How the Few Inflict Inflation on the Many

The “Carter” years gave the American economy one of its worst sicknesses, stagflation.  In this disease, the economy doesn’t grow and government spending does grow, and an oil embargo caused a surge in inflation.  In the 1970s, the annualized rate of inflation peaked at about 12% a year.  But, in recent years another source of inflation originating in the private sector has emerged in a very dramatic way.  In a month of dismal economic news, did anyone see this:

U.S. inflation surged in July primarily because of climbing energy and food prices, but those costs are likely to retreat in coming months as prices for oil, grains, and other raw materials fall in a lagging economy…

The consumer price index jumped by a seasonally adjusted 0.5% in July, up 3.6% from a year earlier, the Labor Department said Thursday.  Higher gasoline prices accounted for about half the gains, reflecting high crude oil prices earlier this year…

The more recent acceleration in core inflation—up at a 3.1% annualized rate over the past three months—could limit the Fed’s options in bolstering the recovery.  ‘There’s more inflation than the Fed has been expecting,’ said UBS economist Drew Matus…

Fed officials do expect inflation to ease in coming months as commodity prices decline and consumer demand is damped by high unemployment and sluggish wages.  Workers’ inflation-adjusted weekly earnings fell 0.1% in July from a month earlier and 1% from a year earlier, the Labor Department said in another report.

It is a government dictum that everyone talk about core inflation without food and fuel, when oil and food prices are rising.  Then, when core inflation is taking off, we discover that their story is core inflation will be tamed by “falling oil and food prices.”

Everyone who opens a credit card or debit card statement (bank statement) is repeatedly irritated at how food and fuel dominate our daily expenses.  This might make you interested in how we as a nation have inflicted inflation on ourselves because of villains and processes that would be incredibly easy to terminate.

In business and financial news media, almost every day you read about some disruption in the supply of various things that are important in our lives.  They make it sound like our economy is at the mercy of constant supply disruptions or excesses.

Over the 50 year period between 1960 and 2010, corn consumption in America grew at a compounded annual rate of 2.5%.  Are you surprised how consistent the growth rate is?  Perhaps, it approximates our population growth or is some function of our long-term economic growth.  Regardless, it was very steady.

Corn Production,  Consumption and Price in US from 1960-2010
	Consumption (1000 MT)	U.S. Consumption Rate of Growth	Domestic Production (1000 MT)	U.S. Domestic Production Rate of Growth	Avg. U.S. Price Rec’d by Farmers ($ per Bushel)	Price Rate of Growth
1960-2010	7,727,691	2.50%	9,674,991	2.39%	$2.18	3.44%
1960-1969	931,462	2.33%	1,038,452	2.04%	$1.12	1.66%
1970-1979	1,116,139	2.99%	1,513,440	7.45%	$1.90	7.36%
1980-1989	1,358,192	1.80%	1,817,012	1.41%	$2.46	-3.02%
1990-1999	1,730,637	2.56%	2,192,185	1.94%	$2.36	-2.47%
2000-2010	2,591,261	3.89%	3,113,902	2.30%	$2.97	10.99%

 

The graph also shows that price movements are more uneven and in fact very volatile at different periods of time.

The first period of volatility had a very specific cause:

On October 16, 1973, OPEC announced a decision to raise the posted price of oil by 70%, to $5.11 a barrel.

This was the beginning of a period of historic inflation in America that would peak around 1980 with inflation annualized at almost 12% a year.  As you can see from the graph, the price of corn rose from about $1.25/bushel in 1971 to around $3.20/bushel in each of 1975, 1980 and 1983.  This is about a 250% increase in price of corn at each of those peaks with no real increase in consumption.  Since oil is an input in corn production, more expensive oil certainly raised the price of corn somewhat, but should it have more than doubled the price?  This is a good question since consumption growth appears pretty even throughout the volatile price period which ended around 1986 with the price of corn dropping to under $2.00/bushel.

Going forward to 1996, we see a series of large crops over 200,000,000 metric tons (MT) per year.  Such a consistent surplus could account for this negative volatility.  Prices oscillated around $2.00/bushel until 2005.  In fact, the growth rate in price from 1960 to 2005 is just 1.5% compounded for 45 years.  And again, consumption continued on its pretty even path.  Then it happened, as most people now know:

The new ethanol mandate is perhaps the most disappointing program in the Energy Policy Act of 2005…

The 2005 energy bill mandated that 4 billion gallons of renewable fuel (mostly corn-based ethanol) must be added to the gasoline supply in 2006.  That amount rises to 4.7 billion gallons for 2007 and 7.5 billion in 2012.  These targets represent a large percentage increase in ethanol use but are still only a small fraction of the 140 billion gallons of gasoline that the U.S. currently uses every year…[1]

While a boon to Midwestern corn farmers and big ethanol producers like Archer Daniels Midland, ethanol has been bad news for the driving public.  Ethanol usually costs more than gasoline, so adding it to gasoline increases fuel prices at the pump.[2]

Notwithstanding the waste of corn from ethanol by substitution in gasoline, let’s just answer the following question:  how much ethanol does a bushel of corn produce?  One bushel of corn produces 2.8 gallons of ethanol.  So, to produce the 7.5 billion gallons of ethanol under the 2012 mandate would require 3 billion bushels of corn.  Each metric ton contains 35.7 bushels and, therefore, the number of metric tons required for the 2012 mandate is 84,033,600 MT.

This would be 29.7% of the base year (2005) crop.  By 2010, production had increased to 316,165,000 MT, or just an 11% increase.

The average price in 2005, approximately $2.00/bushel, looks like it is just below the average of the average prices for the prior 3 decades of approximately $2.24/bushel.  Nonetheless, consumption increased from 105,472,000 MT in 1970 to 239,549,000 MT in 1999, or just 2.8% compounded over 20 years.  Thus, with the price being relatively constant for about 30 years while consumption slightly more than doubled suggests that for this extended time there was generally a surplus of corn.

Now look at what a violent price spike the passage of the Energy Policy Act of 2005 caused.  After 30 years of adequate corn supply, the mandate was not an immediate requirement.  Like everything else, it was supposed to be phased in over a number of years.  And, it will take time to build more ethanol plants, etc.  A price change from around $2.00/bushel to over $5.00/bushel in about 5 years is 20% a year compounded. Over the same period, consumption of corn increased from 232,015 MT to 290,082 MT, which is just 25%, or a compounded growth rate of 4.5%.  You have to wonder what is really going on here to cause these price spikes.

Let’s look at the graph of consumption and price of oil to see if we can get any additional insights.

Here are some more surprises.  For the 50 year period from 1960 to 2010, the consumption of oil grew at a compounded rate of 1.35%.  Yes, you read this correctly, just 1.35%.  Over the same period, the United States’ GDP grew from $526.4 billion to $14.526 trillion.  So, in 1960, a unit of oil produced 53.7/units of GDP.  In 2001, a unit of oil produced 745 units of GDP.

This is a tremendous growth in efficiency of 7.21% compounded over these 50 years.  It is pretty amazing. And, it demonstrates how a market economy advances by becoming increasingly more efficient in the use of this critical resource as well as all other resources.  That is what productivity is all about–getting more economic outputs from economic inputs.

For the period from 1960 to 1999, 39 years, the price of oil went from $2.91 to $16.56, or 4.6% compounded.  We are picking 1999 as an ending point for reasons we will reveal later.

From 1960 to the Arab Oil Embargo of 1973, the price of oil was practically constant.  Oil increased in price from $2.91/barrel to $4.75, or just 3.8% compounded over these 13 years.  Yet, consumption actually increased from 9.8 million barrels to 17.3 million barrels, or at a compounded rate of 4.5%, which makes this a very stable period with a mild element of price deflation.

