Marshall Auerback: “Many years of economic stagnation” interview: excerpt

Yes, I think it was the straw that broke the camel’s back, or the “icing on the cake”. But I think it would be more accurate to say that  the oil price spike catalysed the subsequent collapse. However, recessionary pressures were already “baked in the cake” well before the oil price spike. If anything, I would say that the oil price spike (largely a product of speculation, not final demand) provided a perfect illustration of the dysfunction of our financial system, something Doug Noland has been particularly strong in illustrating.

Could you explain that?

Simply a demonstration that our financial system has become hooked on cheap financing for the purposes of speculation. To me, it is no coincidence that when Bernanke began to reduce rates in response to the 2007 sub-prime meltdown, he simply incited another speculative bubble in commodities via the leveraged speculating community.

Let’s return to the inter-relation of the oil price spike of last year and the current recession. Can you tell us about your reading of last years oil price spike?

Let me begin my answer to that question with the observation that economists were almost universally opposed to the idea that speculation was playing much of a role in the oil price spike. A Wall Street Journal survey found that 89%, as close as you ever come to unanimity in most polls, saw the increase in commodity prices, including oil, as the result of fundamental forces. 6 Nobel prize winner Paul Krugman argued the case forcefully in a series of New York Times op-eds and blog posts with titles like “The Oil Non-Bubble,” “Fuel on the Hill,” and “Speculative Nonsense, Once Again.”7

I think too little attention has been paid to the role of speculation in last year’s oil market rally.  Part of this is a usual blind spot amongst economists.  Paul Krugman’s presence in this camp lent credibility to the “oil prices are warranted” view. The Princeton economist had been a Cassandra on the housing mania and had also correctly anticipated that the deregulation of energy prices in California could lead to manipulation. So Krugman, sensitive to the notion that speculation can distort prices, nevertheless fell in with the argument that oil prices were simply reflecting supply and demand.

Yet that belief was spectacularly incorrect. Oil peaked at $147 a barrel in July and fell even more dramatically than it had risen. By October, prices had fallen to $64 a barrel. Bloomberg columnist Caroline Baum described the world as “drowning in oil.”8 A report by the Commodities Futures Exchange Commission attributed the large swings in oil prices to speculation. CFTC Commissioner Bart Chilton said that earlier studies that found that the moves were the result of supply and demand relied on “deeply flawed data.”9

Why were economists unable to read the information correctly, and so inclined to dismiss the views of experts and participants in the energy markets who were saying that prices were out of whack with what they saw on the ground?

The short answer is that they had undue faith in their models. Modeling has come to be a defining characteristic of modern economics. Practitioners will argue, correctly, that economic phenomena are so complex that some abstraction is necessary to come to grips with the underlying phenomenon, to sort out persistent behaviours from mere noise in the system.

Good models filter the “noise” out of a messy situation and distil the underlying dynamics to provide better insight.  The implications of a mathematical model can be developed in a deliberate, explicit fashion, rather than left to intuition. Models force investigators to contend with loose ends and expose inconsistencies in his reasoning that need either to be resolved or diagnosed as inconsequential. They also make it easier for the researchers to communicate with each other.

Any model, be it a spreadsheet, a menu, a clay mock up, a dressmaker’s pattern, of necessity entails the loss of information.  Economists admit this is a potential danger. But this inherent feature is precisely what makes laypeople and even some insiders uncomfortable, because what was discarded to make the problem manageable may have been essential.

Worse, someone who has become adept at using a particular framework is almost certain to be the last to see its shortcomings. A model-user is easily seduced by his creation and starts to see reality through it. Users wind up trusting the results because they follow from the axioms, irrespective of their initial understanding. Practitioners can become hostage to them, exhibiting a peculiar sort of selective blindness. Cats form their visual synapses when their eyes open, when they are two to three days old, and if they do not get certain inputs, the brain circuits never get made. A kitten who sees only horizontal lines at this age will bump into table legs the rest of its life.

If we would discuss the speculation aspect of last years oil price spike, would it be wrong to take a closer look at “Government Sachs” – the artist formerly known as Goldman Sachs?

