Monday, January 12, 2015

On Commodity Price Manipulation Using Futures or Derivative Markets

This is an educated non-economist's attempt to understand one mechanism for commodity price manipulation, and its ramifications.  One need only search "price manipulation using futures" or similar phrase to see that it is not a new topic.  For example, writing in Forbes about crude oil prices in 2011 (which at the time were high and increasing), Jerry Taylor and Peter Van Doren of the Cato Institute concluded that "[e]ventually, futures prices have to reconcile with 'market fundamentals' (the term of art for the real supply and demand . . .in physical markets)." They explained how the price manipulation mechanism works and concluded that it was not likely behind recent increases in crude oil prices for essentially two reasons.  First, they saw no reason for traders to push prices upward only, when they can just as easily push prices downwards.  Second, they believed there was a lack of evidence of increasing oil inventories that should naturally accompany collusion to artificially bid futures prices upwards, by action of arbitrage of spot market prices.   I am no expert in the oil markets and have no opinion as to the reasonableness of their conclusions regarding crude oil price action in 2011.  That is not the point.  The crude oil market is complex and includes too many variables to draw quick conclusions.

A simpler market exists in precious metals such as gold, where the commodity is not perishable or consumable, and cost or supply of  storage facilities are not major factors.  Repeating the search mentioned above with the added word "gold" produces a spate of recent articles on the topic, at or near the top of which is likely this article by Paul Craig Roberts. Written almost exactly a year ago, the article summarizes processes for manipulating the price of gold, notes that some of these processes require gold to be supplied by the party manipulating the price downwards, and predicts that once the supply runs out "the Fed will have to abandon QE or the US dollar will collapse and with it Washington’s power to exercise hegemony over the world."  Numerous articles along the lines of Mr. Robert's can likewise be found, but typically not from mainstream sources.  Many are published by gold investment services, who might be expected to promote stories predicting future increases in gold prices. Nonetheless, there is a  evident widespread populist belief in a grand conspiracy to depress the price of gold, expected to end with a dollar collapse and/or end of QE and therefore sharp rise of interest rates, that goes beyond mere shilling for gold investors.  Mainstream media stories on the topic can be found, but these ignore or dismiss the grand conspiratorial story.  For example, this story from Bloomberg describes an actual instance of price manipulation using gold futures, under limited circumstances now reported as corrected.  Grand conspiracies are beneath mention.  This recent story, also from Bloomberg, ascribes the fall in gold prices to weak oil prices and diminished inflation fears.  This conclusion seems reasonable enough.

Actually, the dollar has been increasing against most commodities since July of last year, as illustrated by this chart (partially reproduced above).  The general weakness of commodities since that time until now can be verified from many sources.  Not only has the dollar done well against commodities over the past six months or so, but it has also outperformed most if not all of the world's major currencies.  It's been a remarkable performance, and it is not clear what might have triggered such a broad advance.  One thing thing that probably helped were reports that the U.S. had surpassed Saudi Arabia as the world's largest oil producer, back in July 2014.  A glance at the charts confirms that for at least the past six months, a major factor in gold price has been dollar strength, probably outweighing other factors including price manipulation, to the extent it occurs.  But I digress.  Trends analysis is not the purpose of this post.

No, this post was inspired by a sort of waking dream that has been floating around my head for a while, a thought experiment if you will.    Imagine the planet Economa, much like our own Earth, on which a global empire of intelligent aliens has evolved.  Like us, the aliens discovered the utility of gold as a medium of exchange, and transitioned through gold certificates and a great war in which one nation amassed most of the planet's gold, to a global fiat money backed by that nation's gold certificates, which eventually became its fiat reserve currency.  So, urged and guided by a coalition of bankers who recognized the superior profit opportunities they would enjoy as officiators of inexhaustible fiat money supplies,  the entire planet used fiat currencies, and traded fiat currencies.  Generations passed, fiat currencies were digitized, and the aliens forgot the utility of gold as a medium of exchange.  Gold was much less convenient than the digital tokens they used for exchange, and prone to taxation and other forms of theft.  Gold had a few uses, but was mainly valued as a long-term asset for storing value at a relatively low cost.  Thus, the aliens were prone to buy gold when they perceived other commodity prices increasing, and sell gold when they perceived commodity prices to be falling.  The bankers of the coalition found these habits annoying, and vaguely threatening.

Control over the money supplies of the entire planet of Economa made the coalition of banks extremely powerful, and so it came to control all of the important social institutions of Economa, including its politicians, bureaucrats, police, military, and religious leaders.  These institutions it funded partly by newly-created fiat money certificates, and partly by requiring payment of taxes in the fiat money.  The coalition knew it was important to keep taxes high enough so that all economic activity on the planet would continue to use the fiat money that the coalition controlled.  They found that keeping taxes high allowed them the opportunity to create even more fiat money, and thereby control a greater share of total economic activity on Economa.  Even if that meant that the total economic activity was a lot smaller than it might otherwise have been, the coalition preferred to make sure that they controlled a great enough share so that they would not face any threat of opposition.  Their share was much more than enough to securely enjoy all the pleasures and services that Economa provided.  Mostly, they used it to work their will, such as by rewarding their allies and undermining their opponents.  Any alien that attempted to get into the fiat money business, and certainly the gold certificate business, without the coalition's approval quickly found itself out of business, if not behind bars! 