The first economic impact of the 1973 crisis was OPEC’s increase in the base price of oil to $5.11/barrel. Then in 1979,

[t]he'(second) oil crisis in the United States occurred in the wake of the Iranian Revolution.  Amid massive protests, the Shah of Iran, Mohammed Reza Pahlavi, fled his country…  Protests severely disrupted the Iranian oil sector, with production being greatly curtailed and exports suspended… However, a widespread panic resulted, added to by the decision of U.S. President Jimmy Carter to order the cessation of Iranian imports, driving the price far higher than would be expected under normal circumstances.

So, from 1973 to 1981, the average price of oil rose in two steps.  First, from 1974 to 1978, the average price increased from $9.35/barrel to $14.95/barrel.  The events in Iran in 1979 caused an almost vertical spike in the price to $35.75/barrel by 1981, or another 139%.  We again recall that during this period of our history, the “Carter years,” domestic inflation peaked at an annualized rate of almost 12%.  After 1981 average oil prices drifted downward to a level of $16.56/barrel by the end of 1999.  How about this for an annualized deflation rate in oil prices of -4.3% for 18 years?  Remarkably, consumption continued to rise during the same 19 year period from 17.3 million barrels/day to 19.5 million barrels/day.

So, if you drop out the period of the OPEC oil disruptions and look at the change in price over the 1960 to 1999 period, oil prices rose from $2.91/barrel to $16.56/barrel, or 4.56% compounded annually. Consumption began at 9.8 million barrels/day and ended at 19.5 million barrels/day, which is a compounded growth rate of just 1.78%.  For something so important to our economy, oil supply seems like a remarkable bargain.

But, then in 1999 something radical happened.  Oil prices took off in an almost vertical ascent.  From the beginning value of $16.56/barrel, oil prices shot up to an unbelievable near peak price of $140.00/barrel on June 30, 2008.  The compounded growth rate from this time frame would be 26.8% compounded annually for 18 years.  Phenomenal, unprecedented and unjustified.

And guess what the change in consumption was during this period?  In 1999, it was 19.5 million barrels/day and in 2008 it was the still 19.5 million barrels/day.  No change!  Well, this certainly proves that Hurricane Katrina had absolutely nothing to do with it.  And, as we will discover, it was something much worse.

In our search for this “something,” let’s take a look at a substance that is not very useful except as a substitute for copper in micro-sized electrical circuits.  Oh, yes, some people, especially women think it is beautiful and thus it very useful for making jewelry, but in the end, we can all survive very well without it—gold.  And this is not the case with essentials like corn and oil.

There will be a few surprises here too.  We need to go farther back into history, because there are two relevant periods for gold.  The first is while prices were fixed by the government and we were on a “gold standard.”  And the second is thereafter when prices were market determined.

Gold Production, Consumption and Price in US from 1900-2009
	Primary Production	U.S. Production Rate of Growth	Consumption	U.S. Consumption Rate of Growth	Avg. Price ($/ton)	Price Rate of Growth
1900-1960	5,715.9	-1.39%	4260.5	2.09%	$849,278	1.04%
1900-1909	1,297.0	2.51%	471.8	6.11%	$608,700	0.00%
1910-1919	1,303.6	-5.54%	714.3	6.93%	$618,700	0.59%
1920-1929	706.6	-1.61%	919.7	-3.68%	$663,700	0.05%
1930-1939	1,019.3	9.05%	320.6	-6.67%	$960,700	5.91%
1940-1949	749.5	-9.42%	959.7	15.32%	$1,095,000	-0.73%
1950-1959	588.1	-4.36%	874.4	-2.14%	$1,124,000	0.10%
1960-1969	496.8	0.44%	2037	11.73%	$1,167,000	1.91%
1970-1979	378.1	-6.36%	2458	-1.43%	$4,277,000	26.77%
1980-1989	1,058.4	27.35%	1855	2.48%	$13,560,000	-5.10%
1990-1999	3,288.0	1.66%	2826	8.10%	$11,329,000	-2.93%
2000-2009	2,723.0	-4.98%	2438	-3.09%	$16,826,000	14.84%
*All Values in Metric Tons.  Data from U.S. Geological Survey.

 

Here is a short lesson in how government control of prices just does not work.  You can only be on a gold standard if you can buy and sell gold in the free market.  In theory, the value of labor exchanged in a free economy is theoretically infinite whereas the supply of gold is definitely finite.

‘For a long period, the United States government set the value of the US dollar so that one troy ounce was equal to $20.67 ($664.56/kg), but in 1934 the dollar was devalued to $35.00 per troy ounce ($1125.27/kg).  By 1961, it was becoming hard to maintain this price, and a pool of US and European banks agreed to manipulate the market to prevent further currency devaluation against increased gold demand.

On March 17, 1968, economic circumstances caused the collapse of the gold pool, and a two-tiered pricing scheme was established whereby gold was still used to settle international accounts at the old $35.00 per troy ounce ($1.13/g) but the price of gold on the private market was allowed to fluctuate; this two-tiered pricing system was abandoned in 1975 when the price of gold was left to find its free-market level…

Gold’s history enters our graph at 1900 when the price of gold was fixed at $20.67/oz.  This continued until 1934 when the government raised the price to $35.00/oz.  At this fixed price only the easiest low cost mines could afford to operate and this would therefore artificially suppress production.  With production suppressed, consumption is also suppressed.  So, for the controlled period, the rate of production growth was negative.  More gold was produced in 1900 than 1960.  Beginning production in 1900 was 120 MT (metric tons) and this had dropped to 51 MT by 1960.  This is a negative growth rate of minus 1.39% a year.

This is why price controls are a disaster—no matter what it is, you will always get less of it under government price controls.

By 1961, the difficulty of maintaining this price of $35.00/oz for gold resulted in upward pressure on gold prices throughout the decade.  In 1968, the “collapse of the gold pool and the two-tiered pricing scheme put further pressure on gold prices.”  So, by the end of the 1960’s, prices had increased by just under 2.0% compounded for the 10-year period.  And, thereafter, the chaos was just about to being.  The 1973 Oil Embargo and the resultant surge in oil prices demonstrated that gold was much undervalued.  Then, more pressure came from the beginning of stagflation.

Too much of this pressure culminated in the United States abandoning the “price fixed” gold standard in 1975.  Freely priced gold would parallel the surging price of oil, surging inflation and peak at $850/oz on January 21, 1980.  Here is a table of gold prices over the relevant periods.  Therefore, 1975 marked the real beginning of gold as an “investment asset” in the financial markets.

Gold Prices from 1833 to 1998
	Gold Price	Difference in Gold Price between Years	Years	Compounded Rate of Return
1833	$20.65	–	–	–
1934	$35.00	–	–	–
1975	$175.00	–	–	–
1980	$850.00	–	–	–
1833-1980	–	$829.35	157	2.4%
1934-1980	–	$815.00	46	7.1%
1975-1980	–	$675.00	5	37.2%
1980-1998	–	$564.20	18	-6.2%

 

After its peak in 1980, gold declined with oil prices, which bottomed in 1998 at about $10/bbl and corresponded with the Soviet Union’s default on its debts and its resulting need for it to pump and sell a lot of oil.  Gold’s yearly average low price following the Soviet Union’s default was $271.45/oz in 2000.  But, please permit me the editorial license to say that the low occurred in 1999.  Here are the low prices for the surrounding years:  1998-$285/oz; 1999-$276/oz; and 2000-$269/oz.

Therefore, we say once again that 1999 marked the beginning of another radical ascent in the price of something whose long term compounded growth in its average yearly price from 1833 to 1980 was 2.1%. What was the event in 1999 that was a take off point for commodity prices in corn, oil and gold?  The event would ultimately help precipitate the financial catastrophe of 2008/09 from which we are still struggling to recover.  This next uptick in the price of gold looks like this with the high price indicated:

Gold Prices from 1998 to 2011
Year	Highest Yearly Gold Price ($/oz)
1998	$295
1999	$290
2000	$275
2001	$278
2002	$349
2003	$416
2004	$454
2005	$536
2006	$648
2007	$833
2008	$880
2009	$1,212
2010	$1,420
2011	$1,877

 

This is another almost vertical price spike in an economy so weak that we may be dropping back into a recession. Unemployment is greater than 9% and 40 million people more or less are on food stamps.  And we have already learned that gold does not defend against deflation, its price can drop to a level seen during the 1980-1998 period.  Although the 1980 peak was $850/oz, the average price for the year was $594/oz. Nonetheless, the compounded growth rate expressed in the chart is 15.3% compounded for 13 years.