As far as Goldman Sachs itself goes, yes, they had a significant role in this speculation, but there were a lot of other factors. Mike Masters, who really knows this area well, is a Managing Member of Masters Capital Management, LLC. He demonstrated during last year’s oil boom that large financial institutions, such as investment banks and hedge funds, which were “hedging” their off exchange futures transactions on energy and agricultural prices on U.S. regulated exchanges, were being treated by NYMEX, for example, and the CFTC as “commercial interests,” rather than as the speculators they clearly are. By lumping large financial institutions with traditional commercial oil dealers (or farmers) even fully regulated U.S. exchanges are not applying traditional speculation limits to the transactions engaged in by these speculative interests.  Masters demonstrated that a significant percentage of the trades in WTI futures, for example, were controlled by non-commercial interests.  These exemptions from speculation limits for large financial institutions hedging off-exchange “swaps” transactions emanate from a CFTC letter issued on October 8, 1991 and they have continued to present day (Brooksley Born wasn’t even aware of this letter until much later). Interestingly enough, the CFTC puts position limits on most commodities, BUT NOT ENERGY. Masters’ testimony, aided by a widely discussed cover story in the March 31, 2008 issue of Barron’s, has made clear that the categorization of swaps dealers outside of speculative controls even on U.S. regulated contract markets has been a cause of great volatility in food prices, as well as in the energy markets.

You also had the expanding role of the Dubai Merc, which has minimal reporting requirements.  There is also this report from the US Senate (I wrote an analysis of this before which is below the US Senate report – feel free to pass on).

“Until recently, US energy futures were traded exclusively on regulated exchanges within the United States, like the NYMEX, which are subject to extensive oversight by the CFTC, including ongoing monitoring to detect and prevent price manipulation or fraud. In recent years, however, there has been a tremendous growth in the trading of contracts that look and are structured just like futures contracts, but which are traded on unregulated OTC electronic markets. Because of their similarity to futures contracts they are often called “futures look-alikes.”

The only practical difference between futures look-alike contracts and futures contracts is that the look-alikes are traded in unregulated markets whereas futures are traded on regulated exchanges. The trading of energy commodities by large firms on OTC electronic exchanges was exempted from CFTC oversight by a provision inserted at the behest of Enron and other large energy traders into the Commodity Futures Modernization Act of 2000 in the waning hours of the 106th Congress.

The impact on market oversight has been substantial. NYMEX traders, for example, are required to keep records of all trades and report large trades to the CFTC. These Large Trader Reports, together with daily trading data providing price and volume information, are the CFTC’s primary tools to gauge the extent of speculation in the markets and to detect, prevent, and prosecute price manipulation. CFTC Chairman Reuben Jeffrey recently stated: “The Commission’s Large Trader information system is one of the cornerstones of our surveillance program and enables detection of concentrated and coordinated positions that might be used by  one or more traders to attempt manipulation.

In contrast to trades conducted on the NYMEX, traders on unregulated OTC electronic exchanges are not required to keep records or file Large Trader Reports with the CFTC, and these trades are exempt from routine CFTC oversight. In contrast to trades conducted on regulated futures exchanges, there is no limit on the number of contracts a speculator may hold on an unregulated OTC electronic exchange, no monitoring of trading by the exchange itself, and no reporting of the amount of outstanding contracts (“open interest”) at the end of each day.”

Then, apparently to make sure the way was opened really wide to potential market oil price manipulation, in January 2006, the Bush Administration’s CFTC permitted the Intercontinental Exchange (ICE), the leading operator of electronic energy exchanges, to use its trading terminals in the United States for the trading of US crude oil futures on the ICE futures exchange in London – called “ICE Futures.”

Previously, the ICE Futures exchange in London had traded only in European energy commodities – Brent crude oil and United Kingdom natural gas. As a United Kingdom futures market, the ICE Futures exchange is regulated solely by the UK Financial Services Authority. In 1999, the London exchange obtained the CFTC’s permission to install computer terminals in the United States to permit traders in New York and other US cities to trade European energy commodities through the ICE exchange.

