[PhebaAndThePilgrim]

Good day From Pheba, still from the farm, lol.
My husband came home from work all upset yesterday because he heard on the radio that "oil futures trading" had just been released to the general public.
I was exhausted from a day of gardening, and barely understood what he was trying to say to me.
He said that this situation is very similar to what happened in the 1920's that triggered the Great Depression.
I am a total moron when it comes to economics. Gardening I understand, economics is confusing.
What is "oil futures trading", and is my husband correct?
I would really like to impress him that I have half a clue about a what's happening.
Pheba

[rogerhb]

More legalised gambling.

One of the claimed causes of the stock market crash in 1929 was mom and dad getting loans to buy shares, as they were told it was a dead-cert.

[mark]

What you've said he said makes no sense.

Oil is traded, like many other commodities, at exchanges commonly called 'futures markets.' The public has always been able to participate in this form of trading.

Search on 'futures charts' for more info.

[rogerhb]

$this->bbcode_second_pass_quote('mark', 'T')he public has always been able to participate in this form of trading.

[CARVER]

$this->bbcode_second_pass_quote('rogerhb', '')$this->bbcode_second_pass_quote('mark', 'T')he public has always been able to participate in this form of trading.

[zberry]

Is he concerned because the new ETF (USO) will create additional extra demand for oil and therefore cause the price to increase more/faster than it would otherwise?

[Pops]

To my little brain, the Pinstripe Casino should be limited to those that produce and use commodities – period. None of the options crap; you want 100 pork belly contracts? Fine, where do you want them delivered? The bellies that is.

Huge investment funds and probably half the members of this board for that matter add absolutely nothing except volatility to the markets. When they decide this or that commodity is undervalued and therefore is the next big thing, they buy massive positions in the hope the price will rise and they’ll get some money for nothing.

Of course if enough of these investors (and I use the term loosely since their only vesting is in money-for-nothing) buy in, the price rises above what it should naturally be due to their false demand and/or crashes when they bail out.

Now if it were only the gamblers who lost money – since for someone to make money someone must lose money, I wouldn’t give a rip. But the producers of many of these commodities are just little guys without the time, resources, or wherewithal bet the farm on much more than the weather. I’m talking about ag related producers here.

Of course there would still be variability due to any number of factors but the false demand of huge institutional funds that never expect to make anything tangible with the commodity and don’t give a rip about either the producer or consumer just hacks me off!

No real surprise to me that small farmers go belly-up

[DoctorDoom]

We could well fall into a re-run of the great depression, but it won't be caused by futures trading. Here's probably more than you want to know about futures.

Oil, like all commodities, is traded globally on a number of exchanges. There's a "spot" market for oil that has nearly immediate delivery - this isn't any different (except for scale) to you pulling up to the gas station and taking immediate delivery of gasoline, paying today's price.

That's not the whole story, though. Commodities have long value chains, ranging from people who find/grow/mine/whatever the raw product all the way through finishers/refiners/whatever down to, well, us the consumers. Because of this, people involved in these businesses often want to arrange to buy (or sell) a product that they know they'll need (or produce) at some point in the future. Whether it's oil or oranges, a lot of people want to be sure that someone will take something they're pumping/growing today at a known price, while others want to ensure that some input they need (refiner needs to know where his oil's coming from next month, orange juice company needs to know where his oranges are coming from) will be there, and at a known price.

Futures markets enables people to buy and sell contracts to deliver or receive goods at later points in time. Generally, there are contracts on each that come due monthly, and are traded out years into the future. You can look at the prices of contracts for oil going out 2 years and get a sense for where the traders collectively think the market's headed. Don't kid yourself that you know more than they do because you're a PO'er, those professional traders are sharp and they'll skin you alive.

The existence of the futures markets means that even people without any interest in the underlying commodity can buy or sell contracts for it. People have been piling into these markets over the past few years, riding the boom in commodity prices. Indeed, it's likely that much of the trading activity in, say, oil, is done by investors basically betting against each other. There are likely many more contracts outstanding than there are units of the commodity actually being delivered through the system. Obviously if you've sold a futures contract (shorted it) but you don't have the goods, you're going to have to buy it back before the contract deadline, or you'll be stuck having to deliver the goods that you don't have.

Now, a lot of oil and other commodities change hands completely outside of this system, but the system still serves a function - it sets the market price on which other deals are based. Even if you (a refiner) are making a deal for oil from a producer for oil at regular intervals over the next 5 years, how are you going to agree on a price? Answer: you are going to look at the futures prices and then haggle based on that information.

A lot of people think futures trading is the spawn of the devil, and I don't really understand that. Markets are efficient, at least at price-setting. I wish everything I bought had a price established by a completely open, public market. Instead, you and I get ripped off every day because of inefficiencies and information-hiding built into most other pricing processes. (The internet is changing that, though, e.g. prices on high-tech goods.)