In this historical review of the price and consumption of corn, oil and gold, we have learned some very interesting things.  We have always had an adequate supply of the necessities of oil and corn.  And, if we need more corn, we can just take it back from the feeder cattle.  The only exception was the short period of time after OPEC’s oil embargo when gas stations ran out of gas and fighting broke out among people waiting in line to get some.  Offsetting this has been the ongoing dramatic increase in the efficiency with which we use oil to produce GDP.

Gold was in inadequate supply during the period when government controlled prices.  For the most part, it is a non-essential except for jewelry and some manufacturing components.  Since price controls have been suspended, it has become a financial asset.

Finally, let’s look at the long-term price increases as a frame of reference for our further discussion.

Gold, Oil and Corn Price Changes
	Time Frame	Years	Price Change
Corn	1960-1999	39	1.5%
Oil	1960-1999	39	4.5%
Gold	1935-1999	64	3.2%

 

What is perplexing is the shorter period of time from 1999 until today when there have been violent price changes way outside of the norms of balancing supply and demand.

A pretty long time ago, farmers out in the agricultural lands were advancing their productivity by raising increasing amounts of crops beyond their immediate needs.  They had something to sell and needed a market.  Maybe they traded some with their neighbors.  This would work on a small scale but farmers have always had a peculiar problem.  They have to expend a lot of labor and supplies for a long time, the growing season, before they could get any revenue.  Some supply store merchants may have offered the farmer credit to buy supplies if they promised to give them a certain amount of the farmer’s crop when harvested.   More farmers, more growing and larger crops resulted in the need for collection and distribution system so that the supply of crops harvested in a month could be distributed to all final consumers for the next 12 months of the ensuing year.  Then, grain elevators started to appear on the horizon, and food manufacturers and grocery stores developed in growing communities.  Elevator operators came to know both sides of the market between the seasonal farmer suppliers and the yearly cycles of processors and consumers.

They took advantage of the knowledge of both sides of the market and their storage elevator and, consequently, could offer farmers a certain price before harvest.  Selling his crop before harvest would ease the farmers’ burdens in acquiring supplies.  And these processes evolved too.  An elevator operator, who could store the grain for the full 12 month distribution cycle, could take advantage of events that would affect the price of the grain over the 12 month period, whereas the farmers in the beginning had a one time shot at selling his crop just after harvest.  Then somebody got the idea that if he knew where to sell a farmer’s crop at the higher price, he could buy and resell it without being a farmer or an elevator operator. And then some farmer who sold his crop early in the season noticed deadly worms in his field and decided to buy somebody else’s crop from an unaware farmer, because he was confident that prices would rise before the end of the season.

As this all eventuated, another person decided to provide a location where all these people could come together to buy and sell farm crops.  Once this happened, someone who didn’t know anything about farming at all, but knew about a food company’s special need, went to this meeting place and bought several farmers crops before harvest and immediately turned around and resold the whole thing to the needy food companies.  Then the guy who put up the assembly building decided to offer a place where all these deals could be defined in one place.  Then more and more farmers and end users could get together and make all offers to buy and sell and resell and deliver to end users the farmer’s crops.  And the farmers could get many more offers for his crops.  And then one guy found out that he could sell and buy back his crop and resell his crop again and again.  Thus, the speculator came into existence.  The guy who organized the assembly room, now called an exchange, gets a brilliant and profitable idea, he could lend all the farmers, grain elevator operators, and food processors some money to buy and sell their contracts.  And now maybe you can even be a speculator.  By the way, why could you or anyone want to be a speculator?  Oh, you want to make a profit.

Have you ever heard of a Futures Contract?

In finance, a futures contract is a standardized contract between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today (the futures price or the strike price) with delivery occurring at a specified future date, the delivery date. The contracts are traded on a futures exchange. The party agreeing to buy the underlying asset in the future, the ‘buyer’ of the contract, is said to be ‘long,’ and the party agreeing to sell the asset in the future, the “seller” of the contract, is said to be ‘short.’

How would you like to see what you could do as a speculator in corn, something which is a very basic foodstuff?

Here is a short training course in opportunity for profit and/or loss.  You need to learn about what you can do and what it can do to you.

Since corn is a basic essential, let’s examine how it would behave in up and down price cycles.  We want you to be prepared, so we will look at the worst case scenario first.  Do not be intimidated by this chart.  It will quietly reveal essential data to you.

To purchase 5,000 bushels of corn you only have to deposit $2,363 into your trading account.  That is only the equivalent of $.47/bushel because the total market value your contract is $36,500.  Or, you only have to put up equity at this point of purchase of 6.5% of the value at which your contract has to be settled in the future. For the future settlement of this contract, if you buy corn today, you expect the price of corn to increase by the date of settlement in order to make a profit.  Then you can resell your corn at the other higher price.

The reciprocal transaction is to sell corn today, because you expect that on the date of the future settlement, the price of corn will fall, and then, at that time, you can buy corn at the then lower price to satisfy your early obligation to sell the corn.  This results in a profit for you.

That is the good news.  If the price of corn starts to drop, you have to start depositing more and more money into your account to assure your performance at settlement date.  At anytime, instead of putting more money into your account, you can sell corn for coterminous delivery with your buy corn contract and this will limit your losses and close out your obligation.  For purposes of demonstration, we have extended the chart of declining prices.

For the first $1.00 decrease in price, you have to deposit into the account $887, which is an additional 38% of the original $2,363 initial deposit.  For each $1.00 decrease in the price thereafter, you would have to deposit another $5,000 into your account, or 212% of your initial deposit.  For total price decreases of $5.00, your total equity would have soared to $23,250 and your potential loss is $25,000, which is the purchase value of $36,500 less the then market value of $11,500.  You would have sold out earlier to prevent this.  But our point is that losses get expensive very quickly during downward trading.  Even though you can buy a contract with just $2,363, you definitely want the price to increase.

To explore this much happier situation, we turn to our second demonstration chart.  Here the price increases from $7.30/bu to $11.30/bu.

For the first $1.00 increase (a 14.3% increase), your account increases in value from $36,500 to $41,500. Now the margin surplus (market value-cost) of your account is $5,000.  And here is the “exciting” news. The $5,000 increase in your account permits you to borrow the money to purchase another contract on margin.  Your broker will be more than happy to lend you the money and make some interest on it.  And so now, your $2,363 cash deposit permits you to acquire another 5,000 bushels of corn.  You are now the proud owner of 10,000 bushels of corn.  Your equity per unit is $.24/bu and your effective margin is 94.3%.

The Initial Margin is the cash equity required to purchase the contract, which is in this case, 6.5% of the market value.  Every time the price of the contract increases 13%, about  double the initial margin rate, you should be able to purchase at least one more contract.

You are just on the cusp of discovering the engine of acceleration in futures contracts that is operative in large upside price movements.  In order to illustrate it, we have exaggerated the size of the price movements.  This will emphasize the point so you won’t forget it as we go forward.

Here is how our accounting works.  The prior box contains the price at the beginning of the period.  This increases such that at the end of the period the value has increased to the price indicated in the subsequent price box.  The appreciation of the contract is measured at the end of each period, and, if possible, any subsequent contract is assumed to have been purchased at the same point in time.

Here is a chart that diagrams the heights you have scaled.

