Get Ready: $5 Gasoline on the Horizon

Iran's (probably) hollow threat to close the Strait of Hormuz is a danger that has long faced the oil-consuming world. The 34-mile wide strait offers a strategic chokehold on the Persian Gulf, and Iran appears to have the upper hand in controlling it. In my (as yet unpublished) book Trust Me, I painted a picture of what would happen if Hormuz were closed after an Iranian missile strike on Israel:

Almost 40% of the world's seaborne oil supply goes through the Strait of Hormuz, around 15 million barrels per day. The loss of this oil on the open market, even for a day or so, would send prices even further through the roof. The traders were ready. If the Strait was closed, they would hold and profit. If it didn't they would sell tomorrow morning - and still profit. There was bound to be a bit of a panic in the Asian and European markets when they opened. Oh, life was sweet! Oil markets love a good disaster.

Although Trust Me is fiction, I have drawn a fairly accurate portrait of the oil trading community. Oil is a scarce, highly desired commodity, making it a magnet for traders.

Even at today's prices oil is an extremely cheap source of energy. The reason that prices have been rising gradually but doggedly for the past 30 years is because developing nations need more and more oil to power their cars and factories. But because it comes from countries where democracy is a pipe dream and despots and dictators treat oil reserves as their personal 401K's, it will not remain cheap. From the smallest coup to the most outrageous missile strike against a neighboring country, many of the producing countries' instability is palpable, Every ripple reflects in the price of oil, making the market easy to hype and to spook.

Add to this general uncertainty the snail's pace of refinery development in the western world, and we will see refined products such as gasoline and diesel become increasingly more expensive as demand rises. In fact, the refinery count is decreasing in certain countries. In the US, few permits to build new refineries make it past the environmental lobbyists or local residents. One old, but still productive, 145,000 b/d East Coast refinery owned by Sunoco is slated for dis-assembly to be taken lock, stock and smokestack to India.

Conoco Phillips shut its 185,000 b/d Trainer, PA refinery in September, and Sunoco closed the 175,000 b/d Marcus Hook, PA refinery recently. That effectively removes over 500,000 barrels of refined product per day from the US East Coast market - nearly 3% of daily US consumption.

In Europe the largest independent refiner, Petroplus, has had such terrible margins that its $1bn line of credit has been cut off. It will be tough for it to buy crude to refine if it survives, and even tougher for it to find buyers for its five refineries in this climate if it doesn't.

If there is anyone out there who does not believe that oil prices will stay over $100 a barrel, and probably rise to nearer $200, then they are delusional. And gasoline, jet, diesel and heating oil will rise disproportionately more. Get ready for $5.00 gasoline.

Deja Vu All Over Again for JP Morgan

  Twitter is alight with MF Global customers asking for the boycotting of JP Morgan. The bank may have received "stolen goods" when MF Global settled a debt allegedly using $200m of customer money. Dealbook said:

One e-mail chain refers to the transfer of roughly $200 million that MF Global owed JPMorgan Chase on Oct. 28 — the firm’s last business day before it filed for bankruptcy. In that chain, a senior official in the firm’s Chicago office was told to make the transfer, said the people close to the investigation who requested anonymity because the inquiry was still open... The roughly $200 million that JPMorgan Chase received is said to be entirely customer money.

 This must seem like deja vu for JP Morgan, which also pulled a snatch-and-grab before Lehman Brothers hit the dust. JPM asked for two lots of $5bn each in collateral just days before Lehman collapsed, prompting speculation that it and Citi (which did a similar thing) may have caused the lack of liquidity that brought Lehman down. (The case is still in court.)
  I'm no fan of JP Morgan, it comes off as greedy and callous, but from where I sit it looks like it has some bloody good risk management people and processes. Maybe if Lehman and MF Global had had the same, they would still be around.

