The Commodity Futures Trading Commission on Tuesday filed a civil enforcement action alleging that Nicholas Wildgoose and James Dyer, who worked as traders for Arcadia Petroleum Ltd. and its affiliates, profited by manipulating the price of oil and oil futures in early 2008. I was interested to take a look at the details of the CFTC allegations.
Let me begin by providing a little background. Cushing, Oklahoma has an important network of pipelines and storage facilities that allow it to serve as a major trading hub for crude oil. There exists a physical market in which you can arrange to buy or sell oil for delivery in Cushing. Yesterday (the 25th calendar day of May) was the last day you could have scheduled a pipeline to deliver physical oil to Cushing some time in June. Economists might describe an agreement reached in May to receive oil some time in June as a forward contract.
There are also separate arrangements known as futures contracts, such as the well-known light sweet crude contract traded on NYMEX. Whereas a forward contract is an agreement between two particular parties accompanied by a stand-by letter of credit from a bank ensuring the buyer’s ability to pay, a futures contract is intermediated by an exchange that insists on maintenance of a continually adjusted margin account, creating the possibility for an anonymous, purely financial transaction. Many of the people who buy futures contracts do not want to receive physical oil in Cushing, but instead intend from the beginning to later sell the contract to somebody else in order to reap a financial gain if the price goes up, as a way to hedge against certain risks. For example, a refiner, even if not located in Cushing, might buy (and later sell) a NYMEX futures contract as a form of insurance against an increase in the price of oil during the time the contract is held. Alternatively, a pension fund might want to buy (and later sell) a futures contract in order to have some insurance against inflation or commodity price moves that could adversely affect other holdings in its portfolio. Other people might be interested in a futures contract because they have a particular belief about the direction that oil prices will head. If someone buys a futures contract and at some later date sells the same contract, the futures exchange nets out those transactions, so much of the time when two parties enter into a futures contract, no oil ends up being physically delivered to anybody.
But if you buy a futures contract and never sell it, a NYMEX contract entitles you to receive delivery of 1000 barrels of physical oil at Cushing, Oklahoma some time in the month specified by the contract. Trading in the June NYMEX futures contract ended on May 20, three business days before the last day of pipeline scheduling on the 25th, to allow parties who held on to their futures contract all the way to expiry 3 days in which to schedule a date in June for physical delivery to Cushing.
The CFTC complaint alleges that between January 8 and January 18 of 2008, oil traders Nicholas Wildgoose and James Dyer entered into forward contracts to buy 4.6 million barrels of oil for physical delivery in February, an amount that represented 66% of their beginning-of-month estimate of the total physical Cushing market. Between January 3 and January 16, the pair is alleged to have also bought about 13,600 February futures contracts (equivalent to 13.6 million barrels of oil) and sold the same number of March futures contracts. The claim is that by creating the appearance of temporarily tighter conditions in the physical market, the February futures price would rise relative to the March and the traders would profit as they closed out their futures positions between January 16 and January 22.
The graph below plots the prices of the February and March NYMEX futures contracts during the month of January 2008. Note that the CFTC is not alleging that these actions were a cause of rising oil prices– in fact, the price of oil was falling during this period. Rather, the allegation is that these actions resulted in an increase in the spread between the February and March futures price, that is, in the absence of these actions, the February price would have fallen more and the March price would have fallen less.
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The CFTC complaint alleges that Wildgoose and Dyer subsequently acquired by January 25 a net short position in March futures and long position in April futures equivalent to 12.2 million barrels. The allegation is that this was done in anticipation of suddenly selling off on the last possible day (Jan 25) all 4.6 million barrels of the physical oil previously accumulated; I gather that the allegation is that this was achieved by finding somebody currently holding rights to delivery of an equivalent volume in March who was willing to swap and take delivery instead in February, provided that the offered February price was sufficiently low. The effect of such a huge last-day sale would have been to depress the February physical price as the market discovered that the apparent big demand for oil just wasn’t there. Although Wildgoose and Dyer would of course have taken a big loss on their physical contracts (by virtue of having bought at the artificially higher prices that their bids created and then selling at the artificially lower prices that their sales induced), the CFTC alleges that they more than made up for these losses with bigger profits on the corresponding futures transactions. The CFTC complaint alleges that the pair lost $15 million on the physical transactions but gained $50 million on futures transactions, profiting first by the increase in the February-March spread induced by creating the impression of an unusually tight February physical market, and then later profiting by the decrease in the March-April spread by surprising the market with much more physical oil available for delivery than people had been assuming.
