classical economics
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Energy Crisis Now
Courtesy of Financial Inventiveness
 By Wayne Jett © June 25, 2008

    This is reality: crude oil at $137 per barrel will wreck the U. S. economy in the near term unless promptly corrected, and would have already if the Federal Reserve had not been so generous with liquidity. The Fed has little further capability to fend off economic collapse. The dollar has already been devalued almost beyond recognition – certainly beyond respect – and the Fed’s own portfolio has been downgraded from Treasuries to significant investment risk.
    If ever it could, the Fed can no longer mask the fact that neither the U. S. economy nor other economies around the world can maintain production, much less expand, with oil at or near $137. Unless the oil price collapses, and soon, the economy will.
House Energy Oversight Hearing
    On June 23, a Monday no less, the subcommittee on oversight of the House committee on energy and commerce held eight hours of hearings into the causes of high prices of oil, gasoline and diesel fuel. Monday is ordinarily not used for hearings in Congress, so that fact alone lends a degree of urgency to the deliberations, though not nearly enough. Energy costs are in such crisis that both House and Senate (hold onto your wallets) ought to be in session around the clock until remedial election is enacted and sent to the president for signing.
    A full month passed since the Senate committee on homeland security heard similar (though less extensive) testimony May 20, with little noticeable action so far. As Congress dithers, air transport, both passenger and freight, is being liquidated and downsized to sharply smaller capacity. Trucking transport – ditto; used trucks are being sold into Viet Nam because secondary markets in the U. S. have collapsed. Heating oil prices have soared so sharply that even dealers in the fuel, much less consumers of it, are struggling to finance purchases of inventory for the coming Winter even at this early date.     
    When economic growth resumes, capacity will be expensive to replace in industries hit by fuel prices, so near-monopoly pricing will prevail for the few survivors. Who will own them? Most likely, major players in the financial sector, which produced the energy fiasco, will acquire assets at depressed prices. Meanwhile, those same players, knowing their actions would push up energy costs, surely were among the short sellers who crushed the share prices of such firms as YRC Worldwide (YRCW), which fell from $62 in March, 2005, to $12 in March, 2008.
The Rise of ICE
    How did financial sector players (think the usual suspects: Goldman Sachs, Morgan Stanley, J. P. Morgan Chase, et al.) produce high energy prices. Watch the testimony. Upon enactment of the “Enron clause” in December, 2000, permitting trading of oil futures between institutions without reporting to the Commodities Futures Trading Commission, these financial players promptly organized the Intercontinental Exchange (“ICE”) to exploit the “dark market” advantage. Headquartered in Atlanta, ICE bought a London entity that enjoyed an additional “no action” letter advantage granted by the CFTC in the U. S. commodities markets. ICE sold $415 million of its shares to the public in a 2006 IPO in which about 84% of the funds raised went to the organizers, with GS and MS still owning 11% of ICE shares.
    Thanks to Goldman Sachs, Morgan Stanley, Morgan Chase and ICE, a major portion of large oil futures trading in the U. S. is shielded from CFTC monitoring. Moreover, CFTC appears captured and intimidated by these financial players. CFTC’s acting chairman, Walter Lukken, testifying under oath Monday, was unwilling to answer candidly who organized ICE when asked by Congressman John Dingell, the Michigan Democrat who chairs the Energy and Commerce Committee.
    CFTC claims to have been alert to potential manipulation in oil futures for years, but contradictorily alibis its lack of action by saying it is still requesting and gathering “data.” By indications of its acting chairman’s testimony Monday, CFTC is unable or unwilling to say what price manipulation looks like when found.
“Video Barrels” in the Oil Pricing Game
    Dingell succeeded in gaining CFTC’s admission that trading of SWAPS derivatives creates “video barrels” of oil 13 times greater than actual oil production. Oil futures swaps enable the investor to replicate financial results of owning oil without actually owning it. Video barrels are fictional oil that will never be produced or delivered, yet are priced and traded as if real, moving billions of dollars in the process. Suggestion that swaps trading does not, in itself, affect the price of oil is preposterous. Yet that appears to be CFTC’s posture on the subject, ambiguous though it may be.
    Four expert witnesses testified at Monday’s hearing that oil prices currently are inflated by speculation and unjustified by market fundamentals. Fadel Ghiet of Oppenheimer & Co., an energy analyst with 30 years experience who speaks with energy producers continuously, unhesitatingly advised that the price of crude oil would be in the range of $45 to $60 per barrel without the financial sector’s inventive influences through derivative instruments and unmonitored trading. Ghiet also related how Goldman Sachs analysts forecast much higher oil prices, then Goldman as the largest trader of crude oil futures proceeds to make the forecast happen.
Remedies and Retribution
    Recommended remedies to the ongoing calamity: (1) require reporting and monitoring of all trading in crude oil, whether in U. S. markets or affecting U. S. oil, whether on exchanges or over-the-counter; (2) strict position limits on ownership of crude oil futures by non-commercial investors who do not take delivery; (3) prohibit index replication funds and investment banks from owning crude oil futures; and (4) raise margin requirement from 5% to 50% on crude oil futures bought by non-commercial investors. Mere prospects of these reforms in the near future would spark prompt unwinding of speculative positions and prices.
    Additional recommendations: President Bush should fire Treasury secretary Henry Paulson and his Energy secretary immediately. Their failures of policy and performance are far more consequential than any by Defense secretary Donald Rumsfeld, who lost his position promptly after the 2006 elections. Oil, gasoline and diesel fuel prices have doubled in the past year, while the dollar has lost half its value relative to gold. The falling dollar (Bernanke’s and Paulson’s doing) is partly to blame for energy’s price rise, but not entirely. Oil priced in gold is at or near its historical high presently at 6.1 barrels per ounce, when ordinarily the price is in the 12 to 14 barrels per ounce range. This means oil is priced at about double the price caused by dollar inflation alone.
    Treasury’s Paulson is primarily to blame, as he came to Washington only after being granted the powers of “economic czar” to call the shots on policy. By every measure, his performance has been disastrous, and that is true without regard to his previous ties as CEO of Goldman Sachs. The dollar, housing, oil, unemployment – the credit crisis - each has worsened since his arrival, and he has made no improvement in policy on any one of these. Indeed, his results are akin to consolidating the worst possible outcome for the Bush economic record.
    When his Goldman Sachs ties are considered, Paulson’s conduct transforms from dismal to scandalous. As Paulson made his tax-exempt move to Treasury in mid-2006, Goldman was underwriting and marketing sub-prime mortgage backed securities while shorting them and the related ABX index. The ABX was designed to exaggerate swings in value of those securities and, thus, was pivotal in precipitating the sub-prime market collapse.
    Now Monday’s hearing sheds more light on the Goldman role between 2000 and 2006 (during Paulson’s tenure there) in ICE and the economically destructive run-up in energy prices. Need mention be made of Paulson’s orchestration from Treasury of the Federal Reserve’s recapitalization of J. P. Morgan Chase Bank through the ordained buyout of Bear Stearns?
Context and Prospects
    When Fed chairman Bernanke complies so readily with Paulson’s wishes regarding Morgan Chase and Bear Stearns, reticence of the CFTC acting chairman in testifying to Congress about manipulative trading practices in the oil futures markets is seen in context. A mere interim regulator of commodities trading must think twice before offending an economic czar, much less the commanders of the czar’s mother ship on Wall Street.
    Remedial legislation from Congress is likely by the end of July, though the end of June would be far better. Provisions included in the farm bill to close the Enron loophole turned out to be illusory, so real reform is within reach but uncertain until actually in hand. ~