Daniel McKenzie, CFA - Hudson SecuritiesFuture of Aviation Advisory CommitteeCompetition SubcommitteeAugust 4, 2010‘Excessive’Speculation in theFutures Markets Impacts Oil Prices“Financial speculators in oil are costing consumers atleast $300B a year, according to almost 75% of theindustry players surveyed by Reuters.”- David Sheppard of Reuters (4/27/10)2Recognition / Appreciation~Special thanks to Dave Berg, David Frenk, JohnHeimlich, Ben Hirst, and Mike Masters, all of whom didthe heavy lifting for this presentationSeparately, special thanks to Fowler West- Appointed to CFTC (1982-93)by President Reagan. Workedto bring some regulatorystructure to derivativesbut found few allies on the CFTC at that time.3Background - Why ImportantFuel expense historically 10-12% of overall costs (as high as 40%, today 30%)As an airline analyst, worked with fundamental energyanalysts & prop tradersPerverts Economics: In 2008, U.S. AirlinesSpent $16B More on Fuel Than in 2007and $42B More Than in 20033⁄4A $1 change in oil pricesequals $425-$475M in annual expenses3⁄4So, a $20 move in WTI costsairlines roughly $9B (whichcould otherwise be spent on newplanes, or a wage increase for labor).3⁄4Price volatility resulting from excessive speculating is damaging asit makes the cost ofhedging more expensiveGiven high fixed cost structures, airlines poorly positioned torespond quickly torapid moves in fuel prices (the initial spike in fuel prices in 2005 a major factorbehind Ch. 11 filings by Deltaand Northwest – see Slide 9).Consumers adversely affectedby higher fare prices (LUV’s avg fare today is $132vs $94 in 2005, a 40% increase)Airline management teams have afiduciary duty to shareholders to make sure that30% of their costs are not being driven byexcessive speculation or manipulation.Source: ATA and Hudson Securities ests.4Competing Ideas for Oil Price Volatility (View #2 Has Won)Source: Tang & Xiong (2010); pg 1, 2, &12; Masters; & Hudson Securities ests.View #1: The conventional view among manyeconomists is partially correct, butregrettably, incompleteCommodity prices soared in 2008because of surging demand, propelledby rapid growth of emergingeconomies.Prices later fell when the Great Recession promptedslower demand; Speculative activity dismissed asa causeSimplifying assumptions used to reach conclusions don’t match the real worldView #2: Attributes high prices & volatility ofprices to distortions caused by the largeinvestment flows into commodity indicesAccording to a CFTC staff report (2008) and Masters (2008), the total value of various commodityindex-related instruments purchasedby institutional investors wentfrom $15B in 2003to $260B in2008 (& could quadrupleto $1 trillion).The World Bank; Oppenheimer; Goldman Sachs; Citigroup; Offit CapitalAdvisors; Stanford (Singleton)and Princeton (Xiong) economics faculty are all on record acknowledging that forces beyond supply &demand drove pricesTraditional speculators, commodity producers, & commercial users are all important, but havelimited capacity to absorb price impact from index investors trades5Congress Has Acted - DOT Involvement EssentialUS Permanent Subcommittee on Investigations (2009) argued dramatic indexrelated investment flow distorted the price of some commoditiesTheDodd-Frank Wall Street Reform& Consumer Protection Actattacksexcessive speculation & market manipulation3⁄4Directs CFTC to set aggregate position limits on speculative trading3⁄4Requires derivatives totrade on exchanges withreal-time reporting3⁄4Narrow exemption for true physical hedgers3⁄4Wall Street dealers are trying to undermineDodd-Frank as it goes to rule makingDOT Involvement Essential3⁄4Both the volatility and the level of energy prices directlyimpact the public and are atodds with a stable transportation infrastructure which makes DOT involvementessential3⁄4Dedicate DOT resources to assist the CFTCSource: ATA, Tang & Xiong 2010 pg 26The Commodities Markets (What We’re Talking About)Source: Tang & Xiong 2010; pg 6 &33 & Hudson Securities Ests#Commodities GSCI DJ-UBS Exchange Contracts1 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 MonthSub-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 & Dec10 Minneapolis Whea--MGE Mar, May, Jul, Sep & Dec11 Soybean Meal --CME Jan, Mar, May, Jul, Aug, Sep, Oct & Dec12 Rough Rice --CME Jan, Mar, May, Jul, Sep & Nov13 Oats --CME Mar, May, Jul, Sep & Dec14 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 & Nov19 Orange Juice --ICE Jan, Mar, May, Jul, Sep & Nov20 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, Aug24 Gold 1.5% 6.1% NYMEX Feb, Apr, Jun, Aug, Oct, Dec25 Silver 0.2% 2.4% NYMEX Jan, Mar, May, Jul, Sep, Oct26 Copper 2.6% 6.7% NYMEX Mar, May, Jul, Sep, & Dec27 Platinum --NYMEX Jan, Apr, Jul, & Oct28 Palladium --NYMEX Mar, Jun, Sep, & Dec

