McCain, amazingly, spent all summer telling us reporters that the reason for the spike in gas prices was that socialists like Barack Obama were refusing to permit immediate drilling for oil off the coast of Florida...How about Barack Obama? He offered a lot of explanations, too. In many ways the McCain-Obama split on the gas prices issue was a perfect illustration of how left-right politics works in this country. McCain blamed the problem, both directly and indirectly, on a combination of government, environmentalists, and foreigners.
Obama knew his audience and aimed elsewhere. He blamed the problem on greedy oil companies and also blamed ordinary Americans for their wastefulness, for driving SUVs and other gas-guzzlers.
Both candidates were selling the public a storyline that had nothing to do with the truth. Gas prices were going up for reasons completely unconnected to the causes these candidates were talking about. What really happened was that Wall Street had opened a new table in its casino. The new gaming table was called commodity index investing. And when it became the hottest new
game in town, America suddenly got a very painful lesson in the glorious possibilities of taxation without representation. Wall Street turned gas prices into a gaming table, and when they hit a hot streak we ended up making exorbitant involuntary payments for a commodity that one simply cannot live without
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All the way back in 1936, after gamblers disguised as Wall Street brokers destroyed the American economy, the government of Franklin D. Roosevelt passed a law called the Commodity Exchange Act that was specifically designed to prevent speculators from screwing around with the prices of day-to-day life necessities like wheat and corn and soybeans and oil and gas.
Let's say you're that cereal company and your business plan for the next year depends on your being able to buy corn at a maximum of $3.00 a bushel. And maybe corn right now is selling at $2.90 a bushel, but you want to insulate yourself against the risk that prices might skyrocket in the next year. So you buy a bunch of futures contracts for corn that give you the right—say, six months from now, or a year from now—to buy corn at $3.00 a bushel.
Now, if corn prices go up, if there's a terrible drought and corn becomes scarce and ridiculously expensive, you could give a damn, because you can buy at $3.00 no matter what. That's the proper use of the commodities futures market.
It works in reverse, too—maybe you grow corn, and maybe you're worried about a glut the following year that might, say, drive the price of corn down to $2.50 or below. So you sell futures for a year from now at $2.90 or $3.00, locking in your sale price for the next year. If that drought happens and the price of corn skyrockets, you might lose out, but at least you can plan for the future based on a reasonable price.
These buyers and sellers of real stuff are the physical hedgers. The FDR administration recognized, however, that in order for the market to properly function, there needed to exist another kind of player—the speculator. The entire purpose of the speculator, as originally envisioned by the people who designed this market, was to guarantee that the physical hedgers, the real
players, could always have a place to buy and/or sell their products.
Again, imagine you're that corn grower but you bring your crop to market at a moment when the cereal company isn't buying. That's where the speculator comes in. He buys up your corn and hangs on to it. Maybe a little later, that cereal company comes to the market looking for corn—but there are no corn growers selling anything at that moment. Without the speculator there, both grower and cereal company would be fucked in the instance of a temporary disruption.
With the speculator, however, everything runs smoothly. The corn grower goes to the market with his corn, maybe there are no cereal companies buying, but the speculator takes his crop at $2.80 a bushel. Ten weeks later, the cereal guy needs corn, but no growers are there—so he buys from the speculator, at $3.00 a bushel. The speculator makes money, the grower unloads his crop, the cereal company gets its commodities at a decent price, everyone's happy.
This system functioned more or less perfectly for about fifty years. It was tightly regulated by the government, which recognized that the influence of speculators had to be watched carefully. If speculators were allowed to buy up the whole corn crop, or even a big percentage of it, for instance, they could easily manipulate the price. So the government set up position limits, which guaranteed that at any given moment, the trading on the commodities markets would be dominated by the physical hedgers, with the speculators playing a purely functional role in the margins to keep things running smoothly.
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in 1991, J. Aron—the Goldman subsidiary—wrote to the Commodity Futures Trading Commission (the government agency overseeing this market) and asked for one measly exception to the rules.
