The easiest way to think about commodities is that they are things — physical things — that can be measured in size, quantity or volume. Fruit. Oil. Grains. Metals. Currency. All these have unique characteristics and trade against one another on commodities exchanges throughout the world.
It is a complicated system that’s not for the faint of heart. Only a select few traders on Wall Street have the acumen and desire to deal in this sector, an exchange that had been efficiently regulated by the CEA since 1936. To help understand the markets, in 2008 I interviewed Michael Greenberger, an outspoken critic and former employee of the CFTC, who described these as “backwater markets,” but ones that recently have become “as important to understand and regulate as the securities and debt markets are.”
Once upon a time, commodities traders were highly specialized in their fields and their discipline was so narrow that it was largely misunderstood. Because it represented such a small portion of the vast economic market of debt and equities, it existed in the shadows of the global marketplace.
In her book "The Futures," Emily Lambert, a senior writer for Forbes, offers incredible insight that takes readers beyond the world of Eddie Murphy and Dan Akroyd in "Trading Places" and places them into the murky and misunderstood world of Chicago commodities trading. One of the more insightful anecdotes is the story of Sam Siegel and Vincent Kosuga, an unlikely duo.
Siegel owned cold-storage facilities on the outskirts of Chicago, which held and distributed, among other things, onions delivered by farmers from around the country. Kosuga was a boisterous, larger-than-life farmer and amateur chef from the Catskills who grew onions that would find their way to Siegel’s warehouses. The man could cook just about anything as long as the recipe called for onions. Perhaps his greatest concoction, however, was the scheme he cooked up while trading onions on the floor of the Chicago Mercantile Exchange (the “Merc”) with his storage partner-turned accomplice, Sam Siegel.
Both men made good money hedging their onion farming and gathering operations by trading onion futures in the 1950s at the Merc. Like most of the men they traded alongside, Siegel and Kosuga possessed iron constitutions for risk. To outsiders theirs was a bizarre world filled with a ragtag bunch of gamblers who spoke furiously with their hands, called one another by their trading nicknames and kept mostly to themselves. It was an insular existence. Then one day Siegel and Kosuga’s activities drew an unwelcome light on the clandestine world of commodities trading and prompted Congress to blacklist onions from trading on the exchanges.
According to Lambert, here’s how it went down. Because Kosuga controlled a large portion of onion growth and both men had the capacity to store excess supply along with the financial wherewithal to purchase contracts for delivery from other onion growers, they effectively controlled the price when the product came to market. It was a classic “corner.” When the harvest came in 1956, they bet against the same growers they contracted with by placing sell orders in the Merc while simultaneously dumping their excess inventory, thereby flooding the market with onions and driving prices into the ground. In an instant, Siegel and Kosuga made millions while many farmers went broke, buyers were left bewildered and onions were rendered worthless.
Their plan worked so well that President Dwight D. Eisenhower signed the Onions Futures Act in 1958 to prevent the trading of onions forever. Onions, it seemed, were too important to allow unscrupulous speculators to monkey with.
By and large the commodities markets were extraordinary examples of self-regulation. Instances of malfeasance such as the corner perpetrated by Siegel and Kosuga were typically rooted out quickly. Volatility might have been a trader’s best friend, but fraud was never tolerated. It was somewhat of a code of honor, the trader’s ethos. The self-policing activities at the Merc or their cross-town rivals at the Chicago Board of Trade caught the eye of free market ideologues like the economist Milton Friedman, who would argue in the latter half of the 20th century that free markets were pure and without boundaries; that any outside influence, particularly governmental, would dilute and corrupt the process.
Friedman’s work would not only earn him a Nobel Prize in Economics, it would inspire a generation of free-market enthusiasts such as Alan Greenspan, Federal Reserve chairman who, in his autobiography referred to Friedman as “legendary” and an “iconoclast” who was never “off target,” and Robert Rubin, Secretary of the Treasury under Bill Clinton. But it was Friedman’s friend and protégé, Leo Melamed, the egotistical and charismatic head of the Merc, who would change the nature of trading more than any other person in modern history.
In 1972 Melamed established the International Monetary Market (IMM) within the Merc to facilitate the trading of currencies after President Richard Nixon repealed Bretton-Woods, which removed the United States from the gold standard and allowed world currencies to float. In short order Chicago would no longer be known as the “second city” when it came to trading. The IMM caught fire and opened the possibility of trading futures on just about anything. This included oil, which would begin as a small corner of the New York Mercantile Exchange in the late 1970s trading home heating oil futures. Soon, almost everything would be fair game to trade. Everything, that is, except onions.
