glut of excess oil is emerging in the mid-Atlantic, with inventories rising at a rate of 1m barrels a day. Angola and Nigeria are sitting on 80m barrels of unsold crude and excess cargoes are building up in the North Sea and the Mediterranean.
Morgan Stanley echoed the concerns, warning that speculators and financial investors have taken out a record number of “long” positions on Brent crude on the futures markets even though the world economy keeps falling short of expectations. “We have growing concerns about crude fundamentals in the second half of 2015 and 2016,” it said.
Shale producers in the US are taking advantage of the artificial surge in prices to hedge a large part of their future output, more or less guaranteeing that the US will continue to pump 10m b/d and wage a war of attrition against high-cost producers in the rest of the world.
A comparable dynamic is playing out in the copper market, where net long positions have jumped 60pc since the start of the year and helped power the longest rally in copper prices since 2005, even as industrial output grinds to a halt in China.
The warnings come as a draft report from OPEC painted a gloomy picture of energy industry, predicting that oil wouldn’t touch $100 in the next 10 years.
The mini-boom in energy and metals has taken on huge significance since it is being taken as evidence that global recovery is under way and that the dangers of a deflationary spiral have abated. Barclays said that this in turn is a key factor driving up global bond yields, and therefore in repricing the cost of global credit.
If the commodity rally is being driven by investor exuberance in the derivatives markets – rather than a genuine recovery in the world economy – it is likely to short-circuit before long and could even lead to a relapse into deflation. It is extremely difficult for central banks to navigate these choppy waters, raising the risk of a policy mistake.
Fresh data suggest that the US economy may have contracted in the first quarter, and is currently growing at a rate of just 0.8pc, below the US Federal Reserve’s stall speed indicator.
Deutsche Bank has also warned that the energy rally is showing “signs of fatigue”, with near-record inventories in the US, and little likelihood of further stimulus from central banks at this stage to keep the game going. “We see fresh downside risks to crude oil prices heading into the summer,” it said.
Durable oil rallies are typically driven by OPEC cuts but this time the cartel has boosted supply by 500,000 b/d to 31m as Saudi Arabia tries to drive marginal drillers out of business across the world.
Contrary to expectations, America’s shale producers have yet to capitulate. The rig count has fallen by more than half but output has held up longer than expected. While a few drillers have gone bankrupt, others are already signalling plans to crank up production.
Houston-based EOG said it expects to boost output in the third quarter at the Eagle Ford basin in Texas, benefiting from dramatic gains in technology that are cutting shale costs at an astonishing speed. Devon Energy has raised its growth target to 25pc to 35pc this year, having cut its production costs by a fifth in the first quarter.
Tactical stockpiling of crude oil by China and other countries has masked the scale of oversupply but oil analysts say this effect may be fading. The deep economic slowdown in resource-hungry emerging markets has snuffed out the commodity supercycle. There is little sign yet of a durable rebound.
China is still slowing as President Xi Jinping deliberately engineers a deflation of the country’s investment bubble.
A series of cuts in the reserve requirement ratio and interest rates – including a 25pc reduction over the weekend – merely offsets “passive tightening” caused by capital outflows and rising real borrowing costs.
It is not yet a return to ‘”stimulus as usual”.
Not everybody is willing to throw in the towel on crude oil.
Michael Wittner, from Societe Generale, said US output will decline in the coming months as the delayed effects of lower investment start to bite, ultimately vindicating the Saudi’s shock strategy of flooding the market.
Crude stockpiles tend to build up from March to May. This is the “window of greatest vulnerability for a crude price correction”, Mr Wittner said. That window will be closing within weeks.
by MIKE WHITNEY
President Barack Obama is determined to prevail in his battle with GOP congressional leaders on the debt ceiling issue, but not for the reasons stated in the media. Obama is less concerned with the prospect of higher interest rates and frustrated bondholders than he is with the big Wall Street banks who would be thrust back into crisis if there is no resolution before October 17. Absent a debt ceiling deal, the repurchase market–known as repo–would undergo another deep-freeze as it did in 2008 when Lehman Brothers defaulted triggering a run on the Reserve Primary Fundrepurchase market which had been exposed to Lehman’s short-term debt. The frenzied selloff sparked a widespread panic across global financial markets pushing the system to the brink of collapse and forcing the Federal Reserve to backstop regulated and unregulated financial institutions with more than $11 trillion in loans and other obligations. The same tragedy will play out again, if congress fails lift the ceiling and reinforce the present value of US debt.