Some dangers in the futures market:

You don't have to put up all the money to buy a futures contract, you just have to put a down payment. This is reasonable, after all you don't have the goods yet. Oil is traded in 1000 barrel units, but you don't have to plump down $70k to buy a contract for, say, June. As little as $4k might do the trick. Naturally, if the price heads south, you're still on the hook for the full $70k. If the price drops to, say, $60 / barrel, you're down $10k but you only put up $4k, so your broker will demand that you pony up the $10k, or he'll sell out your position. Actually the broker would do that before you went "negative" in the position - the $4k is supposed to be enough to ride out any minor fluctuations so he's not calling you every day for more money.

You can buy options on futures contracts. The option to buy doesn't obligate you to buy, but it guarantees you a price in the future. This is a so-called "derivative" investment, because it derives it's value from the underlying asset. Naturally, you pay for the privilege - I'm not selling you the option to buy oil at even $70 / barrel at some point in the future unless I get some cash from you, cash that you won't get back from me. That cash is my compensation for taking the risk that oil could head north to $80 / barrel and I'll be stuck selling it to you at $70. A lot of people have been concerned that derivatives are the spawn of the spawn of the devil.

The problem in both of the above cases is leverage, and I think that's where your husband is drawing the analogy to the great stock market crash. Buying things with just a few percent down and the rest borrowed money means that a small move in the wrong direction can wipe out an investment. Stocks, which can be bought on margin, were the cause back in 1929; today, margin requirements are 50%, meaning a stock has to drop in half before you're wiped out. Commodities don't need anywhere near that much of an adverse move to wipe you out.

I have a commodities trading account, but I haven't used it in years. Anyone can do it, but there are financial requirements you have to meet before getting approved. Everyone in the investment community knows about the risks above, so they want to make sure you have sufficient assets to back up a commodities position (especially a short position, where you sell a contract without owning the underlying goods). Put it another way, the loan sharks want to know what stuff you have that they can take if you don't pay up. So, not as dangerous as it appears.

Most commodities trading is of course done by pros. A lot of people invest in "hedge funds" and these hedge funds have been big players in the recent commodities run-up. They have deep pockets too, but unlike me, they have all sorts of ways to get around the leverage rules. You may remember hearing about the infamous failure of a company called Long Term Capital Management back in the late 90s. This was a fund run by financial wizards who thought they couldn't lose, had carefully constructed computer models, etc., etc. They were like gamblers laying off action against different markets all designed to make money on the spread. Problem was, they didn't count on some of the other players to just flat-out default. It's like you won big in a poker game only when you go to collect, you find that the guy you beat says his wife left him and he can't pay. Because of leverage, the whole thing fell like a house of cards with just a small adverse move in one area.

Nothing's changed recently except that Wall Street has made a new Exchange-Traded Fund (ETF) available to the mass market so that they, too, can invest in commodities, without being a hedge fund manager or a well-heeled investor. ETFs work just like stocks, you buy and sell shares in them, and you have to put up all the money (well, OK, half the money). What I do not know is what assets these new ETFs have. If they are just buying outright commodities futures contracts (i.e. putting the whole $70k into an oil contract), then it doesn't really seem so bad. In fact, it's probably the only way the little guy gets a chance at direct participation in oil's upside (before, all he or she could do is put money into oil company stocks or oil mutual funds). It's possible that the ETFs use leverage, though. Then, like, yikes.

[alecifel]

Dr. Doom pretty much sums it up succintly.

In lay terms: Futures are the selling of products you don't have yet, but are in the works. For example, if I grow wheat, I'll presell it three months before it's harvested. So people will buy "April" wheat in February. All it is, is a contract to deliver the goods at a certain point in the future. So the market sells these IOU's back and forth.

The danger, what happened in the Depression, and the same that's happening now, isn't specific to the futures markets. The danger is that ordinary people can go through Ameritrade or whatever, and buy and sell securities on a speculator's market. You have this huge infusion of money into the market, driving prices to levels that make savvy investment bankers nervous.. then they pull their money out if it gets to risky (that's called a panic). But a lot of that money is "on margin", which means the money to buy the future or the stock was borrowed, and when the stock price drops, the debt inflates. It is possible to turn $4 million worth of stock into $10 million worth of DEBT in four or five days.

So it's not really new, and it's always been dangerous, but now, it's going to be really dangerous, because every joe bob and betty that hear about Peak Oil are going to realize that petroleum is the safest investment there is - a guaranteed Giffen Good - and will buy it up until it goes out of sight. Which will help to soften demand some, and maybe encourage the development of some Altenative E's.

[Carlhole]

In a straightforward futures contract, a buyer agrees to buy a set amount of commodity such as oil, soybeans, corn, t-bonds, chicken, etc. at a set price. The contracts are pre-dated in commodity exchanges so that buyers and sellers talk of "April beans" or "July oil" - a buyer might buy the beans or oil in January, way in advance, and take delivery in April or July.

This is not a contract between a particular buyer and a particular seller; rather, the commodity exchange acts as a mediator. All buyers are matched with sellers by the exchange when the contracts come due. This is called "making a market".

The reason that there is futures trading in commodities is that, for example, a producer like Kellogg's Corn Flakes wants to know exactly what price he is going to pay for his corn so that he can calculate all his other business operations accordingly. If Kellogg's buys July corn in January at an agreed upon price of $5.00/bushel but the price soars to $10.00/bushel by the time the contract comes due, Kellogg's can still get his corn for $5.00/bushel.

