Daniel McKenzie, CFA - Hudson Securities

Future of Aviation Advisory CommitteeCompetition SubcommitteeAugust 4, 2010

‘Excessive’ Speculation in 

Futures Markets Impacts Oil 

“Financial speculators in oil are costing coleast $300B a year, according to almost 7industry players surveyed by Reuters.”

- David Sheppard of Reute
Recognition / Appreciation

~ Special thanks to Dave Berg, David Fren

Heimlich, Ben Hirst, and Mike Masters, all of 

the heavy lifting for this presentation 

Separately, special thanks to Fowler We

- Appointed to CFTC (1982-93) by President Reagan. Worked to bring 

structure to derivatives but found few allies on the CFTC at t
Background - Why Important

 Fuel expense historically 10-12% of overall costs (as high as 40% As an airline analyst, worked with fundamental energy analysts &  Perverts Economics: In 2008, U.S. Airlines Spent $16B More on 

and $42B More Than in 2003

3⁄4 A $1 change in oil prices equals $425-$475M in annual expenses3⁄4 So, a $20 move in WTI costs airlines roughly $9B (which could otherw

planes, or a wage increase for labor). 

3⁄4 Price volatility resulting from excessive speculating is damaging as it 

hedging more expensive

 Given high fixed cost structures, airlines poorly positioned to resp

rapid moves in fuel prices (the initial spike in fuel prices in 2005 a behind Ch. 11 filings by Delta and Northwest – see Slide 9). 

 Consumers adversely affected by higher fare prices (LUV’s avg f

vs $94 in 2005, a 40% increase)

 Airline management teams have a fiduciary duty to shareholders 

30% of their costs are not being driven by excessive speculation 

Source: ATA and Hudson S
Competing Ideas for Oil Price Volatility (View #2 H

Source: Tang & Xiong (2010); pg 1, 2, & 12; Masters; & Huds

View #1: The conventional view among many economists is partial

regrettably, incomplete

 Commodity prices soared in 2008 because of surging demand, propelled by ra

economies. 

 Prices later fell when the Great Recession prompted slower demand; Speculat

a cause

 Simplifying assumptions used to reach conclusions don’t match the real worldView #2: Attributes high prices & volatility of prices to distortions c

investment flows into commodity indices

 According to a CFTC staff report (2008) and Masters (2008), the total value of 

index-related instruments purchased by institutional investors went from $15B 

2008 (& could quadruple to $1 trillion). 

 The World Bank; Oppenheimer; Goldman Sachs; Citigroup; Offit Capital Advis

and Princeton (Xiong) economics faculty are all on record acknowledging that 

demand drove prices

Traditional speculators, commodity producers, & commercial users are a

limited capacity to absorb price impact from index investors trades
Congress Has Acted - DOT Involvement Essential

 US Permanent Subcommittee on Investigations (2009) argue

related investment flow distorted the price of some commoditi

 The Dodd-Frank Wall Street Reform & Consumer Protection A

excessive speculation & market manipulation

3⁄4 Directs CFTC to set aggregate position limits on speculative trad3⁄4 Requires derivatives to trade on exchanges with real-time report3⁄4 Narrow exemption for true physical hedgers 3⁄4 Wall Street dealers are trying to undermine Dodd-Frank as it goe

 DOT Involvement Essential

3⁄4 Both the volatility and the level of energy prices directly impact th

odds with a stable transportation infrastructure which makes DOT essential

3⁄4 Dedicate DOT resources to assist the CFTC

Source: ATA, Tang & X
The Commodities Markets (What We’re Ta

Source: Tang & Xiong 2010; pg 6 & 33 & Hudson 

# Commodities GSCI DJ-UBS Exchange Contracts

1 WTI Crude Oil 40.6% 15.0% NYMEX Every Month2 Heating Oil 5.3% 4.5% NYMEX Every Month3 RBOB Gasoline 4.5% 4.1% NYMEX Every Month4 Natural Gas 7.6% 16.0% NYMEX Every Month

