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By Barani Krishnan
Investing.com -- Speculation before fact: It’s the reason for price moves that get overdone in any market, particularly commodities. What if 25% of the current oil price is made up of speculation by Wall Street’s biggest but inadequately-regulated traders? What if that speculation is shut down? Will a barrel go from $110 to $80? Intriguing? Read on.
As commodity traders caught in the throes of U.S. recession fears sent a barrel down more than $10 for the just-ended week, an investigative report by TYT Network that appeared on salon.com said a handful of congressional Democrats had turned their attention as well to an arcane trading loophole that may be helping drive gas and food prices beyond justification.
The loophole, called Footnote 563 under the trading guidelines of the Commodity Futures Trading Commission, or CFTC, has been flagged to the Biden administration by California’s Democratic Representative Ro Khanna, who wants it shut down.
According to CFTC subject-matter experts interviewed by TYT, it is Footnote 563 that principally allows Wall Street’s biggest financial firms to overwhelm healthy price-setting with massive volumes of commodity-based swaps - which are essentially bets on commodity prices.
In healthy markets, buyers and sellers set prices by finding middle ground between them. One party wants low prices, the other wants high prices. The problem is buyers and sellers of oil and other commodities are outnumbered by something like 10 to one by Wall Street traders, none of whom have a genuine buyer's incentive to keep prices low, because few of them ever actually buy it; they mostly bet on it.
Because deregulated traders dramatically outnumber them, genuine buyers and sellers are virtually irrelevant now when it comes to setting prices, says Michael Greenberger, former director of trading and markets at CFTC. Footnote 563 is what's causing Ukraine and other supply issues to create disproportionately large impacts on prices, Greenberger told a virtual talk hosted recently by Americans for Financial Reform.
To be sure, sanctions not just on Russia but also Iran and Venezuela, as well as civil strife in Libya, are all squeezing world crude supply while demand is back to pre-pandemic highs. The problem is Wall Street banks and traders are amplifying price spikes from this tight oil situation where a functioning futures market would cushion them.
The problem is not corporate greed, as President Joe Biden and the Democrats have suggested. Or, at least, it's not the corporate greed that they have in mind.
In healthy markets, price gouging would inspire competitive undercutting, especially with gasoline at record highs above $5 a gallon. In theory, an opportunistic gasoline wholesaler could try to scoop up new customers by low-balling their price-gouging competitors. But even if some wholesalers did that, it wouldn't move the market price, because gasoline sales are a drop in the bucket compared to Wall Street's bets.
As Greenberger said in his talk last week, oil companies may benefit from spiking prices, but they're not the primary mover.
And Greenberger has more than a little experience with the issue. He played a similar role back in the aughts when gas topped $4 a gallon, pointing out a regulatory weakness called the "Enron loophole" that let Wall Street speculate on energy. In 2008, both presidential candidates, John McCain and Barack Obama pledged to close the Enron loophole. Then, the financial crisis erupted and oil went from $147 a barrel in July 2008 to below $33 by January 2009. Wall Street banks on their own shut down their commodity trading desks and stiff financial regulations did the rest.
Despite this, by February 2011, the Arab Spring and Libyan war that preceded the downfall of Muammar Gaddafi took oil back to $100 a barrel. It remained between there and $90 till late 2014. But Wall Street banks weren’t trading commodities like before. And gasoline prices rarely went above $3.50 a gallon. Thus, inflation wasn’t a problem; in fact, the Federal Reserve was praying that it’ll hit its inflation target of 2% a year and was cutting rates under a quantitative easing cycle that ran from 2008 through 2014. Even the greatest fiscal hawk then might have struggled to imagine the current inflation of 8% a year.
Then something else happened: Oil prices crashed from 2014 and would not return to $100 for another seven years at least.
Despite the relative market lull then, Greenberger said the CFTC under Obama discovered the Footnote 563 as a new potential danger after the Enron loophole. He said the International Swaps and Derivatives Association carved out the loophole for themselves as the CFTC was translating the financial crisis-era Dodd-Frank Wall Street Reform Act into rules and regulations.
