ON THE CONFLICT OF INTEREST THAT EXISTS BETWEEN RESEARCH AND COMMODITY TRADERS

These are some pretty interesting comments by Oppenheimer’s Fadel Gheit on the big banks and their involvement in the commodity markets. In market action that is similar to the tech bubble and the conflict of interest between research firms and their investment banking arms, today, there seems to be a credible argument that the same sort of conflict of interest could exist between research arms and the trading arms of these big banks. Some will argue that this speculation is good for the economy, however, I fail to see how it is good for the economy when Goldman Sachs is changing their position on oil prices every few weeks, moving the market, creating volatility, never taking delivery and reaping the benefits by trading on these same market moving opinions. Gheit elaborates in what appears like a very common sense approach to the current commodity market craze (via Bloomberg TV):

“Unfortunately, without repeating the names of the brokers, everybody knows who the usual suspects are. These are the people in 2008 that were making a bet on $200 oil.”

“This is another form of market manipulation in my view. It is in another form of basically pushing the envelope. What you are saying or doing is not illegal, but they are allowed to do it. The government has a responsibility to slap them hard.”

Gheit on whether he thinks the notes out of Morgan Stanley and Goldman Sachs are market manipulation:

“The interpretation will be left to the market. It is a self-fulfilling prophecy. They can invent reasons why oil prices go to $130 or $150, but history has shown that these people are able to move markets. It is not Exxon or BP or Shell that moves the oil markets. It is the financial players. It is the Goldman Sachs, the Morgan Stanley, all of the other guys. It is a shame on the government that allows them to get away with that.”

“It is not illegal. All banks need to make a profit. The M&A business is not doing too well. Therefore, they need to improve their profit outlook and commodities has been the area where they make a lot of money. Commodity speculation is now a big driving force in Wall Street. Everybody wants to do it. It is not illegal, but it is not well-supervised. It is like speeding over the speed limit. If a cop doesn’t stop you, you get away with it and you continue to do it. [The CFDC] has absolutely done nothing. They talked about this for three or four years. Nothing happens. Nothing changes and I think nothing will change. Any changes will be cosmetic because financial institutions have a lot of clout and the financial lobby is very strong. Much stronger than the oil lobby.”

On whether he thinks Goldman Sachs is manipulating the price of oil:

“I am saying it is very easy to scream fire in a crowded place, everyone will run. All I am saying is that there has to be rules and the only way is to position them. You cannot allow a financial institution to take a huge chunk of the oil market and that’s a pure speculation…Why did they control hundreds of millions of barrels of oil if they cannot refine or mine. Because it is because it is legal and they can get away with it. As long as they make a profit, that is fine. Basically, the consumer will pay the price. The economy will slow down because of the few that will make a huge amount of profits.”

“All I can tell you is that when the big financial players, whether it is the buy side or the sell side, when Warren Buffet takes a position of Company X, the stock will move up. Whether or not they are influencing the market and manipulation could be a stronger word, but they are influencing the market. They are doing things that could be beneficial to them but harmful to the rest of us. That is where government comes in and says stop, enough. You have a Ferrari or a Maserati and can go 120 mph, but guess what? Those of us who can only go 60 miles per hour will be pulverized. That is where the government has to come in and say there is a speed limit here, but that is not happening.”

On whether he is surprised at today’s inventory figures:

“You have to take into account that we see these numbers don’t mean much unless they are consistent. We have not seen a trend yet, but definitely higher gasoline prices at the pump will curtail driving. By how much, we do not know. Some companies say as much as a 5% drop from last month. We’re entering the summer driving season so things could change. Gasoline prices are retreating, but obviously not by as much as they surged in the last four to five weeks. It is still in flux. We don’t know exactly which way it will go. I can tell you one thing — don’t expect much lower gasoline prices, especially oil prices.”

On demand destruction and prices coming down over the next couple of months:

“Prices will come down and the next couple of months for a couple of reasons. Oil prices are down by almost15% from more than three weeks ago. That is not reflected fully in the price of gasoline. It will happen, but it is a question of when. The mitigating factor here is how strong it will be the driving season this time around. We are still very early. Next week compared to one year ago, we will see where we are. Right now, it is a balanced picture. There is demand destruction on one hand, but there is also the beginning of the heavy driving season.”

 

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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  • wsm

    I don’t think this is a “very common sense approach” at all. This guy makes the mistake of conflating “manipulating” the markets with “influencing” the markets.

    Manipulation implies wrongdoing, such as circumventing rules (naked short selling comes to mind).

    Influencing the markets is the result of market participants “choosing to be influenced”, if you will, by taking the research reports seriously and acting upon them. Each trade consists of a willing buyer and seller.

    I agree that there should be limits on positions taken by non-industry participants (i.e. banks vs. oil companies). But to my knowledge, those limits already exist.

  • http://www.pragcap.com Cullen Roche

    He was actually very specific in stating that he didn’t know if they were “manipulating” anything….

  • wsm

    Yes, he did try to backtrack – but initially he says “This is another form of market manipulation in my view.”