Cumulative Profit Per Contract
	Contracts
Price	First	Second	Third	Fourth	Fifth	Borrow	Yearly Margin Surplus
$7.30-8.30	$5,000	–	–	–	–	$0	$5,000
$8.30-9.30	$10,000	$5,000	–	–	–	$2,363	$15,000
$9.30-10.30	$15,000	$10,000	$5,000	–	–	$4,726	$30,000
$10.30-11.30	$20,000	$15,000	$10,000	$5,000	–	$7,089	$50,000
$11.30-12.30	$25,000	$20,000	$15,000	$10,000	$5,000	$9,452	$75,000
Contract Total	$25,000	$20,000	$15,000	$10,000	$10,000		$75,000

 

This chart discloses what is not really apparent to the casual observer.  As you accumulate a chain of contracts, during an upside price trend, all prior contracts are continuing to generate margin surplus.  And this results in a compounded increase in margin surplus from just a linear acceleration in prices.

So, where on this upward path do you realize that you can’t sleep at night because of the margin calls you could face if prices started to decline?  With your stock of 25,000 bushels of corn priced at $12.30/bu is at a total value of $307,500, it would only take a price decline of 24.4% to wipe out you and your equity because of margin calls of $75,000.  And once this starts and others expect margin calls, the race to preserve profits can cause a collective violent acceleration in the collapse in prices.

But, these features, excessive up and down leverage because of low initial margin requirements, have always been present in future contracts and their markets.  Are we getting closer to understanding the post 1999 unprecedented volatility in almost all future markets?  No, because we haven’t found out what makes this principle of leverage go rogue and become very destructive by creating inflation.

Do you remember Robert Rubin?  Maybe you have never heard of him.  But, what he did has affected you in some, if not many, ways.

There is a general consensus about one of the most significant contributing factors to the financial crisis of the Great Depression:

In the nineteenth and early twentieth centuries, bankers and brokers were sometimes indistinguishable. Then, in the Great Depression after 1929, Congress examined the mixing of the ‘commercial’ and ‘investment’ banking industries that occurred in the 1920s.  Hearings revealed conflicts of interest and fraud in some banking institutions’ securities activities.

Commercial Banks for the most part are lenders to persons and businesses whose borrowing requirements are too small to utilize public markets.  Commercial Banks have to have detailed personal knowledge of their borrowers. And they have historically tended to lend to local borrowers in their local communities.

Investment Banks, on the other hand, tend to raise money for larger businesses from the sale of common and preferred stocks and longer term corporate debt.  The criteria for borrowing in the public markets are more rigorous than those of local bank lending.  Therefore, it is much more expensive and complicated to qualify for this type of lending.  Investment Banks also tend to make markets in the securities they issue or those that are already outstanding in the public market.  This is all done by brokerages, the buyers and sellers of public securities for private and institutional investors.  Now back to the Great Depression.

To remedy these problems, Congress passed a historic piece of legislation:

The second Glass-Steagall Act (the Banking Act of 1933) was a reaction to the collapse of a large portion of the American commercial banking system in early 1933.  It introduced the separation of bank types according to their business (commercial and investment banking), and it founded the Federal Deposit Insurance Corporation for insuring bank deposits.

Commercial banks and Investment banks would remain in separate domains.  And Invstement banks would tend to remain in private partnerships.  In this form, its owners would be personally liable for its debts and losses rather than stockholders.  We have now finally discovered that critical event that would lay the ground work for the financial crisis of 2008:

‘Robert Kutter (Stanford University) testified before Barney Frank’s Committee on Banking and Financial Services in Oct. 2007.  ‘Since repeal of Glass-Steagall (FDR Banking Act) in 1999, after more than a decade of de facto inroads, super banks have been able to re-enact the same kinds of structural conflicts of interest that were endemic in the 1920s – tending to speculators, packaging and securitizing credits and then selling them off, wholesale or retail, and extracting fees at every step along the way.  And, much of this paper is even more opaque to bank examiners than its counterparts were in the 1920s.  Much of it isn’t paper all, and the whole process is supercharged and automated formulas.’

Robert Rubin left the top of his career at Goldman Sachs in 1995 to become Treasury Secretary in the Clinton Administration.  He quickly, and controversially, disbursed $20 billion to support the bailout of Mexico’s government bond market in which Goldman Sachs had extreme, if not life threatening, risk.  He then became the architect and engineer of the removal of the Glass-Steagall Act whose principal immediate beneficiary would be Sandy Weill, who would make billions by merging his Travelers Group into Citicorp.  Not surprisingly, Robert Rubin would go to work almost immediately for Sandy Weill as a top executive for Citicorp.

When the dust finally cleared, it became obvious that the demise of Glass-Steagall allowed the risk-taking traders at Citicorp to jeopardize nearly $1 trillion worth of customer deposits, which is the main reason the feds had to spend so much bailing it out.  With that, Bob Rubin’s Wall Street career was over.  He was forced to resign from the Citi board and the firm itself with his reputation in tatters, but not without earning more than $100 million.

In a word, the repeal of the Glass-Steagall Act in 1999 was the primary cause of rivers of money flowing between commercial banks, investment banks, hedge funds, pension funds and endowments to be used in leveraged investments for their own accounts thereafter.

After years of stonewalling by the Fed, the American people are finally learning the incredible and jaw-dropping details of the Fed’s multi-trillion-dollar bailout of Wall Street and corporate America…

What have we learned so far from the disclosure of more than 21,000 transactions? We have learned that the $700 billion Wall Street bailout signed into law by President George W. Bush turned out to be pocket change compared to the trillions and trillions of dollars in near-zero interest loans and other financial arrangements the Federal Reserve doled out to every major financial institution in this country. Among those are Goldman Sachs, which received nearly $600 billion; Morgan Stanley, which received nearly $2 trillion; Citigroup, which received $1.8 trillion; Bear Stearns, which received nearly $1 trillion, and Merrill Lynch, which received some $1.5 trillion in short term loans from the Fed.

And through these institutions, excessive and bad lending would find its way into the highly leveraged trading of futures contracts.  And this is the combination of toxic stuff that propelled and is still propelling volatility on an unprecedented scale in almost all categories of commodities and producing inflation throughout our economy.

So, that you will never forget how futures trading exports inflation into the economy, and, thereby is constantly imposing an effective tax on consumption of most all our
necessities, we are going to examine in extensive detail from 1999 to 2010.  This is the period of extreme volatility in oil prices which commenced with the removal of the Glass-Steagall Act.  Using oil futures trading, we will show how massive futures trading caused massive increases in inferred demand and unprecedented higher prices.  This inflation tax on all consumers transfers wealth to a very small group of people—futures contract traders.  When you compare the cost/benefits, consumers are big losers, as you notice in this month’s credit card or bank statement.

Let’s expand our analysis with the detailed yearly data from 1998 to 2010:

Oil Consumption and Price in US from 1998-2010
	Consumption (millions of bbl.)	U.S. Avg. Price ($/bbl.)
1998	18.9	$11.91
1999	19.5	$16.56
2000	19.7	$27.39
2001	19.6	$23.00
2002	19.8	$22.81
2003	20.0	$27.69
2004	20.7	$37.66
2005	20.8	$50.04
2006	20.7	$58.30
2007	20.7	$64.20
2008	19.5	$91.48
2009	18.8	$53.48
2010	19.2	$71.21

 

This information speaks for itself.  Oil consumption was virtually unchanged over the 12 year period.  The average consumption was 19.8 million barrels/day.  Note consumption peaked in 2005, the year that Hurricane Katrina was supposed to have severely damaged was our oil supplies.  At the beginning price, the daily market value of consumption was $225 million/day.  The value of the daily consumption at the ending price is $1.367 billion/day.  What could possibly account for such a huge value increase where there is no real change in consumption or supply?

We now would like to introduce you to all the villains, miscreants and opportunists who profited from inflicting inflation on you and your neighbors.

The world of oil investors reached far beyond Wall Street in recent years as foreign pension funds, corporate icons and even an Ivy League endowment placed big wagers on oil prices, according to a list compiled by U.S. regulators.

The U.S. Commodity Futures Trading Commission list shows that just before crude prices reached record highs in 2008, investments tied to millions of barrels of oil were held by a diverse group of at least 219 investors…

Banks such as Goldman Sachs Group Inc. and Morgan Stanley, which have long played a central role in oil trading, dominate the list. Also featured prominently are producers and consumers such asBP PLC and Delta Air Lines Inc., which buy and sell large amounts of oil products.

