In a recently published research paper in the Journal of Applied Corporate Finance, Tim Adam (from the MIT Sloan School of Management) and Chitru Fernando (from the University of Oklahoma Michael F. Price College of Business) report in their research paper "Can Companies Use Hedging Programs to Profit from the Market? Evidence from Gold Producers" that during the 10 year period of 1989-1999, the gold derivatives market was characterized by a positive risk premium that resulted in short forward positions generating positive cash flows. The authors found that the gold mining companies that hedged their production during this time realized an average cash flow gain of $11 million, or $24 per ounce of hedged gold per year, compared on average to an annual net income of only $3.5 million without hedging. Of interest is that as a result of the positive risk premium that resulted from a positive spread between the forward price and the realized future spot price, short derivatives positions did not result in significant losses, even when the price of gold increased. In summary, hedging helped increase profits.

Also of interest in the article was the finding that there was also a significant level of volatility in corporate hedge ratios, implying that some managers were incorporating market timing into their hedging strategies (no surprise, as hedgers will sometimes begin to speculate). The authors found that attempts to time the market by "selective hedging" were futile and unprofitable, even causing the company to consistently lag the markets as they attempted with little success to successfully adjust their hedge ratios in response to expectations regarding market direction.

In summary, hedging helped profits, but the benefits were from hedging, and not from the risk managers ability to predict price moves as they set their hedge ratios. Therefore, one can expect, at least for the gold mining companies, that while earnings and profits may remain volatile, those investors holding longer-term investments should see higher returns from companies that successfully implement and execute a defined hedging program that do not try to engage in market timing. While it is difficult to know when any company that you are investing in begins to move from hedging to market timing, at least knowing that a company is hedging will give you the potential for higher returns as long as you can weather a few up or down moves that may temporarily reduce profit margins.

Just last summer as crude oil moved towards $150 a barrel, some companies were being applauded for having had the foresight to hedge their energy and fuel cost by locking into lower prices for future delivery. Unfortunately, as crude oil fell sharply from its summer highs to below $40 a barrel, some of these same companies were now finding themselves on the other side of the profit/loss equation (see WSJ article). Just recently, Delta Airlines reported a $507 million loss on its fuel hedges in Q4, while UAL reported a $370 million hedging-related loss. Southwest Airlines, known in the past for its smart use of hedging, is finding that its needs to post $300 million in collateral with its various counterparties as the price of crude oil and fuels continue to decrease. Not surprising, or maybe surprising to some, it how investors are punishing the stocks of those companies that were considered to be "prudent" in their use of hedging. What is often forgotten by both investors and management is that hedging is not speculation, or at least should not be treated as such when done correctly. A properly managed hedge should theoretically provide a predictable cost, but changes in the price structure of an industry could cause earnings to be volatile, not to mention the company stock price.

For instance, if an airline company has hedged its fuel cost based on crude oil being around $70 a barrel, the company should see some benefit compared to its un-hedged competitors as crude moves above $100 a barrel. Yet if companies in the industry have pricing power, they can pass some or all of this cost on to their consumers. Therefore, higher costs are followed by higher product prices (obviously, never exactly one-to-one, even with pricing power). For the un-hedged company, their profit margin will theoretically be the same, while the hedged company will experience increased profits due to their lower cost structure compared to their competitors. On the other hand, as crude oil prices fall into the range of $30 per barrel, the un-hedged companies could once again adjust prices, but now to reflect their lower cost (and attempt to take business from those paying higher costs who may not be able to adjust prices as quickly). Those companies that are hedged and are forced to pay the higher $70 per barrel price will experience a lower profit margin, lower earnings, and potentially a lower stock price.

So while hedging can help a company "lock-in" to a specific cost structure, if others within the same industry are not hedged, and those companies have pricing power, the hedged company can expect to see higher swings in profit margins and earnings, and subsequently a more volatile stock price. Not only does this surprise investors who were expecting a less volatile stock given that the company was hedged and should experience consistent costs, but it also generates inquiries from management as to why the risk management department suddenly turned into speculators, and more importantly why they made such a bad bet. In reality, the hedging allowed the company to control what it could (the cost), but still left it at the mercy of what it had less control over - industry pricing and investor reaction. Something to keep in mind as you invest in companies and industries that actively engage in hedging, especially in commodity markets that are volatile.

New draft legislation in Congress is considering two key changes to the CDS market (see Bloomberg article). First, the bill would require that all trading in the over-the-counter derivatives market would have to be processed by a clearinghouse. Second, the draft legislation would ban CDS (Credit Default Swap) trading unless investors owned the underlying bonds. While the CME group, ICE, and other exchanges would certainly cheer the first move, the second could make any added revenue streams disappear.