The CFTC discovered the loophole in October 2016. By then, Wall Street's biggest banks were able to escape regulation of virtually all their swaps by executing them through affiliates that they claimed were overseas and claimed weren't backed up by their parent firms. Neither of those claims was true, and in some cases the affiliates themselves barely existed beyond a piece of paper, Greenberg says.
He said the CFTC began the process of trying to close down the loophole before the next financial crisis erupted. But there was another problem. Donald Trump’s November 2016 election win and the Republican president’s deregulatory crusade killed any progress in shutting down Footnote 563. The loophole was exploited to the hilt by Wall Street banks in the run-up to oil’s historic negative pricing as the Covid-19 crisis broke. Footnote 563 also expedited oil’s run from $77 a barrel in December to $130 in March, the Ukraine notwithstanding, Greenberger says.
The former CFTC official says the agency could still take quick action to fix the loophole. In fact, Greenberg says, the Biden administration doesn't have to do much more than say a few words in public to have a dramatic impact on gas and other prices. "If they just [say], 'Hey, this is going on, this is bad, we're gonna look at it,' I think the price of oil would go down at least 10% upon that acknowledgement, maybe 25%."
That's because just the prospect of regulatory attention could spook the banks and other big financial firms that are betting on gas prices. (Greenberger cites Goldman Sachs, Citigroup, Bank of America and JPMorgan Chase; private equity is also in the game.)
Greenberger's short-term remedy is for the administration to address the problem publicly. The long-term fix is to re-regulate those swaps.
Oil: Market Settlements and Activity
Crude prices fell as much as 9% on the week as the oil market saw its biggest plunge since April on growing fears of a recession in the United States amid aggressive rate hikes by the Federal Reserve to curb inflation at 40-year highs.
New York-traded West Texas Intermediate, the benchmark for U.S. crude, settled down $7.11, or 6%, at $110.48 per barrel. For the week, WTI was down almost 9%, for its first weekly loss since April.
London-traded Brent crude, the global oil benchmark, settled down $6.2, or 5.1%, at $113.61. For the week, Brent tumbled more than 7% for its first weekly drop as well in two months.
WTI surged earlier this week to a three-month peak of $123.18, its highest since the March run-up to almost $130 after the start of the Russia-Ukraine conflict. Brent reached $125.16, after the March peak, which itself was the highest in 14 years.
Technical analysts have been warning for weeks that WTI and Brent prices were severely overbought as both crude benchmarks tacked on about $20 each over the past eight weeks. The oil trade appeared to take serious note of the warning on Friday after US factory output fell for a fifth straight month, as firms struggled with supply-chain bottlenecks and high costs, despite industrial production itself rising.
The Federal Reserve’s divisional chief for Minneapolis, Neel Kashkari, meanwhile warned that the central bank might need to get more aggressive with interest rates if U.S. inflation doesn't retreat from four-decade highs.
That was a sign that June’s three-quarter percentage point increase - the largest in 28 years - could be followed up by more major hikes, despite Fed Chair Jerome Powell’s assurance earlier this week that there will be no more super-sized hikes this year and that rate cuts could actually come as early as 2024.
The U.S. economy has already shown a negative growth of 1.4% for the first quarter. If it does not return to the positive by the second quarter, the United States will technically be in a recession, given that it takes just two straight quarters of negative growth to make a recession.
“Recessions are increasingly likely as central banks race to dramatically raise rates before inflation spirals out of control,” Craig Erlam, analyst at online trading platform OANDA, said as the European Central Bank indicated three big rate hikes as well for 2022. “It is better than the alternative though; stagflation.”
While the world, particularly the United States, was not yet in a stagflationary environment, where prices keep rising while the economy continues falling, the term has “been thrown around way too much in recent months, which perhaps highlights the trepidation around it,” Erlam said.