Without historical context, it would be impossible to comprehend why President Barack Obama isn’t doing more to contain the ravenous behavior of market traders. There are really two overarching reasons why this is the case. First, to understand these markets is to appreciate how institutionalized and endemic trading is to Chicago culture. Then-Illinois Sen. Obama, for example, was one of the first to congratulate the aging Melamed on the historic merger of the Merc and the Board of Trade to create the behemoth CME Group. The political and financial elite in Chicago would sooner give up the Cubs rather than commodities trading.
The second, more obvious reason is that financial markets today dwarf the federal government. Trading futures on commodities such as wheat, flax, onions and potatoes are quaint reminders of a bygone era. Images of bleary-eyed traders crammed into pits, throwing paper on the ground and making quizzical gestures in the air belong on the walls of a museum.
The marriage of deregulation and technology over the past several decades has birthed franken-markets that influence nearly every aspect of our daily lives. From controlling pensions and mortgages to home-heating oil and bread, traders are pagan gods and we are their minions. Although markets today are bigger and faster, the underlying truth to the trading game is simple, proven and unwavering:
For every winner, there is a loser.
In today’s world Siegel and Kosuga are Goldman Sachs and Morgan Stanley. Except these guys won’t be caught because they changed the rules. They control the markets, the exchanges, the products that are traded and the currencies we use. They have the ability to name their price then bet against their own recommendations. It’s the perfect modern corner. And it has the markets behaving badly and acting counter-intuitively.
It is why exchanges no longer react to normal market forces like supply and demand, weather patterns and monetary policy. It is why oil prices remain high during a recessionary period and weak demand, why the dollar has retained relative strength despite “quantitative easing,” and why food prices remain out of reach for people in developing nations. It is why deregulation failed the public and enriched companies like Goldman and Morgan.
These companies do more than move the markets. They move economies. Nixon may have started the ball rolling by repealing Bretton Woods and Obama might be powerless to control it today, but every Congress and president in between have been complicit in the world’s greatest shell game that moves money from around the globe into the accounts of just a handful of firms.
An important aspect to the commodities market is that there has always been a ceiling to the transactions and every investment made in the United States, for example, must be overseen by the CFTC. This market cap and theory of transparency kept the commodities market in relative obscurity against its much bigger counterparts, the stock market ($36 trillion), bond market ($82 trillion) and the punishingly high derivatives market (estimated between $600 trillion and $1.2 quadrillion).
With a few structural changes to the regulatory environment, the commodities market grew from a little over $10 billion in assets to more than $450 billion over the past decade.
Expressed as a percentage, this growth is stunning. But compared to the other trillion-dollar markets commodities are still relatively small, which begs the question as to why such rapid growth is such a big deal. Michael Masters, the managing member of Masters Capital Management LLC, a hedge fund that invests in private equity, answered this very question in 2008 when testifying before the Senate’s Committee on Homeland Security and Governmental Affairs. His testimony is now widely quoted by the anti-speculation critics who decry the lack of oversight created by the Enron loophole.
“Commodities futures markets are much smaller than the capital markets, so multibillion-dollar allocations to commodities markets will have a far greater impact on prices,” Masters stated. Essentially, introducing investment banks and hedge funds that have deep pockets and no one looking over their shoulders has the singular ability to move the entire market. It’s like allowing professional athletes to compete in the Olympics. It’s what Masters referred to as “demand shock.”
Two primary tools have restrained zealous speculators in the commodities markets since the CEA’s adoption-transparency and position limits. The transparency came from federally regulated markets like the New York Mercantile Exchange (NYMEX), which historically tracked and oversaw the transactions of its own commodities. Position limits were enacted under the CEA to keep any one investor, or group of investors, from overwhelming the exchange and flooding it with money.
The Enron loophole essentially bypassed this process and permitted the trading of energy futures on OTC markets, thereby allowing a new set of investors — hedge funds and investment banks — to trade energy futures. But because these trades were still transparent, the OTC exchanges still saw relatively little activity as compared to their European counterparts, where the oversight was far more lax.
Because commodities trade in real time and U.S.-based companies have the most money to invest, the investment banks and hedge funds were still slow to drive great sums of capital into the market. What they needed to really make this thing soar was the ability to invest serious capital within the United States, like their counterparts could on the London Exchange, for example.
In 2000, Goldman Sachs, Morgan Stanley and British Petroleum became the primary founders of a little-known exchange based in Atlanta, Ga., known as the IntercontinentalExchange (ICE). A year later, the ICE purchased the London-based International Petroleum Exchange (IPE), and was renamed ICE Futures. It was an acquisition that was fairly straightforward until 2006, when the CFTC under President George W. Bush — seemingly out of nowhere — officially recognized the ICE as a foreign-based exchange because it had purchased the IPE.
Even though the ICE is based in Atlanta, backed by U.S. banks and now traded publicly on the New York Stock Exchange, the CFTC somehow decided to treat it as if it were based in London and thereby no longer subject to federal trading regulations. This one small shift meant that the investment banks could suddenly trade every type of commodity, especially crude oil, without any spending limits or federal oversight. Greenberger calls it one of Wall Street’s “most successful ventures,” because the ICE was now “competitive to NYMEX.”