The Culture of Corruption

  I spent 20 years working on the fringes of the oil industry - mostly writing about trading and oil prices and OPEC, but also broking a bit and doing some (dreaded) marketing of oil price services. Once I left Platts, the oil industry bible owned by McGraw-Hill's Standard & Poors, people within the industry opened up to me a little and I got a taste for just how corrupt the oil industry is. From blatant bribery of government officials to inspectors and, yes, reporters the corruption in that business was (and still is to an extent) all in a day's work.
  The corruption I see today in the financial services arena makes oil traders look like amateurs: Rogue traders such as Kweku Adoboli at UBS, with his $2.3 billion worth of hidden trading losses; MF Global with $1.2 billion of customer money seemingly vanishing into the maw of a bad trade on European debt; Ponzi schemes such as Bernie Madoff's. 
  Few oil traders would steal money from their firms to pay a bribe or for a client's night with an 'escort'. Also, few of them would hide trading losses until they escalated into disaster. It is difficult to hide losses on a cargo that got delivered and paid for. Most of their activities, while under the radar of much of the world, were above board and known by management (if slightly less than legal).
  There is a culture of greed infiltrating the financial markets and it isn't pretty. It leads to the kinds of major corruption we saw in 2011 and all sorts of minor, though still significant, acts of creative accounting which we may never see. But shareholders and customers of these firms are paying the price. Occupy Wall Street may have had a point, even if they weren't quite sure what it was.
  Happy Christmas!

MF Global Story Goes from Bad to Personal

  The MF Global story gets worse and worse; the firm had been dipping into client funds for weeks and the customer shortfall may be as high as $1.2 billion. Therefore I was thrilled to hear that the Board resigned last week, and that Jon Corzine will be forced to testify in front of Congress. Meanwhile regulators moved quickly for a change. Bloomberg reported:  

U.S. derivatives regulators voted today to restrict how brokers can invest customer funds, acting on a delayed rule after as much as $1.2 billion went missing before MF Global Holdings Ltd. sought bankruptcy protection. The Commodity Futures Trading Commission voted 5-0 at a Washington meeting to limit how brokers invest clients’ margin in money market funds, and ban investments in foreign sovereign debt and in-house transactions such as repurchase agreements.

  This is a good start, but it doesn't address the client money segregation bit of the problem. In today's FT, two professors had some suggestions though. Darrell Duffie, Professor of Finance at Stanford University’s Graduate School of Business, and Joe Grundfest, Professor of Law and Business at Stanford Law School and a former Commissioner of the SEC, penned a comment suggesting that the rules be more stringent. 

  They offered two possibilities: 1.) Segregate customer funds with an independent custodian, and 2.) Form an information-technology firewall at the broker, creating a “virtual custodian”. Both of these are valuable and realizable solutions. So why did the comments to the article say things like this is "old news" and one wondered why such a big deal is being made of "tiny MF?"

  I'll tell you why it is a big deal. A good friend of my husband's, his boss, and some colleagues of his are missing hundreds of thousands of dollars of their investments. MF Global has made good only a tiny percentage of their money thus far, and they are very concerned that they may not get any more back. And I know people who are MF Global employees, they are also receiving a good rogering by the firm; part of their compensation was tied up in MF Global shares which are now as good as worthless.

  The fallout is large, it is personal and it tells a story of what happens when transparency is not mandated. And although investors are getting more savvy, as purported by the FT's Gillian Tett's column on November 24th, it should not be incumbent upon them to inspect every crevice and cranny of their broker's books before they turn over their money to be invested.  

Who Comes First - Traders or Shareholders?

  When UBS caught alleged rogue trader Kweku Adoboli with his hand in the till, it must have been pretty clear to other UBS traders that bonus season might be a tad disappointing. Indeed if the missing $2.3 billion wiped 40% off of third quarter profits for UBS, that new Lamborghini Gallardo could be a bit OTT. But it seems the bank had ring-fenced 90% of Q3 revenues for staff pay and bonuses. And although the new CEO Sergio Ermotti has said that the bonus pool will probably be cut (FT) it is likely to be only by 10%.
  This has infuriated shareholders who believe they are left holding the bag for UBS' shocking lack of credible risk management practices. But are they holding the bag? UBS' share price on NYSE actually went UP after the scandal was revealed, and it is hovering around the same levels today as it was pre-scandal. And although one rogue trader did a hell of a lot of financial damage, the other traders appeared to be making money. Do they deserve to be punished for Kweku Adoboli's actions?
  It is an age-old argument in any company that has trading desks. If one desk loses and the rest make money, do the winners get punished with lower-than-expected bonuses? The answer is invariably yes, unless they have iron-clad contracts that guarantee a share of profits. Andy Hall at Phibro had a contract like that, which is one of the reasons Citi had to get rid of Phibro - Hall's $100 million compensation during what can only be termed a market crash was considered obscene. Even though he had made Citi a lot of money (close to $2 billion).
  If UBS cuts trader bonuses by 10% or more, they will probably leave for greener pastures. This leaves UBS temporarily without the money-makers as it scrambles to attract new ones. Traders outside UBS will take one look at the mess the bank got into last year and demand a premium to work there. So UBS will end up paying more for traders than it would if it paid its existing ones their expected bonuses. Shareholders have to be careful what they wish for, because the pay and bonus pool could RISE.
  On the other hand, if UBS is really downsizing its investment banking arm maybe bonus cuts is a good way to achieve that.