A range of investors were in the market, too. Yale University, Singapore’s government, hedge fundsBrevan Howard and D.E. Shaw & Co., as well as pension funds for Texas teachers and Danish workers all held positions, according to the list.

Also featured were a handful of individuals, including Aubrey McClendon, chief executive ofChesapeake Energy Corp., one of the nation’s largest producers of natural gas. Cascade Investment LLC, the investment arm for Microsoft Corp. co-founder Bill Gates, appeared…

The list represents only a snapshot of the oil market and a partial view of big investors’ portfolios. But it captured a picture at a key moment—on June 30, 2008, when oil hit $140 a barrel, just days before it reached a record $145. It doesn’t imply that any person or company on it has done anything improper.

This is a summary of a visual graph showing various entities which held oil futures contracts on June 30, 2008 when oil hit $140 bbl.

Oil Trading of Futures Contracts on June 30, 2008
Investors	# Contracts (millions)	% Held	Buy %	Sell %	Contracts Bought (millons)	Contracts Sold (millions)
Banks	5.600	54.2%	49%	51%	2.744	2.856
Energy Companies	2.700	26.1%	51%	49%	1.377	1.323
Airlines	0.204	1.9%	56%	44%	0.114	0.089
Hedge/Pension Funds	0.884	8.6%	55%	45%	0.486	0.397
Others	0.938	9.1%	49%	51%	0.46	0.489
Total	10.326	100.0%			5.181	5.154
*Source:  WSJ

 

As we discuss this you may want to refer back our earlier charts and for a little refresher.

Here are the main observations that we can make from this data:  10.326 million oil futures trading contracts is about one for every 30 people in the United States.

Banks, who were these banks?  These were then both investments banks and the commercial banks that owned each other.  Because of the repeal of the Glass-Steagall Act, they were borrowing from each other to conduct all sorts of financial speculations with vast sums of money, the losses on which would end up contributing to the 2008 financial meltdown.  And you, a taxpayer, would end up as a potential guarantor of the failures.  As we just learned, the Federal Reserve, without telling anyone, provided more than $3.0 trillion of taxpayer guaranteed funding to failed banks which had destroyed your deposits.  These so-called “banks” held 54.2% or 5.6 million of the June 30, 2008 contracts.  Do we really need to say anything else? Do you think that any of the catastrophic losses that required the Fed Bailout might have been associated with this massive oil trading?

Energy companies who produce the real thing, oil and gas, from reserves, held only 26.1% of the contracts. And they did not require any help from the Federal Reserve.  But, you can be sure that they made tons of money by selling their oil at these ridiculously high speculators’ prices.  Yes, they sold it to you too at the pump every time you filled your gas tank.  Here is what a top oil executive said:

Peter Voser, chief financial officer at Royal Dutch Shell, said it was hard to explain current crude-oil prices, which on Thursday were over $88 a barrel.  ‘The oil price seems to be driven by speculation,’ he said, as there were indications of a well-supplied market…

This Peter Voser, as chief financial officer of Royal Dutch Shell, is an expert on whose judgment we can rely.

Airlines who you would think would be really interested in the cost of the oil only accounted for just 1.9% of the contracts.  After labor costs, fuel is far and away the next largest sector of costs for flying airplanes.

If oil companies, as suppliers, see no reasons for such high prices and one of the largest single class of users, airlines were not large participants in this speculation, the only remaining villains are banks, hedge funds and pension funds.  These emerging non-users accounted for 71.9% of all the contracts.  This is almost per se evidence of who are inflating the price of oil by trading oil futures.  They are banks at 54.2%, hedge funds and pension funds at 8.6% and others at 9.6%.

What would any of them do with a barrel of oil?  These entities are in the business of making money on financial assets.  This makes them prime candidates for speculation.  Speculation is trying to make a lot of money in a small change in value by using huge quantities of borrowing of other peoples’ money.  Since they neither produce crude oil nor refine it, nor use it in vast quantities, they may write the other side of almost all their own contracts.  What did they accomplish but drive up the price of oil by the creation of massive inferred increase in demand that attracted other speculators with the same bias?

The “others” would certainly include wealthy individuals like those listed above in the catch-all, plus all other smaller personal traders.

‘We are just an investor,’ said Anders Svennesen, vice president of investment at ATP, the Danish pension fund, which represents most of the Nordic nation’s populace.  ‘In order to have liquid markets, you need to have investors.’

Like others on the 2008 list, ATP is still active in the market. Goldman and other banks continue buying and selling vast numbers of oil contracts, as part of their trading with clients.  Hedge funds, too, still trade…

Over-the-counter trading exploded in recent years amid rising investor interest in riding the wave carrying prices for oil and other commodities higher.

‘We were under enormous pressure to find out what was going on,’ says Jeffrey Harris, then the CFTC’s chief economist.

Wall Street was the biggest presence because banks often take one side of over-the-counter trades.

Goldman topped the list, with the equivalent of 451,997 contracts that would profit if oil rose, or ‘long’ bets, and 419,324 contracts that would pay off if prices dropped, or ‘short’ bets.  Much of that likely represented Goldman being on the other side of client trades…

Oil has paid off for ATP recently. Oil-linked investments earned the $90 billion fund about $535 million in the first quarter, a 13.4% return, Mr. Svennesen says.

Yale University, which pursues alternative investments for its endowment, held the equivalent of 2,968 short contracts according to the list.

Representatives for Yale, the Singapore government, Brevan Howard, Morgan Stanley, declined to comment, or didn’t respond to calls or emails.

‪When oil was rising in 2008, the growing role of investors frustrated oil users, especially airlines, who were trying to use the oil market to protect against price swings.

Isn’t this just fascinating!  Goldman Sachs is called a bank.  Weren’t they an investment bank?  Yes, before the financial crisis of 2008, they were called an investment bank.  But, when the federal government took them over during the financial crisis, they became subject to banking laws, which permitted the Federal Reserve to lend them over $600,000,000,000 during the financial crisis to prevent them from evaporating and destroying themselves and their mythical legend of being the world’s greatest “money maker.”

Their contract positions suggest a net long (buy) position of 32,673 contracts.  This is a buy position for 32,673,000 barrels of oil which would be 168% of the average daily consumption of $19.5 million/bbl on June 30, 2008.  This is unbelievable that they could have had this net buy position, or an even larger one, for any number of days during this period of incredible increase in oil prices.  This one entity had expressed an inferred demand for 168% of the actual amount of oil used in consumption using borrowed money. Should this be a crime??

We just read above that on June 30, 2008 oil hit $140/bbl, just days before it reached a record $145/bbl. Did this have anything to do with their need for a bailout?  Were they just making gasoline and jet fuel more expensive for everyone by using borrowed money to artificially inflate the price of oil?  And the only reason they could borrow this amount of money for “betting” was the removal of the Glass-Steagall Act in 1999. And don’t forget that Robert Rubin was a former CEO of Goldman Sachs, as well as Treasury Secretary under the Clinton Administration.

Would anybody like to come forward and explain how the oil industry which has markets with at least thousands and thousands of suppliers, and also billions and billions of end users like you and me around the whole world, needs speculators to facilitate liquid markets?

Energy producers, refiners, sellers and probably the largest single class of oil suppliers had a total of 28% or just about one-half of the contracts held by the so-called “banks.”  Amazing!

In the title of their graph, the Wall Street Journal acknowledges and gives away the whole game “crude bets/wagers on the direction of oil prices as of June 30, 2008.”  Futures trading is nothing more than just “bets and wagers.”  This is what you do when you go to a casino.  But, what you do, or do to yourself at a casino, has nothing to do with inflation in all the commodities which are essential to basic production and consumption in our economy.  We therefore, recommend that the Wall Street Journal change the title of their graph from “As Oil Spiked, Many Traded” to “As Many Traded, Oil Spiked.”