The aliens of Economa raised vast farms of geekonut trees bearing geekonuts, from which they extracted geekonut oil.  Geekonut oil was not only edible and nutritious; it was very clean-burning, producing only water and carbon dioxide when burned at high temperature.  Accordingly, geekonut oil was used for food, and as an energy source for industry, households, and transportation.  Despite advances in geekonut farming technology, the supply of geekonut oil could not keep up with demand.  Exacerbated by the ever-increasing supplies of fiat money washing over Economa, geekonut oil was always going up in price for as long as anybody could remember, with only seasonal dips now and then.  Prices of everything else went up pretty much along with it.  Whenever the aliens perceived or feared that prices would soon be going up fast, the price of gold would go up especially fast.

One day, a process was discovered for recovering geekonut oil not only from geekonuts, but from the constantly shedding leaves of the geekonut tree also.  It was estimated that this discovery would increase Economa's supply of geekonut oil three fold and outstrip all demand for the foreseeable future, at only a marginally higher cost of extraction.  Investors rushed to build processing plants, and the planet's supply of geekonut oil began to increase.  After a time, the price of geekonut oil began to fall.  And fall. And fall still further.  So did prices of everything that depended mainly on geekonut oil, or competed with it.  However, because the coalition of banks was still regularly increasing fiat money supplies, prices of everything else started to go up.  And up.  And still further up.  But this was not noticed as much by ordinary aliens, because so many of day-to-day things depended mainly on geekonut oil.

Imagine that these aliens had futures and derivatives markets that were founded in response to demand for hedging price volatility by commodity producers, but that had grown to be dominated by speculators.  The coalition of banks used these markets to influence commodity prices up or down as they pleased.  When the coalition wished to depress a commodity price, it sold "naked" futures or derivatives in the commodity, driving the price down, buying the futures back just before expiration, even if at a loss.  By "naked," it is meant the underlying commodity is not owned by the seller, who intends to repurchase the future closer to its expiration, without ever delivering any of the actual commodity.  The coalition repeated the selling/rebuying of the naked futures, "rolling" the future forward near the end of each cycle.  It did the reverse when it wished to drive a price up; it bought futures or derivatives, driving the price up, and rolling it forward just prior to expiration, at a loss if necessary.  The coalition did not fear losses in fiat because of its control over an inexhaustible supply.

A debate raged among the bankers of the coalition.  Some wanted to stabilize the price of geekonut oil, fearing the unpredictability of prolonged lower prices in so vital a commodity.  Others (not letting a good crises go to waste) wanted to use the confusion caused by the unexpected fall in geekonut oil prices to crush the idea of gold as a safe "store of value" forever, or at least enough so that the coalition could buy back the gold it had sold off after the great war, and once again own most of Economa's gold.  It was decided to concentrate all firepower on driving the price of gold down for a long enough period to secretly repurchase most of the gold.  So the question for the thought experiment is, all other things being equal, can the coalition accomplish its goal?

There is no mathematical formula that can be applied in the general case to answer this question, because there is no general case.  Market behavior will depend on the behavior of its participants, which behaviors depend on numerous variables, including the knowledge and motivations of buyers and sellers, that are beyond reckoning.  It is necessary to assume a specific case.  Assume the participants in the Economa gold futures market consist of coalition banks, wholesalers for gold retailers, gold producers, and speculators.  Nobody else is interested.  Assume the coalition banks always act in concert, being controlled by a single person, named "Stan."  Assume the wholesalers buy to supply retail inventory, and gold retailers tend to adjust inventory levels in response to trends in gold prices.  That is, retailers tend to favor increasing inventory when prices are rising, and decreasing inventory when prices are falling.  Assume producers participate for price hedging purposes, to ensure that future production will receive at least a certain minimum price, and that production is only a small fraction of total market volume.  Assume speculators are interested in short-term profits only.  The behavior of ordinary retail purchasers has already been noted: they tended to buy gold when perceiving other commodity prices increasing, and to sell gold when perceiving commodity prices to be falling.  Assume derivatives are settled in cash (fiat) only, while futures are settled in the underlying commodity if held at expiration, but can be traded for cash up to the date of expiration.