Energy Sector Grain Sector Soft Sector Livestock Sector

Metals Sector*Commodities (particularly WTI) arefrequently a favorite topic onCNBC’s “Fast Money” Segment3 Investment Vehicles ThatMake Fast Money* Possible1Commodity Index Swaps2Exchange Traded Funds(ETFs)3Exchange Traded NotesNote: index compositions canchange over time; perwww.wikipedia.com(on 8/4/2010),Energy comprised 79% of the GSCIas of 5/23/2008.7Source: Masters1987– 2003 excluding First Persian Gulf WarInventories Used to Be a Good Price Predictor8Inventories 1987 – 2003(including First Persian Gulf War)Source: Masters9But in 2004, it Began to Change (Inventories 1987 – 2004)Source: Masters & Hudson Securities EstsDelta and Northwest struggledwith higher fuel prices;both extracted huge concessions from labor &predicated business plans on$35 WTI (conservative atthe time). $50+ Crude an outof nowhere curveball thatnot even Wall Street energy analysts anticipated.10Inventories 1987 – 2005Fundamental Energy Analysts continuedto declare that the Supply DemandBackdrop Didn’t Support Prices (Citigroup)Source: Masters & Hudson Securities Ests11Inventories 1987 – 2006“The Surf’s Up”Source: Masters & Hudson Securities Ests12Inventories 1987 – 2007Drumbeats of an economic downturngetting louder; news of aworsening economy / slowing economy frequently makeheadline new. Stocks began a steady decline from Julyonwards suggesting a slowing economy loomed and thus,slowing demand for oil.Source: Masters & Hudson Securities Ests13Inventories 1987 – 2008Jun/Jul 2008: Goldman Sachs publishes $200 PT for WTI even asFannie & Freddie experience financial distress and the economicdownturn is well underway.Feb 2008: Greenspan declares a 50% probability of arecession. Real estate pricesare already under great pressure.Source: Masters, Citigroup & Hudson Securities Ests“Despite the economic gloom many commodityprices hit new highs in recent weeks, driven largelyby investment inflows.” - Citigroup “A Tidal Waveof Fund Flow” (April 7, 2008)Note: Speculators didn’t behave theway macro economists would predict(ie. no oil hording)14Prop Trader Perspective – Post Crash, Aug 2008“When you look at it from a market dynamicperspective, the big trade that you had ...on thespeculative side - a number of big trades -- were...people ... short crude oil,long natural gas basedon a BTU convergence.”“They’re a lot of people who wereshort crude versus baskets of various equities viewing that as agood play and there were a lot of macro playerswho were short crude. Soas we’ve come down --and come down prettymaterially -- you’re actually seeing a lot of those different types unwind thosetrades...”Source: Publicly Available Info / Aug 2008Key Take-AwaysTraditional speculators that invested ona fundamental supply demand view had adifficult time overcoming the power of long-only index money.The only way to truly understand demand isto disaggregate trading volume byparticipant. Academic researchers and eventhe CFTC itself haven’t had access totrading information across all markets inwhich speculative activity has occurredWTI average daily volume is about 600-800Kcontracts. Index speculators range from25% to over 50% of open interest. In 2008,index speculation effectively owned more oilsynthetically than the US Strategic Reserve.Source: Better Markets, Inc.and Hudson Securities Ests15Example of Distorted Decision MakingSlide Intentionally Left Partially BlankKey Take-Away:Fear and greed frequently rule markets, with sentiment often timesextreme one way or the other (whichis in contrast to “rationalexpectations” broadly assumed bymany macro economists)Source: Goldman Sachs and Hudson Securities ests.16Markets Are Not Always Efficient (A Fast Money* Society)Reasons for market failures:1.Imperfect, misunderstood, or misinterpreted information frequently distortsinvestment decision making....thus resulting in...2. Excessive technical order imbalanceswhich distort information contained inprices. So even if other participants are being perfectly rational, the presence ofexcessive trades means the information theyare rationally processing is flawed.3⁄4DOE weekly releases helpful, but actualsupply and demand for oil is virtuallyimpossible to forecast looking ahead.e.g. OPEC vs. Non-Opec production capability; countries that are nationalizing oil production vs.refineries subsequently falling into disrepair;actual consumption andelasticity vs. perceivedconsumption and elasticity patterns).3⁄4Standard economic theory states: speculation is a naturalconsequence whenproblems exist in “core learning.”3⁄4Most Portfolio Managers and investment decision makers are generalists(hence their reliance on Wall Street experts).Key Take-Away: the market cannotdistinguish between buying fromconsumers and buying from speculators, so there's no way totell precisely from where a price increase or decrease comes*Fast Money is a segment on CNBC. Source: Better Markets,Inc & Hudson Securities Ests17Market Failure Ex 1 - dot.com BubbleDow Jones Composite Internet Index0100200300400500600 7 / 4 / 1 9 9 7 9 / 4 / 1 9 9 7