Repo is at the heart of the shadow banking system, that opaque off-balance sheet underworld where maturity transformation and other risky banking activities take place beyond the watchful eye of government regulators. It is where banks exchange collateralized securities for short-term loans from investors, mainly large financial institutions. The banks use these loans to fund their other investments boosting their leverage many times over to maximize their profits. The so called congressional reforms, like Dodd Frank, which were ratified after the crisis, have done nothing to change the basic structure of the market or to reign in excessive risk-taking by undercapitalized speculators. The system is as wobbly and crisis-prone ever, as the debt ceiling fiasco suggests. The situation speaks to the impressive power of the bank cartel and their army of lawyers and lobbyists. They own Capital Hill, the White House, and most of the judges in the country. The system remains the same, because that’s the way the like it.
US Treasuries provide the bulk of collateral the banks use in acquiring their short-term funding. If the US defaults on its debt, the value that collateral would fall precipitously leaving much of the banking system either underwater or dangerously undercapitalized. The wholesale funding market would grind to a halt, and interbank lending would slow to a crawl. The financial system would suffer its second major heart attack in less than a decade. This is from American Banker:
As banking policy analyst Karen Shaw Petrou describes it, Treasury obligations are the “water” in the financial system’s plumbing.
“They’re the global reserve currency and they are perceived to be the most secure thing you can own,” said Petrou, managing partner of Federal Financial Analytics. “That is why it is pledged as collateral. … The very biggest banks fear that a debt ceiling breach breaks the pipes.”….
Rob Toomey, managing director and associate general counsel at the Securities Industry and Financial Markets Association, said institutions are concerned about whether Treasury bonds that default are no longer transferable between market participants.
“Essentially, whatever the size is of the obligation that Treasury is unable to pay, that kind of liquidity would just disappear from the market for whatever time the payment is not made,” Toomey said.”
By some estimates, the amount of liquidity that would be drained from the system immediately following a default would be roughly $600 billion, enough to require emergency action by either the Fed or the US Treasury. Despite post-crisis legislation that forbids future bailouts, the government would surely ride to rescue committing taxpayer revenues once again to save Wall Street.
Keep in mind, the US government does not have to default on its debt to trigger a panic in the credit markets. Changing expectations can easily produce the same result. If the holders of US Treasuries (USTs) begin to doubt that the debt ceiling issue will be resolved, then they’ll sell their bonds prematurely to avoid greater losses. That, in turn, will push up interest rates which will strangle the recovery, slow growth, and throw a wrench in the repo market credit engine. We saw an example of how this works in late May when the Fed announced its decision to scale-back its asset purchase. The fact that the Fed continued to buy the same amount of USTs and mortgage-backed securities (MBS) didn’t stem the selloff. Long-term rates went up anyway. Why? Because expectations changed and the market reset prices. That same phenom could happen now, in fact, it is happening now. The Financial Times reported on Wednesday that “Fidelity Investments, the largest manager of money market funds… had sold all of its holdings of US Treasury bills due to mature towards the end of October as a “precautionary measure.”
This is what happens when people start to doubt that US Treasuries will be liquid cash equivalents in the future. They ditch them. And when they ditch them, rates go up and the economy slips into low gear. (Note: “China and Japan together hold more than $2.4 trillion in U.S. Treasuries” Bloomberg)
Now the media has been trying to soft-peddle the implications of the debt ceiling standoff by saying, “No one thinks that holders of USTs won’t get repaid.”
While this is true, it’s also irrelevant. The reason that USTs are the gold standard of financial assets, is because they are considered risk-free and liquid. That’s it. If you have to wait to get your money, then the asset you purchased is not completely liquid, right?
