Why I’m a little worried about the drop in oil

(8 am. – promoted by ek hornbeck)

Can’t sleep, been thinking about the price of oil, worrying about it to be honest. Now you may be thinking “Venom, what are you crazy? A putz? A drop in the price of oil is a good thing!”  And I would reply, yes, under normal circumstances it is.  But these days, things ain’t so normal.  Actually, right now, oil is up since yesterday, but it’s been in a slide for the past week or so.

A prophetic lunch

A couple years ago, I had lunch with a trading friend/mentor of mine at Hackney’s on Harms Road.  He was an older gentleman, made his money in options, in fact was one of the first to trade at the CBOE back in the 1970s.  We had just gotten back from one of those sales seminars from Equis, a company that makes a product called Metastock.  While gobbling down on Hackney’s infamous onion loaf and later cheeseburgers, topics ranging from the software to commodities came up.  This was around 2002, and Enron was still in the headlines.

I commented that a lot of the buy-side got burned by the fraud commited by folks like Kenneth Lay.  The stock had collapsed, and the whole idea of trading energy products like electricity now seemed completely discredited.  This was a big problem for Wall Street, I said.  He then shook his head and said something that has stuck in my mind.

“John, what’s good for Main Street may not be good for Wall Street.  What’s good for Wall Street may or may not be good for Main Street.  But what is bad for Wall Street will be made bad for Main Street.”

Years later, through all the scandals, and now today’s financial crisis, that quote seems more truer than ever. Tax payers are now bailing out financial gamblers who knew better.  From Long-Term Capital Management to Fannie and Freddie, all got cash infusions either from the government or a pool of investors corralled by the Treasury.  In the end, even when it didn’t come directly from the tax payer, the tax payer soon paid through special tax deals and such.  C’mon, you don’t think they aren’t talking about tax breaks in the halls of Congress for these financial firms that help out?

Lehman, oil, and anyone else holding the bag?

This brings us back to Lehman.  For the past month, the price of oil has been dropping.  A while back I commented that one of the reasons was that China stopped buying, because they stocked up before the Olympics.  Coincidentally, this was also around the same time that Richard Fuld, the company’s CEO, said it was starting to sell assets to raise cash (kinda like what AIG has been saying for the past few days..hrmmmm).  Lehman Brothers ran trading operations that dealt with everything from those infamous Credit Derivatives to commodities like oil or financial products based on oil (yes, believe it or not such a thing does exist!).  Well whose to say that part of the fall in oil could be attributed to Lehman?  That sounds like a good thing at first, that is until you think about it a bit longer. Their pain is your gain..or is it?

What’s bad for Wall Street will be made bad for Main Street!

Back in the beginning of the year, Lehman announced that they had bad earnings, yet Fuld said he would not raise capital.  Then in June, the Times reported that Lehman was indeed raising capital.  It was then made public that besides the issuance of new shares, that it was beginning to jettison some of it’s other holdings.  If this is indeed the case, it would serve as an impetus for the fall in crude.  Now as prices fall, other things start to happen.


You see, all these trades with these contracts involve margin.  Now margin for futures trading is simply a deposit of a certain amount to control a commodities contract.  The latest margin rates at the New York Mercantile Exchange shows that members pay $10,175/contract, while non-members pay $12,488. That’s, rounding them out, 10k-12.5k to control $93,750 (using latest prices) or 1,000 barrels worth of oil. Depending whether you were long or short, the margin maintenance, that is what is required to hold on to your position, could go up or down.  If you are in a losing position, expect your margin requirements to increase mark to market.

You have to figure that a lot of folks, from institutional trading desks to pensions, are taking a bath.  It has only been recently, in the past two years or so, that everyone has been saying that commodities/futures are now an asset class.  Jim Rogers even wrote a damn book on why you should plow cash into commodities!  It’s been my experience that when you see everyone talking about getting into something, that that’s often the top.  Whether it’s stocks in ’99, pork bellies in the 70s, real estate in this decade, or even beanie babies, it’s all the same!  Crowd mentality, it never changes.

What’s bad for Wall Street will be made bad for Main Street!

Looking at the events transpiring this past week.  One could easily come to the conclusion that even the so-called Masters of the Universe aren’t such market mavens.  Well, perhaps Goldman Sachs or George Soros, but for a lot of hedge funds and institutional trading desks, this is their last quarter.  And this is what worries me.