  • wsm

    What I’m saying is it is neither good nor bad. So long as the banks are not allowed to control the majority of the market, there is absolutely no reason why they should be barred from speculating at the margins. Whether market participants choose to react to their research reports is the decision of market participants.

  • wsm

    Put it another way: if you think it is bad for banks to be able to both conduct research regarding commodities and trade commodities, which of these 2 activities should they be barred from?

    Regardless of which you choose, think of the slippery slope that is implied by that restriction.

    Apparently you are fine with it, but I think it would be just another over-regulation that they would work around. Bottom line is that willing market participants should be able to transact with each other based on their own due diligence.

  • http://www.pragcap.com Cullen Roche

    That’s sort of like saying if the government chooses not to lock up murderers that it’s the choice of citizens to stay inside all day and night. Sure, it’s their choice, but they’re just reacting to their environment.

    GS moves markets. It’s that simple. So, when this behemoth firm announces something you either listen or get steam rolled. Personally, I have no problem with a firm that speculates in markets. Where my concern resides is with regards to outside entities that influence these prices for the wrong reasons. For instance, when the Fed comes out with misguided policies and forces speculators to respond I think that’s wrong.

  • quark

    Stating the obvious and the Bloomberg interviewer expresses disbelief? She is either completely clueless or incompetent.

    The financial media which refuses to allow a critical thought to enter their reporting (they are not going to bite the hand that feeds them), the government which refuses to enforce our laws and protect the public because they are either corrupt/incompetent or both and then there is Wall Street, an collective group of institutions run by the type of men and women who if replaced by Kadafi one could barely recognize any change in behavior, are all to happy to watch J.Q. Public get fleeced.

  • http://www.pragcap.com Cullen Roche

    Personally, I think it’s absurd that banks have these massive trading arms. Why does an institution with a bank charter and FDIC membership get to gamble? Why do we allow these systemically important firms to gamble in these markets at all? I don’t get it.

    If they want to gamble then go form a private partnership and push your research all you want. I don’t care. My concern is with these big banks and their constant need for increased shareholder profits at any cost. At what point does this negatively impact the real economy? Or in our case, how did we not learn from 2008?

    If they’re colluding to use research to front run positions then that’s a whole different story. Obviously, there are big problems there is it’s happening. But I don’t know if you can stop that from happening….It’s not Goldman’s fault that they are so influential….

  • wsm

    “That’s sort of like saying if the government chooses not to lock up murderers that it’s the choice of citizens to stay inside all day and night. Sure, it’s their choice, but they’re just reacting to their environment.”

    It’s sort of like saying that, only if you believe that the restrictions currently in place are so inadequate as to be tantamount to murder. As I said before, I believe there are already restrictions in place barring banks from taking over more of the commodities markets than the industrial users/refiners.

    Incidentally, I read a headline the other day that prisons ARE going to be releasing criminals because of overcrowding (maybe in CA, but I do not remember).

  • wsm

    “Why does an institution with a bank charter and FDIC membership get to gamble?”

    I agree with you 100% there. Although that was not the original thrust of this discussion.

  • http://www.pragcap.com Cullen Roche

    Right, but my concern is whether there is a conflict of interest between the research and trading? Is that healthy? I don’t know.

  • BK

    This guy is very right, but as he said nothing will change and everyone is paying the price. But that’s how it is. Wallstreet is running the country, not a gov of puppets. Nothing will change until the country is down on it’s knees.
    I’m actually wondering whether he will be still in his job next week.

    wsm The more power one has the more resposibility one has. That’s universal.
    In this case the people with the most power just don’t give a shit what’s happening to the rest. Of course it’s a market manipulation because they are talking in their own interest and they know that what they are saying will move the markets.

  • wsm

    @ BK:

    “Of course it’s a market manipulation because they are talking in their own interest and they know that what they are saying will move the markets.”

    Are you sure they are talking in their own interest? Do you even know what their interest is? (long? short? which commodities?) One recent Goldman report calls for a slowdown in China. Another calls for a rebounding in the price of oil. Some have argued that these two calls are contradictory (although I do not agree with that assessment). My point is, if you read these research reports and respond by making an investment based on the research, YOU have chosen to be influenced. Goldman did not force you to do anything. Your rhetoric-laden post does not refute the fact that all trades have two willing participants.

    “nothing will change and everyone is paying the price”

    Everyone also pays the price when commodities sharply reverse downward, as oil has done in recent weeks. But I suppose that “manipulation” is OK with you?

  • quark

    I disagree. I don’t think that companies who have zero physical inventory should be allowed to push/manipulate/speculate in a market that is the centerpiece of our national security and vital to our economic and military power.

    Have we not invaded countries for this same reason!

    You know what next…it’s time for our military to occupy Goldman Sachs.

  • quark

    Are you willing to allow the markets to fail?

  • quark

    my question was directed to wsm.

  • http://business.financialpost.com/2011/05/25/shipping-magnate-fredriksen-in-eye-of-oil-manipulation-storm/ T. Blazedman

    This link is along the same lines. Market manipulation via shipping.

    Cullen, maybe you have addressed this in a previous article (if so can you provide link), but what is your position on the CME margin hikes in the various commodities.