Sub-Total 58.0% 39.6%

5 Corn 3.6% 6.9% CME Mar, May, Jul, Sep & Dec6 Soybeans 0.9% 7.4% CME Jan, Mar, May, Jul, Aug, Sep & Nov7 Chicago Wheat 3.0% 3.4% CME Mar, May, Jul, Sep & Dec8 Kansas Wheat 7.0% - KCBT Mar, May, Jul, Sep & Dec9 Soybean Oil - 2.9% CME Jan, Mar, May, Jul, Aug, Sep, Oct & Dec

10 Minneapolis Whe

a - - MGE Mar, May, Jul, Sep & Dec

11 Soybean Meal - - CME Jan, Mar, May, Jul, Aug, Sep, Oct & Dec

12 Rough Rice - - CME Jan, Mar, May, Jul, Sep & Nov

13 Oats - - CME Mar, May, Jul, Sep & Dec

14 Coffee 0.5% 2.7% ICE Mar, May, Jul, Sep & Dec15 Cotton 0.7% 2.2% ICE Mar, May, Jul, Oct & Dec16 Sugar 2.1% 2.8% ICE Mar, May, Jul, & Oct17 Cocoa 0.2% - ICE Mar, May, Jul, Sep & Dec18 Lumber - - CME Jan, Mar, May, Jul, Sep & Nov

19 Orange Juice - - ICE Jan, Mar, May, Jul, Sep & Nov

20 Feeder Cattle 0.3% 0.0% CME Jan, Mar, Apr, May, Aug, Sep, Oct & Nov21 Lean Hogs 0.8% 2.5% CME Feb, Apr, May, Jul, Aug, Oct, Dec22 Live Cattle 1.6% 4.1% CME Feb, Apr, Jun, Aug, Oct, Dec23 Pork Bellies - - CME Feb, Mar, May, Jul, Aug

24 Gold 1.5% 6.1% NYMEX Feb, Apr, Jun, Aug, Oct, Dec25 Silver 0.2% 2.4% NYMEX Jan, Mar, May, Jul, Sep, Oct 26 Copper 2.6% 6.7% NYMEX Mar, May, Jul, Sep, & Dec27 Platinum - - NYMEX Jan, Apr, Jul, & Oct 

28 Palladium - - NYMEX Mar, Jun, Sep, & Dec

Energy 

Sector Grain Sector Soft Sector Livestock 

Sector

Metals 

Sector*Commoditie

frequently a CNBC’s “Fas

3 Investment VMake Fast Mon

1Commodity 2Exchange T(ETFs)3Exchange T

Note: index cchange over www.wikiped

Energy compas of 5/23/20
Source

1987– 2003 excluding First Persian Gulf War

Inventories Used to Be a Good Price Predictor
Inventories 1987 – 2003 (including First Persian Gulf War)

Source
But in 2004, it Began to Change (Inventories 198

Source: Masters & Hudson Se

Delta and Northwest struggled with hboth extracted huge concessions from predicated business plans on $35 WTthe time). $50+ Crude an out of nowhnot even Wall Street energy analysts 
Inventories 1987 – 2005

Fundamental Energy Analysts continued to declare that the SupplBackdrop Didn’t Support Prices (Citigroup)

Source: Masters & Hudson Se
Inventories 1987 – 2006

“The Surf’s Up”

Source: Masters & Hudson Se
Inventories 1987 – 2007

Drumbeats of an economic downturn gettinworsening economy / slowing economy freqheadline new. Stocks began a steady declionwards suggesting a slowing economy loslowing demand for oil. 

Source: Masters & Hudson Se
Inventories 1987 – 2008

Jun/Jul 2008: Goldman Sachs publishes $200 PT for WTI even Fannie & Freddie experience financial distress and the economdownturn is well underway.