And it works the other way around, too. You can agree to SELL corn in July at $5.00/bushel. If July rolls around and the price of corn has doubled, then you still have to sell at $5.00.

Speculators are allowed to participate in commodity markets in the US. You can make a ton of money really fast and you can lose your ass in a heartbeat, too. Oil is one of the most widely traded markets. It's huge and is popular amongst speculators. Futures and options on futures contracts get pretty complicated mathematically and conceptually. They form the basis of what are called "derivatives" these days.

What your husband said doesn't make sense. In the twenties people would go greatly into debt, borrowing money in order to play the stock market. This is called trading on margin and in the twenties people could borrow as much as 90% of a stock's value. Similarly, there were not many constraints upon commodity markets either. So all the debt the people were taking on in the twenties found its way into the markets and created a huge bubble - which popped in 1929.

After the crash, Congress enacted several major laws which were intended to prevent the excesses of the twenties. Those laws are still largely in effect. One could argue that the explosion of derviatives (another book-length subject) has circumvented those protections but so far so good.

The Exchange Traded Funds seem designed to allow investors to participate in commodity plays like the oil market without having to trade in futures and options which can be risky as hell for ordinary people. There's nothing particularly outrageous about ETFs; it's just that there is alot of investor interest in petroleum because people think it's going to rise in price considerably.

Your husband propably thinks that these new market vehicles like ETFs are going to introduce a whole shitload of volatility with speculators bidding the market to extreme heights. But this is not possible in a market the size of oil. And there are plenty of buyers and sellers to keep things steady.

Huge hedge funds such as George Soros fund can influence the price of oil a little bit but not much and not for long.

[Pops]

Good explanation Doctor. I understand some about options and I can see the value of them to both Farmer John and Wheaties Inc.

I do agree that a market can set the fairest price – but to me futures trading is like going to a huge auction where theory says you should get/pay a fair price for a product - but 90% of the bidders are shills that get a spiff from both the producers and buyers (and thereby eventual consumers) checks – with NO value added.

I know I’m just *issing in the wind but it’s all those shills feasting on the spawn that hacks me off.

[alecifel]

I sure am glad somebody out there knows better than I do how this stuff works!!! (This is why I don't trade futures. Needs to be left to the pros like you guys)

hahaha

Although the growing oil crisis is going to make all markets dicey, I think.. and even on 50% margin levels, a collapse could happen in a panic.

[Chaparral]

"Getting Started In Futures" by Todd Lofton is an excelent introductory book. "The Complete Guide to Futures Trading" by the Refco Private Client Group is a good desktop reference. There are other books extolling the COT report, candlestick charting blah blah blah but a book titled "The Education of a Speculator" by Victor Niederhoffer is just an absolute treasure chest of pure white-hot triple distilled wisdom.

[coyote]

Thanks Doctor Doom, Carlhole et. al. Good explanations. Many people still don't realize that when you invest in futures you can lose a lot more than the amount you put in. Also the zero-sum aspect. My father had to explain to me, when I was young, that this is why so many previously wealthy investors did Peter Pans from 14th floors after the crash in 1929. Not only had they lost everything, they were also in debt for life.

$this->bbcode_second_pass_quote('DoctorDoom', 'I')f they are just buying outright commodities futures contracts (i.e. putting the whole $70k into an oil contract), then it doesn't really seem so bad... It's possible that the ETFs use leverage, though. Then, like, yikes.

[kochevnik]

$this->bbcode_second_pass_quote('Pops', 'G')ood explanation Doctor. I understand some about options and I can see the value of them to both Farmer John and Wheaties Inc.

I do agree that a market can set the fairest price – but to me futures trading is like going to a huge auction where theory says you should get/pay a fair price for a product - but 90% of the bidders are shills that get a spiff from both the producers and buyers (and thereby eventual consumers) checks – with NO value added.

I know I’m just *issing in the wind but it’s all those shills feasting on the spawn that hacks me off.

[coyote]

$this->bbcode_second_pass_quote('kochevnik', 'I')t is so small a fund that it will always be just a drop in the bucket when it comes to setting world wide oil prices.

[pigleg]

It seems like speculators ("the funds"!) are becoming the majority investors in whatever is going up. This would be frustrating if you actually had a company that made stuff out of, lets say copper, yet could no longer afford the raw material.

[MrBill]

$this->bbcode_second_pass_quote('', 'W')hy do they need to yell and make funny gestures?

[kochevnik]

$this->bbcode_second_pass_quote('coyote', '')$this->bbcode_second_pass_quote('kochevnik', 'I')t is so small a fund that it will always be just a drop in the bucket when it comes to setting world wide oil prices.

[coyote]

$this->bbcode_second_pass_quote('kochevnik', 'I')'d say PO is already headline news in the MSM - I've seem articles and TV shows on CNN, NYT, Wash Post etc. I'm not sure how much more mainstream it could get. Granted, many of the articles and show try to put a rosy face on it, but polls show energy is considered the number one problem by many voters right now.