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The CFTC complaint goes on to allege that the pair repeated the same sequence of transactions in March of 2008– initially profiting from a long position on the April-May spread by surprising the market by buying a large quantity of physical oil for April delivery in the first part of the month, and then profiting from a short position on the May-June spread by surprising the market by selling off their physical positions on the last possible day.
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Again, March 2008 was not a month in which the oil price overall is alleged to have been driven up as a result of the traders’ actions. Instead, the claim is that their actions led to an initial increase in the April-May spread and a subsequent decrease in the May-June spread.
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Arcadia Petroleum Ltd. has said the CFTC charges are “completely without merit”.
An oil wheeler-dealer named “Wildgoose”? Right out of central casting.
Nice explanation.
This is always an interesting debate. Professor, have you provided your opinion in the past on whether or not you believe this manipulation is indeed real?
I think the problem most people have with this debate is that they believe the spot prices always justify the futures prices. This is sort of like saying that home prices can’t ever really deviate too much from the new Case Shiller housing derivative product. Well, that’s true and when you buy a home the price is always “right”. That is, the spot price is never wrong. However, the problems arise when a whole bunch of speculators come into the marketplace and start bidding up prices for financial gain (sound familiar?). Then you get an environment where prices really do become distorted. Sure, they’re always “right”. The market is never wrong, but that doesn’t mean they’re sustainable or good for the economy.
And that’s the problem today in my opinion. There are now too many people playing the game of flipping homes. Except instead of it being 2006 and real estate it’s 2011 and oil contracts.
I’d love your thoughts on this. Thanks for you great analysis daily.
But why only this period? Shouldn’t this trick be good every month? Why was it only during the oil shock period?
By choosing these dates, the CFTC will have to show that there was something special about this period that made the trick work. Failing that, if I were the defense lawyer, I would argue that the CFTC succumbed to political pressure to “do something” to show that speculators influenced the market during periods of high oil prices. In essence, I would argue that the CFTC is grasping at straws to meet the demands of its political masters.
I might point out that the House voted to cut the CFTC budget at just this time, even as Michael Dunn, a CFTC commissioner, warned that that cuts would prevent the commission from policing markets and protecting consumers. “There would essentially be no cop on the beat,” Mr. Dunn said at the hearing.
To prevent a couple of guys from making no material difference to oil prices.
Yes, indeed, I might mention that.
Steven:
Perhaps the CFTC was looking harder after 2008, but that’s ultimately irrelevant to whether or not they are guilty of charges.
Its also important to keep in mind that even if the scheme worked as purported, we are talking about a manipulation in prices of less than $1.00 for only a couple of weeks. This goes to the point that if manipulation is moving prices, its not moving prices at a very significant level.
An interesting link from Naked Capitalism discussing how the Saudis, even in private cables with Washington, believe that oil speculation is a big part of the rise of oil: http://www.mcclatchydc.com/2011/05/25/114759/wikileaks-saudis-often-warned.html
Here is a simple question, and maybe somebody can answer it on here:
In this article, it claims that “A McClatchy investigation earlier this month showed the extent to which financial institutions now influence the price of oil. Until recently, end users of oil — such as airlines, refineries and other consumer of fuel — accounted for about 70 percent of oil trading as they tried to hedge against price fluctuations.
Today, however, speculators who’ll never take possession of a barrel of oil account for that 70 percent of oil futures trading, and the volume of speculative trading has grown fivefold.”
Assuming this is true, that the overal futures trading has increased five fold from say in the early 2000s and late 1990’s, where does the money that all of these speculators make in profit come from? I mean is it immaculately created? I assume that when the price is going up, pretty much the whole market is long on the market and they are all making profit. Is it basically a ponzi scheme where they collect money from other speculators that come in after them? Or are these guys extracting money out of the real oil market? I just am unsure about the mechanics of the oil market, and would be curious.