The whole definition of physical hedgers was needlessly restrictive, J. Aron argued. Sure, a corn farmer who bought futures contracts to hedge the risk of a glut in corn prices had a legitimate reason to be hedging his bets. After all, being a farmer was risky! Anything could happen to a farmer, what with nature being involved and all!
Everyone who grew any kind of crop was taking a risk, and it was only right and natural that the government should allow these good people to buy futures contracts to offset that risk.
But what about people on Wall Street? Were not they, too, like farmers, in the sense that they were taking a risk, exposing themselves to the whims of economic nature? After all, a speculator who bought up corn also had risk—investment risk. So, Goldman's subsidiary argued, why not allow the poor speculator to escape those cruel position limits and be allowed to make transactions in unlimited amounts? Why even call him a speculator at all? Couldn't J. Aron call itself a physical hedger too? After all, it was taking real risk—just like a farmer!
On October 18, 1991, the CFTC-in the person of Laurie Ferber, an appointee of the first President Bush—agreed with J. Aron's letter. Ferber wrote that she understood that Aron was asking that its speculative activity be recognized as "bona fide hedging"—and, after a lot of jargon and legalese, she accepted that argument. This was the beginning of the end for position limits and for the proper balance between physical hedgers and speculators in the energy markets.
In the years that followed, the CFTC would quietly issue sixteen similar letters to other companies. Now speculators were free to take over the commodities market. By 2008, fully 80 percent of the activity on the commodity exchanges was speculative, according to one congressional staffer who studied the numbers—"and that's being conservative," he said.
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One congressional staffer, a former aide to the Energy and Commerce Committee, just happened to be there when certain CFTC officials mentioned the letters offhand in a hearing. "I had been invited by the Agriculture Committee to a hearing the CFTC was holding on energy," the aide recounts. "And suddenly in the middle of it they start saying, 'Yeah, we've been issuing these letters for years now.' And I raised my hand and said, 'Really? You issued a letter? Can I see it?' And they were like, 'Uh-oh.'
"So we had a lot of phone conversations with them, and we went back and forth," he continues. "And finally they said, 'We have to clear it with Goldman Sachs.' And I'm like, 'What do you mean, you have to clear it with Goldman Sachs?'"
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[What you're doing when you invest in the S&P GSCI is buying monthly futures contracts for each of these commodities. If you decide to simply put a thousand dollars into the S&P GSCI and leave it there, the same way you might with a mutual fund, this is a little more complicated—what you're really doing is buying twenty-four different monthly futures contracts, and then at the end of each month you're selling the expiring contracts and buying a new set of twenty-four contracts. After all, if you didn't sell those futures contracts, someone would actually be delivering barrels of oil to your doorstep. Since you don't really need oil, and you're just investing to make money, you have to continually sell your futures contracts and buy new ones in what amounts to a ridiculously overcomplex way of betting on the prices of oil and gas and cocoa and coffee.
This process of selling this month's futures and buying the next month's futures is called rolling. Unlike shares of stock, which you can simply buy and hold, investing in commodities involves gazillions of these little transactions made over time. So you can't really do it by yourself: you usually have to outsource all of this activity, typically to an investment bank, which makes fees handling this process every month.
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To look at this another way—just to make it easy—let's create something we call the McDonaldland Menu Index (MMI). The MMI is based upon the price of eleven McDonald's products, including the Big Mac, the Quarter Pounder, the shake, fries, and hash browns. Let's say the total price of those eleven products on November l, 2010, is $37.90. Now let's say you bet $1,000 on the McDonaldland Menu Index on that date, November 1. A month later, the total price of those eleven products is now $39.72.
Well, gosh, that's a 4.8 percent price increase. Since you put $1,000 into the MMI on November 1, on December 1 you've now got $1,048. A smart investment!
Just to be clear—you didn't actually buy $1,000 worth of Big Macs and fries and shakes. All you did is bet $1,000 on the prices of Big Macs and fries and shakes.