And if there is some doubt, however small, that you will not be repaid in full, then the asset is not really risk free, right?
This is what the Fidelity flap is all about. It’s about the erosion of confidence in US debt. It’s about that sliver of doubt that has entered the minds of investors and changed their behavior. This is a significant development because it means that people in positions of power are now questioning the stewardship of the present system. And that trend is going to intensify when the Fed begins to reduce its asset purchases later in the year, because winding down QE will precipitate more capital flight, more currency volatility and more emerging market runaway inflation. That’s going to lead to more chin scratching, more grousing and more resistance to US stewardship of the system. None of this bodes well for Washington’s imperial aspirations or for the world’s reserve currency, both of which appear to be living on borrowed time.
The media has done a poor job of explaining what’s really at stake. While, it’s true that higher interest rates would make consumer loans more expensive and put the kibosh on the housing recovery, that’s not what the media cares about. Not really. What they care about is the looming massacre in shadow banking where USTs are used as collateral to secure short-term loans by the banks so they can increase their leverage by many orders of magnitude. In other words, the banks are using USTs to borrow gobs of money from money markets and financial institutions so they can finance their other dodgy investments, derivatives contracts and ancillary casino-type operations. If there’s a default, the banks will have to come up with more capital for their scams that are leveraged at 40 or 50 to 1. This systemwide margin call would trigger a deflationary spiral that would domino through the entire system unless the Fed stepped in and, once again, provided a giant backstop in the form of blank check support. Here’s how Tim Fernholz sums it up over at Daily Finance:
“…Many informed people are worried” (about) “A freeze in the tri-party repo market, akin to the cascade of troubles that followed the Lehman Brothers bankruptcy in 2008.”….
In 2008, more than a third of that collateral was mortgage-backed securities. When Lehman went bankrupt, its lenders began a “fire sale” of the securities it used as collateral, which drove down the value of other mortgage-backed securities, which led to more fire sales. This dynamic would eventually lead to a freeze in the repo markets, which, at the time, provided $2.6 trillion in funding to the banks each day…..
Today, most of the collateral in use is U.S. Treasuries and “agency securities” — mortgage-backed securities guaranteed by the U.S. government:
… if the ugly day of a default comes, lenders may simply stop accepting U.S. debt as collateral. That will have the effect of sucking some $600 billion in liquidity out of the banking system. Unable to get funding for Treasurys, securities dealers would be pressured to sell them-or other assets-to find new funding, creating a fire sale dynamic…..
And, of course, this scenario is only about how the Treasurys work in the repo markets. U.S. debt is used as collateral for derivatives swaps and numerous other transactions; if they are suddenly worth less than expected, lenders can be expected to demand more collateral up front, putting even more pressure on the financial system. That’s why pressure is building to raise the ceiling before the world’s largest economy enters a scenario with so much uncertainty.”
Repeat: “That’s why pressure is building to raise the ceiling before the world’s largest economy enters a scenario with so much uncertainty”.
So the Obama team isn’t worried that Joe Homeowner won’t be able to refi his mortgage or that the economy might slip back into recession. They just don’t want to see Wall Street take it in the shorts again. That’s what this is all about, the banks. Because the banks are still up-to-their-eyeballs in red ink. Because they still don’t have enough capital to stay solvent if the wind shifts. Because all the Dodd Frank reforms are pure, unalloyed bullsh** that haven’t fixed a bloody thing. Because the risks of another panic are as great as ever because the system is the same teetering, unregulated cesspit it was before. Because the banks are still financing their sketchy Ponzi operations with OPM (other people’s money), only now, the Fed’s over-bloated balance sheet is being used to prop up this broken, crooked system instead of the trillions of dollars that was extracted from credulous investors on subprime mortgages, liars loans and other, equally-fraudulent debt instruments.
Can you see that?
This is why the media is pushing so hard to end the debt ceiling standoff; to preserve this mountainous stinkpile of larceny, greed and corruption run by a criminal bank Mafia and their political lackeys on Capital Hill. That’s what this is all about.