It was here that the wheels began to fall off the commodities market.
The Book of Morgan
John Mack, the former chairman and CEO of Morgan Stanley, had an illustrious career, holding some of the most lucrative and prestigious positions on Wall Street. Nicknamed “Mack the Knife” because of his hard-edged, no-nonsense approach and hardcore cost-cutting measures, Mack ran Morgan Stanley through the ’90s before accepting the job as co-CEO of Credit Suisse First Boston, a leading investment bank, in 2001. Mack left CSFB in 2004 to pursue options outside the large investment-banking world but was wooed back to run Morgan Stanley in 2005. Upon his return, Mack’s Morgan Stanley went on an aggressive oil-buying spree — but not necessarily the kind you might expect.
On May 24, 2006, Morgan’s resident oil expert, Terreson, announced that integrated oil equities were “15 percent undervalued” and in a research report, he wrote that “Independent refining and marketing remains the largest sector bet in the global model energy portfolio.” Soon after, on June 18, 2006, Morgan Stanley acquired TransMontaigne, Inc. and its subsidiaries — a half-billion dollar group of companies operating in the refined petroleum business.
How convenient ... After their oil analyst decides that this portion of the industry is looking up, Morgan Stanley gets into the oil business and buys an oil terminal company. However, it did not take only 25 days to conceive and work out the TransMontaigne transaction. This had to be a long-planned, well-thought-out takeover. One that worked for the great benefit of Morgan Stanley’s future oil plans, as TransMontaigne now owns one-third of the nation’s oil terminal storage capacity.
This type of freewheeling environment, with little separation between the proprietary desks at the banks and their investment analysts, has been the subject of much scrutiny and concern of late. “[There must be] a verifiable and hardened wall between analysts and the investment entities,” said Greenberger — it’s the only way to maintain integrity. And this is essentially what the CFTC was dismantling, right under everyone’s noses.
Morgan’s investments in the oil business continued aggressively over the next year into the far corners of the industry. In short order it closed the circle of the supply chain by acquiring Heidmar, a shipping company that owns 120 massive oil tankers, as well as various stakes in foreign-based energy supply companies. It even snagged a contract from the U.S. Department of Energy to store 750,000 barrels of home heating oil at its corporately owned terminal in New Haven, Conn. Morgan Stanley, which was at the time the largest trader in oil futures, was now a serious international oil company.
It was the Masters testimony that brought speculation into the light and sent shockwaves through the halls of Congress. Masters was able to simplify the exchange and put the issues in a context that lawmakers could grasp. One of the telling examples he gives is that “Index speculators [companies such as Morgan Stanley] have now stockpiled, via the futures market, the equivalent of 1.1 billion barrels of petroleum, effectively adding eight times as much oil to their own stockpile as the United States has added to the Strategic Petroleum Reserve over the last five years.”
This essentially squashed the claims of the investment banks that demand from parts of the world such as China and India was solely responsible for the increase in oil futures prices.
Greenberger noted that after the spike, prices immediately retreated despite no major news regarding supply and demand. “Instead of oil going up,” said Greenberger, “oil is going down. Has India and China dramatically cut back? Nothing has changed and, in fact, the supply-demand factor has probably gotten worse because of Russia’s aggression [and] the severe weather, but oil is sinking, sinking, sinking. How can that possibly be?”
So if oil prices could be so easily manipulated, why didn’t it happen more severely and immediately when restrictions were lifted in 2006? While oil prices did indeed climb between the time the ICE was created in Atlanta and the regulations were lifted in January 2006, they didn’t skyrocket until late in 2007. Which brings us back to Doug Terreson. But there’s more to learn from his unceremonious departure than there is from his forecasts.
The award-winning, nationally recognized Terreson had fielded questions in relation to oil prices and futures since the mid-1990s. On March 14, 2008, he said that oil would settle in at around $95 per barrel for the remainder of 2008. Moreover, Terreson also concluded that oil would retreat to around $83 per barrel for 2009.
This would be Terreson’s last forecast for Morgan Stanley.
Two short months later, Dow Jones Newswires reported that Terreson had been ousted in a round of layoffs. Two weeks after that, Richard Berner, Morgan Stanley co-head of global economics and chief U.S. economist, issued a statement saying that crude oil could easily reach $150 a barrel.
This forecast set off a round of speculative fervor never before seen in the market. Goldman Sachs immediately followed suit by forecasting oil to roar beyond $150, saying it could hit $200 a barrel in the near future. Oil prices were off to the races, with the investment banks in full lobbying mode while pointing the finger at China and India. Remember that this was smack-dab in the middle of what we now know was one of the worst liquidity crises in banking history.
