A Look at the ESP Spectrums - Social

I started this series a while back and haven’t come back to it until now. In hindsight, I should have much sooner. I’m going to start this look at the social spectrum by copying exactly from my first post in this series. From my previous column:

“Let’s start with the social in Figure 1.

Note the barbell approach I’ve taken. In this context, pure freedom is the equilibrium. In theory, I suppose we could say pure freedom is anarchy, but for this column, we’re going to assume a government is in place. As we move to the left of the center, we see a secular government begin to encroach on the pure freedom, leading ultimately to a totalitarian secular government. Likewise, as we move right of center, we see a theocratic, religious-based government encroach on pure freedom.

The point is, as we move further left or right, freedom falls under attack. I deliberately structured the color scheme to show that the attacker of freedom is irrelevant.”

The symbolism in color selection (freedom is light and oppression is dark) is intentional.

There were two out-of-scope points. First, is the US semi-freedom secular or theocratic? I contend secular. Second is my belief that the USA is the global champion of freedom, given that we have entities far to our left (China, Russia, North Korea, etc.) and far to our right (Iran).

You wouldn’t believe how much heat I take from the conservatives for saying secular over theocratic. I think it’s a slam-dunk argument, honestly. The beginning of the 1st amendment of our Constitution reads, “Congress shall make no law respecting an establishment of religion, or prohibiting the free exercise thereof.” The conventional line of thought is for a wall of separation between church and state.

I often hear that the USA is a Christian nation founded on Christian values. I disagree. Not only is that inconsistent with the Constitution (nowhere in there are we described as a Christian nation, even if many of the Founding Fathers were of the faith themselves), but Section 11 of the Treaty of Tripoli explicitly said the USA is not a Christian nation. It reads, “As the government of the United States of America is not in any sense founded on the Christian Religion.” Now, this issue has its fair share of controversy because it’s still questionable whether Article 11 was present in the Arabic version of the treaty (I think it was), but it is generally accepted that Article 11 was in the version of the treaty voted upon by Congress and signed by President John Adams.

As for the second point, that the USA is the global champion of freedom, I get just as much heat from the liberals for thinking that “imperialist America” (their words, not mine) is a worldwide beacon for freedom. Simply put, their view is inaccurate, both from an absolute and a relative perspective. It’s not even a matter of opinion. It’s a matter of historical fact.

First is the absolute perspective. They argue, “Well, Tim, the early USA wasn’t so free of a place for anyone who wasn’t a white male.” They’re right. But that was also well over 200 years ago. Things are very different today. The big injustices like slavery, Jim Crow, and voter disenfranchisement (women and minorities) have all been done away with on the national level. The biggest area of struggle I see today is full equal legal rights for gays (including marriage) and the Obama administration has done more to advance gay rights than any president before. Sure, there are still less widespread injustices, but this is leadership in human rights and social progress.

Now, from the relative perspective, let’s compare the USA to some other countries. Historically, the USA has been a global frontrunner in spreading freedom. Compare the USA to Russia (USSR and present), China, and North Korea on the far left. Compare the USA to Iran on the far right. Which country of those listed has the greatest level of personal freedom? The clear answer is the USA. Engaging in political dissent in any of those countries besides the USA gets you imprisoned, tortured, exiled, and/or killed. I’ve heard countless stories of how bad life was behind the Iron Curtain (here’s a great series).

The bottom line is I see the USA as a semi-free secular entity and the global champion of freedom.

Links: http://www.investors.com/NewsAndAnalysis/SpecialReport.aspx?id=512665

Why the Futures Market Matters to Everyone Part 3

I wasn’t originally planning to do a Part 3 for this topic, but I’m going to anyway. What I’d like to do here is further explore the ‘artificial demand’ I spoke of previously. Unlike in my previous posts, I won’t limit the concept of artificial demand to simply financially-driven artificial demand because there’s one other source I’d like to discuss.

Earlier, I briefly talked about financial sources of artificial demand via the futures markets and Exchange Traded Funds (ETFs). I also mentioned how many ETFs have options attached to them. Futures and options are also known as derivatives because their existence is derived from something else (stock, commodity, ETF, etc.). We also have two types of ETFs. Some of them create their commodity exposure by stockpiling the commodity in question and others create their exposure through futures. Thus, it’s fair to say the former are derivatives and the latter are derivatives of derivatives or second-order derivatives.

This is what they mean when discussing derivatives in a financial context. It’s not exactly the rate of change (or rate of change of the rate of change in the case of second-order derivatives) that you learned of in calculus class. What is applicable from the calculus definition about the financial definition is how it’s possible for the derivative and original to decouple from each other. It’s also even possible for the derivative to drive the original in a ‘tail wags the dog’ sort of way. We see both of these in the financial markets quite often.