1 1 / 4 / 1 9 9 7 1 / 4 / 1 9 9 8 3 / 4 / 1 9 9 8 5 / 4 / 1 9 9 8 7 / 4 / 1 9 9 8 9 / 4 / 1 9 9 8

1 1 / 4 / 1 9 9 8 1 / 4 / 1 9 9 9 3 / 4 / 1 9 9 9 5 / 4 / 1 9 9 9 7 / 4 / 1 9 9 9 9 / 4 / 1 9 9 9

1 1 / 4 / 1 9 9 9 1 / 4 / 2 0 0 0 3 / 4 / 2 0 0 0 5 / 4 / 2 0 0 0 7 / 4 / 2 0 0 0 9 / 4 / 2 0 0 0

1 1 / 4 / 2 0 0 0 1 / 4 / 2 0 0 1 3 / 4 / 2 0 0 1 5 / 4 / 2 0 0 1 7 / 4 / 2 0 0 1 9 / 4 / 2 0 0 1

1 1 / 4 / 2 0 0 1 1 / 4 / 2 0 0 2 3 / 4 / 2 0 0 2 5 / 4 / 2 0 0 2 7 / 4 / 2 0 0 2 9 / 4 / 2 0 0 2

1 1 / 4 / 2 0 0 2 1 / 4 / 2 0 0 3 3 / 4 / 2 0 0 3 5 / 4 / 2 0 0 3

Index PriceSource: Bloomberg18Market Failure Ex 2 – Hi-Tech BubbleSource: BloombergS & P 500 Information Technology Index020040060080010001200 1 1 / 1 8 / 1 9 9 4 2 /1 8 / 1 9 9 5 5 /1 8 / 1 9 9 5 8 /1 8 / 1 9 9 5

