Why I'm a little worried about the drop in oil

Can't sleep, been thinking about the price of oil, worrying about it to be honest. Now you may be thinking "Venom, what are you crazy? A putz? A drop in the price of oil is a good thing!" And I would reply, yes, under normal circumstances it is. But these days, things ain't so normal. Actually, right now, oil is up since yesterday, but it's been in a slide for the past week or so.
A prophetic lunch

A couple years ago, I had lunch with a trading friend/mentor of mine at Hackney's on Harms Road. He was an older gentleman, made his money in options, in fact was one of the first to trade at the CBOE back in the 1970s. We had just gotten back from one of those sales seminars from Equis, a company that makes a product called Metastock. While gobbling down on Hackney's infamous onion loaf and later cheeseburgers, topics ranging from the software to commodities came up. This was around 2002, and Enron was still in the headlines.

I commented that a lot of the buy-side got burned by the fraud commited by folks like Kenneth Lay. The stock had collapsed, and the whole idea of trading energy products like electricity now seemed completely discredited. This was a big problem for Wall Street, I said. He then shook his head and said something that has stuck in my mind.

"John, what's good for Main Street may not be good for Wall Street. What's good for Wall Street may or may not be good for Main Street. But what is bad for Wall Street will be made bad for Main Street."

Years later, through all the scandals, and now today's financial crisis, that quote seems more truer than ever. Tax payers are now bailing out financial gamblers who knew better. From Long-Term Capital Management to Fannie and Freddie, all got cash infusions either from the government or a pool of investors corralled by the Treasury. In the end, even when it didn't come directly from the tax payer, the tax payer soon paid through special tax deals and such. C'mon, you don't think they aren't talking about tax breaks in the halls of Congress for these financial firms that help out?

Lehman, oil, and anyone else holding the bag?

This brings us back to Lehman. For the past month, the price of oil has been dropping. A while back I commented that one of the reasons was that China stopped buying, because they stocked up before the Olympics. Coincidentally, this was also around the same time that Richard Fuld, the company's CEO, said it was starting to sell assets to raise cash (kinda like what AIG has been saying for the past few days..hrmmmm). Lehman Brothers ran trading operations that dealt with everything from those infamous Credit Derivatives to commodities like oil or financial products based on oil (yes, believe it or not such a thing does exist!). Well whose to say that part of the fall in oil could be attributed to Lehman? That sounds like a good thing at first, that is until you think about it a bit longer. Their pain is your gain..or is it?

What's bad for Wall Street will be made bad for Main Street!

Back in the beginning of the year, Lehman announced that they had bad earnings, yet Fuld said he would not raise capital. Then in June, the Times reported that Lehman was indeed raising capital. It was then made public that besides the issuance of new shares, that it was beginning to jettison some of it's other holdings. If this is indeed the case, it would serve as an impetus for the fall in crude. Now as prices fall, other things start to happen.

You see, all these trades with these contracts involve margin. Now margin for futures trading is simply a deposit of a certain amount to control a commodities contract. The latest margin rates at the New York Mercantile Exchange shows that members pay $10,175/contract, while non-members pay $12,488. That's, rounding them out, 10k-12.5k to control $93,750 (using latest prices) or 1,000 barrels worth of oil. Depending whether you were long or short, the margin maintenance, that is what is required to hold on to your position, could go up or down. If you are in a losing position, expect your margin requirements to increase mark to market.

You have to figure that a lot of folks, from institutional trading desks to pensions, are taking a bath. It has only been recently, in the past two years or so, that everyone has been saying that commodities/futures are now an asset class. Jim Rogers even wrote a damn book on why you should plow cash into commodities! It's been my experience that when you see everyone talking about getting into something, that that's often the top. Whether it's stocks in '99, pork bellies in the 70s, real estate in this decade, or even beanie babies, it's all the same! Crowd mentality, it never changes.

What's bad for Wall Street will be made bad for Main Street!

Looking at the events transpiring this past week. One could easily come to the conclusion that even the so-called Masters of the Universe aren't such market mavens. Well, perhaps Goldman Sachs or George Soros, but for a lot of hedge funds and institutional trading desks, this is their last quarter. And this is what worries me.

While we're rejoicing in the price of crude dropping, margin clerks, the repo men of the financial industry, are also sharing in your joy. There isn't a trader alive who doesn't dread that one phone call. If you're a retail client (like most folks), then odds are your broker will notify you to pay up the difference in margin. You normally got less than 24 hours before they liquidate your account. For larger clients, and I mean big time ones, they often have a risk management department or a guy somewhere keeping tabs on this...well that's the idea anyways.