Financial Firms' Shenanigans Show Need for Transparency

  I have been thinking a lot about transparency lately (sad, I know), especially since Pipeline Trading's sneaky tricks and MF Global's seemingly full-scale fraudulent activities were exposed. Since the dawn of financial markets (I include energy and commodities here) people have been able to make great profits, not all of them legal. Over the years I have reported on some of these barely-legal activities, and there are many more that I cannot write about for fear of reprisals. So whenever lawmakers and regulators try to make strides toward transparency I applaud. Transparency makes investors happy, it gives them a warm and fuzzy feeling that the markets or companies they are investing in are as straight-forward as possible.
  MF Global let the transparency side down for brokers and broker-dealers by using segregated customer money for prop trading. What it allegedly did was not only illegal, but immoral. Customers were harmed, the CFTC and CME's reputations for being the good guys were damaged. A slightly loony post today on Zerohedge went so far as to say that MF Global has destroyed the whole system. Written by a broker called Ann Barnhardt from Barnhardt Capital Management, the post blames everyone from Obama to the government for orchestrating a conspiracy to defraud her customers. She has closed her business and says she won't get back in until everyone in power today is either dead or deposed. Here is one alarming passage:
Finally, I will not, under any circumstance, consider reforming and re-opening Barnhardt Capital Management, or any other iteration of a brokerage business, until Barack Obama has been removed from office AND the government of the United States has been sufficiently reformed and repopulated so as to engender my total and complete confidence in the government, its adherence to and enforcement of the rule of law, and in its competent and just regulatory oversight of any commodities markets that may reform. So long as the government remains criminal, it would serve no purpose whatsoever to attempt to rebuild the futures industry or my firm, because in a lawless environment, the same thievery and fraud would simply happen again, and the criminals would go unpunished, sheltered by the criminal oligarchy.
  Hers is an extreme case, she even invokes God at one point, but it shows how pissed off people can be when their protectors let them down. But regulators and exchanges are only human, and cannot read the minds of fraudsters and tricksters. They can only sniff around the edges and try to ensure that financial firms are doing the right thing. MF Global clearly wasn't, but its timing was perhaps the key to getting away with swiping customer money. A Dealbook article in today's New York Times says that the brokerage probably used some of the money to cover trading losses. Where the rest went is thus far a mystery. The NYT said: "The firm may have used some of the cash to keep its own lenders at bay, which means the money could be sitting in an account at another firm." OK...which firm? Who are the trading partners? This is the opposite of transparency and I can see where this might royally piss off clients and counterparties.
  One firm's actions post-M F Global warmed my little heart. Market maker Jefferies Group's shares got hammered when it was mentioned in the same breath as MF Global as having a preponderance of European debt on its books. Jefferies took the bold step of revealing its positions, then selling out of about half of them to mollify shareholders. Now that's what I call transparency. Unfortunately, the firm remains tarred with the MF Global brush.

Goldman Sachs Taste on an MF Global Budget

  Jon Corzine, the Goldman Sachs trader/governor/Senator/broker, thought he had MF Global under control. He would leverage what little cash the brokerage had, make a huge bet on European debt, flatter his contacts at the ratings agencies, and walk away with a gigantic bonus for 2011. Except he ran out of money - even customers' money it appears.
  There is an old saying in the markets that goes "He who has the most money wins". It refers to playing poker, where if you have more money than your opponents you can keep on betting until they all fold - broke. But it is also applicable to trading. If you have a very large position which you believe is right and will be profitable, you have to have enough capital to stick with it when it is going wrong. Jon Corzine made the mistake of using his Goldman Sachs champagne taste on MF Global's beer/broker budget. The money wasn't there. Capital requirements are not just for large investment banks, Mr. Corzine.
  Corzine never really seemed to understand what a brokerage actually did. He started out on the wrong foot, I heard, when he told the brokers that they would all take pay and bonus cuts. They responded by putting two fingers up and walking into other brokerage shops, for the same money they had been making previously at MF Global. I get the feeling he had no idea what brokers actually do, and tried to treat them like lowly floor traders.  Then took the money they brought in and tried to leverage it into a Goldman-like fortune. You can file this blog under "hubris."