But here's the thing: if you were just some schmuck on the street and you wanted to gamble on this nonsense, you couldn't do it, because your behavior would be speculative and restricted under that old 1936 Commodity Exchange Act, which supposedly maintained that delicate balance between speculator and physical hedger (i.e., the real producers/consumers). Same goes for a giant pension fund or a trust that didn't have one of those magic letters. Even if you wanted into this craziness, you couldn't get in, because it was barred to the Common Speculator. The only way for you to get to the gaming table was, in essence, to rent the speculator-hedger exemption that the government had quietly given to companies like Goldman Sachs via those sixteen letters.
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[T]he people who managed the great pools of money in this world—the pension funds, the funds belonging to trade unions, and the sovereign wealth funds, those utterly gigantic quasi-private pools of money run by foreign potentates, usually Middle Eastern states looking to do something with their oil profits. It meant someone was offering them a new place to put their money. A safe place. A profitable place.
Why not bet on something that people can't do without—like food or gas or oil? What could be safer than that? As if people will ever stop buying gasoline! Or wheat! Hell, this is America. Motherfuckers be eating pasta and cran muffins by the metric ton for the next ten centuries! Look at the asses on people in this country. Just let them try to cut back on wheat, and sugar, and corn!
But there were several major problems with this kind of thinking—i.e., the notion that the prices of oil and gas and wheat and soybeans were something worth investing in for the long term, the same way one might invest in stock.
For one thing, the whole concept of taking money from pension funds and dumping it long-term into the commodities market went completely against the spirit of the delicate physical hedger/speculator balance as envisioned by the 1936 law. The speculator was there, remember, to serve traders on both sides. He was supposed to buy corn from the grower when the cereal company wasn't buying that day and sell corn to the cereal company when the farmer lost his crop to bugs or drought or whatever. In market language, he was supposed to "provide liquidity."
The one thing he was not supposed to do was buy buttloads of corn and sit on it for twenty years at a time. This is not "providing liquidity." This is actually the opposite of that. It's hoarding.
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The other problem with index investing is that it's "long only." In the stock market, there are people betting both for and against stocks. But in commodities, nobody invests in prices going down. "Index speculators lean only in one direction-long—and they lean with all their might," says Masters. Meaning they push prices only in one direction: up.
The other problem with index investing is that it brings tons of money into a market where people traditionally are extremely sensitive to the prices of individual goods. When you have ten cocoa growers and ten chocolate companies buying and selling back and forth a total of half a million dollars on the commodities markets, you're going to get a pretty accurate price for cocoa. But if you add to the money put in by those twenty real traders $10 million from index speculators, it queers the whole deal. Because the speculators don't really give a shit what the price is. They just want to buy $10 million worth of cocoa contracts and wait to see if the price goes up.
To use an example frequently offered by Masters, imagine if someone continually showed up at car dealerships and asked to buy $500,000 worth of cars. This mystery person doesn't care how many cars, mind you, he just wants a half million bucks' worth. Eventually, someone is going to sell that guy one car for $500,000. Put enough of those people out there visiting car dealerships, your car market is going to get very weird very quickly. Soon enough, the people who are coming into the dealership looking to buy cars they actually plan on driving are going to find that they've been priced out of the market.
An interesting side note to all of this: if you think about it logically, there are few reasons why anyone would want to invest in a rise in commodity prices over time. With better technology, the cost of harvesting and transporting commodities like wheat and corn is probably going to go down over time, or at the very least is going to hover near inflation, or below it. There are not many good reasons why prices in valued commodities would rise—and certainly very few reasons to expect that the prices of twenty-four different commodities would all rise over and above the rate of inflation over a certain period of time.
What all this means is that when money from index speculators pours into the commodities markets, it makes prices go up. In the stock markets, where again there is betting both for and against stocks (long and short betting), this would probably be a good thing. But in commodities, where almost all speculative money is betting long, betting on prices to go up, this is not a good thing—unless you're one of the speculators.