    Seems to me in the end, though some blogs are all up in arms when it comes to the increases in silver margins and the effect on their terribly overweight silver positioning, that these margin hikes are really the only way to exert some control over the biggest players.

    We can be reasonably sure the government isn’t going to take GS to task criminally in any meaningful way.

    Any thoughts?

  • T. Blazedman
  • VRB II

    There is not an economic benefit to GS moving the oil markets. There was no economic benefit to them moving the mortgage markets. I think Goldman would not be able to do it today had they failed then. They would have lost their clients money and more importanly the would face not only private litigation but public as well. They would not be in the position given the pain we would be coming out of today. That did not happen. I don’t believe it will be allowed to occur thus the mechanism which should have prevented this occuring is not in place today.

    I’m against policy makers interferring into markets but it’s because they have that I worry what they now do will still benefit those they protect and cause further distortions. I can’t stress enough how little I think this would be an issue today had the solutions been different. It wasn’t and those that helped us get to this discussion are who we are relying on to alter their thinking on the remedy.

    Also sever the relationships which keep them in power.

    I’ve answered nothing….sorry.

  • rhp

    To me, the answer to some of the above questions is related to intent of GS’s communications. Are the releases really to inform the public of their particular position, or are the releases timed and cherry-picked so that a particular outcome is obtained that is beneficial to their position.

    The weight of authority IS carried by GS and other large financial institutions (I mean ethically) or at least should be. Should they be held to a different standard in relation to the public’s economic/financial health than doctors are to the public’s physical health?

    I trained as a physician. If you are not as knowledgeable in the field of health as I am, you will probably listen to me. I also need to make a living. Does that give me the right to advise you to pursue a certain line of therapy if I just happen to own the PT center that I advise you to go to? (actually now illegal in most states) or take the pill that the drug company happens to give me “incentives” to prescribe? or advise you to have a spinal fusion using the instrumentation that a certain company pays me $400,000 to “research” for 8 days of work? (true example).

    Is Goldman making its announcements as a public service? I agree with Cullen (I think). When such large sums of money are involved, there is far too big an incentive to engage in conflicts of interest.

  • flow5

    “Move the market” Not much different than jawboning or moral suasion. You always have to figure that any announcement was preceded by market positioning. To be believable the high-profile proclamation has to be made by someone with a track record. And if you cry wolf enough the game would end anyway. It not too much different than buy the rumor, sell the news. Remember also that always being in the news didn’t help the HUNTs who filed chapter 11 bankruptcy trying to corner the silver market.

    That said (history shows), that in a free capitalistic society it is hard for laws and regulations to be too restrictive (at least when it comes to the financial markets). I don’t find the CFTC’s arguments that farmers are better off shorting (hedging), when the market price of corn is skyrocketing. There’s nothing productive about derivatives. Were better off completely without them, than with them.

  • B B

    Cullen,

    I agree totaly. This is actually the biggest risk facing the economy. As i have asked before, why is a hedge fund/invesment bank able to buy $100,000 of oil with $8,250 down versus $30,000 down to buy $100,000 of apple stock.

    Last time I checked oil was a strategically important input into the economy.

    Then again the 2 & 20 crowd needs to get their 15:1 leverage somewhere…

  • GreedsGood

    In regard to Goldman and the flip-flop around oil price targets over the past month, not sure what to make of it. If they are telegraphing to buy here, I’m assuming that they are loaded up and ready to sell into their bullish call? Anyone have an idea what this is all about?

    On one hand, it would be easy for them to whipsaw the dumb money and lock in easy profits. On the other, if they are making frequent directional calls and consistently putting their research clients & retail on the wrong side (by trading the other side), they won’t hold much clout for long.

  • goodfriend

    I have a friend who did a master at a top french school back in the days when i was also a student (10 years ago). They had a presentation by an oil company trader…during this presentation he basically explained them how to create a shortage…in a typical banker like cunning way (without explicitely putting appropriated words on this strategy)

  • In Banking

    The vast majority of bank Commodities trading is not speculation and not proprietary trading. It’s actually for client servicing providing clients (drillers, refiners, even sovereign nations) the ability to offload market risk for fixed pricing. There are also three levels of limits: bank exposure limits, exchange limits (for non-OTC trades) and CFTC limits on how many unhedged contracts can be held by individual entities. Dodd-Frank will make even more limits across exchanges and products that will need to be monitored on much shorter time lines (even intraday). Eventually, just about all OTC products will be traded on exchanges and require clearing houses in order to trade. At the exchange level, exemptions can be granted when proof is provided that a hedge exists (either in other exchanges or on the OTC market) and even then it is on one side (long/short) and only for a certain time period before require a new application for exemption.

    There’s also big differences between financially settled and physically delivered commodities. Its a mistake to assume outright that a massive risk exists at the banking level – there’s a far greater complexity to these markets than is being covered here.

  • T. Blazedman

    Greed is good,

    I wish I could agree with you….”they won’t hold much clout for long”….but the reality is the masses are still reacting to their calls despite the recurring role they played in the collapses in 2000 and 2008 and their clear manipulation (if not outright frontrunning) now.

    It’s rediculous.