To Understand the Angst in the Financial Services Industry, You Have to Understand the Real Consumption of Oil

This month, the Wall Street Journal ran a piece about oil consumption: Oil, at $31.41, Skids to 2003 Levels. The piece suggests that demand and consumption have driven the fluctuating prices of oil over the past few decades and are now causing a crisis in the energy industry.

Several years ago I wrote a detailed analysis about oil inflation, and I discussed the impact that futures trading has had on our economy and economies all over the world.

[I]n 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.

[G]uess what the change in [America’s] consumption was during this period? In 1999, it was 19.5 million barrels/day and in 2008 it was the still about 19.5 million barrels/day. No change![1]

Oil consumption was not massively fluctuating and the huge spikes in oil prices were not justified by demand. Instead, something else has skewed the market and artificially inflated oil prices to numbers far beyond reality:

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.’

To understand 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 the period from 1999 to 2010. This was a period of extreme volatility in oil prices. It was triggered by the removal of the Glass-Steagall Act.

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.[2]

Commercial banks and Investment banks would remain in separate domains. And Investment 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.

As the years ticked by, though, banks found ways around many of the imposed separations and when the legislation was repealed in 1999, we had much the same problem we faced in the 1920s:

‘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.’

[T]he 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 . . . [T]hrough these institutions, excessive and bad lending would find its way into the highly leveraged trading of futures contracts.

The key element causing artificially high oil prices was and is the low margin requirements on futures contracts. You only have to put up cash of 10% percent of the value of the contract. Stocks in contrast require 50% of the price to be put up in cash.

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.

This inflation has had a profound benefit on a number of Arab nations whose “economies” are built on the price of oil. For years, these countries have been flooded with money in exchange for their oil. This money funds lavish lifestyles for the ruling class and what is left is distributed to the people.

The artificially high price of oil, however, has encouraged more and more people to jump into the energy game. Oil became so profitable, Americans began sinking deep wells in the gulf and invested in fracking operations. As supply shifted, the Middle Eastern countries began to feel a pinch as the price of oil dropped toward realistic levels.

The cheap price is ruining the Eastern economies, because economic growth depends on the free exchange of goods and services. Their “economies” are built on oligarchs profiting off of inflated oil prices.

The collapse of oil is one of the greatest benefits to free nations, but will crush oil dependent tyrannies and their redistributive economies.

It will be very interesting to see how this develops. In the meantime, you can find more details on futures trading and the creation of the current market in my complete piece: How the Few Inflict Inflation on the Many.

[1] How the Few Inflict Inflation on the Many

[2] Wikipedia: The Glass-Steagall Act

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