Then, in January 2006, ICE Futures in London began trading a futures contract for West Texas Intermediate (WTI) crude oil, a type of crude oil that is produced and delivered in the United States. ICE Futures also notified the CFTC that it would be permitting traders in the United States to use ICE terminals in the United States to trade its new WTI contract on the ICE Futures London exchange. ICE Futures as well allowed traders in the United States to trade US gasoline and heating oil futures on the ICE Futures exchange in London.

Despite the use by US traders of trading terminals within the United States to trade US oil, gasoline, and heating oil futures contracts, the CFTC has until today refused to assert any jurisdiction over the trading of these contracts.

Persons within the United States seeking to trade key US energy commodities – US crude oil, gasoline, and heating oil futures – are able to avoid all US market oversight or reporting requirements by routing their trades through the ICE Futures exchange in London instead of the NYMEX in New York.

Is that not elegant? The US Government energy futures regulator, CFTC, opened the way to the present unregulated and highly opaque oil futures speculation. It may just be coincidence that the present CEO of NYMEX, James Newsome, who also sits on the Dubai Exchange, is a former chairman of the US CFTC. In Washington doors revolve quite smoothly between private and public posts.

A glance at the price for Brent and WTI futures prices since January 2006 indicates the remarkable correlation between skyrocketing oil prices and the unregulated trade in ICE oil futures in US markets. Keep in mind that ICE Futures in London is owned and controlled by a USA company based in Atlanta, Georgia.

In January 2006 when the CFTC allowed the ICE Futures the gaping exception, oil prices were trading in the range of $59-60 a barrel. Today some two years later we see prices tapping $120 and trend upwards. This is not an OPEC problem, it is a US Government regulatory problem of malign neglect.

By not requiring the ICE to file daily reports of large trades of energy commodities, it is not able to detect and deter price manipulation. As the Senate report noted, “The CFTC’s ability to detect and deter energy price manipulation is suffering from critical information gaps, because traders on OTC electronic exchanges and the London ICE Futures are currently exempt from CFTC reporting requirements. Large trader reporting is also essential to analyze the effect of speculation on energy prices.”

The report added, “ICE’s filings with the Securities and Exchange Commission and other evidence indicate that its over-the-counter electronic exchange performs a price discovery function — and thereby affects US energy prices — in the cash market for the energy commodities traded on that exchange.”

In the most recent sustained run-up in energy prices, large financial institutions, hedge funds, pension funds, and other investors have been pouring billions of dollars into the energy commodities markets to try to take advantage of price changes or hedge against them. Most of this additional investment has not come from producers or consumers of these commodities, but from speculators seeking to take advantage of these price changes. The CFTC defines a speculator as a person who “does not produce or use the commodity, but risks his or her own capital trading futures in that commodity in hopes of making a profit on price changes.”

The large purchases of crude oil futures contracts by speculators have, in effect, created an additional demand for oil, driving up the price of oil for future delivery in the same manner that additional demand for contracts for the delivery of a physical barrel today drives up the price for oil on the spot market. As far as the market is concerned, the demand for a barrel of oil that results from the purchase of a futures contract by a speculator is just as real as the demand for a barrel that results from the purchase of a futures contract by a refiner or other user of petroleum.

In 2008, Goldman Sachs and Morgan Stanley were the two leading energy trading firms in the United States. Citigroup and JP Morgan Chase were also major players and fund numerous hedge funds as well who speculate.

In June 2006, oil traded in futures markets at some $60 a barrel and the Senate investigation estimated that some $25 of that was due to pure financial speculation. One analyst estimated in August 2005 that US oil inventory levels suggested WTI crude prices should be around $25 a barrel, and not $60.

That would mean today that at least $50 to $60 or more of today’s $115 a barrel price is due to pure hedge fund and financial institution speculation. However, given the unchanged equilibrium in global oil supply and demand over recent months amid the explosive rise in oil futures prices traded on NYMEX and ICE exchanges in New York and London, it is more likely that as much as 60% of the today oil price is pure speculation. No one knows officially except the tiny handful of energy trading banks in New York and London and they certainly aren’t talking.