1 1 / 1 8 / 1 9 9 5 2 / 1 8 / 1 9 9 6 5 /1 8 / 1 9 9 6 8 / 1 8 / 1 9 9 6

1 1 / 1 8 / 1 9 9 6 2 /1 8 / 1 9 9 7 5 /1 8 / 1 9 9 7 8 /1 8 / 1 9 9 7

1 1 / 1 8 / 1 9 9 7 2 /1 8 / 1 9 9 8 5 / 1 8 / 1 9 9 8 8 /1 8 / 1 9 9 8

1 1 / 1 8 / 1 9 9 8 2 /1 8 / 1 9 9 9 5 /1 8 / 1 9 9 9 8 /1 8 / 1 9 9 9

1 1 / 1 8 / 1 9 9 9 2 / 1 8 / 2 0 0 0 5 /1 8 / 2 0 0 0 8 / 1 8 / 2 0 0 0

1 1 / 1 8 / 2 0 0 0 2 /1 8 / 2 0 0 1 5 / 1 8 / 2 0 0 1 8 /1 8 / 2 0 0 1

1 1 / 1 8 / 2 0 0 1 2 /1 8 / 2 0 0 2 5 /1 8 / 2 0 0 2 8 /1 8 / 2 0 0 2

1 1 / 1 8 / 2 0 0 2 2 /1 8 / 2 0 0 3 5 /1 8 / 2 0 0 3 8 /1 8 / 2 0 0 3

1 1 / 1 8 / 2 0 0 3

Index Price19Market Failure Ex 3 - Telecom BubbleDow Jones US Telecom Index050100150200250300350400 1 1 / 1 3 / 1 9 9 2 2 / 1 3 /1 9 9 3 5 / 1 3 /1 9 9 3 8 / 1 3 /1 9 9 3

1 1 / 1 3 / 1 9 9 3 2 / 1 3 /1 9 9 4 5 / 1 3 /1 9 9 4 8 / 1 3 / 1 9 9 4

1 1 / 1 3 / 1 9 9 4 2 / 1 3 /1 9 9 5 5 / 1 3 /1 9 9 5 8 / 1 3 /1 9 9 5

1 1 / 1 3 / 1 9 9 5 2 / 1 3 /1 9 9 6 5 / 1 3 /1 9 9 6 8 / 1 3 /1 9 9 6

1 1 / 1 3 / 1 9 9 6 2 / 1 3 /1 9 9 7 5 / 1 3 /1 9 9 7 8 / 1 3 /1 9 9 7

1 1 / 1 3 / 1 9 9 7 2 / 1 3 / 1 9 9 8 5 / 1 3 /1 9 9 8 8 / 1 3 /1 9 9 8

1 1 / 1 3 / 1 9 9 8 2 / 1 3 / 1 9 9 9 5 / 1 3 / 1 9 9 9 8 / 1 3 /1 9 9 9

1 1 / 1 3 / 1 9 9 9 2 / 1 3 /2 0 0 0 5 / 1 3 / 2 0 0 0 8 / 1 3 / 2 0 0 0

1 1 / 1 3 / 2 0 0 0 2 / 1 3 /2 0 0 1 5 / 1 3 /2 0 0 1 8 / 1 3 /2 0 0 1

1 1 / 1 3 / 2 0 0 1 2 / 1 3 /2 0 0 2 5 / 1 3 /2 0 0 2 8 / 1 3 /2 0 0 2

1 1 / 1 3 / 2 0 0 2 2 / 1 3 / 2 0 0 3 5 / 1 3 /2 0 0 3 8 / 1 3 /2 0 0 3

1 1 / 1 3 / 2 0 0 3

Index PriceSource: Bloomberg20Market Failure Ex 4 – Real Estate BubbleDow Jones US Real Estate Index050100150200250300350400 1 1 / 1 0 / 2 0 0 0 2 /1 0 / 2 0 0 1 5 /1 0 / 2 0 0 1 8 /1 0 / 2 0 0 1