Its also important to keep in mind that even if the scheme worked as purported, we are talking about a manipulation in prices of less than $1.00 for only a couple of weeks. This goes to the point that if manipulation is moving prices, its not moving prices at a very significant level.
This is the old argument that it isn’t stealing if you take $1 from 50 million people, but you can be put away for 10 years if you take $100 from one person.
Well, well. The oil producers themselves indicated that there was oil price manipulation…
http://www.nakedcapitalism.com/2011/05/wikileaks-saudis-warned-about-oil-speculators-in-2007-and-2008.html
One may wonder why experienced traders would use NYMEX when they would have been better off trading on OTC.
http://www.gao.gov/new.items/d0825.pdf
“Exempt commercial markets are electronic trading facilities where certain commodities, such as energy, are traded between large, sophisticated participants. OTC markets allow eligible parties to enter into contracts directly, without using an exchange. While the exempt commercial and OTC markets are subject to the CEA’s antimanipulation and antifraud provisions and CFTC enforcement of those provisions, some market observers question whether CFTC needs broader authority to oversee these markets. CFTC is currently examining the effects of trading in the regulated and exempt energy markets on price discovery and the scope of its authority over these markets—an issue that will warrant further examination as part of the CFTC reauthorization process. Moreover, because of changes and innovations in the market, the methods used to categorize these data can distort the information reported to the public, which may not be completely accurate or relevant.”
ICE (Delaware juridiction)
Established as late as 2000, ICE shareholders represent some of the world’s largest energy companies. ICE headquaters are located in Atlanta (USA). This exchange also have offices in New York, London, Chicago, Winnipeg, Calgary, Houston and Singapore.
ICE Futures Europe hosts trade in half of the world’s crude and refined oil futures.
Strong customer demand led us to introduce the ICE West Texas Intermediate (WTI) Crude futures contract on February 3, 2006
ICE operate the leading market for trading in Brent crude futures, as measured by the volume of contracts traded in 2005. The IPE Brent Crude futures contract that is listed by ICE Futures is a leading benchmark for pricing
crude oil produced and consumed outside of the United States.
(Please see the charts prices and volatility of the GAO report)
Bloomberg
Nasdaq OMX Group Inc. (NDAQ) and IntercontinentalExchange Inc. (ICE) told NYSE Euronext (NYX) shareholders they should demand their board meet with the two companies before the July 7 vote on a merger with Deutsche Boerse AG. (DB1)
I don’t see the difference between these trades and ordinary speculation. W&D were taking the chance that they would be unable to find buyers for their long position at anything other than a ruinously low price. Such a strategy may make money one month and lose another month. As Steven Kopits writes, there ought to have been something about these particular months that made the risk worth taking.
Perhaps the CFTC are on a wild goose chase here (I’m sorry, that’s a dyer joke!)
Jeff –
I agree. The guys might be guilty.
But there are many markets more thin and less transparent. Frankly, almost all commodity markets are thinner and less transparent than oil. Some of these markets are truly easy to manipulate.
And did you read about manipulation of these in the paper? Did our kind professor write a post about them? No indeed.
This story may be about justice. But the timing, both of the announcement and the period of the allegedly malfeasance, is highly unusual, don’t you think, when the Democrats are trying to make the case that oil prices are primarily about speculation and manipulation? To me, it feels more like politics.
The largest forward/futures/physical oil player is our good friend Goldman.
In the face of a world wide gut of oil, tankers are still being used for off shore storage, the price of oil goes up, then GS tells their clients to short the market mid April, in May the longs are wiped out in a mini-flash crash and now GS is going long oil again.
Nice of the government to go after the small fish.
Isn’t a big point the line in the post that an allegation is they had an arrangement in place? The lawyer in me notes that ordinary speculative behavior can become illegal – maybe, depending on the law applied – if you rig the game. The allegation would thus seem to be that they were running a scam on the market. The questions legally would include:
– is this actually a scam or was there still enough risk in any arrangement they had with the March buyer?