By purchasing large numbers of futures contracts, and thereby pushing up futures prices to even higher levels than current prices, speculators have provided a financial incentive for oil companies to buy even more oil and place it in storage. A refiner will purchase extra oil today, even if it costs $115 per barrel, if the futures price is even higher.

As a result, over the past two years crude oil inventories have been steadily growing, resulting in US crude oil inventories that are now higher than at any time in the previous eight years. The large influx of speculative investment into oil futures has led to a situation where we have both high supplies of crude oil and high crude oil prices.

Compelling evidence also suggests that the oft-cited geopolitical, economic, and natural factors do not explain the recent rise in energy prices can be seen in the actual data on crude oil supply and demand. Although demand has significantly increased over the past few years, so have supplies.

Well, now that we have entered the territory of recession, the pundits talk about “the Road to Recovery”. In order to travel that road one would need oil, especially cheap oil, because it does provide a good amount of our energy-basis. Here sets in a quite tricky part of the overall picture, that Mike Ruppert, the former publisher of “From the Wilderness”, expressed in an exclusive interview with MMNews this way: 

a) The current global economic paradigm — governed by fractional reserve banking, fiat currency, and compound interest (debt-based growth) — is inherently and by definition a pyramid scheme. Money is useless without energy. One cannot eat a dollar bill or crumble it up and throw it in his gas tank. Each of the trillions of dollars created out of thin air since the fall of 2008 is a commitment to expend energy that cannot and will not ever be there.

b) There can be no “recovery”, no return to growth (which is what the economic paradigm demands), without energy. 10

Why this is an observation worth contemplating with regard to Peak Oil?

I don’t really know if I have anything to add here. To the degree that money is not a store of value but simply a means to completing a commercial transaction, Mike Ruppert’s observations can apply to food as well as energy. 

The monetary system, itself, was invented to mobilize resources to serve what government perceived to be the public purpose. Of course, it is only in a democracy that the public’s purpose and the government’s purpose have much chance of alignment. In any case, the point is that we cannot imagine a separation of the economic from the political—and any attempt to separate money from politics is, itself, political. Adopting a gold standard, or a foreign currency standard (“dollarization”), or a Friedmanian money growth rule, or an inflation target is a political act that serves the interests of some privileged group. There is no “natural” separation of a government from its money. The gold standard was legislated, just as the Federal Reserve Act of 1913 legislated the separation of Treasury and Central Bank functions, and the Balance Budget Act of 1987 legislated the ex ante matching of federal government spending and revenue over a period determined by the heavenly movement of a celestial object. Ditto the myth of the supposed independence of the modern central bank—this is but a smokescreen to hide the fact that monetary policy is run for the benefit of Wall Street.

Money was created to give government command over socially created resources. Skip forward ten thousand years to the present. We can think of money as the currency of taxation, with the money of account denominating one’s social liability. Often, it is the tax that monetizes an activity—that puts a money value on it for the purpose of determining the share to render unto Caesar. The sovereign government names what money-denominated thing can be delivered in redemption against one’s social obligation or duty to pay taxes. It can then issue the money thing in its own payments. That government money thing is, like all money things, a liability denominated in the state’s money of account. And like all money things, it must be redeemed, that is, accepted by its issuer. As Hyman Minsky always said, anyone can create money (things), the problem lies in getting them accepted. Only the sovereign can impose tax liabilities to ensure its money things will be accepted. But power is always a continuum and we should not imagine that acceptance of non-sovereign money things is necessarily voluntary. We are admonished to be neither a creditor nor a debtor, but all of us are always simultaneously debtors and creditors. Maybe that is what makes us Human—or at least Chimpanzees, who apparently keep careful mental records of liabilities, and refuse to cooperate with those who don’t pay off debts—what is called reciprocal altruism: if I help you to beat Chimp A senseless, you had better repay your debt when Chimp B attacks me.