And we’re still at risk of it happening all over againby Adam Taggart Saturday, March 30, 2013, 12:42 PM
Then, when the Fed’s fire hoses started spraying an elephant soup of liquidity injections in every direction and its balance sheet grew by $1.3 trillion in just thirteen weeks compared to $850 billion during its first ninety-four years, I became convinced that the Fed was flying by the seat of its pants, making it up as it went along. It was evident that its aim was to stop the hissy fit on Wall Street and that the thread of a Great Depression 2.0 was just a cover story for a panicked spree of money printing that exceeded any other episode in recorded human history.
David Stockman, The Great Deformation
David Stockman, former director of the OMB under President Reagan, former US Representative, and veteran financier is an insider’s insider. Few people understand the ways in which both Washington DC and Wall Street work and intersect better than he does.
In his upcoming book, The Great Deformation: The Corruption of Capitalism in America, Stockman lays out how we have devolved from a free market economy into a managed one that operates for the benefit of a privileged few. And when trouble arises, these few are bailed out at the expense of the public good.
By manipulating the price of money through sustained and historically low interest rates, Greenspan and Bernanke created an era of asset mis-pricing that inevitably would need to correct. And when market forces attempted to do so in 2008, Paulson et al hoodwinked the world into believing the repercussions would be so calamitous for all that the institutions responsible for the bad actions that instigated the problem needed to be rescued — in full — at all costs.
Of course, history shows that our markets and economy would have been better off had the system been allowed to correct. Most of the “too big to fail” institutions would have survived or been broken into smaller, more resilient, entities. For those that would have failed, smaller, more responsible banks would have stepped up to replace them – as happens as part of the natural course of a free market system:
Essentially there was a cleansing run on the wholesale funding market in the canyons of Wall Street going on. It would have worked its will, just like JP Morgan allowed it to happen in 1907 when we did not have the Fed getting in the way. Because they stopped it in its tracks after the AIG bailout and then all the alphabet soup of different lines that the Fed threw out, and then the enactment of TARP, the last two investment banks standing were rescued, Goldman and Morgan [Stanley], and they should not have been. As a result of being rescued and having the cleansing liquidation of rotten balance sheets stopped, within a few weeks and certainly months they were back to the same old games, such that Goldman Sachs got $10 billion dollars for the fiscal year that started three months later after that check went out, which was October 2008. For the fiscal 2009 year, Goldman Sachs generated what I call a $29 billion surplus – $13 billion of net income after tax, and on top of that $16 billion of salaries and bonuses, 95% of it which was bonuses.
Therefore, the idea that they were on death’s door does not stack up. Even if they had been, it would not make any difference to the health of the financial system. These firms are supposed to come and go, and if people make really bad bets, if they have a trillion dollar balance sheet with six, seven, eight hundred billion dollars worth of hot-money short-term funding, then they ought to take their just reward, because it would create lessons, it would create discipline. So all the new firms that would have been formed out of the remnants of Goldman Sachs where everybody lost their stock values – which for most of these partners is tens of millions, hundreds of millions – when they formed a new firm, I doubt whether they would have gone back to the old game. What happened was the Fed stopped everything in its tracks, kept Goldman Sachs intact, the reckless Goldman Sachs and the reckless Morgan Stanley, everyone quickly recovered their stock value and the game continues. This is one of the evils that comes from this kind of deep intervention in the capital and money markets.
Stockman’s anger at the unnecessary and unfair capital transfer from taxpayer to TBTF bank is matched only by his concern that, even with those bailouts, the banking system is still unacceptably vulnerable to a repeat of the same crime:
The banks quickly worked out their solvency issues because the Fed basically took it out of the hides of Main Street savers and depositors throughout America. When the Fed panicked, it basically destroyed the free-market interest rate – you cannot have capitalism, you cannot have healthy financial markets without an interest rate, which is the price of money, the price of capital that can freely measure and reflect risk and true economic prospects.