While we’re rejoicing in the price of crude dropping, margin clerks, the repo men of the financial industry, are also sharing in your joy.  There isn’t a trader alive who doesn’t dread that one phone call.  If you’re a retail client (like most folks), then odds are your broker will notify you to pay up the difference in margin.  You normally got less than 24 hours before they liquidate your account.  For larger clients, and I mean big time ones, they often have a risk management department or a guy somewhere keeping tabs on this…well that’s the idea anyways.

Are we going to have to bail out a commodities trading fund next?

Many of these desks, like we are seeing with Lehman or even AIG, were trading with enormous leverage.  Often, able to borrow money at a discount, management would often grant the trading desk leverage many times the cash they carried; 40 to 1 was a norm in many places.  And to the folks running the company, risk management was in their minds so what was the big deal?

Of course, with oil ratcheting on an ever higher price and research pointing to $100 then $200 price, things only looked good. What was the harm in increasing their position?  You look at the volume, a 1000 lots of crude would go in a blink of an eye.  And it wasn’t just oil, we saw an influx of new cash into everything from boring ol’ corn to gold.  There was even Exchange Traded Funds on the American Stock Exchange and the NYSE that represented positions in these things.  You got to figure that behind each new commodities mutual fund or ETF was a trading desk.

Yet, as you can see in that chart above, things didn’t go as high as people predicted.  That isn’t to say oil couldn’t go to $200, I’m sure it will, but that won’t help the trader facing a margin call.  Some jackass daytrader like myself facing a margin call is one thing, but say a hedge fund with twenty or forty billion dollars worth of commodity contracts is a whole other ball game.

What’s bad for Wall Street will be made bad for Main Street!

Look, I wish we could say “fuck ’em” and things turn out fine.  But they won’t.  Mark my words, you’re going to hear that some pension fund or trading desk or someone big got blown away dealing in futures.  There is nothing wrong with futures trading, but despite what Jim Rogers says, this ain’t for everybody.  You had smart Street folks who probably were more experienced in say equities or bonds or who knows what, enter something completely alien.  Maybe they were familiar, but when you’re told to take advantage of a Goldman Sach’s research saying oil is going to $200, what are you going to do?  

We are, as I’ve said already, going to pay for this.  CDOs, swaps, corn, defaults, it don’t matter.  At the end of the day, you and I will pay for someone else’s mistake.  What is needed is more regulation in regards to leverage, that is critical.  And if you think I’m making this up, Google the word “Forex” and you’ll see modern day bucket shops saying you’ll make oodles of unbelievable money trading currencies at 100-1 leverage! So yes, we need to reign in leverage.  And you can’t be trying to get average folks to play the futures game.  I’m sorry, but I’ve seen so many burned by this, it’s almost sick.  

Maybe I’m wrong, maybe we should let anyone “play the market”, but then we’d still end up paying.  Right now, or at least in this recent past, the financial machine didn’t care who their clients were.  And if there was a problem, well you know what my mentor said:

What’s bad for Wall Street will be made bad for Main Street!

<sup>Cross posted on

The Economic Populist

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  1. Thanks for reading my latest entry.  Look, couldn’t sleep, I worry about things like this. I’m an econ geek, what can I say?  Hey, maybe I’m wrong, and we’ve turned a corner and won’t be bailing out more funds or someone.  Honestly, I wish I were, and hopefully, for the taxpayers’ sake, I am.  You all take care today.  Be safe.

  2. Are we going to have to bail out a commodities trading fund next?

    But I think the Fed has made clear that it is now focusing its efforts primarily on the housing sector.

    Although what the Fed might do next week is anybody’s guess.

    One vital question:

    I had lunch with a trading friend/mentor of mine at Hackney’s on Harms Road.

    What’s your position on using black rye bread slices for hamburger buns?

  3. …when oil was at $140, I heard a lot of people talking about shorting it.  The Wall Street CW was that it would go down, not keep going up.  Further, by the start of the summer, no one had any real access to credit; the interbank lending market had cratered.  Even if folks had been inclined to pile into oil, they couldn’t do it with meaningful leverage.

    Credit Default Swaps are the real area of interest.  I think we’ll see utter paralysis now until they shake out.

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