1 1 / 1 0 / 2 0 0 1 2 /1 0 / 2 0 0 2 5 /1 0 / 2 0 0 2 8 / 1 0 / 2 0 0 2

1 1 / 1 0 / 2 0 0 2 2 /1 0 / 2 0 0 3 5 /1 0 / 2 0 0 3 8 / 1 0 / 2 0 0 3

1 1 / 1 0 / 2 0 0 3 2 /1 0 / 2 0 0 4 5 / 1 0 / 2 0 0 4 8 /1 0 / 2 0 0 4

1 1 / 1 0 / 2 0 0 4 2 /1 0 / 2 0 0 5 5 / 1 0 / 2 0 0 5 8 /1 0 / 2 0 0 5

1 1 / 1 0 / 2 0 0 5 2 /1 0 / 2 0 0 6 5 / 1 0 / 2 0 0 6 8 /1 0 / 2 0 0 6

1 1 / 1 0 / 2 0 0 6 2 /1 0 / 2 0 0 7 5 / 1 0 / 2 0 0 7 8 /1 0 / 2 0 0 7

1 1 / 1 0 / 2 0 0 7 2 /1 0 / 2 0 0 8 5 /1 0 / 2 0 0 8 8 /1 0 / 2 0 0 8

1 1 / 1 0 / 2 0 0 8 2 /1 0 / 2 0 0 9 5 /1 0 / 2 0 0 9 8 /1 0 / 2 0 0 9

1 1 / 1 0 / 2 0 0 9 2 /1 0 / 2 0 1 0 5 /1 0 / 2 0 1 0

Index PriceSource: Bloomberg21“You have a generalized commodity bubbledue to commodities having become anasset class that institutions use to an increasing extent.”George Soros, April 17, 2008Market Failure Ex 5 – Commodities BubbleSource: A Short History of Financial Deregulation in the US; Matthew Sherman; Globe and Mail(Toronto; 5/31/08); Bloomberg; and Hudson Securities ests.Price Chart for WTI Futures020406080100120140160 4 / 1 / 1 9 8 3 4 / 1 / 1 9 8 4 4 / 1 / 1 9 8 5 4 / 1 / 1 9 8 6 4 / 1 / 1 9 8 7 4 / 1 / 1 9 8 8 4 / 1 / 1 9 8 9 4 / 1 / 1 9 9 0 4 / 1 / 1 9 9 1 4 / 1 / 1 9 9 2 4 / 1 / 1 9 9 3 4 / 1 / 1 9 9 4 4 / 1 / 1 9 9 5 4 / 1 / 1 9 9 6 4 / 1 / 1 9 9 7 4 / 1 / 1 9 9 8 4 / 1 / 1 9 9 9 4 / 1 / 2 0 0 0 4 / 1 / 2 0 0 1 4 / 1 / 2 0 0 2 4 / 1 / 2 0 0 3 4 / 1 / 2 0 0 4 4 / 1 / 2 0 0 5 4 / 1 / 2 0 0 6 4 / 1 / 2 0 0 7 4 / 1 / 2 0 0 8 4 / 1 / 2 0 0 9 4 / 1 / 2 0 1 0

WTI Futures Price (CL1)No Limits on SpeculationCommodity Futures Modernization Act -Passed withthe support from the Clinton Administration, incl TreasurySecretary Lawrence Summers, and bi-partisan supportin Congress. The Bill prevented the Commodity FuturesTrading Commission from regulating most over-thecounter derivative contracts, including credit defaultswaps.Source: A Short History of Financial Deregulation in the US; M atthewLimits on SpeculationTransnor Case:Paved theway for wide-rangingdergulation of commoditiestrading, an effort that helped tospur the rise of Enron.Source: Globe and M ail; "Who is Responsiblefor the Food Crisis"1991: “For the 1sttime, a bankapproaches aCFTC regulator torequest anexemption fromspeculative tradinglimits.”22So, Supply Demand Horrible, but it Doesn’t Tell the Whole StoryThe CFTC Has Concluded:“Large concentrated positions in the energyfutures and option markets can potentiallyfacilitate abrupt price movements and price distortions.”Congress has determined that “extreme or abrupt price fluctuations attributable tounchecked speculative positions areharmful to the futures markets.- CFTC, January 26, 2010Separately:“Apart from strong and sustained economicgrowth, the recent boom was fueled bynumerous factors, including low past investmentin extractive commodities, weak dollar,fiscal expansion, and lax monetary policy inmany countries, and investment fund activity.”- World Bank report from July 2010by Baffes and Haniotis;“Putting the 2006/2008 Commodities Boom into Perspective”“The world’s financial and oil markets are becoming increasingly connected and oil pricesare no longer driven by the fundamentals of supply and demand alone.”- Daniel Yergin, December 2007Co-founder/Chairman of Cambridge Energy Research Associates“No matter how bad the spot market looks fundamentally, prices can riseas long as storageeconomics are positive. Thus, if investors buy oil futures based on economic recovery,stagflation or peak oil,speculation can drive up the spot price of oil.”- Adam Robinson – RBS Sempra Commodities23Creation of unregulatedmarkets in 2000 facilitated shift to treatingcommodities as an asset class, which led to explosive money flow intomarkets3⁄4Volume of paper demand for oil far exceeds physical demand3⁄4Price discovery function of futures market distorted or worseEnergy Information Administration (DOE) - Financial Markets Initiative3⁄4“Energy markets have developed inways that were not anticipated”3⁄4EIA’s traditional coverage offundamentals must be expanded3⁄4EIA will assess the market influences of speculation, hedging,investment, interest rates andexchange ratesWhy Fundamentals Do Not Tell the Whole Story24Source:Masters(GoldmanSachs,Standard&Poor’s,DowJones,calculationsbaseduponCFTCCITreport.Mid2008figureisasofJuly1.)Passive Commodity Index Pushed UpOil Prices; Energy=58% GSCI25Paper Dominates PhysicalSource:Masters(Bloomberg,EIA)26532.385.4469.302004006008001,0001,200World Consumption Oil Traded on ExchangesA Billion Barrels of Crude Traded Daily on Exchanges in 2008In 2008, Paper Market – Not Even Counting OTC Markets – Almost 12X PhysicalSources:CitiFuturesPerspective,InternationalEnergyAgency,NewYorkMercantileExchange(NYMEX)andLondonIntercontinentalExchange® (ICE)