“The risk of one is rising, which is why central banks are becoming increasingly accepting of their actions tipping the economy into recession,” he added.
While the Ukraine invasion and subsequent Western sanctions on major energy exporter Russia have exacerbated the global tightness in crude supplies, this year’s rally in oil has gone beyond the affordability of many poor consuming nations, say analysts.
In the United States, the best gauge of public burden from the rally was the pump price of gasoline, or petrol, which exceeded $5 a gallon for the first time ever this month. Many US pumps, especially those in West Coast states like California, were selling at close to $6 a gallon, the American Automobile Association said. Diesel was even higher in California, at beyond $7 a gallon.
“It’s nuts, what the bulls have been doing,” said John Kilduff, partner at New York energy hedge fund Again Capital.
“I know we have a global deficit in oil but seriously, how much more do you want consumers to pay?” said Kilduff. “There is a limit to the supply tightness hype. I’m pretty sure that we’ll be hearing cries of ‘oversold’ from the other side after this and we could jump a couple of dollars or more after the weekend. But this is a good reminder that there are still some sane heads in the market examining all the macroeconomic data that’s coming in, and reacting accordingly.”
Among that “other side” was Goldman Sachs chief commodities analyst Jeff Currie, who has stood out as Wall Street’s chief cheerleader for oil in calling for even higher crude prices before any real demand destruction could set in.
Some oil bulls also remained unperturbed by Friday’s selloff.
“Unless the economy goes into a total meltdown, those drops in prices should be opportunities to put on long-term bullish positions,” said Phil Flynn, analyst at Chicago’s Price Futures Group, who pointed out that the demand for oil during most recessions had not fallen by more than 2%.
Oil: Price Outlook
Price action in the just-ended week has confirmed the bearish DOJI pattern in WTI formed in the previous week, said Sunil Kumar Dixit, chief technical strategist at skcharting.com.
He said a test of the $100 support for U.S. crude could not be discounted.
“We saw a steep $15 drop in WTI from $123.66 to $108.25,” Dixit said, adding that stochastic readings of 54/65 on the weekly chart and 8/30 on the daily chart reinforced U.S. crude’s potential volatility and bearish mood.
The close below the 50-Day Exponential Moving Average of $109.83 was another bearish sign.
On the flip side, he said WTI could show a bounce back from the weekly middle Bollinger Band of $106 and retrace to the $113 - $116 - $119 levels.
“If that happens, sellers could again reactivate another round of pounding for the next leg lower, which is targeting the 200-Day Simple Moving Average of $101,” Dixit said.
Gold: Market Settlements and Price Outlook
Front-month gold futures for August on New York’s Comex settled down $8.00, or 0.4%, at $1,841.90.
For the week, the benchmark gold futures contract fell 1.9%.
Dixit noted that the week-long price action in gold saw the yellow metal straddling through the $75 ascending rectangular channel formed after Comex’s April high of $1,998 when the metal could not breach $2,000.
“Such ascending channels often tend to be bearish with potential for another drop if support is decisively breached,” he said.
Dixit also noted that the weekly price action indicated a bearish continuation of the metal’s close beneath the 50-Day Exponential Moving Average of $1,851 and the 100-Day Simple Moving Average of $1,845.
“Further into next week, gold is likely to begin in the neutral zone of $1,830-$1,850 before finding its next move,” said Dixit. “A sustained move above $1,830-$1,840 will have potential for a short-term rebound to $1,850-$1,860, which is required to be cleared for the next resistance at $1,878.”
But a rejection from $1,850-$1,860 can push gold toward a retest of the $1,830-$1,820 that could extend toward channel support at $1,805, Dixit said.
“Any decisive breach of $1,878 or $1,805 will open a further $30-$75 move in the direction of breakout, either straight or in phases, depending on the trigger,” he added.
Disclaimer: Barani Krishnan does not hold positions in the commodities and securities he writes about.