Well, once you basically unplug the pricing mechanism of a capital market and make it entirely an administered rate by the Fed, you are going to cause all kinds of deformations as I call them, or mal-investments as some of the Austrians used to call them, that basically pollutes and corrupts the system. Look at the deposit rate right now, it is 50 basis points, maybe 40, for six months. As a result of that, probably $400-500 billion a year is being transferred as a fiscal maneuver by the Fed from savers to the banks. They are collecting the spread, they’ve then booked the profits, they’ve rebuilt their book net worth, and they paid back the TARP basically out of what was thieved from the savers of America.
Now they go down and pound the table and whine and pout like JP Morgan and the rest of them, you have to let us do stock buy backs, you have to let us pay out dividends so we can ramp our stock and collect our stock option winnings. It is outrageous that the authorities, after the so-called “near death experience” of 2008 and this massive fiscal safety net and monetary safety net was put out there, is allowing them to pay dividends and to go into the market and buy back their stock. They should be under house arrest in a sense that every dime they are making from this artificial yield group being delivered by the Fed out of the hides of savers should be put on their balance sheet to build up retained earnings, to build up a cushion. I do not care whether it is fifteen or twenty or twenty-five percent common equity and retained earnings-to-assets or not, that is what we should be doing if we are going to protect the system from another raid by these people the next time we get a meltdown, which can happen at any time.
You can see why I talk about corruption, why crony capitalism is so bad. I mean, the Basel capital standards, they are a joke. We are just allowing the banks to go back into the same old game they were playing before. Everybody said the banks in late 2007 were the greatest thing since sliced bread. The market cap of the ten largest banks in America, including from Bear Stearns all the way to Citibank and JP Morgan and Goldman and so forth, was $1.25 trillion. That was up thirty times from where the predecessors of those institutions had been. Only in 1987, when Greenspan took over and began the era of bubble finance – slowly at first then rapidly, eventually, to have the market cap grow thirty times – and then on the eve of the great meltdown see the $1.25 trillion to market cap disappear, vanish, vaporize in panic in September 2008. Only a few months later, $1 trillion of that market cap disappeared in to the abyss and panic, and Bear Stearns is going down, and all the rest.
This tells you the system is dramatically unstable. In a healthy financial system and a free capital market, if I can put it that way, you are not going to have stuff going from nowhere to @1.2 trillion and then back to a trillion practically at the drop of a hat. That is instability; that is a case of a medicated market that is essentially very dangerous and is one of the many adverse consequences and deformations that result from the central-bank dominated, corrupt monetary system that has slowly built up ever since Nixon closed the gold window, but really as I say in my book, going back to 1933 in April when Roosevelt took all the private gold. So we are in a big dead-end trap, and they are digging deeper every time you get a new maneuver.
Is the U.S. economy about to experience a major downturn? Unfortunately, there are a whole bunch of signs that economic activity in the United States is really slowing down right now. Freight volumes and freight expenditures are way down, consumer confidence has declined sharply, major retail chains all over America are closing hundreds of stores, and the “sequester” threatens to give the American people their first significant opportunity to experience what “austerity” tastes like. Gas prices are going up rapidly, corporate insiders are dumping massive amounts of stock and there are high profile corporate bankruptcies in the news almost every single day now. In many ways, what we are going through right now feels very similar to 2008 before the crash happened. Back then the warning signs of economic trouble were very obvious, but our politicians and the mainstream media insisted that everything was just fine, and the stock market was very much detached from reality. When the stock market did finally catch up with reality, it happened very, very rapidly. Sadly, most people do not appear to have learned any lessons from the crisis of 2008. Americans continue to rack up staggering amounts of debt, and Wall Street is more reckless than ever. As a society, we seem to have concluded that 2008 was just a temporary malfunction rather than an indication that our entire system was fundamentally flawed. In the end, we will pay a great price for our overconfidence and our recklessness. (Read More….)
In joining private equity firm Carlyle Group to help rescue Sunoco Inc‘s Philadelphia plant from likely closure, the Wall Street titan cast its multibillion-dollar physical commodity business as an essential client service, financing inventory and trading on behalf of the new owners.