In retrospect, the turning point appears to be Morgan’s $150 forecast by Berner. It fueled the apprehension of the media and Wall Street alike. Americans were quick to do the math and knew that the spike would mean $5 per gallon at the pump. Maybe more. Suddenly everyone recalled the 1970s, and new terms such as “stay-cation” were on everyone’s lips.
So, where did this $150 number come from? Who better to answer that question than Richard Berner, the man behind the proclamation? Unfortunately, a spokesperson for Morgan Stanley told me at the time that Richard Berner “doesn’t do interviews on oil stuff.” In fact, “he doesn’t deal in oil” at all, said his assistant matter-of-factly. That’s because for more than a decade this had been the exclusive domain of Terreson, who was, until then, purportedly relieved of his duties. But a month after the press release that Terreson had been laid off, Morgan Stanley issued a statement claiming that Terreson voluntarily left his position at Morgan for the promise of higher pay from a hedge fund.
Not so, according to a Morgan Stanley employee familiar with the circumstances surrounding Terreson’s departure, who asked not to be identified. Taken aback by the confusion, the employee, who claimed to have worked in close proximity to Terreson, told me, “He (Terreson) said he was retiring. He was getting ready to head off into the sunset.”
Depending upon whom you believed, Doug Terreson had been fired, moved to a hedge fund, or simply retired.
The only person I couldn’t seem to locate was Terreson himself. Once an integral part of the Houston community and a rising star in the financial sector, he seemingly disappeared from the city altogether. His home phone has been disconnected. His former co-workers were unsure of his whereabouts. And almost no one from the firm at which he spent years as a superstar in his field wanted to discuss why.
After a couple of weeks I finally reached Terreson at a family member’s house in Alabama. Knowing I could slip in one, maybe two questions as best, I asked him first why he had left Morgan Stanley so abruptly to which he simply offered, “I’m retired. I’m not with Morgan anymore and can’t talk about any of this.” Sensing the inevitable dial tone, I quickly pushed him for a brief comment on current oil prices. The man who spent his entire career thus far talking about crude oil pricing and the markets said, “I don’t feel comfortable talking about it,” and hung up the phone.
Still, the question persists: If the market conditions surrounding the price of crude oil futures remained unchanged, why were the analysts at the world’s largest banks determined to drive up the price of oil at a historic pace?
Was it merely dumb luck that this rampant speculation occurred at a time when the major investment banks were reporting record losses and write-downs due to the sub-prime mortgage meltdown? It was Greenberger’s assertion that “a lot of people were very upset that they were in a sense humping their own product — not only their physical holdings but their future holdings.” What he’s referring to is the fact that Morgan Stanley doesn’t just trade oil futures; it’s also very much in the business of oil. This is a fact that is “unseemly,” according to Greenberger and many onlookers of the financial markets. One such observer is Gary Aguirre, a former staff lawyer and investigator for the Securities and Exchange Commission (SEC), who has testified several times in front of Congress and is widely considered a leading authority on financial markets.
“The way it ran up had all the earmarks of manipulation,” said Aguirre, who spoke to me on the phone from his office in San Diego. “It looked like somebody was playing a game. I don’t know what the game was or how they did it but that was ... the smell drifting my way.” As far as Morgan Stanley and Mack are concerned, Aguirre knows firsthand just how powerful the Wall Street tycoon is.
In 2005, Aguirre headed up an investigation into an insider-trading claim involving Mack and a hedge fund named Pequot Capital Management. Mack’s involvement came during the period between his tenure at Credit Suisse First Boston and his return as chairman of Morgan Stanley. There were allegations of insider trading on the part of Mack by the SEC, but just when the investigation seemed to be gaining momentum, Aguirre was told to back off by his bosses at the SEC. After a glowing review from his superior, Aguirre went on vacation. When he returned, he got a pink slip, not a raise.
Aguirre insists that his own experience is merely part of a larger and much scarier problem running rampant on Wall Street.
“What we have are the markets highly leveraged, highly speculative and without any regulation, effectively, of the abuses,” he explained. “In short, it’s not much different than it was just before the crash in 1929.”
The cozy relationship between oil companies and the U.S. government is nothing new to people like Aguirre, who are familiar with the system. Aguirre explained the “you scratch my back” culture in monetary terms by saying, “These people are sponsored by the industry. Paulson’s straight out of Goldman. We have the fox guarding the henhouse.” (He’s referring to former U.S. Treasury Secretary Henry Paulson, who was chairman of Goldman Sachs until June 2006.)
This was certainly true for Wendy Gramm, leaving the CFTC for the Enron board, and for her husband, who received nearly $100,000 in financial contributions from Enron while in office.
“These Enron traders were highly sought after,” says Greenberger. “Enron showed in its dying days how you could make a lot of money trading unregulated energy futures products.”
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