Feb 2008: Greenspan declares a 50% prorecession. Real estate prices are already 

Source: Masters, Citigroup & Hudson Securit

“Despite the economic glooprices hit new highs in receby investment inflows.” - Cof Fund Flow” (April 7, 20

Note: Speculators way macro econom(ie. no oil hording)
Prop Trader Perspective – Post Crash, Aug 2008

“When you look at it from a market dynamic perspective, the big trade that you had speculative side - a number of big trades -- were ...people ... short crude oil, long n

on a BTU convergence.”“They’re a lot of people who were short crude versus baskets of various equities vi

good play and there were a lot of macro players who were short crude. So as we’v

and come down pretty materially -- you’re actually seeing a lot of those different ty

trades...”

Source: Publicly Available Info / Aug 2008

Key Take-Aways

Traditional speculators that invested on a fundamental supply deman

difficult time overcoming the power of long-only index mon

The only way to truly understand demand is to disaggregate trading 

participant. Academic researchers and even the CFTC itself haven’t h

trading information across all markets in which speculative activity h

WTI average daily volume is about 600-800K contracts. Index speculat

25% to over 50% of open interest. In 2008, index speculation effectively 

synthetically than the US Strategic Reserve.

Source: Better Markets, Inc. and Hudson 
Example of Distorted Decision Making

Slide Intentionally Left Partially Blank

Key Take-Away:

Fear and greed frequently rule markets, with sentiment 

extreme one way or the other (which is in contrast to 

expectations” broadly assumed by many macro eco

Source: Goldman Sachs and Hudson Securities ests
Markets Are Not Always Efficient (A Fast Money* 

Reasons for market failures:1. Imperfect, misunderstood, or misinterpreted information frequently 

investment decision making....thus resulting in...

2. Excessive technical order imbalances which distort information co

prices. So even if other participants are being perfectly rational, thexcessive trades means the information they are rationally proces

3⁄4 DOE weekly releases helpful, but actual supply and demand f

impossible to forecast looking ahead. e.g. OPEC vs. Non-Opec production capability; countries that are nationalizing oil prefineries subsequently falling into disrepair; actual consumption and elasticity vs. p

consumption and elasticity patterns). 

3⁄4 Standard economic theory states: speculation is a natural con

problems exist in “core learning.”

3⁄4 Most Portfolio Managers and investment decision makers are 

(hence their reliance on Wall Street experts).

Key Take-Away: the market cannot distinguish between 

consumers and buying from speculators, so there

tell precisely from where a price increase or decr

*Fast Money is a segment on CNBC. Source: Inc & Hudson Securities Ests
Market Failure Ex 1 - dot.com Bubble

Dow Jones Composite Internet Index

0

100200300400500600

7/4/1997

9/4/1997

11/4/1997

1/4/1998

3/4/1998

5/4/1998

7/4/1998

9/4/1998

11/4/1998

1/4/1999

3/4/1999

5/4/1999

7/4/1999

9/4/1999

11/4/1999

1/4/2000

3/4/2000

5/4/2000

7/4/2000

9/4/2000

11/4/2000

1/4/2001

3/4/2001

5/4/2001

7/4/2001

9/4/2001

11/4/2001

1/4/2002

3/4/2002

5/4/2002

7/4/2002

Index Price 

Source: 
Market Failure Ex 2 – Hi-Tech Bubble

Source: 