A side note on options. With stocks and ETFs, you can often gain much more exposure for much less money. In other words, they’re highly leveraged. We’ll use stock options to illustrate this real quickly. To buy 100 shares of United Technologies (UTX – full disclosure, I am long UTX), it costs about $9,000 based on a ~$90 share price. To buy a June $85 call option, which is the right, but not obligation, to buy 100 shares of UTX stock before the third Friday in June at $85, I only need to pony up $3.40/share, or $340. So, I can get the equivalent, albeit time-limited, exposure to UTX using options for about 4% of the cost of buying the shares outright. Obviously, a longer-dated call would cost more. A January 2013 $85 call costs $11.35/share or $1,135, but you’d get an extra 18+ months. It’s a contango curve. I’m not going deep into stock/option strategies here; just providing an example of the powerful leverage.

So, how do we reduce the impact of derivatives? We need global coordination to limit margin on these instruments, position size limits, and we need to differentiate between the producer/consumer class (those who use futures for business purposes) and the financial class (those who use futures for speculation only). Dan Dicker provides some more surgical solutions in his book versus these broader tools. Again, I’m not saying speculators shouldn’t be allowed to speculate, but when their actions have such broad impact as they clearly do, we need to try to insulate their impacts from the rest of the world. Note that we’ve seen some exchanges like the CME (Chicago Mercantile Exchange) tighten margin requirements on both oil and silver. This is a good thing.

One last side note. It wouldn’t be a bad idea to explore returning the exchanges like the CME to non-profit status. I think the conflict of interest is too powerful because they profit from higher volumes rather than orderly markets.

Ok, enough about the financial end. Let’s look at one other source of artificial demand for commodities, particularly corn. As you know, corn isn’t just used for corn-based foods, but it’s also used to feed livestock. You’ve no doubt seen the signs at gas stations that say, “Up to x% ethanol in this fuel,” or something like that. Usually it’s around 10%. Guess what. We use about 40% of our corn crop to provide about 10% of our gasoline. How’s that for self-inflicted artificial demand?

The sad truth is there’s a strong lobby to increase our ethanol use. That’s such a terrible idea that I don’t even know where to start. First, ethanol is very hard on engines, even when they’re designed for it. It basically rots the engine from the inside. Second, ethanol produces less thermal energy than gasoline, so by adding ethanol to gasoline, we’re reducing the overall thermal output of the mixture. That’s exactly what you don’t want to do if you want to increase your car’s miles per gallon. Third, by using corn in our gas tanks in addition to our food, we’re driving up the price of corn. Assuming a constant supply, when demand increases, price increases. So, we’re paying more at the grocery store and at the gas pump. Fundamental supply and demand still is a driver of the futures market in addition to speculation. Fourth, using corn to fuel humans and livestock instead of cars simply makes more sense to me, seeing as how we have millions, if not billions, of people worldwide who are starving, undernourished, malnourished, etc.

I left out the details of the corrosion and thermodynamics from the first two reasons because that’s engineering nerd stuff, however if anyone’s curious, I’ll gladly go into greater detail. :-) I discussed the futures market mechanics extensively already, and the fourth reason is pretty straight-forward, methinks.

Also, on a related note, farm subsidies are a terrible waste of taxpayer dollars and should be discontinued. Why should we pay farmers not to grow crops? That’ll save us a few billion dollars per year.

If our leaders got a little smarter about how they’re imposing artificial demand, thereby driving prices higher and hurting a lot of people, these prices would drop. That’s in the collective best interest, but our leaders aren’t seeing it.

Why the Futures Market Matters to Everyone Part 2

In Part 1, I provided an introduction to the futures market, what’s wrong, and why it matters. In Part 2, we’re going deeper.

When we look at commodity futures curves, we see some variations in pricing. Let’s set commodity type C, amount A, and strike price P as constants, so the only changing variables are date D and contract price X. We have three possible conditions because as D goes further out in time, X can either increase, decrease, or remain unchanged.

If X increases as D increases, we have contango. This is generally more demand-sensitive and is the most common state of the curve. Intuitively, it makes sense that one would have to pay more money for a contract with a longer duration (assuming all else is equal) because the seller is essentially selling the buyer more time to act.

If X decreases as D increases, we have backwardation. This is generally more supply-sensitive, as in we have backwardation when the market is trying to price in a short-term supply disruption.

If X remains constant as D increases, we have a flat curve. It’s not contango and it’s not backwardation.

The curves ‘naturally’ want to be in contango, but they’ll flatten or even go into backwardation when a short-term supply disruption is expected, such as recently with the Middle Eastern and North African turmoil when some oil curves flattened and some even went into backwardation from their usual contango states.

