'Liquidity' and oil don't mix

Wed, Oct 28 05:48 AM

Oil prices have resumed their inexorable march towards $100 and beyond. Rather than just passively accept this and issue oil bonds to cover the resultant shortfall, the Indian government needs to be more assertive in international fora like the G-20 and tackle head-on the root cause of the problem which is the undue influence that financial markets have on commodity prices. At issue is not just the adverse budgetary impact, but the Indian government's broader, philosophical, approach to financial markets.

We knew six months ago that oil prices were likely to surge again as a result of global monetary efforts to re-inflate asset markets. At the time, in April, oil was trading at $52 and futures markets were pricing it at $59 for October. Last week they hit $80 and we could very quickly see a return to the stratospheric levels of last year as financial market participants benefit from renewed wind in their sails.

Regrettably, little has been done to address the dysfunctional state of affairs. The best-placed regulator is the US's CFTC. Under a new Obama-appointed Chairman, Gary Gensler, it has adopted a two-pronged approach: promising greater transparency and the threat of position limits. Despite Gensler's assertions that "economists have for decades recognized that transparency benefits the marketplace", the CFTC's attempts at transparency in recent months resemble something of a data striptease with the latest and apparently final instalment the most revealing.

The CFTC currently classifies market participants into four broad categories: producer/consumers, swap dealers (mainly investment banks), money managers (pension funds, hedge funds and so on) and all others. The data show that the actual producers and consumers of oil saw their share of trading actually drop from just under 30 per cent pre-crisis to 13 per cent today; with the big drop-off coming the week the crisis began (9 Aug 2007). Swap dealers currently account for roughly 45 per cent of oil trading and while some of it is on behalf of actual producers/consumers of oil, it would be naïve to believe that investment banks are only "providing liquidity". In fact, Goldman Sachs and Morgan Stanley were estimated to have made $7.5bn from "liquidity provision" in the commodities markets in 2007. While the data are highly indicative of an inflow of money from credit markets into commodities, it will not be possible to draw definitive conclusions unless the CFTC makes public the data by contract month, preferably with strike prices. This will not compromise trader positions and will provide some of the transparency which the markets clearly need.

But all this data perusal is subsumed under a more fundamental point. Commodities do not pay dividends like stocks, nor do they pay interest like bonds. They can only be consumed. They should therefore not be considered an "asset class". If regulators wish to provide liquidity, they should allow only "brokers", who match buyers and sellers over a day or so — and not "dealers", who take a longer-term risk on to their books and can therefore benefit from large directional changes in price. Allowing large financial institutions who do the latter to provide "liquidity", risks overwhelming the commodity markets with a tidal wave of money generated by excessively leveraged balance sheets. It is only a matter of time before the foolishly circular logic is redeployed, of "investors" buying commodities to protect against inflation only to drive up prices — thus causing the inflation they feared.

The CFTC's other prong, limiting the positions traders can take in energy markets, also appears to be getting whittled away. The financial services industry has mounted a sustained lobbying effort and warned that trading will simply move overseas. Last week, The

Financial Times reported that the CFTC's "swing voter" made what could be construed as an abdicating plea for help: "It has to be something for the G-20 working with the FSB (Financial Stability Board) and Iosco (International Organisation of Securities Commissions). All of these countries should be concerned. I think it is something they need to bring up and talk about."

The stakes for India are huge. We consume roughly a billion barrels of oil a year, so the difference between oil at $50 and oil at $100 is Rs 250,000 crores or 30 per cent of Central government revenue.

The way forward is clear. In concert with other emerging and

developed markets, India should demand much greater transparency and regulation of international commodity markets. The window of opportunity is fast closing, and the course we choose now will be indicative of the

government's philosophical approach to finance. The rules and norms which will govern international finance for years, if not decades to come, are being written now and India needs to be more assertively engaged.

The writer is a Delhi-based strategic analyst

express@expressindia.com

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