Anyway, from 2003 to July 2008, the amount of money invested in commodity indices rose from $13 billion to $317 billion—a factor of twenty-five in a space of a little less than five years.
By an amazing coincidence, the prices of all twenty-five commodities listed on the S&P GSCI and the Dow-AIG indices rose sharply during that time. Not some of them, not all of them on the aggregate, but all of them individually and in total as well.
The average price increase was 200 percent. Not one of these commodities saw a price decrease. What an extraordinarily lucky time for investors!
And the top oil analyst at Goldman Sachs quietly conceded, in May 2008, that "without question the increased fund flow into commodities has boosted prices."
One thing we know for sure is that the price increases had nothing to do with supply or demand. In fact, oil supply was at an all-time high, and demand was actually falling. In April 2008 the secretary-general of OPEC, a Libyan named Abdalla El-Badri, said flatly that "oil supply to the market is enough and high oil prices are not due to a shortage of crude." The U.S. Energy Information Administration (EIA) agreed: its data showed that worldwide oil supply rose from 85.3 million barrels a day to 85.6 million from the first quarter to the second that year, and that world oil demand dropped from 86.4 million barrels a day to 85.2 million.
Not only that, but people in the business who understood these things knew that the supply of oil worldwide was about to increase. Two new oil fields in Saudi Arabia and another in Brazil were about to start dumping hundreds of thousands more barrels of oil per day into the market. Fadel Gheit, an analyst for Oppenheimer who has testified before Congress on the issue, says that he spoke personally with the secretary-general of OPEC back in 2005, who insisted that oil prices had to be higher for a very simple reason—increased security costs.
"He said to me, if you think that all these disruptions in Iraq and in the region... look, we haven't had a single tanker attacked, and there are hundreds of them sailing out every day. That costs money, he said. A lot of money."
So therefore, Gheit says, OPEC felt justified in raising the price of oil. To 45 dollars a barrell At the height of the commodities boom, oil was trading for three times that amount.
"I mean, oil shouldn't have been at sixty dollars, let alone a hundred and forty-nine," Gheit says.
This was why there were no lines at the gas stations, no visible evidence of shortages. Despite what we were being told by both Barack Obama and John McCain, there was no actual lack of gasoline. There was nothing wrong with the oil supply.
All of these factors contributed to what would become a historic spike in gas prices in the summer of 2008. The press, when it bothered to cover the story at all, invariably attributed it to a smorgasbord of normal economic factors. The two most common culprits cited were the shaky dollar (investors nervous about keeping their holdings in U.S. dollars were, according to some, more likely to want to shift their holdings into commodities) and the increased worldwide demand for oil caused by the booming Chinese economy.
Both of these factors were real. But neither was any more significant than the massive inflow of speculative cash into the market.
The U.S. Department of Energy's own statistics prove this to be the case. It was true, yes, that China was consuming more and more oil every year. The statistics show the Chinese appetite for oil did in fact increase over time:
If you add up the total increase between each of those years, i.e., the total increase in Chinese oil consumption over the five and a half years between the start of 2003 and the middle of 2008, it turns out to be just under a billion Barrels — 992,261,824 to be exact.
During the same time period, however, the increase in index speculator cash pouring into the commodities markets for petroleum products was almost exactly the same—speculators bought 918,966,932 barrels, according to the CFTC.
Oil shot up like a rocket, hitting an incredible high of $149 a barrel in July 2008, taking with it prices of all the other commodities on the various indices. Food prices soared along with energy prices. According to some estimates by international relief agencies—estimates that did not blame commodity speculation for the problem, incidentally—some 100 million people joined the ranks of the hungry that summer worldwide, because of rising food prices.
Then it all went bust, as it had to, eventually. The bubble burst and oil prices plummeted along with the prices of other commodities. By December, oil was trading at $33.
And then the process started all over again.
