classical economics
for analysis,  forecasting
and policy design

Lewd Crude Price Fuel
By Wayne Jett (c) April 3, 2008

    The high point of President George W. Bush’s economic policy was in May, 2003, when House Committee on Ways and Means chairman Bill Thomas engineered well-designed cuts in marginal rates of income tax. Absent the strong surge in economic growth that followed, the president almost surely would have been denied a second term. Sadly, that resounding economic success was brought to a standstill by bad monetary policy. Democratic presidential candidate Hillary Clinton credibly points to Jimmy Carter-like “economic malaise” during Bush’s eighth and final year as president.
    The current state of U. S. economic affairs is truly pitiful:

•    The dollar devalued 65% in five years
•    Economic growth near zero or worse
•    Dysfunctional mortgage and credit markets
•    Major financial institutions failing
•    Russia proposes international standards for reserve currency
•    France asks no further use of dollar as weapon of trade war
•    Euro strong vs. dollar even after ECB injects $500 billion euros
With problems this bad, the president should have trouble-shooters looking for economic problems that are fixable. That means something outside the Federal Reserve’s ambit, as the Fed insists its operations exemplify perfection.
    Ask most Americans what the biggest problem in the economy is right now and they will say the high prices of gasoline and diesel fuel. Years ago, a poorly considered Supreme Court decision noted that obscenity is difficult to define but easy to recognize when you see it. Gasoline prices are near $4 per gallon and diesel fuel (used by truckers in swimming-pool quantities to haul food and other essentials) are even higher. In the past 12 months, crude oil is up about 40%, gasoline is up about 25% and diesel fuel is up nearly 70%. Many Americans struggling to provide for families see these prices as obscene. Forget the long lost fuel prices of four years ago.
    Bush administration officials respond with platitudes about alternative fuels and lectures on supply and demand. True, these are better responses than proposals from Democratic politicians to pillory “big oil” executives for price-fixing or to take their profits with taxation. These are not the avenues worth exploring.
Setting the World Price of Crude Oil
    Neither “big oil” nor OPEC sets the world price for crude oil. The price is determined by price-seeking market transactions in oil futures contracts traded primarily in the U. S. Supply and demand ordinarily are controlling influences on prices of commodities such as crude oil. In the case of crude oil, however, its price has departed from historical norms in relation to supply and demand. Normally, the price of crude oil rises when demand exceeds supply and inventories decline. Since 2004, however, crude oil prices have risen even when inventories are high. In the eyes of every fuel consumer, that anomaly is worth examining with a microscope. Why has this been the case, despite all historic experience to the contrary?
    Surprisingly to almost every observer, that question has already been investigated in detail. In 2006, the Permanent Subcommittee on Investigations of the U. S. Senate Committee for Homeland Security finished its inquiry and issued a report.
“Enron Clause” Allows Unmonitored Oil Futures Trading
    The PSI found that an obscure federal statute known as the “Enron clause” enacted in 2000 during the last year of the Clinton administration allows trading in crude oil futures contracts without reporting large transactions to the Commodities Futures Trading Commission, so long as the trade is between institutions and does not occur on an exchange that performs a price-seeking function. The senators found that about three-quarters of all large transactions in crude oil futures contracts during 2006 occurred on such institutional exchanges without reporting to the CFTC, even though the exchanges concede they perform a price-seeking function!
    In the PSI’s analysis, hedge funds began buying crude oil futures contracts in 2004 on unmonitored institutional exchanges, and the price of crude oil departed from historic norms in relation to inventories. In turn, this departure from historic pricing norms was depicted as a secular bull market in oil, which enabled hedge funds to attract additional investments in crude oil futures contracts by large pension funds. As prices paid for crude in futures contracts escalated, new futures contracts could be bought with terms guaranteeing profits at the time of signing. This pushed the price of crude oil reflected in the futures contracts ever higher.
    Here is the Senate PSI’s chart depicting the historically abnormal price action since 2004.
Data source: EIA
CFTC Ducks Regulatory Duties
        Seeing this suspicious, unmonitored environment for trading futures contracts that are so crucial to the world price of oil, the Senate PSI adamantly urged the CFTC to exert existing authority over exchanges with price-seeking functions so as to require immediate reporting of all large transactions in crude oil futures contracts. Inexplicably, the CFTC did nothing except wait until the 2006 elections handed Senate chairmanships to the new Democratic majority. Then CFTC belatedly reported in October, 2007, that it has no jurisdiction. No action will be taken without new laws from Congress.
    Financial media have devoted little attention to this crucial and intriguing Senate report. No matter. President Bush and other Republicans ought to relieve most Americans of their primary reason for thinking the country is on the wrong track. They should leave no stone unturned in learning whether the price of crude oil is being manipulated by hedge funds through unmonitored trading in futures contracts. A good first step would be for President Bush to pick up the phone and call Norm Coleman, the Republican senator from Minnesota who chaired the subcommittee that wrote the report in 2006. Or Senator Coleman should call the president. Congress is talking about combining the CFTC with the Securities & Exchange Commission. Far worse, Treasury’s Paulson is proposing a takeover of both the SEC and the CFTC by the Federal Reserve! Before doing anything else, the president and Congress should be sure that trading in crude oil futures contracts does not go another day unmonitored. ~