S & P 500 Information Technology Index

0

200400600800

10001200

11/18/1994

2/18/1995

5/18/1995

8/18/1995

11/18/1995

2/18/1996

5/18/1996

8/18/1996

11/18/1996

2/18/1997

5/18/1997

8/18/1997

11/18/1997

2/18/1998

5/18/1998

8/18/1998

11/18/1998

2/18/1999

5/18/1999

8/18/1999

11/18/1999

2/18/2000

5/18/2000

8/18/2000

11/18/2000

2/18/2001

5/18/2001

8/18/2001

11/18/2001

2/18/2002

5/18/2002

8/18/2

Index Price
Market Failure Ex 3 - Telecom Bubble

Dow Jones US Telecom Index

0

50

100150200250300350400

11/13/1992

2/13/1993

5/13/1993

8/13/1993

11/13/1993

2/13/1994

5/13/1994

8/13/1994

11/13/1994

2/13/1995

5/13/1995

8/13/1995

11/13/1995

2/13/1996

5/13/1996

8/13/1996

11/13/1996

2/13/1997

5/13/1997

8/13/1997

11/13/1997

2/13/1998

5/13/1998

8/13/1998

11/13/1998

2/13/1999

5/13/1999

8/13/1999

11/13/1999

2/13/2000

5/13/2000

8/13/2000

11/13/2000

2/13/2001

5/13/2001

8/13/2001

11/13/2001

2/13/2002

5

Index Price

Source: 
Market Failure Ex 4 – Real Estate Bubble

Dow Jones US Real Estate Index

0

50

100150200250300350400

11/10/2000

2/10/2001

5/10/2001

8/10/2001

11/10/2001

2/10/2002

5/10/2002

8/10/2002

11/10/2002

2/10/2003

5/10/2003

8/10/2003

11/10/2003

2/10/2004

5/10/2004

8/10/2004

11/10/2004

2/10/2005

5/10/2005

8/10/2005

11/10/2005

2/10/2006

5/10/2006

8/10/2006

11/10/2006

2/10/2007

5/10/2007

8/10/2007

11/10/2007

2/10/2008

5/10/2008

8/10/2008

11/10/2008

2/1

Index Price

Source: 
“You have a generalized commodity bubble due to commodities ha

asset class that institutions use to an increasing extent.” George So

Market Failure Ex 5 – Commodities Bubble

Source: A Short History of Financial Deregulation in the US; Matthew Sherm

(Toronto; 5/31/08); Bloomberg; and Hudson Securities ests.

Price Chart for WTI Futures

0

20406080

100120140160

4/1/1983

4/1/1984

4/1/1985

4/1/1986

4/1/1987

4/1/1988

4/1/1989

4/1/1990

4/1/1991

4/1/1992

4/1/1993

4/1/1994

4/1/1995

4/1/1996

4/1/1997

4/1/1998

4/1/1999

4/1/2000

4/1/2001

4/1/2002

4/1/2003

4/1/2004

4/1/2005

4/1/2006

4/1/2007

4/1/2008

4/1/2009

WTI Futures Price (CL1)

No Limits on Speculation

Commodity Futures Modernization Act - Passed with the support from the Clinton Administration, incl Treasury Secretary Lawrence Summers, and bi-partisan support in Congress. The Bill prevented the Commodity Futures Trading Commission from regulating most over-thecounter derivative contracts, including credit default swaps. 

Source: A Short History of Financial Deregulation in the US; M atthew 

Limits on Speculation

Transnor Case: Paved the way for wide-ranging dergulation of commodities trading, an effort that helped to spur the rise of Enron. Source: Globe and M ail; "Who is Responsible for the Food Crisis"
So, Supply Demand Horrible, but it Doesn’t Tell the W

The CFTC Has Concluded:

“Large concentrated positions in the energy futures and option markets c

facilitate abrupt price movements and price distortions.”

Congress has determined that “extreme or abrupt price fluctuations attrib

unchecked speculative positions are harmful to the futures markets.

- CFTC, January 26, 2010

Separately:“Apart from strong and sustained economic growth, the recent boom was numerous factors, including low past investment in extractive commoditiefiscal expansion, and lax monetary policy in many countries, and investm

- World Bank report from July 2010 by Baffes an

“Putting the 2006/2008 Commodities Boom into 

“The world’s financial and oil markets are becoming increasingly connectare no longer driven by the fundamentals of supply and demand alone.”

- Daniel Yergin, December 2007 

Co-founder/Chairman of Cambridge Energy Res

“No matter how bad the spot market looks fundamentally, prices can rise economics are positive. Thus, if investors buy oil futures based on econostagflation or peak oil, speculation can drive up the spot price of oil.”