This was about helping conclude a deal that would preserve jobs and avert a potential fuel price spike during the heat of an election year summer — not another risky trading venture after the more than $2 billion ‘London Whale’ loss.
But the deal also highlights a largely overlooked clause in the Volcker rule that threatens to squeeze banks out of physical markets if applied strictly by regulators, one that JPMorgan and rivals like Morgan Stanley have been quietly fighting for months.
While it has long been known the Volcker rule will ban banks’ proprietary trading in securities, futures, and other financial tools like swaps, a draft rule released in October cast a net over commercial physical contracts known as ‘commodity forwards’, which had previously been all but exempt from financial oversight.
The banks say that physical commodity forwards are a world away from the exotic derivatives blamed for exacerbating the financial crisis. A forward contract in commodities exists somewhere in the gray area between a derivative like a swap – which involves the exchange of money but not any physical assets – and the spot market, where short-term cash deals are cut.
Banks say they are also essential to conclude the kind of deal that JPMorgan lauded on Monday.
“JPMorgan’s comprehensive solution, which leverages our physical commodities capabilities… demonstrates how financial institutions with physical capabilities can prudently, yet more effectively, meet our clients’ capital needs,” the bank said in a press release.
But regulators say they are keen to avoid leaving a loophole in their brand new rule, named after former Federal Reserve Chairman Paul Volcker, that could allow banks to shift high-stakes trades from financial to physical markets.
“We intended the Volcker Rule to prohibit a broad swath of risky bets, including bets on the prices of commodities,” said Democratic Senator Carl Levin, who helped draft the part of the 2010 Dodd-Frank financial reform law that mandates the proprietary trading ban.
“The proposed Volcker Rule should cover commodity forwards because those instruments often constitute a bet on the future prices of commodities.”
In the latest example of a refining company outsourcing its trading operations to Wall Street, JPMorgan will not only provide working capital for the joint venture between Carlyle Group and Sunoco Inc, but will also operate a ‘supply and offtake’ agreement that has the bank’s traders shipping crude oil from around the world to the plant, then marketing the gasoline and diesel it makes.
If the rule is finalized as it stands the question will turn on whether banks can convince regulators that their physical deals are only done on behalf of clients, making them eligible for an exemption from the crackdown.
BANKS GET PHYSICAL
Over the last decade Wall Street banks quietly grew from financial commodity traders into major players in the physical market of crude oil cargoes, copper stockpiles and natural gas wells, often owning and operating vast assets too.
Bankers argue that forward contracts are necessary if they are to help refineries like Philadelphia curb costs and free up capital, to help power plants to hedge prices, or to let metals producers and grain farmers finance storage.
Forwards are essentially contracts to buy or sell a certain amount of a physical commodity at an agreed price in the future. Their duration can range from a few days to a number of years.
“To pull forwards into the Volcker rule just because someone has a fear that they could, in some instances, be used to evade the swap rules is just ridiculous,” one Wall Street commodities executive said.
“We move oil all over the world. We have barrels in storage. They are real, not just things on paper. They go on ships and they go to refineries. It is basically equating forwards with intent for physical delivery as swaps – and they’re not.”
She added: “You can’t burn a swap in a power plant.”
Unlike a swap, which will be settled between counterparties on the basis of an underlying financial price, a forward will usually turn into a real asset after time. Unlike hard assets, however, the forward contract can be bought or sold months or years before the commodity is produced or stored.
Historically the physical commodity markets have remained beyond financial regulatory supervision and forwards are not mentioned specifically in the part of the 2010 Dodd-Frank law that mandates the drafting of the Volcker rule.
But the drafters of Dodd-Frank say it was always their aim to prevent banks that receive government backstops like deposit insurance from trading for their own gain. They worry that banks could quickly boost trading for their own book in forward markets rather than purely for the benefit of clients.
“The issue is the potential for evasion,” said one official at the Commodity Futures Trading Commission (CFTC) who was not authorized to speak on the matter. He said traders could easily buy and sell the same commodity forward contract, profiting on the price difference, without the goods ever changing hands.