Are we going to have to bail out a commodities trading fund next?

Many of these desks, like we are seeing with Lehman or even AIG, were trading with enormous leverage. Often, able to borrow money at a discount, management would often grant the trading desk leverage many times the cash they carried; 40 to 1 was a norm in many places. And to the folks running the company, risk management was in their minds so what was the big deal?

Of course, with oil ratcheting on an ever higher price and research pointing to $100 then $200 price, things only looked good. What was the harm in increasing their position? You look at the volume, a 1000 lots of crude would go in a blink of an eye. And it wasn't just oil, we saw an influx of new cash into everything from boring ol' corn to gold. There was even Exchange Traded Funds on the American Stock Exchange and the NYSE that represented positions in these things. You got to figure that behind each new commodities mutual fund or ETF was a trading desk.

Yet, as you can see in that chart above, things didn't go as high as people predicted. That isn't to say oil couldn't go to $200, I'm sure it will, but that won't help the trader facing a margin call. Some jackass daytrader like myself facing a margin call is one thing, but say a hedge fund with twenty or forty billion dollars worth of commodity contracts is a whole other ball game.

What's bad for Wall Street will be made bad for Main Street!

Look, I wish we could say "fuck 'em" and things turn out fine. But they won't. Mark my words, you're going to hear that some pension fund or trading desk or someone big got blown away dealing in futures. There is nothing wrong with futures trading, but despite what Jim Rogers says, this ain't for everybody. You had smart Street folks who probably were more experienced in say equities or bonds or who knows what, enter something completely alien. Maybe they were familiar, but when you're told to take advantage of a Goldman Sach's research saying oil is going to $200, what are you going to do?

We are, as I've said already, going to pay for this. CDOs, swaps, corn, defaults, it don't matter. At the end of the day, you and I will pay for someone else's mistake. What is needed is more regulation in regards to leverage, that is critical. And if you think I'm making this up, Google the word "Forex" and you'll see modern day bucket shops saying you'll make oodles of unbelievable money trading currencies at 100-1 leverage! So yes, we need to reign in leverage. And you can't be trying to get average folks to play the futures game. I'm sorry, but I've seen so many burned by this, it's almost sick.

Maybe I'm wrong, maybe we should let anyone "play the market", but then we'd still end up paying. Right now, or at least in this recent past, the financial machine didn't care who their clients were. And if there was a problem, well you know what my mentor said:

What's bad for Wall Street will be made bad for Main Street!

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Comments

Okay, I'll say it: "Eff 'em!"

I agree, the precipitous decline, certainly the last $10 in Oil, is probably forced liquidation of some sort. Some hedge fund, investment bank, pension fund, whatever, and it's probably plural, has blown up.

Eff 'em.

Here is James Kroeger, commenting yesterday at Economist's View:

[T]he cogent assumption is not that a collapse of AIG wouldn't spread; the cogent assumption is that even if it did, the 'horror' of the collapse that everyone is saying we should fear would simply NOT BE ALL THAT HORRIBLE. That is to say, if we had enlightened people running our federal government, the 'horror' would not be all that bad for the Average American and it would be over so quickly, people would wonder what the big deal had been that everyone had been so worried about.

Let's go through this a step at a time... How would the Average American be hurt by a complete collapse of the financial sector of the economy? The answer is that he/she would be hurting only if aggregate demand were drop as a consequence of banks lending less money and businesses spending less money. Without intervention by Congress, businesses that are too heavily leveraged would go out of business and many people would lose their jobs. But if the federal government were to increase its spending enough (by taxing the rich and spending that money on infrastructure & human capital) aggregate demand could not only be maintained, we could also easily increase AD if that is what we wanted to do.

To maintain aggregate demand at the levels we desire, it might be desirable for Congress to create taxpayer-owned banks that would buy up the assests of failed private banks at fire-sale prices, fully capitalize them with public funds, and then provide whatever loanable funds might be desired by borrowers. If loan demand is inadequate to maintain aggregate spending at the desired level, then Congress can simply spend more money on public investment.

So what's the problem? What's the horror? The evil geniuses who created our private financial markets would suffer massive losses because they did not prepare themselves for excessive risk. They would lose Big Time, as they should. Within a month of two after such institutions fail, the government could be replacing them with publicly owned entities that have no reservations whatsoever about lending to would-be borrowers.