Another aspect of the asset demand is Exchange Traded Funds (ETFs). ETFs are like mutual funds in that they can be formed with any focus, like commodities. However, unlike mutual funds, which you can only buy based on the closing price, one can buy ETFs in the pre-market trading, during regular trading, and in the aftermarket trading. You can also buy/sell options on many ETFs (options contracts are just like futures contracts except they cover shares of stocks or ETFs). Some commodity-based ETFs get their exposure by actually buying the commodity itself, but most use futures, which can be trouble depending on how the curves are behaving.

Let’s think in terms of supply and demand and how they relate to price. As demand increases, price increases assuming constant supply (and vice versa). As supply increases, price decreases assuming constant demand (and vice versa).

Prior to the passage of a law called the Commodity Future Modernization Act, pretty much the only source of demand for commodities was consumers or end users. However, this act created a new source of demand, namely the financial community. In essence, commodities went from being just strictly commodities to also being an asset class. So, demand has increased and this raises prices. It’s not unreasonable to say we’ve created an artificial source of demand.

The addition of more speculative money into the mix has also increased volatility. Remember how we surged to $150 oil in 2008 and then collapsed to $35 oil in 2009? That kind of volatility is a nightmare for business planning and it’s very hard on everyday people.

One could argue that all we have to do is increase production to allow supply to catch up demand. That’s a reasonable argument to address the extra demand, but it won’t solve the volatility problem and I don’t think we can increase production quickly or fully enough to satiate the user and asset demand.

I’m not saying that global demand for commodities from the user side hasn’t increased. It clearly has because of the rise of big emerging market countries like China, Brazil, and India. This is a good thing because it means the world’s getting wealthier and more people are living with a better quality of life.

I’m also not saying that speculators shouldn’t be allowed to speculate. They should be allowed to, and they’re not evil. But, the futures market is broken. Minor reforms could make a big difference, such as increasing margin levels, setting position size limits, and differentiating between the producer/consumer class and the investment/asset class. Due to the global nature of the futures market, this needs to be a global effort. If the USA makes changes, the speculators will simply go elsewhere.

I recommend Dan Dicker for further reading. He’s a former NYMEX oil futures trader with a couple decades of experience. Currently, he’s a market commentator at www.realmoney.com and recently wrote a book called, “Oil’s Endless Bid” that explores this topic. I’ve not read the book yet, but I’ve regularly read his columns for the past couple years.

Why the Futures Market Matters to Everyone Part 1

You know I have my opinions about energy policy. Everyone does.

In a nutshell, many of the conservatives/right/GOP focus on “Drill, baby, drill!” and nuclear power and believe that those on the other side of the argument want some kind of ‘watermelon’ world (environmental green on the outside, but socialist red on the inside; and I’ve still no answer about what the seeds represent, though they may refer to seedless watermelons because those are very popular nowadays since people like watermelon in fruit salad and hate seeds, but I digress). On the other side, many of the liberals/left/Democrats focus on renewable/green energy and conservation/efficiency and view their counterparts as greedy capitalists who care not about raping/plundering the Earth.

The truth is, both are right and both are wrong, but that’s out of scope here. I want to talk about something else. There is a more fundamental problem than what sources of energy we pursue. This problem is the futures market.

First, note that this problem doesn’t just apply to energy prices (oil). It also applies to food prices, as crops like wheat, corn, and soybeans are also traded on the futures market. It further applies to various commodities like gold, silver, copper, and other raw materials. The point is this is a very broad problem.

Ok, so what is a ‘future’? It’s basically a contract made between two parties. The buyer of the contract is buying the right, but not obligation, from the seller to purchase amount A of commodity C by date D at strike price P. The buyer pays the seller a certain price for this right/contract. This contract price X is set by the bid/ask prices in the futures market. The bid is the highest price somebody will buy the contract at, and the ask is the lowest price somebody will sell the contract at. These bid/ask prices are dynamic, meaning they change in real time. They also vary based upon the aforementioned variables A, C, D, and P. The varying contracts create what’s called a futures curve for a given commodity. I’ll save the mechanics of futures curves for another day.

This is also commonly referred to as an option. For example, say you’re a homebuyer and you find a willing seller. In theory, you two could write and sign a contract. You pay the seller say $10,000 for the right (but not obligation) to buy the house at $100,000 by the end of this year.

The futures market was designed to give commodity producers (farmers, miners, drillers, refiners, etc.) and consumers (average people and businesses) a means of forecasting future prices to aid in business planning. Being able to forecast future prices helps with production planning, hedging of risk, locking in prices, capital expenditure planning, and so on. With this, fundamental supply and demand drives the market.

But, things have changed. No longer is fundamental supply and demand driving the futures market. Enter the investment class. These are the speculators we hear of, the people and firms who buy and sell commodity futures. The speculators aren’t evil despite what the liberal media would have you believe. They’re just trying to do their jobs, which is to make money for themselves and their clients.