- Adam Robinson – RBS Sempra Commodities
 Creation of unregulated markets in 2000 facilitated shift to tre

commodities as an asset class, which led to explosive money markets

3⁄4 Volume of paper demand for oil far exceeds physical demand3⁄4 Price discovery function of futures market distorted or worse

 Energy Information Administration (DOE) - Financial Markets 

3⁄4 “Energy markets have developed in ways that were not anticipated”3⁄4 EIA’s traditional coverage of fundamentals must be expanded3⁄4 EIA will assess the market influences of speculation, hedging, investment, 

exchange rates

Why Fundamentals Do Not Tell the Whol
Source: Masters (Goldman Sachs, Standard & Poor’s, Dow J

upon CFTC CIT report. Mid 2008 figure is as of July 1.)

Passive Commodity Index Pushed Up Oil Prices; Ene
Paper Dominates Physical

Source: Masters (Bloombe
532.3

85.4

469.3

0

200400600800

1,0001,200

World Consumption Oil Traded on E

A Billion Barrels of Crude Traded Daily on Exchanges 

In 2008, Paper Market – Not Even Counting OTC Markets – Almost 12X 

Sources: Citi Futures Perspective, International Energy Agency, New York Mercantile Exchange (NYME

Intercontinental Exchange® (ICE)

Daily Barrels of Crude Oil (Millions) –20081,001.6 11.7 X ICE NYME

Source: www.airlines.or

26

“If the US, the greatest country in the world, cannot ensure the public that it can provide sound regulatory oversight of mature energy commodity markets with integrity, then how can it ever trade carbon without market fraud and manipulation?”

Paul Cicio, Industrial Energy Consumers 

of America (July 17, 2008)
 Large amounts of institutional investor money flowed into commoditie

generally, and oil futures specifically beginning 2004

 The pace of inflows accelerated substantially at the beginning of 200 This created a speculative bubble in oil prices which popped in the m Since March of 2009 this echo-bubble has been steadily re-inflating a

rates than 2008

 For example (see following slides)

What Really Happened in 2008 – A Wall of Invest

Source
Source: Masters (based on 

$25‐$30 Billion Flows into Indices

130‐150 Million Barrels are Bought

Prices rise from $58‐$96 (+65%)

2007
$45‐$65 Billion Flows into Indices

145‐165 Million Barrels are Bought

> 1 Million Barrels per Trading Day

Prices rise from $96‐$137 (+42%)

1st Half 2008

Source: Masters (based on 
$60‐$80 Billion Flows out of Indices

230‐260 Million Barrels are Sold

~ 2 Million Barrels per Trading Day

Prices fall from $137‐$39 (‐72%)

2nd Half 2008

Source: Masters (based on 
$95‐$115 Billion Flows into Indices

350 ‐ 400 Million Barrels are Bought

> 2 Million Barrels per Trading DayPrices rise from $39‐$79 (+102%)

2009

Source: Masters (based on 
$10 Billion InflowFirst Week of April

Oil popped from$82 to almost $87

2007 – 2010 

Source: Masters (based on 
Source: Masters (Bloomberg. Rolling 3 month average of 3 month daily cor

U.S. Dollar Index (DXY) to WTI Crude Oil).

Dollar vs. WTI
Source: Masters (Bloomberg. Inflation expectation is 10 Year U.S. Treasur

Treasury Inflation Protected Securities [TIPS] )

Inflation vs. WTI
Source: Masters (Bloomberg. Rolling 3 month average of 3 month daily c

S&P 500 to WTI Crude Oil)

S&P vs. WTI
Pers

Cont

Source: Masters (Bloomberg. Monthly averages of annualized spread betwe

from expiration and 1st WTI crude oil future from expiration)

Persistent Contango 
Oil Now “Financialized”

 Investors have transformed the price discovery function for oil 

now dominate the oil derivatives markets from a volume tradin

 Oil futures (paper contracts) have become a financial “asset” t

correlates with financial markets; 

3⁄4 Because of “core learning” issues and uncertainty over true suppl

or stored, participants don’t know the true supply or demand and current physical spot price from futures prices what other people m

3⁄4 That is, oil traders and end users rely heavily on pricing services s

determine the spot price of oil, which in turn, relies heavily on futuare the most readily available information about market activity)

 Because it’s “financialized,” oil prices are now subject to spec

and busts

 Governments must take steps to re-instate speculative positio

derivatives markets and severely restrict the phenomenon of pinvestment.