Daily Barrels of Crude Oil (Millions) –20081,001.6

1 1 . 7 XICENYMEXSource: www.airlines.org26“If the US, the greatest country inthe world, cannot ensure thepublic that it can provide soundregulatory oversight of matureenergy commodity markets withintegrity, thenhow can it evertrade carbon without market fraudand manipulation?”Paul Cicio, Industrial Energy Consumersof America (July 17, 2008)27Large amounts of institutional investormoney flowed into commodities futuresgenerally, and oil futures specifically beginning 2004The pace of inflows accelerated substantially at the beginning of 2008This created a speculative bubble in oil prices which popped in the middle of 2008Since March of 2009 this echo-bubble hasbeen steadily re-inflating at even fasterrates than 2008For example (see following slides)What Really Happened in 2008 – A Wall of Investor MoneySource: Masters28Source:Masters(basedonCFTCCITreport)$25‐$30BillionFlowsintoIndices130‐150MillionBarrelsareBoughtPricesrisefrom$58‐$96(+65%)200729$45‐$65BillionFlowsintoIndices145‐165MillionBarrelsareBought>1MillionBarrelsperTradingDayPricesrisefrom$96‐$137(+42%)1stHalf 2008Source:Masters(basedonCFTCCITreport)30$60‐$80BillionFlowsoutofIndices230‐260MillionBarrelsareSold~2MillionBarrelsperTradingDayPricesfallfrom$137‐$39(‐72%)2ndHalf 2008Source:Masters(basedonCFTCCITreport)31$95‐$115BillionFlowsintoIndices350‐400MillionBarrelsareBought>2MillionBarrelsperTradingDayPricesrisefrom$39‐$79(+102%)2009Source:Masters(basedonCFTCCITreport)32$10BillionInflowFirstWeekofAprilOilpoppedfrom$82toalmost$872007 – 2010Source:Masters(basedonCFTCCITreport)33Source:Masters(Bloomberg.Rolling3monthaverageof3monthdailycorrelationofpriceschanges–U.S.DollarIndex(DXY)toWTICrudeOil).Dollar vs. WTI34Source:Masters(Bloomberg.Inflationexpectationis10YearU.S.Treasuryminus10YearU.S.TreasuryInflationProtectedSecurities[TIPS])Inflation vs. WTI35Source:Masters(Bloomberg.Rolling3monthaverageof3monthdailycorrelationofpriceschanges–S&P500toWTICrudeOil)S&P vs. WTI36PersistentContangoSource:Masters(Bloomberg.Monthlyaveragesofannualizedspreadbetween7thWTIcrudeoilfuturefromexpirationand1stWTIcrudeoilfuturefromexpiration)Persistent Contango37Oil Now “Financialized”Investors have transformed the price discovery function for oil because theynow dominate the oil derivatives markets from a volume trading perspective.Oil futures (paper contracts) havebecome a financial “asset” that nowcorrelates with financial markets;3⁄4Because of “core learning” issues and uncertainty over truesupply being producedor stored, participants don’tknow the true supply or demand and instead infer fromcurrent physical spot price from futures prices what other people may know.3⁄4That is, oil traders and end users rely heavily on pricing services such as Platt’s* todetermine the spot price of oil, which in turn, relies heavily on futures prices (whichare the most readily available information about market activity)Because it’s “financialized,” oil pricesare now subject to speculative boomsand bustsGovernments must take steps to re-instate speculative position limits in thederivatives markets and severely restrict the phenomenon of passiveinvestment.Source: *Platts Oil Pricing and Market-on-Close Methodology Explained – ABackground (Platts McGraw-Hill, 2007); Masters; and Hudson Securities ests.38Why Do Many Academics and Investment Banks Disagree?All Trying Hard, but, Key AssumptionsInconsistent with Actual MarketsInvestors have perfect foresight and themarkets are rational; thus no role forspeculation in mostmodels (e.g. Hamilton)Elasticity of demand estimates a source oferror. It varies not only by country, butalso by market participant (absent frommost models). Separately, there is demandfor immediate consumption, but alsofor sovereigns reserves which changesperiodically (China, U.S.). In short, there are too many elasticity variables to list. Asmall change in an elasticity assumption can lead to wildly varying conclusions;Rogoff (Harvard); Credit Suisse Strategist (2008)Investment Banks: Have the opposite Fiduciary Duty vs airlines. Banks have a dutyto defend, preserve, & protect for their shareholders profits earned fromcommodities activities (so don’t expect public acknowledgements).However:All of economic theory says there will bespeculation when there are problems incore learning and when there is uncertainty over key components of economicgrowthThe problem is not speculators per se, but the magnitude of speculative money thathas come to dominate the commodities marketSource: Hudson Securities ests39DOT’S Role Going ForwardQ: How much speculation is necessary to allow the markets to function smoothly?A: No more speculative activity that is necessary to provideliquidity and price discoveryfor hedging.According to industry sources; CFTC Chairman Gensler would appreciate the DOT’sinvolvement3⁄4Secretary LaHood has a history of activelyworking with the CFTC going back to the early 1990sRequest involvement with CFTC on rulemaking process & speculative position limits3⁄4Dedicate DOT resources to assistthe CFTC & also file comments in forthcoming rulemaking.3⁄4Recommend that the CFTC adoptan overall limit on the amountof speculation in the markets3⁄4Urge the CFTC to consider separate action directed at index fund activity3⁄4OtherReform Actrulemakings: e.g. Large traders havesimultaneous positions here and globally(i.e. London, etc..), so the DOTshould remain involved withthe CFTC to assure loop holesresulting from public comment donot violate the “bill’s intent.”3⁄4Communicate DOT views informally with Chairman Gensler, other members, & key staffNote: Wall Street dealers are pushing to ‘defang’ Dodd-Frank legislation in the RulemakingMaking process, and unless DOT stays involved,there's a good chance Wall Street wins.Recall: the banks are responding totheir own interests (and fiduciary duties), which in thiscase run contrary to the broader public and global community.The future of the airline industryand other transportation modes dependon the availability and the fair pricing of fuel.Source: ATA & Hudson Securities ests.40Further Reference MaterialsDissent of Fowler West (9/20/1990);http://www.cftc.gov/ucm/groups/public/@aboutcftc/documents/file/fwestdissent092090.pdfCommissioner of the Commodity Futures Trading Commission“Placing the 2006/08 Commodity Price Boom into Perspective” Baffes& Haniotis; World Bank (July 2010)“The 2008 Boom / Bust in Oil Prices”Kenneth J Singleton (Stanford University)“Index Investment and the Financialization of Commodities” (June 2010)Ke Tang & Wei Xiong (Princeton)“The Three Epochs of Oil” (Aug 2009)Eyal Dvir (Boston College)and Kenneth S. Rogoff (Harvard)The Accidental Hunt Brothers: How Institutional Investors are Driving up Foodand Energy Prices (2008)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 ItFrederick Kaufman; Harpers Magazine (July 2010)“Who is in the Oil FuturesMarket and How Has it Changed?”Medlock and Jaffe; James A. BakerIII Institute For Public Policy (2009)“The Merchants of Grain”;Dan Morgan“Comments of the Air Transport Association ofAmerica, Inc”; Dave Berg (General Counsel)“Better Markets”; Review of Irwin Sanders 2010OECD Reports; David Frenk and Staff (6/30/2010)Too many others to list on one page41IMPORTANT NOTICES AND DISCLOSURESAs of this publication, Hudson Securities Inc. makes a market in securities of the companies mentioned in this report.In the course of normal business, Hudson Securities Inc. (the “Firm”) intends to seek compensation for investment banking or non-investmentbanking services from the companies in its coverage universe.No part of the compensation received by the analyst principally responsible for the preparation of this report was, is or willbe directly or indirectlyrelated to the specific recommendations and guidance expressed in this report. Direct or indirect analyst compensation may bebased onperformance-related considerations with the recommendation and guidance expressed by the analyst in this report.Hudson Securities assigns researchequity ratings of Buy,Hold and Sell. For Buys, we willpublish a 12-monthtarget price forany stock with anestimated appreciation potential of at least 20% or more. 