To make the chart of barrels really informative, we need to go back to the immediately preceding low point in the long cycle of oil prices in December 1999 when oil traded an average $25.01/bbl.  From there we have plotted the average price of oil in December in each of the next 12 years.  This shows in the long run of the hyper cyclical in crude oil prices which would peak at $145/bbl on July 4, 2008.

Average Oil Prices from 1999 to 2010
Month/Year	Oil Price
Dec-99	$25.01
Dec-00	$25.28
Dec-01	$18.52
Dec-02	$27.89
Dec-03	$29.95
Dec-04	$39.09
Dec-05	$56.47
Dec-06	$61.00
Dec-07	$89.43
Jul-08	$132.55
Dec-08	$41.53
Dec-09	$74.88
Dec-10	$90.10

 

Now, one more important fact you will recall and now never forget:  oil consumption was 19.5 million bbl/day in 1999 and 19.2 million bbl/day in 2010.

We will now take a close look at the leverage generator that caused this to happen and drive oil prices to completely irrational, non-economic heights immediately preceding the commencement of the 2008 financial crack-up.  To facilitate the process we are going to make you a speculator.

The initial margin for holding an oil contract on August 18, 2011 was $7,763 when oil was $87.58/bbl. This is 8.8% of the market value.  It was certainly different in 2008, but we only intend to illustrate the principal features of the futures’ system.  We are not trying to recreate a simulation or an accounting of the 2008 period.  But, we will use 8.8% as the amount of equity required for your initial margin.

So, in order not to scare you at the outset, we are only going to ask you to acquire just one buy/long crude oil contract on December of 1999 when the price of one barrel of crude oil was $25.01.  Since the contract is traded in 1,000 barrel minimums, the current market value of the oil you will have to buy is $25,010. And, that’s a lot of oil.  But, you knew that you will only have to put up the initial margin of $2,201 to have the right to buy $25,010 worth of oil at a future settlement date.

Remember that at each pricing date you will have to deposit cash for any margin deficit.  And for any increase in the market value of your contract, you will accumulate margin surpluses some of which you can borrow from your broker.  They will be happy to lend you this money because they can charge you interest.  We are making a hypothetical schematic projection to illustrate how leverage works.  So, we are picking 10 points in a 12 year period in spite of the fact that trading gains and losses in futures accounts are balanced every day.  In reality, any participant in futures trading would have probably traded many contracts during any year to year period.  As prices oscillated, they could have offered contracts to buy or sell oil for different settlement dates or offset any pre-existing contracts.  In fact, there are almost infinite combinations of contracts which can be offered by buyers or sellers during any one year period of this huge acceleration of oil prices.  This is not an attempt to simulate any large segment of behavior of the oil futures market.  We intend only to illustrate how leverage works in futures trading.

During the first four years of your contract, things are not very exciting.  The ambient economic conditions were the bursting of the tech bubble and the 9/11 attacks and resulting economic problems until the Bush tax cuts of 2003 took hold.  Your market value declined to $18,520 from $25,010 resulting in a margin call of $740 in December 2001, meaning you had to deposit cash of a like amount.  Thereafter, your margin surpluses started to increase as the market value of your contract started to exceed your cost.

By 2004, your margin surplus had reached $14,080 (market value minus cost).  Now you have your first temptation.  To purchase another contract with oil now priced at $39.09/bbl, you will only have to put 8.8% of the $39,010 market value or $3,440.  But you can borrow the money out of your margin surplus with $10,640 left over.  You have had a pretty quiet ride for five years, but this rise in the price of oil to $39.09 has made you optimistic about what you are doing.

You have made the stock market look like a dog and so you decide to push on, take a chance, or should we say make a “bet,” that prices will continue to rise, and so you elect to buy the second contract.  You now have contracts to purchase 2,000 barrels of oil.  Your shrewdness, foresight or luck has served you well.

12/31/2004 Current Position
Price	Equity	Debt	Barrels	Margin Surplus Less Debt	Potential Return on Equity	Oil Controlled
$39.09	$2,941	$3,440	2,000	$10,640	362%	$78,180

 

There are now thousands and thousands of others like you who have been drawn into this process of “betting” on higher oil prices.  Now when people can invest cheaply, $2,941 of equity and $3,440 amount of debt to control 2,000 barrels of oil with a market value of $78,180, you have the beginning of a self fulfilling prophesy that oil prices will go up.

By December 2005, the price of oil had risen to $56.47.  This is another amazing increase of $17.38, or 44%, in one year.

What else do you know that has an economic demand increasing at these incredible annual rates?  How about stocks, cars, houses, computers hardware or bread?

And in spite of the fact that oil consumption is basically flat, you notice that your margin surpluses on your first contract are now $31,460, and, on your second contract, it is $17,380, or a total of $48,840.  You have only borrowed $3,440 out of this amount, and so, you now face your second temptation.  Do you borrow to buy some more of these contracts?  You know that you can offer a contract to sell oil (i.e.-short), at almost anytime, if the price starts to decline.  You believe this will protect you.  Your net margin surplus is $48,840 less the $3,440 that you borrowed for the second contract or $45,400.  This has really been successful.

You have caught the bug.  Everyone and especially the financial media, is talking about all the reasons that oil prices must keep going up.  Hurricane Katrina supposedly just ruined oil production in the Gulf.  You agree.  Still, no one, especially the financial media, ever talks about consumption being pretty flat.  But, you still notice gasoline prices rising at your local service station.  And so you decide to take the next step.

This is a big step.  You are buying five new contracts, four will be financed from borrowing $19,876 out of your surplus margin of $48,840.  And just to be safe, one will be financed with a deposit of equity in the amount of $4,969.  More and more speculators are hatching like locusts to guarantee that oil prices will go up.

12/31/2005 Current Position
Price	Equity	Debt	Barrels	Margin Surplus Less Debt	Potential Return on Equity	Oil Controlled
$56.47	$7,910	$23,316	7,000	$25,524	322%	$395,290

 

2006 was not a great year in that the price of oil just increased $4.53/bbl over the course of the year.  You only increased your equity to $7,910.  But your 7,000 barrels of oil generated a margin surplus of $80,550. This resulted in your return on equity after deducting beginning debt of $23,316 being reduced to 322%. And, this really excites you.  You are in fact addicted to the notion that with another irrational rise in prices you can make a real killing.  Throwing all caution to the wind, you buy nine more contracts using equity for five and margin surpluses for four, which you believe will help insulate you from a decline in prices.  In your dreamy state you are forgetting an extremely critical fact.  In a secular rise in the market, any short term decrease in market price would normally affect your most recent long positions.  And if the number of contracts you are purchasing is increasing, you expose yourself to a violent margin call on a larger amount of contracts in which may have little or no surplus margin.

12/31/2006 Current Position
Price	Equity	Debt	Barrels	Margin Surplus Less Debt	Potential Return on Equity	Oil Controlled
$61.00	$34,750	$44,788	16,000	$35,762	103%	$976,000

 

Well, it turns out that 2007 is one of the best years in your life.  Oil surged from $61.00/bbl to $89.43/bbl or an increase of $28.43/bbl.  This 46% rise in oil prices rewarded your bold purchase of those 9 contracts at the very end of 2006.  This has helped you produce an incredible surplus margin of $535,430.  Way to go!

The gateway to the big leagues is now open to you.  Although the most “oil” you have ever purchased before was 29 gallons of gas for your pickup truck, you now control 16,000 barrels of oil worth $1,430,880.  Or, you have created artificial demand for these 16,000 barrels of oil with equity of $34,750. If gas is $3.60/gallon, $34,750 would buy just 9,653 gallons of gas for final consumption in cars and trucks. Since a barrel of oil produces 42 gallons of gas, your $34,750 equity plus related borrowings expresses an artificial demand for 672,000 gallons of gas.  Do you think this might be inflating energy prices artificially?