Source: *Platts Oil Pricing and Market-on-Close Methodology ExplaBackground (Platts McGraw-Hill, 2007); Masters; and Hudson Sec
Why Do Many Academics and Investment Banks 

All Trying Hard, but, Key Assumptions Inconsistent with  Investors have perfect foresight and the markets are rational; thu

speculation in most models (e.g. Hamilton)

 Elasticity of demand estimates a source of error. It varies not on

also by market participant (absent from most models). Separatefor immediate consumption, but also for sovereigns reserves whperiodically (China, U.S.). In short, there are too many elasticity small change in an elasticity assumption can lead to wildly varyinRogoff (Harvard); Credit Suisse Strategist (2008)

 Investment Banks: Have the opposite Fiduciary Duty vs airlines. 

to defend, preserve, & protect for their shareholders profits earncommodities activities (so don’t expect public acknowledgement

However: 

 All of economic theory says there will be speculation when there 

core learning and when there is uncertainty over key componentgrowth

 The problem is not speculators per se, but the magnitude of spe

has come to dominate the commodities market

Source: Hudson Securities ests
DOT’S Role Going Forward

Q: How much speculation is necessary to allow the markets to functioA: No more speculative activity that is necessary to provide liquidity a

for hedging. 

 According to industry sources; CFTC Chairman Gensler would appre

involvement

3⁄4 Secretary LaHood has a history of actively working with the CFTC going back to the e

 Request involvement with CFTC on rulemaking process & speculativ

3⁄4 Dedicate DOT resources to assist the CFTC & also file comments in forthc3⁄4 Recommend that the CFTC adopt an overall limit on the amount of specu3⁄4 Urge the CFTC to consider separate action directed at index fund activity3⁄4 Other Reform Act rulemakings: e.g. Large traders have simultaneous po

(i.e. London, etc..), so the DOT should remain involved with the CFTC to a

resulting from public comment do not violate the “bill’s intent.”

3⁄4 Communicate DOT views informally with Chairman Gensler, other membe

Note: Wall Street dealers are pushing to ‘defang’ Dodd-Frank legislation in 

Making process, and unless DOT stays involved, there's a good chanRecall: the banks are responding to their own interests (and fiduciary 

case run contrary to the broader public and global community.

The future of the airline industry and other transportation 

on the availability and the fair pricing of fuel

Source: ATA & Hudson Securities e
Further Reference Materials

 Dissent of Fowler West (9/20/1990); http://www.cftc.gov/ucm/groups/public/@aboutcftc/documents/f

Commissioner of the Commodity Futures Trading C

 “Placing the 2006/08 Commodity Price Boom into Perspective” Baffes & Haniotis;  “The 2008 Boom / Bust in Oil Prices” Kenneth J Singleton (Stanford University) “Index Investment and the Financialization of Commodities” (June 2010) Ke Tang  “The Three Epochs of Oil” (Aug 2009) Eyal Dvir (Boston College) and Kenneth S.  The Accidental Hunt Brothers: How Institutional Investors are Driving up Food and 

Masters, M.W., and White, A.K.

 “Who is Responsible for the Food Crisis”. Globe and Mail (Toronto; 5/31/08) “The Food Bubble”; How Wall Street Starved Millions and Got Away with It

Frederick Kaufman; Harpers Magazine (July 2010)

 “Who is in the Oil Futures Market and How Has it Changed?”

Medlock and Jaffe; James A. Baker III Institute For 

 “The Merchants of Grain”; Dan Morgan  “Comments of the Air Transport Association of America, Inc”; Dave Berg (General  “Better Markets”; Review of Irwin Sanders 2010 OECD Reports; David Frenk and  Too many others to list on one page
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No part of the compensation received by the analyst principally responsible for the preparation of this report was, is or 

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