– is this illegal? You define law by seeing if it applies. This may be such a case.
– the defense may argue this is enforcement of a non-existing rule through the courts. Conduct not technically illegal that could be regulated but which because there are no regulations is being pursued in court. The defense rationale would then be that court cases involve bad acts, meaning those explicitly wrong, not those which may or may not be wrong.
Anybody care to guess at the social welfare losses associated with these ex post successful acts of ‘speculation’.
Otherwise, the CFTA appears to fiddle while Rome burns–literally.
Certainly you should have titled the post “Wildgoose Chased”.
Joseph:
I’m not aware of that argument and that was not the point of my comment. I was simply stating that the facts of this case actually support the idea that fundamentals, and not speculation or manipulation, are the main drivers of price.
Re. Exchange vs OTC – they were trading both, the physical trades were OTC and the futures were on the exchange.
The liquidity and depth of the Nymex futures market is such that you couldn’t really squeeze it. Squeezing Cushing, on the other hand, is doable because it’s physical – you can materially alter the apparent fundamental conditions at the hub.
So, in theory, you take OTC positions to squeeze the physical market, and take futures positions that will benefit from the physical squeeze.
Is affecting rent upon commodities curtailing or creating a market?
Overtly phony prices are inherent to opaque exchanges, such as oil futures. Coercive strategies, such as fixing bids, are one of the most alluring dynamics for players. Intervening in physical oil spreads, to hold slugs of distillates and gas for a mark up, is simply one method for manufacturing tranquility and volatility; the source of trading profits. The subsequent positive profit loop that emerges from speculators also furnishes investors with a thesis to commit capital with amusing fetish-like narratives, such as peak oil. (The same investors are often afflicted with the pestilence of the gold bug.) The inherently flawed structure of oil futures, particularly the rents assessed upon the underlying assets in the complex, derive from limited transparency compounded by leveraged liquidity. Such conditions often end abruptly, unwound at enormous cost, when a better wager emerges. Occasionally such markets just cease to exist.
Which is how the oil futures market was created.
Apparently, the NYMEX stopped serving potatoes when it started frying oil futures.
While fly fishing on the banks of a barren potato field in Maine yesterday, a farmer explained that the river had rebounded and his fortunes had diminished over the last decade due a lack of speculation in spuds. When regulators suddenly asserted that fundamentals, such as supply and demand, should dominate the potato market, the NYMEX abruptly took oil instead.
We caught and released over a dozen healthy, wild Brook Trout.
And ate a pile of French Fried potatoes on the way home.
John Kingston’s take on it:
http://www.platts.com/weblog/oilblog/2011/05/27/cftc_roils_the.html
What’s most interesting about this case is that it works exactly opposite to the usual half-baked theory of how financial speculators allegedly manipulate the oil price, which typically suppose that financial speculators manipulate the oil price upward by hoarding oil futures. Actually, financial hoarding of futures only temporarily runs up the price of futures contracts while the hoarder is buying and then runs down the price while he is selling. This will lose money unless the short-term hoarder correctly predicts a real tightening of the oil market.
Instead what these guys were doing was using short-term trades in the physical oil market to manipulate the futures market.
Apparently the key to the trick is that the turnover or churn of futures is much greater than with physical oil. That allowed the manipulators to make much larger volumes of trades in the futures market, where they were profiting from manipulated prices, relative to the volumes of their unprofitable, manipulative trades in the physical market.
This goes on every month in every market. This is standard operating procedure for WTI, Rotterdam barges, and Singapore cargoes. WTI is easier to manipulate than Brent because of Cushing and physical delivery.
This was a classic spread squeeze which must be run at a minimum of 3:1 paper to physical to pay off enough for the risks.
Going after these two traders is someone’s idea of a token case, but it’s a weak one. Pushing spreads did not make the market climb to $147.50. That was done by the likes of Goldman and their $200 calls, Andy Hall and his Peak Oil length, and the billions of dollars in investor money which poured into commodities.
I think we are missing a key point here:
How is possible that two people could aquire 66% of all of the oil that was going through Cushing? Just how leveraged were they?