In addition to being addicted to futures trading, you are intoxicated with your growing wealth—and the continuing outcry in the financial media that there is no foreseeable limit to the upside in prices.  And you see something you never dreamed of—the chance to quickly enter a lifestyle beyond all expectations.  You gaze at that $535,430 gross surplus margin and wonder what the next step would look like.

You already have contracts on margin of $44,788 which makes your net surplus margin (total margin surplus less prior borrowing) of $490,642.  The theoretical maximum purchasing power is 62 contracts.  If you bought the maximum, any decrease in the price of oil thereafter would result in a margin call.  But you want it badly and so you hedge by electing to buy 40 contracts on margin and 10 with equity for a total of 50 contracts.

12/31/2007 Current Position
Price	Equity	Debt	Barrels	Margin Surplus Less Debt	Potential Return on Equity	Oil Controlled
$89.43	$113,450	$359,588	66,000	$175,842	155%	$5,902,380

 

In just seven months, if you have held your course and been able to meet any margin calls, you would have entered the promised land of instant wealth.  From an average price of $89.43 in December 2007, oil prices rocketed to an average price of $132.55 during the next several months until July 2008.  And there was still no material change in consumption.

As we pointed out earlier, we are using average prices for the months in question.  Oil prices peaked at $145/bbl on July 4, 2008.  As the owner of this portfolio, you are already in an economic torture zone. Who knew why and when that the price of oil had peaked?  How long did it take for futures speculators to realize that the next daily price decline was not a momentary downward adjustment on the way to a continuing upward trend?  At what point did this shrinkage in your net margin surplus, start to raise alarms about how you could save your profits rather than further increase them?  Now every day and even every hour or minute is nightmarish as you try to decide what to do.  Other speculators are also trying to make the same assessment of what to do.  You decide to offset some of your buys with sells.  Others do the same. And at some point, like ants who have been bringing their little mud balls out of the hole, they start to return in greater volume than the ants crawling out of the hole.  And this buying of sell oil contracts starts to overwhelm the buy oil contracts.  Sentiment changes like a bolt of lightning.  This means you and most others no longer believe the rhetoric of the financial media about rising oil prices.  Margin calls are accelerating and no one is writing buy contracts.  This accelerates more selling which causes a downward cascade of further price drops.  Margin calls are killing the most recently purchased buy oil contracts.

Yes, 2008 is a period of torture for futures trading.  Our chart maps the unprecedented one year volatility in oil prices due to violent reversals in future traders’ expectations.

If you had a hard time justifying why oil prices grew at compounded rate of 20% for seven years with basically no change in consumption, what can you say about this?  At average weekly prices, oil increased in price from $97.91/bbl January 2008 to $145.29/bbl on July 4, 2008.  This was compounded rate of 120% a year to $145.29.  What was going on with consumption?  Nothing.  As we stated so many times before, during this period, consumption was 19.5 million/bbl in 1999 a year and it was 19.5 million/bbl a year in 2010.  Economic supply and demand had nothing to do with this catastrophe in high prices.  It was the ability of massive quantities of money to be concentrated in the futures market.  And by this markets low margin requirements, the magnification of leverage on contracts bought and sold would become extreme. Settlement prices would rocket up and crash down.  And each day the financial media would post a resultant cash price for the day.  They never called the oil drillers, refiners, airlines or automobile users to find out what we would be willing to sell or pay for oil.  They just publish the net sum of all the high leverage future traders’ machinations.  And this is what become the irrational prices and of oil at the appropriate delivery place.  The resultant irrational price would then be listed every day in the financial media as the cash price of oil at Cushing, Oklahoma.  These prices were completely artificially effectuated by futures trading on an unimagined and unprecedented scale by financial institutions which had been liberated from all meaningful consequences of restraints by the removal of the Glass-Steagall Act in 1999. This produced the huge rivers of money flowing into all sorts of leverage trading.  And no trading, as we have seen, has the leverage that futures trading has.  The amount of artificial inflation this caused permeated into every corner of our economy wherever energy is used.  You can be your own judge of this.  And almost every other commodity was subjected to the same artificial increased in pricing.  Therefore, almost all other commodity inputs were subject to artificial inflation.  And all consumers were victims of this artificial inflation across the economy.

The absolute proof of this completely non-economic artificial demand is the speed with which it evaporated.  There was an unprecedented collapse of oil prices and other commodities too in the six months from July 4, 2008 from $145.29/bbl to $44.60/bbl on December 31, 2008.  This collapse was clocked at a compounded negative rate of -90% per year, a mega wipeout.  With no change in consumption, the only explanation is the extraordinary compounded acceleration of margin calls on futures contracts of which 10.35 million were in effect on June 30, 2008.  The minute the bubble burst, the extreme force of this mechanism was released.

Now look back on your decision in December of 2007.  By the July 2008 peak, your net margin surplus would have been $3,381,350.  But to realize it, you would have had to sell all your contracts at this price. Highly improbable, if not impossible?  You might have been tempted during the final price rise to add more contracts prior to the peak.  But, at all times, the most recently added contracts to buy oil, would be the first to be subject to a margin call on a downward change in prices.  How much reserve equity did you have to defend your contracts?  In December 2007, you had $131,450 in equity and $359,588 in debt with your total cost at $511,896.  On the way down, you have to cover all your losses or your positions will be sold automatically to balance your account.  You therefore had little maneuvering room.

Your vast holdings of 66,000 barrels on July 4, 2008 are worth $8,743,800.  If the price of oil had dropped just below the $89.43/bbl of your last buy, the repayment of your margin and your equity are wiped out and you too are probably wiped out.  And you thought you were just on the threshold of riches.

But everyone else has the identical problem that you have.  So, a vast uncontrollable but self-propelling acceleration of selling unleashes itself until the accumulating impact drops the price of oil to $44.60/bbl on December 12, 2008, or a compounded rate of minus 90% per year.  And there is still no material change in consumption.  All that was accomplished by this vast surge in oil prices was a completely artificial inflation inflicted on the economy.  And everyone else paid for this so a few futures traders could make fortunes.

In reality, you probably would have gotten beat up pretty badly.  How do you think all those big banks did when they held 5.4 million out of the 10.256 million contracts?  We especially note that Goldman Sachs held 451,324 buys and 419,320 sell shorts on June 30, 2008.  Are we to understand that those supposed geniuses made a lot of money on their oil trading when the Federal Reserve had to lend them $600 billion, which was the total amount of their debt?  Couldn’t they have made enough money on oil trading to savethemselves?

We don’t have enough money to hire their auditors to see of what all their losses were composed.  But the wildly excessive price increases followed by the almost vertical drop in prices suggest “big” losses in oil trading.

It’s too bad the taxpayers cannot garnish the bank managers’ wages retroactively for the entire time period of 1999 to 2009.  The taxpayers ultimately guaranteed their losses and excessive wages and bonuses, while they imposed that most destructive tax upon all consumers—inflation.

There is a trivial proof of our claim that rivers of money borrowed by financial institutions from each other imposed absolutely unnecessary and uneconomic price increases on oil and almost all other commodities.  If futures trading did not exist at all, and there was no change in consumption, what else would have caused this oil price spike and would have done this to our economy?

And they are still doing it.  Here is the state of the world economy more recently.  Europe is falling apart because their governments are spending too much money.  The United States is on the cusp of a possible second recession because the Obama Administration’s uncontrolled spending has increased the public debt by 70% in just 3 fiscal years.  Unemployment in the United States still hovers over 9%.  Just look at the following recap of commodity prices from the period March 2010 to March 2011:

Absolutely unbelievable.  This is just more and more inflicted inflation so that futures traders can make money without producing anything at all.  It is all a corrupt sop for the financial services companies.

Now, here is some more information about the only economic collapse greater than what we are currently experiencing:

Prior to the Great Depression, the amount of credit that could be extended against securities was a matter of brokerage house policy.  The Crash of 1929 and the subsequent depression in both stock prices and economic activity were attributed, in part, to excessive use of debt to buy common stocks. At the time, brokers would lend as much as 90 percent of the money that customers paid for stocks, leaving only a 10 percent equity margin to cushion declines in stock prices.  This lending, it was argued, not only stimulated demand for common stocks, thereby elevating stock prices and encouraging a subsequent crash, but also promoted a sharper decline in prices when customers’ equity positions vanished and brokers made margin calls requiring a deposit of additional cash and securities to restore customer equity.