It’s not that they shouldn’t be allowed to speculate. They should be. I’m a speculator myself, but like the overwhelming majority of people, I’m more of an end consumer of commodities versus a speculator. After all, I drive and I eat. Rather, the problem is there is too much speculative money at work.

Look at 2008 when oil (measured by West Texas Intermediate Crude, or WTIC), surged to $150/barrel. The fundamentals of the oil markets didn’t justify that. At best, I argue the fundamentals justified about $80/barrel oil, give or take a couple bucks based on short-term conditions. That surge to $150 was driven by speculators.

Or look at this week. In the past week, silver has dropped 25% and Thursday, WTIC dropped 8.5% in one day. That’s not fundamentals. That’s margin buyers getting blown out of the water. Margin buyers use leverage to buy more of something. So, if you lever up at say 25-1, you own 25x what your money could buy. Leverage is great when it’s working in your favor, but not so great when it’s working against you. In a 25-1 case, a 4% decline would wipe you out.

The futures market needs to be repaired. In Part 2, we’ll look at that.

Credit and Criticism on Osama bin Laden’s Demise

As you know, Osama bin Laden is dead. He was killed in a US Navy SEAL operation. We finally got him and, though we should rejoice and be happy about this, we must remain vigilant.

Of course, the conspiracy theorists are still doing their thing. They have two lines of thought, one saying that he’s been dead for years and the other saying he’s still alive. I doubt the validity of both theories and I’m merely acknowledging them for completeness.

Ok, back to the topic at hand. I’m partly amused, disgusted, and disappointed by what I see in the mainstream media, not that this is anything new, mind you. It’s par for the course. So what’s the media foolishness this time? It’s this game they’re playing about who really deserves the credit and who came up short. As usual, the MSM’s missing the point. Everybody deserves some credit and some criticism, and I’ll try to handle that briefly here.

The military and intelligence community, first and foremost, deserve a lot of credit for their flawless execution in this operation. The SEAL team completed the mission successfully, quickly, and without casualties. The intelligence community did a great job of putting the puzzle pieces together and finding the compound. Each has had their respective black eyes over the years, but they got results.

Barack Obama took a huge gamble here and it paid off. He ordered a unilateral covert operation into a foreign nation. It worked, and he must be credited with taking the risk. Had it failed, it would’ve been a disaster and Obama wouldn’t hear the end of it. Obama deserves credit for green-lighting the operation and having the courage to act boldly, decisively, and quickly when the opportunity presented itself. This is leadership.

Even in success, Obama is highly vulnerable to criticism. Many on the left are angry because, in many ways, Obama is continuing the foreign policy of his predecessor – the very same foreign policy that he’s been so critical of over the years. Guantanamo Bay remains open, for example. Many on the right are angry because Obama’s been so critical of those policies, yet clearly benefitted from them. Interestingly, Obama can easily be portrayed as a hypocrite in this sense by both sides.

Also, Obama is reneging (yet again) on promises of transparency in his administration by refusing to disclose the photos of Osama’s corpse. I understand the rationale and political strategy associated with not doing so, and I also believe the photos will eventually enter the public realm, perhaps through Wikileaks or some similar outfit. If Obama doesn’t release them, then he gets a degree of insulation should something bad happen as a result, and if something good happens as a result, he could find a way to take credit. Again, neither the left nor the right is happy here.


George W. Bush laid the foundation to make it all possible for Obama. Whether one approves of the intelligence methods or not, one cannot deny that much of the necessary intelligence was gathered during his presidency. One also cannot deny that Bush Jr. did a great job of weakening the terrorist organizations.

Bush Jr. deserves his fair share of criticism, as well. Some conservatives argue that the war in Iraq is justified by the fact that we got a lot of the intelligence for Osama’s death from Iraq. This is nonsense, as it makes the erroneous assumption that we would have been unable to get Osama without invading Iraq. I contend that, had we not invaded Iraq and instead kept our military and intelligence community focused on Afghanistan and Osama, then Osama likely would’ve been killed/captured years ago during Bush Jr.’s presidency. Obviously, we can’t say for sure, but it’s quite possible. Note that discussion of the merit (or lack thereof) in our excursion into Iraq is out of scope here.

This is clearly a quick overview of credit and criticism for the major players involved. I just wanted to hit everyone briefly.

So what happens from here? Obviously, Pakistan is troubling. We have a lot of questions that must be answered about Pakistan, which I suppose I should add to my backlog of posts. We also have to wonder what becomes of the terrorist movement now that Osama is dead. Who, if anyone, is waiting in the wings to take his place as one of the leaders of the terrorist movement?