With these assumptions, it is apparent that the coalition, backed by its inexhaustible supply of fiat, can accomplish its goal, as least for so long as the price of geekonut oil is adjusting downwards or remains at "historically low" values.  There are no independent banks of consequence on Economa. When the coalition floods the futures market with sell orders, it holds steady or slightly decreases its buying activity in futures and spot markets.  Speculators detect the coalition's market actions and deduce that a downtrend is incipient, so they also switch to selling, hoping to ride the trend downward.   Fearing lower future gold prices, producers buy only enough futures to cover committed production, and begin making plans to cut the least profitable mines if prices fall further.  Their diminishing output does not impact the market greatly because it is only a small fraction, and can be balanced by reduced demand from the coalition. Wholesalers are not eager to increase inventory in an atmosphere of falling prices, and buy mainly to supply the consumer market; they may even deplete inventories, fearing lower prices in the future.  The consumers of Economa, true to form, generally perceiving stable or falling prices in geekonut oil and related commodities, sell or hold.  Prices fall; speculators and the coalition profit in the futures markets, and the coalition is able to gradually build back its holdings.

The coalition will suffer short-term losses in its gold holdings as prices continue to fall.  Such losses are of utterly no concern to it.  The coalition has infinite liquidity in fiat, which is only enhanced by the falling price of gold, so can never run out of money.  Also, it can reverse course and control future gold prices upwards whenever inflation starts to bite the consumer again, as it inevitably will.  It knows that it will eventually profit from its gold holdings, which meanwhile will help to dampen panic over its inflating fiat, because it can once again claim that the fiat is "backed by gold."

Earth is not Economa, but many of the assumptions made about about the gold market on Economa seem roughly true on Earth.  We on Earth have also been experiencing falls in commodity prices, driven in part by new technologies, although there may be less clarity about how long this can continue.  There is at least one notable difference.  While there may be a spiritual "Satan" in the form of a love of money and will to dominate at least partly motivating central bank activity, Earth seems to have banking factions that are pretty clearly in competition with one another.  There is no identifiable "Stan" here.

The Federal Reserve coalition has the advantage of reserve status for the moment, but is tied to a nation-state suffering from chronic trade deficits.  Some other national banks, notably China, are tied to countries enjoying trade surpluses.  Would such a bank be willing to exchange a chronic trade surplus from its tax farm with de facto reserve status for its own currency?  One might think so, but China is among the governments advocating replacing the reserve status of the dollar, with a "basket of currencies" rather than a single currency.  Geopolitically such a suggestion makes sense for China, but it is curiously close to the "American dream" of a world reserve bank identified by Murray Rothbard near the end of his book "History of Money and Banking in the United States."  It would in effect convert the international financial system into a consortium of the central banks whose currencies appear in the basket, and would require rules of economic governance for each member bank's tax farm similar to those now applied and failing in the Euro block.  This would certainly disrupt the Federal Reserve's ability to finance a globally-dominant military force, while still leaving it an important but not necessarily dominant member of the ruling consortium.  For many banks outside the United States, this may be the preferred outcome.

If the "currency basket" approach does take hold without major disruptions from acts of war, how much difference would there be between Earth and Economa?  Perhaps not very much.  If major banks such as China are openly or secretly in favor of a "basket" approach, perhaps this explains in part why members of the Federal Reserve might dare to suppress prices without fear that other central banks would embark on massive futures buying and refuse to sell at any price, demanding delivery of gold.  Such tactics would unmask the ruse, and risk sudden devaluation of the dollar and economic shock when it is discovered that the banks selling the futures have no ability to deliver the gold they have sold.  If there were any aggressive buying of gold by banks holding massive quantities of the reserve currency, massive selling of gold futures by the reserve currency issuer bank would be very risky. On the other hand, if central banks collaborate with a shared goal of transitioning to a currency basket approach and destroying faith in fiat alternatives such as gold, allowing certain banks to gently accumulate gold while others reap the benefits of reserve currency status for a while longer may merely be an aspect of the bargain.

Conspiracies by nature are easy to suspect and difficult to prove.  I make no claim of proof here, and will admit that even my suspicions may not be well-founded.  The point is, if a global banking conspiracy to suppress gold prices exists, it might not end in a dollar collapse, but in a collapse in confidence in gold, followed by a transition (gradual or otherwise) to an effectively worldwide fiat currency based on a basket of fiats governed by international agreement.  This would likely be followed in short order by intense international regulation of all fiat alternatives.  In an environment of cooperating central banks enjoying public confidence in their fiat certificates, such an outcome is not unthinkable, and there are reasons to think would be highly preferable to the persons controlling such banks, whomever they are.  The goal is perfect knowledge and a generous percentage of every voluntary exchange of value between strangers facilitated by any medium of exchange, superficially for social goals, in actuality to cement the power of those controlling the fiat spigots and preventing anyone else from accruing real wealth.

If so, accumulating gold, ammunition, bitcoin, or other fiat alternatives will ultimately prove to be of little value in self-preservation.  You might do better by reducing the number of strangers you depend on, and increasing the number of true friends.  By this I mean building communities of mutual trust that do not depend on some medium of exchange to facilitate exchanges of value, by the laying up of treasures "in heaven" instead of the earthly sort.  It means doing excellent things by social trading without any medium that can be exchanged for a fiat certificate.  Such a goal is worth meditating on, even though it seems in a practical sense utterly impossible.  It flowers in a thousand ways that are taken little notice of.  If you see such a flower in your life, take note of it, and water it well.