Given the size of many of the outstanding bonds, the single-name CDS market would have a difficult time existing. At a time when many markets are frozen, eliminating speculation does not seem to be the best course of action for a market that is currently suffering from liquidity issues. Surely, other measures can be taken to curb speculation (such has been done in the futures market with position limits) without further limiting liquidity and price discovery.

While utilizing a clearinghouse would help to define prices in the OTC market (certainly not welcomed news for the investment banks), and seems to make perfect sense, doing so would require some level of standardization. Some worry that a "non-standard CDS" market will still exist, with the proposed legislation simply forcing such trading outside of the US. While this not only forfeits a potential revenue stream for some US exchanges, it may also give up the ability of US regulators to have a say on how this market operates, which also seems counterproductive to the spirit of the draft legislation.

Margin debt at NYSE member companies fell 37.6% for the year through November, down to $201.48 billion (see WSJ article). This is no doubt that some of this reduction came from forced margin call selling over the last few months. While rampant speculation may not reenter the markets anytime some, the reduction of speculative investments, along with past hedge and mutual fund redemption selling, is helping to clear out the excess in the market, allowing it to find a bottom and begin building a base. January is often used as a bellwether for things to come in the markets, and the market action on the first trading day was encouraging - yet one day does not make a market. Nonetheless, January will certainly continue to generate interest as the confluence of a new year, a new president, a new congress, a new stimulus bill, and an unfolding credit crisis continue to intertwine in what will continue to generate some interesting times, not to mention opportunities in the market.

The CFTC is focusing on the swap market, which is currently for the most part unregulated in comparison to the exchanges (see Financial Times article). Currently, swap dealers receive exemptions for speculative positions limits that may apply to other speculators in the commodities markets. In essence, swaps are private contracts between investment banks and investors that allow for exposure to commodity prices without investing directly in the futures that backed the assets. This does allows one to take a speculative position without posting the same margin or abiding by the same position limits that one would encounter on a futures exchange such as the Nymex. A CFTC survey found that of the 550 clients of swap dealers, at least 18 were above the exchange limits as a result of using swaps. Closing this path, or at least imposing the same limits, would put these traders more in-line with current exchange requirements. Whether this curbs speculation to a noticeable degree, beyond affecting the 18 or so mentioned clients, will have to be seen.

The Inspector General for the Commodity Futures Trading Commission (CFTF) has begun to investigate an earlier report on the commodity markets (see Reuters article). At question is the CFTC's role in an inter-agency task force report that came to the conclusion that supply-and-demand and not speculation was responsible for the increase in energy prices. Since the report came to a conclusion that some in Congress did not like, and came at a time that was a few days ahead of a Senate vote on the bill, various senators, including some on the Energy and Natural Resources Committee, allege that: "the CFTC knowingly included "seriously flawed" data and the timing was "suspicious." Interesting. The Senate is debating an important issue, a major regulator provides a report and data in a timely manner, and yet the reaction is to question the timing of the report because it came to a conclusion that did not support their initial assertions. Of course, none of this is surprising, and the report may in fact be flawed, but you have to wonder whether if they had come to another conclusion if an investigation would be occurring. Of course, usually when action is finally taken, it often is too late. Maybe this is just another indication that crude oil prices have indeed peaked, Gustav notwithstanding.

As reported in the cover story this week, Barron's outlines the argument that we may be seeing a near-term top in the crude oil markets, and in fact, this may be a sign of a bursting bubble. To setup the argument, Barron's discusses the impact of supply and demand, along with the effects of institutional investments in commodity-linked indexes. For a quick overview, Barron's provides a nice one page overview of oil supply and demand, along with a chart showing the linkage of the price of crude oil as compared to the rise of the Nasdaq Composite in the late 1990s. While Barron's does present the various points for crude oil prices increasing and decreasing (discussed more below), it refers in both the article and video linked below to the "eerily similar" linkage between crude oil prices and the Nasdaq Composite, and how this implies a correction is possible. While a correction is possible, and may be setting-up as we speak, I am not sure it will be happening simply because the price pattern looks like a previous non-commodity bubble, technical analysis notwithstanding. Even Barron's straddles the fence somewhat by stating that prices could increase to $200 a barrel in the next decade, but could fall to $100 a barrel by year end - not exactly your typical deflating bubble, but more like a short-term pull back or correction.