It would all be over within 6 months and very few people would be unemployed while competing firms buy up the assets of failed firms. As long as demand is strong, everyone would be working and pumping money into the economy at the same time that the few remaining players in the privately-owned financial sector are finding new ways to make a living while competing with The Taxpayer's Bank (one that is not interested in maximizing profits while taking on risks that everyone else must pay for, but only in serving the public interest) and which writes the rules that they must abide by.

(If a reminder is necessary: the Great Depression continued on as long as it did for only one reason: the Federal Government did not spend enough money to eliminate unemployment until World War II began and then unemployment dried up almost over night. Roosevelt's Congress did not authorize enough spending because too many members of the opposition and of the banking community warned that the consequences of 'inflating' the economy would be disastrous. Too bad they listened. Millions of people suffered terribly for no good reason.)

So help me out.... What is this horror that you fear that justifies throwing more billions of dollars at rich people?

____________________

As I diaried yesterday, despite some signs of "contagion", Wall Street's black plague has still not really infected Main Street. Not that Main Street is doing well, but unless you got caught up in the housing bubble, your primary complaint this year has been inflation -- brought about by soaring Oil and food prices, shortly to crash. Take away that, and Main Street ain't going down the tubes just yet. In fact, Joe UltraLight Sixpack gets a bit of a respite.

Wall Street can make these problems Main Street's problems only if We the People allow it. There is a High Political decision to be made shortly, about whether government of the financiers, by the financiers, and for the financiers shall continue; or whether it shall be repudiated and an new New Deal put in its place.

If Americans insist on a new New Deal, and insist on the concrete steps to make it so, there is no reason the sewers can't be sanitized and the black plague kept from decimating Main Street.

I know where I stand.

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new deal

We have people like Glenn Beck busy trying to claim the new deal is some god awful thing (why is this guy on the air, he has zero background, I mean less than any commenter on this site! in economics)

But we do not have anyone offering a comprehensive new deal plan, at least no one running for President.

I think one of the key elements to expose are taxes, deficits versus how social programs if done right and face it we have done wrong benefit the economy is in order.

People do not know what to demand because they do not understand the interactions of all of this. They just know that the government taxes them, then does whatever lobbyists wants. They never see any real benefit. Take tax incentives to keep jobs or grow jobs in some state by companies. It's astounding but if one looks at the stats, often that company never actually increases jobs. No accountability, it's take the money and run.

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Oil drop

I am concerned about it for the above mentioned reasons but also the more practical reasons that because of higher transport costs compnies are now thinking twice about offshoring, and some folks are finally getting serious about alternative energies

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Everybody in the World should not pay for AIG.

When insurers go bust, other insurers take over their policies, claims, customers. What Poulson fears is having a process that exposes the degree of fraud and speculation of AIG and the rest financial America. AIG could have been split up after a Chapter 11 wrote down values of worthless debts.

We the taxpayers will have to pay for the ridiculous speculation of AIG.

How many more AIGs are out there? How big is this? Eventually, the U.S. Treasury runs short, there are dollar runs and real panic if they keep this up.

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Burton Leed

tax the shit out of 'em

Is what I'm thinking. I'm concerned wall street is making these ponzi scheme implosions main streets problems. With the dot con bubble, so many people through bad advice from corrupt brokers put there retirement money into worthless dot com and tech stocks and then it hit the entire stock market. The Dot Con was not contained and that's because it wasn't isolated to those companies. We had Citigroup, Goldman Sachs, Arthur Anderson and so on all in on the scam.

Then, to me, they simply turned to housing as the new poker chip. So, here we are, over $900B and counting on racking up debt, never mind the effect overall on the stock market and that does affect jobs and affects retirements...since of course main street had their traditional pensions denied, replaced with 401ks.

But, I want to see these super rich people who get whatever they want in Congress to pay. I'm in a Robin Hood mood.

Trading bad debt like baseball cards and here comes the last one holding and seemingly the last one holding is us!

I don't know about AIG frankly but considering Lehman was denied purchase, declared bankruptcy and those very assets were immediately purchased, assuredly at a much lower price....

and if oil speculators get burnt, well not will it affect main street but more why should it affect main street?

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Surtax

I'd like to see a surtax charged to everyone who voted in these supply side bozos, to pay the rest of us responsible citizens back for our debt burdens, decreased home, retirement and savings values

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