 

In 1933, the New York Stock Exchange established a requirement that member firms’ customers could borrow no more than 50 percent of the value of securities held.  Because the standards were expressed in terms of account equity, or ‘margin,’ rather than account debt, these standards became known as ‘margin requirements.’

 

Wild speculation in stocks was brought under control by simply raising the margin requirement to 50% of the market value and or purchase price.  Why don’t we see what happens when we implement the 50% margin requirements of stock trades upon your speculator’s portfolio of oil contracts.

 

 

 

We will start at the same place we did before December 31, 1999. You worked to buy one oil contract for 1,000 barrels of oil, the standard contract quantity, at $25.01/bbl.  To purchase the contract you have to put up $12,505 as equity.  This permits you to borrow $12,505.  Thus we notice and feel the increased burdens of this system instead of just depositing $2,200.  Yes, this is going to be different.

Here is your opening position summary:

12/31/1999 Current Position with 50% Margin
Price	Equity	Debt	Barrels	Margin Surplus	Potential Return on Equity	Oil Controlled
$25.01	$12,505	$12,505	1,000	$0	0%	$25,010

 

Please note that in order to make the two systems more easily comparable, we are ignoring the $6,490 maintenance deposit which would otherwise increase equity to $18,995.  This will not materially distort our outcome.

By December 2004, the price of oil has increased to $39.09.  You will recall under futures margin, this is when we added our first contract.  Not so here.  The margin surplus (market value less cost) is still $14,080. But the cost of one contract is now $39,090.  And if you have to put up ½ of this as equity, $19,545, you need to borrow another $19,545.  Your margin surplus is inadequate for this, so we pass on this contract. We are using margin surplus as a guideline in this system to indicate when it would be appropriate to add contract(s).  This helps make the two systems more comparable.  Which gives you the following position:

12/31/2004 Current Position with 50% Margin
Price	Equity	Debt	Barrels	Margin Surplus	Potential Return on Equity	Oil Controlled
$39.09	$12,505	$12,505	1,000	$14,080	126%	$39,090

 

By December of 2005, the price of oil has continued to rise to $56.47/bbl, or $56,470 for 1,000 barrels. Your equity for a new contract is therefore, $28,235, and you need to borrow the other $28,235.  Since your margin surplus is now $31,460, you go ahead and buy your second contract.  Here is your position now:

12/31/2005 Current Position with 50% Margin
Price	Equity	Debt	Barrels	Margin Surplus	Potential Return on Equity	Oil Controlled
$56.47	$40,740	$40,740	2,000	$31,460	77%	$112,940

 

And onwards we go to December 2006.  The price of oil is now $61.00/bbl.  Good for futures traders, bad for consumers of energy.  Your margin surplus has grown to $40,520, but has been retarded by your inability to buy a contract in December of 2004.  At $61.00/bbl, a new contract will cost you $30,500 in equity and an equivalent amount of borrowing.  You notice how burdensome these equity requirements are in a period of rising oil prices.  And it takes more growth to justify the borrowing.  Therefore, you only add one more contract which puts you in this position:

12/31/2006 Current Position with 50% Margin
Price	Equity	Debt	Barrels	Margin Surplus	Potential Return on Equity	Oil Controlled
$61.00	$71,240	$71,240	3,000	$40,520	57%	$183,000

 

All these requirements for cash equity are making this much more difficult than regular futures margin.  We have now been struggling since 1999, and after we pay off our debt, we basically haven’t made any money. Maybe we should have just invested in a few oil stocks without borrowing anything and we certainly would have been ahead of buying these oil futures on 50% margin.

Or, for purposes of illustration, let’s just compare this position to having only invested in the original 1999 contract and held this to December 2006.

12/31/2006 Current Position with 50% Margin for 1 Contract
Price	Equity	Debt	Barrels	Margin Surplus	Potential Return on Equity	Oil Controlled
$61.00	$12,505	$12,505	1,000	$35,990	287%	$61,000

 

Oh, now we see why futures traders don’t like 50% margin requirements.  In a rising price environment, the increasing equity requirements per contract make it harder to generate a satisfactory return during whatever remains of the time until prices peak and start down.  In regular futures margins, the rising price cycle permits you to acquire many more contracts and leverage you profit on the acceleration of units under contract.  This contrasts growth with an increasing equity requirement because of greater cost with less and less time to the peaking of prices.  And this is exactly why the futures market is structured the way it is.  But, current futures margins cause a more violent downside while 50/50 margin dampens the acceleration of price collapse.

And, so, here you stand on 12/31/2007 at the close of the year immediately preceding the final peaking of oil prices in mid-2008.  What should you do?

You feel pretty secure having made $124,810 on your $71,240 equity and decide in this frothy upside market to go for it and buy 2 more contracts.

12/31/2007 Current Position with 50% Margin for 3 Contracts-3rd Option
Price	Equity	Debt	Barrels	Margin Surplus Less Debt	Potential Return on Equity	Oil Controlled
$89.43	$160,670	$160,670	5,000	$125,810	78.0%	$447,150

 

Since you already got enough rewards and/or punishment in managing your regular margin portfolio, let’s get right to the point.  We now juxtapose your go slow 50%/50% margin operation to your highly leveraged regular margin portfolio through the peaking of prices and the collapse thereafter.

Comparison of 8.8% Margin to 50% Margin
Date	12/31/1999	12/31/2007	7/8/2008	12/31/2008
Price	$25.01	$89.43	$132.55	$41.53
.088 Margin
Equity	$2,201	$113,450	$113,450	$0
Debt	$0	$359,588	$359,588	$0
Surplus Margin	$0	$535,430	$3,381,350	-$2,625,970
Oil Controlled	$25,010	$5,902,380	$8,748,300	$0
50% Margin
Equity	$12,505	$167,160	$167,160	$167,160
Debt	$12,505	$160,670	$160,670	$160,670
Surplus	$0	$125,810	$341,410	-$113,690
Oil Controlled	$25,010	$447,150	$662,750	$0

 

Here are the highlights of the chart.  Under Regular .088 Initial Margin, you opened your account with $2,201 in equity and no debt.  The outside limit of your profitability occurred on July 8, 2008, when your surplus margin peaked at $3,381,350 and you controlled 66,000 barrels of oil worth $8,748,300.  By that time, your equity had increased to $113,450 and your debt had peaked at $359,588.  By December 31, 2008, you had an outside limit at a loss of $2,625,970.

50% Margin has produced a decidedly different result.  You opened your account with $12,505 of equity and $12,505 of debt.  The outside limit of your profitability occurred in July 8, 2008 when your profit peaked at $341,410 while controlling 5,000 barrels of oil worth $662,750.  By then your equity had increased to $167,160 and debt had peaked at $160,670.  By December 31, 2008, you had an outside limit of losses of $113,690.

Every consumer who reads this will be outraged at the amount of inferred demand and resultant higher prices that is caused by low margined futures trading.  For the few futures traders that made fortunes, most others probably lost money.  Did the “Big Banks” who got unprecedented bailouts from the Federal Reserve in the order of hundreds of billions of dollars, if not trillions, lose money on futures trading?  You can decide for yourself for they are not going to tell you.

No matter which trader won or lost, low margined future trading has been a catastrophe for everyone else. They rob consumers by inflation absolutely unnecessary inflation throughout our economy.

The outcry for justice by the taxpayers and consumers is overwhelming and self-evident.

Install 50% stock-like margins on all futures trading ASAP to stop artificially inflicted inflation on the American economy.

What are we waiting for?

-Fred N. Sauer is a St. Louis resident and businessman whose blog can be found at www.fredsauermatrix.com. You can also buy his book at www.americasculturalstudies.com.

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