It would be a useful tool “if you want to hide activities or evade margin requirements,” he added.
RISKY BET OR HARMLESS HEDGE?
Kurt Barrow, vice president at IHS Purvin & Gertz in Houston and lead author of a Morgan Stanley-commissioned report on the impact of the Volcker rule on banks’ commodity businesses said deals like JPMorgan’s with Carlyle and Sunoco could be in jeopardy.
“One of the problems with Volcker is the way it is written assumes that every trade the banks make is in violation of it, and then they have to go through a series of steps to prove that it’s not,” Barrow said.
“If the banks have physical obligations they need to hedge, like in supply and off-take agreements with refineries, there are already concerns that they could be seen to be in violation of the Volcker rule. The rules are geared toward equity trading and don’t take account of how commodity markets really work.”
Goldman Sachs and Morgan Stanley, which alongside JPMorgan dominate physical commodity trading on Wall Street, also take part in supply and offtake agreements with independent refiners.
Without leeway to trade forward contracts, banks would have little reason to retain the metal warehouses, power plants, pipelines, and oil storage tanks that are the crown jewels of their commodity empires.
The future of those assets is already in question as the Federal Reserve must soon decide if banks backstopped by the government will be allowed to retain those assets indefinitely.
In the years preceding the financial crisis, major banks were at times booking as much as a fifth of their total profits from their commodity trading expertise, but drew criticism they could combine their physical market knowledge with huge balance sheets to try and push prices in their favor.
That criticism has resurfaced this year.
“Americans are already paying heavily at the pump for excessive speculation in the oil markets,” Senator Jeff Merkley, who co-authored the Volcker provision with Senator Levin, told Reuters.
“The last thing they need is more of that speculation and risk-taking, especially when it would not only drive gas prices even higher but could also contribute to another 2008-style meltdown.”
NO FORWARDS, NO PHYSICAL, NO SERVICE
The inclusion of forwards in the proposed Volcker rule has created concern beyond Wall Street. Some industry groups argue banks have become so embedded in the structure of both financial and physical commodity markets that they are now key trading partners for a wide range of firms.
“We were surprised,” said Russell Wasson at the National Rural Electric Cooperative Association (NRESCA). “To us they are straightforward business contracts because they’re associated with physical delivery. They’re being treated as derivatives when they never have been before.”
The concerns are the same as with other aspects of the Dodd-Frank reforms, the biggest overhaul of financial regulation since the Great Depression: tough new limits will reduce liquidity, thereby increasing market volatility and hedging costs.
The Volcker rule does include key exemptions to allow banks to hedge risk and make markets for clients.
But some commodities experts say proving that forwards fit into these categories may be too onerous to be helpful.
University of Houston professor Craig Pirrong, an expert in finance and energy markets who has generally argued against the proposed regulation, said he was skeptical of the hedging exemption’s utility, and was sure regulators would take a tough line in the wake of JPMorgan’s recent losses.
“They will have to provide justification that these (commodity forwards) are hedges or entered into as part of their “flow” business with customers,” he said.
“In the post-Whale world, banks are on the defensive and I would not bet on them prevailing on an issue like this.”
Banking executives say they are now desperate to convince skeptical regulators that their physical arms have been transformed into purely market making and client facing businesses.
“Banks have been working to reposition their commodities business… under the assumption that physical markets would be covered by Volcker,” one senior Wall Street commodities executive said.
“Several banks shut down their proprietary trading about two years ago in anticipation of this. The argument that physical commodity markets will present some kind of Volcker loophole for banks is false.”
(Reporting By David Sheppard; Editing by Bob Burgdorfer)
- Wall Street Supporters in Congress Unmoved by Libor Probe – Bloomberg (bloomberg.com)
- Reexamining The Volcker Rule After JPMorgan’s Derivatives Loss (seekingalpha.com)
- After Loss, JPMorgan Regulators in Spotlight (dealbook.nytimes.com)
- Oil rises above $84 amid tighter Iran sanctions (news.yahoo.com)