So what exactly are the pro and con arguments regarding the bubble bursting? As to demand, it is mentioned how while the U.S. per-capita oil consumption is 25 barrels annually, both China and India are small in comparison, with China consuming only two barrels per person per year, with India consuming less than one barrel per person per year. Given that China and India have 1.3 and 1.1 billion citizens, respectively, there is an expectation that oil demand will increase in each of these countries as more of their citizens look to enjoy the fruits of the world, such as air conditioning, automobiles, refrigeration, and computers.

It is further speculated that China has been hoarding diesel fuel ahead of the Olympics in order to produce electricity without coal generation - which has been polluting the country, in particular Beijing where the Olympics are being held. China will likely go back to the cheaper coal once the games are over, thereby reducing diesel demand. China has also recently raised prices on gasoline by 18% (see previous post), a move that is expected to place further pressure on demand, although as described in the post, some feel this may just allow pent-up demand to be satisfied as profitability will return for refiners who have been hurt by higher crude oil costs, but have not been able to pass prices on to customers. This has essentially reduced the gasoline supply in China as refiners shut down or scale back operations. Better margins will now increase supply for consumers demanding gasoline, even at higher prices.

It is also mentioned in the article how Saudi Arabia has pledged to boost production by 200,000 barrels a day, from 9.5 million barrels a day to 9.7 million barrels a day, in order to take pressure off prices (see previous post). The potential for supply-oriented news out of this weekend's summit for oil producers and consumers may also generate additional production increase promises. Unfortunately, much of this oil is sour, and not the light sweet crude currently demanded by the markets, and also subsequently responsible for driving up prices. Whether the Saudi's even have the ability to increase production in their aging fields is also a concern regarding any promised production increases.

As for global oil consumption, it is down in total for the OECD nations (which account for more than half of all global oil demand). Demand itself is currently running about 86 million barrels a day and is expected to be relatively flat as nations cut back on consumption, in particular, automobile miles traveled. Yet, oil demand continues to grow in the developing world, and it will be difficult for even developed countries to reverse their trends quickly. As stated by Byron Wien, the chief investment strategist at Pequot Capital Management, "The world isn't finding oil fast enough to replace the 3% to 4% that gets pumped every year." With oil being controlled by governments that have an interest in maximizing revenues, it is unlikely they will have any near-term interest in boosting current production until the signs of demand destruction become more evident. With supply projections even less, at around 85 million barrels a day, with excess demand currently being made up from inventories, lower demand may result in break-even levels at best.

Some analysts are also speculating (hoping) that the U.S. Federal Reserve will begin raising interest rates later this year, which while helping to fight inflation in general, would also help boost the dollar, thereby reducing the cost of dollar dominated crude oil. Given the upcoming presidential election, and the history/attempts of the Fed to stay neutral during the second half of election years, it is unlikely they will do anything until the elections are over in November. The same could also be said for opening up the Strategic Petroleum Reserve. It is unlikely that the president will begin flooding the market this year in an attempt to increase supply and lower prices, although the government recently did stop purchasing oil for the reserve. If the president would begin selling, it would no doubt appear political, even if welcomed. Ironically, opening up the SPR might end up being a good trade if the country was able to sell oil at current prices when it was bought on average at much cheaper prices. Of course, what prices would be paid in the future to replace the oil is unknown. In addition to the SPR, the lifting of off-shore and protected land oil drilling bans could also have some impact. While it is often argued that the impact would be longer-term, as much as 10 years out, lifting of the bans would certainly send a signal that the U.S. is finally getting serious about the problem and is willing to consider all alternatives, not to mention putting political partisanship behind it. Of course, I would not hold my breath on that one, but if prices continue to rise, expect to see pubic support for lifting the bans begin to shift as the U.S. approaches the next election.

Of course, no article on crude oil prices is worth it salt without discussing speculation and investment. While speculation is not discussed in great detail in the article, the increase in commodity index investing is. Investments by endowments, pension funds, and institutional investors has totaled $260 billion as of March, up from just $13 billion in 2003, with $55 billion flowing into commodity investments in Q1 of this year. Calpers alone is listed as increasing its commodity exposure from $500 million to $7 billion. Yet, isn't this to be expected? Good managers should be expected to deploy capital to the areas they feel will see that greatest potential. While the risk are present, fund managers are under increasing pressure to generate abnormal returns. Right now, commodities and energy plays represent some of the best opportunities, but the party may be coming to an end as Congress and regulators are considering limiting fund investment in commodities, along with placing larger margin requirements on speculators. Yet to be seen is whether the higher margin cost, or increase cost of carry will force index funds and speculators to open up stored reserves - speculated in some cases to be in cargo ships off the coasts of various countries. Nonetheless, it will change the dynamic. Whether it changes to price trend is yet to be determined.