I would also like to ask you about some remarks by Matthew Simmons, chairman of “Simmons & Company International”, from March of this year:

“Unless oil demand falls by 10 or 15 percent per annum, which it is not going to do, then we don’t need to wait for oil demand to come back before we have a supply crunch,” he said. “Within a few months, we are going to realize our visible inventories are really tight — squeaky tight — and what would really be inconvenient is to see a recovery in the economy.”

Mr. Simmons also stated that oil prices eventually exceeding last year’s high:

“Sooner or later we will burst through that like a hot knife through butter.”11

What is your opinion about this?

Look, by and large, I accept the Peak Oil thesis, but I tend to shy away from the apocalyptic predictions of people like Matt Simmons.  I think his case for price spikes is very compelling (as is the work done by Colin Campbell), but I think they tend to underestimate the demand response to a major price spike. Here in America, (in marked contrast to Europe or Japan) there has been very little squeezed from energy inefficiencies via conservation, green tech, etc. We could do a lot here, but the price has to get much higher to sustain that kind of change in behaviour to make it happen. I think it will happen. When prices spiked last summer, and gasoline was almost $5.00 a gallon, the roads in southern California were empty. That does have implications for demand. The marginal trip to the mall or the weekend getaway tends to be reconsidered when you get these kinds of price shocks. The decision to invest in solar panels for the house becomes a bit more understandable if the energy bills are exploding.  I tend to think that Simmons and his ilk tend to ignore this dynamic.

I am sure that we have run out of $50 oil. We’re running out of $60-$70 oil. In a few years, we’ll run out of $80 oil. The low hanging fruit has been picked, and it will get more expensive and change the way we live our lives. There’s no doubt about that.

As a fellow of “Economists for Peace & Security” wouldn’t you agree that people around the globe who are concerned about peace should begin to concentrate more and more on the problems that Peak Oil will usher in? The geopolitical implications of it are colossal – and I guess the outlook of endless resource-wars isn’t really a promising vision for the future of mankind.

Yes, this is the area that does concern me the most. Michael Klare has written some excellent stuff on this: the prospect of heightened global tension as the competition for secure energy supplies heats up. I have no doubt that this is a big problem. The Pentagon gradually seems to be expanding its remit to become, in effect, a global energy protection racket for the American consumer. The militarisation of energy policy is a very troubling development, but clearly a strong by-product of Peak Oil.12…

SOURCES:

5 quoted in Michael C. Ruppert: “Crossing the Rubicon. The Decline of the American Empire at the End of the Age of Oil”, New Society Publishers, Gabriola Island, 2004, page 31.

6 Phil Izzo, “Bubble Isn’t Big Factor in Inflation,” May 2, 2008, http://online.wsj.com/article/SB121026120931177437.html

7 Paul Krugman,  “The Oil Non-Bubble,” New York Times, May 12, 2008, http://www.nytimes.com/2008/05/12/opinion/12krugman.html. “Fuel on the Hill.” New York Times, June 27, 2008, http://www.nytimes.com/2008/06/27/opinion/27krugman.html, and “Speculative nonsense, once again,” Conscience of a Liberal blog, June 23, 2008, http://krugman.blogs.nytimes.com/2008/06/23/speculative-nonsense-once-again/

8 Caroline Baum, “World Is `Drowning in Oil’ (Again) After Drought,” Bloomberg, October 28, 2008, http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aZ_wEtBdohjM

9 Ianthe Jeanne Dugan and Alistair MacDonald, “Traders Blamed for Oil Spike,” Wall Street Journal, http://online.wsj.com/article/SB124874574251485689.html

10 Lars Schall: “The sinking Titanic”, Interview with Michael C. Ruppert, published April 29, 2009, at: http://www.mmnews.de/index.php/200904292844/Rohstoffe/Interview-Michael-C.-Ruppert/html

11 Christopher Johnson: ”Financier sees oil shock from credit crunch”, published March 26, 2009, at: http://www.reuters.com/article/reutersComService_3_MOLT/idUSTRE52P2D620090326

12 compare Marshall Auerback: The Militarisation Of Oil”, published March 8, 2005, at: http://www.prudentbear.com/internationalperspective.asp

The link appears to be broken. I found the article on the From the Wilderness archive site here. You have to scroll down the page to find it. -KS