Reduced Liquidity May Actually Raise Prices
Reducing market participation will not impact the fundamentals of supply and demand
April 20, 2012
Unfortunately, President Obama's announced plans for increased oil market regulation will not result in lower gasoline prices. His proposal to increase funding for the Commodity Futures Trading Commission was positive, if only to assuage fears among the general public that oil market is rigged against them. Increasing penalties on those who manipulate prices by illegally holding back supplies or attempting to corner a market are also welcome.
The flaw in the president's plans has to do with empowering the commission to regulate the margin deposits required to trade a crude oil or other commodity futures contract. This reflects a school of thought that somehow increasing these deposits will run the speculators out of town, allowing prices to fall. This assertion attempts to blame the price discovery mechanism or the markets themselves for the underlying conditions that produce the prices being paid by traders.
Raising margin requirements will only serve to concentrate the power of larger hedge funds and other deep-pocketed players. Small investors and even medium-sized players will feel the squeeze, resulting in less liquidity.
The purpose of margin deposits in the futures markets is much different than the stock market. In futures, your margin deposit serves to collateralize the price differential between your purchase and ultimate sale price. Currently, the commodity exchanges determine the amount of margin required based on several factors, most importantly, the current level of market volatility.
Crude oil is a global commodity, whose value is greatly impacted by the many threats to its production. Today, there are real fears about a possible military conflict with Iran that could disrupt oil flows from Saudi Arabia and Iraq. Demand continues to grow. During the past decade, China has gone from being an exporter of oil to the second largest importer of oil. Meanwhile, U.S. refiners are closing plants at an alarming rate.
For commodity prices to fall, you need to produce more and use less. The terrific fall in natural gas prices is a great example of this simple tenet.
Reducing market participation through arbitrarily raised margin deposits will not impact the fundamentals of supply and demand. In fact, the reduced liquidity may have the opposite effect of actually raising prices. After all, there will be fewer people who will be able to go into the market and sell short because they think $100 per barrel is nuts. And they do exist.