Like Barron's, a short-term correction would not surprise me. Nor would a retest to the $100-110 range. Breaking $100 would probably signal or long-term correction, and a possible bursting of the bubble, but even Barron's is not projecting the prices to fall this low. In fact, it has actually done a pretty good job of outlining both the bull and bear arguments, while also tempering how much it expects the prices to fall even if the correction it is predicting is severe enough to be bubble bursting. In the end, Barron's itself may have placed the best crude oil hedge yet.

As mentioned in recent WSJ and Bloomberg articles, the Commodity Futures Trading Commission is conducting an investigation into potential crude oil price manipulation. What is interesting about the story is not only how the CFTC is initiating an investigation, but that they are making a formal announcement of what they are doing, an indirect indication that they are also aware of the public and political outrage given higher energy costs. The CFTC commissioner said it best:

"It's important that people who are paying high gas prices understand the CFTC is on the case and that we're closely monitoring and in this instance deeply investigating any potential abuse in this important energy market"

I guess we will have to wait and see if the investigation uncovers anything of interest, or if it is simply being used to keep regulators and Congress at bay until energy prices hopefully retreat to more "normal" levels (or the public gets used to current prices, which is doubtful).

In addition to reporting about the investigation, the WSJ article does highlight some potential abuses, including using the Platts price-reporting system to manipulate prices. Essentially, traders could issue numerous orders during the window of time that Platts uses for setting the prices that it reports to subscribers. This artificially high or low price could then be used to profit in other markets by taking an opposite position based on the move in reported prices. Another potential manipulation includes spreading false information about oil tankers being either empty or full, sending the wrong impression about supply, and thereby affecting price. Whether either of these potential abuses (if true) could be classified as wide-spread speculation, and thereby causing a larger scale lasting move toward higher energy prices, is yet to be determined.

When considering potential abuses it is important to remember that a company can actually take advantage of insider information regarding its own production and demand when it makes trades, either for hedging or for increasing/decreasing its own position. Since insider information is not technically illegal in the same way it is with equities, this forces regulators to work a little harder to prove that traders were intentionally trying to create an artificial price in order to profit from speculation. Something tells me that this aspect will either be ignored or put into question as some look for validation of out-of-control speculation abuses.

A recent WSJ article highlights a commonly overlooked effect or consequence of commodity trading - that of bad hedging or speculation bets causing buying pressure, driving prices higher. As for speculators, we often assume that they are just following the short-term trend, which is currently up, adding further momentum buying pressure. Sometimes the buying pressure comes from speculators and hedgers that are simply exiting out of a bad past position, either due to margin calls, or simply because they can no longer take the pain.

Many producers entered into contracts to sell crude oil in the future, locking into higher prices for future delivery. While the future prices were higher than the spot price at the time the contract was written, some of the contact prices are now as little as half the current spot price, even for contracts with a delivery of less than one year. As a result, companies and traders are being forced to close these deals by buying back existing contracts that were wrote just months ago.

Longer-term trading has increased over they years, with Nymex oil futures contracts tripling over the last four years, with much of the growth coming from futures contracts that expire more than one year out. This form of long-term hedging and speculation was relatively rare in the past and is certainly contributing to some of the current increase in trading activity and price movement as these trades, which were probably not expected to be as speculative, are now needing to be unwound.

A recent Bloomberg article also discusses the impact of speculators selling out their contracts, but focuses more on short-term speculators that have recently closed out short positions after making bets that the price of crude oil would decrease after the recent run-up. The closing of these contracts has put further buying pressure on the commodity. As evidence, open interest has been falling for months. The CFTC list how "non-reportable" small-size speculators have been closing out their short positions, which were 47% higher than long positions. Any time you have a rising and shrinking market (open interest is decreasing, while prices are rising), it is usually a good indication that speculators are closing out positions and leaving the market.

The New Zealand Rugby Union "dodged a financial bullet in 2007" by hedging against movements between the New Zealand dollar and the U.S. dollar. The hedge was put in place as the New Zealand dollar briefly dropped to 68 cents against the U.S. greenback. The Union hedged more than $24 million U.S, and ended up saving $6 million as the New Zealand dollar rose to 77 cents against the U.S. dollar. No word exactly what they were hedging against (possibly salaries for U.S. players?). Maybe speculating, and not hedging, might be a better description of their position, but who really know.