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The securities described herein may not be eligible for sale in alljurisdictions or to certain categories of investors. Further, this report is not intended as an offer or solicitation to buy or sell any securities orrelated instruments.Past performance is not necessary indicative of future results. The investments discussed or recommended in this report may notbe suitable forspecific investment objectives, financial situations or needs of the reader, and should not be relied upon without consultationwith aninvestment professional. Opinions expressed in this report are subject to change without notice.42IMPORTANT NOTICES AND DISCLOSURESFrom time to time, the Firm, its officers, directors, employees, customers, affiliates may have longor short position in the securities of company(ies)discussed herein and, at any time, may make purchase or sales as principal or agent. The Firm, or persons related thereto, maymakemarket in the securities mentioned herein, and may from time to time perform investment banking or other services for, or solicit investmentbanking or other business from, and may have other relationships with any company mentioned in this report.Hudson Securities accepts no liability whatsoever for any loss or damage of any kind arising out of the use of any part, or all, of this report. Thisreport is for distribution only under such circumstances as may be permitted by applicable law, and may not be reproduced or distributed inany form without the specific consent of Hudson Securities. Redistribution of this report, via Internet or otherwise, withoutpermission isspecifically prohibited. Hudson Securities accepts no liability for the actions of third parties in this regard.Additional information is available upon request.FootnotesThe research analyst or a member of his/her household does not own equity securities of this company.The research analyst or a member of his/her household is not an officer, director or board member of this company.The research analyst or a member of his/her household did not receive compensation from this company in the past 12 months.Hudson Securities officers do not serve as officers, directors or board members of this company.Hudson Securities has not managed or co-managed a public offering of securities for this company in the past 12 months.Hudson Securities has not received compensation for investment banking services from this company in the past 12 months.Hudson Securities has not received compensation for products or services other than investment banking services from this company in the past 12months.Hudson Security does not beneficially own 1% or more of equity securities of this company.This company is, or during the past 12 months prior to this research distribution was not, a client of Hudson Securities.43CORPORATE HEADQUARTERS:111 Town Square PlaceJersey City, NJ 07310Telephone: 201.216.0100Email:Info@hudsonsecurities.comwww.hudsonsecurities.comChicago:1 East Wacker Drive, Suite 2920Chicago, IL 60601Georgia:6 Concourse Parkway, Suite 1460Atlanta, GA 30328Tinton Falls, NJ:106 Apple Street, Suite 200CTinton Falls, NJ 07724Florida:5550 Glades Road, Suite 304Boca Raton, FL 33431Connecticut:488 Main AvenueNorwalk, CT 06851Cleveland, OH:600 Superior Avenue East – Suite 1300Cleveland, OH 44114Hudson Securities, Inc. is a member of FINRA and the SIPC. It is a subsidiary of publicly traded Hudson Holding Corporation(OTCBB “HDHL”). Please be advisedthat this document constitutes Institutional Sales Materialunder Rule2211. This isneither an offer nor a solicitation of an offer to buy or sell securities. This is for use by professional or institutional investorsonly. No investments or services mentioned or described herein are available to "private customers."