Harold Hamm Calls for Investigation into Futures Trading

Harold Hamm

Harold Hamm of Continental Resources was already a critic of the futures market, but seeing it going into the red has him assuming that there must be misconduct involved.

Harold Hamm has definitely distinguished himself as someone who knows the oil business. The United States was, not long ago, not all that big of a player in the oil market, but the country did have large shale oil deposits which many looked at wistfully for a number of years, before we figured out how to make this work.

Hamm was a pioneer in the expansion of the U.S. shale oil market, which catapulted the country to the number one spot in oil production, even surpassing mighty Saudi Arabia which had dominated the market for so many decades. Hamm’s company, Continental Resources, might not be a household name like the big multinational companies, but it’s still plenty big, as far as these companies go, with a production of 340,000 barrels a day.

Hamm started out in the oil business pumping gas, but had much bigger aspirations. At the tender age of 21, all the way back in 1967, he founded the Shelley Dean Oil Company, named after his two daughters. Shelley Dean Oil took on a more corporate sounding name, Continental Resources, in 1990, and today has net assets in excess of $15 billion.

1967 was a time where very few people indeed had much of an idea of the potential of shale oil, but Hamm was definitely one of them, and this was decades before the technology ended up catching up with the dream. Someone has to have the dream first though, and believe in it enough to see it though, and Hamm definitely deserves credit for his vision.

He did pretty well for himself from this, with a fortune that he ran all the way up to almost $15 billion a couple of years ago, although his net worth has fallen upon the same hard times as the industry has, now down to $6 billion, but still a nice stash to be sure.

Hamm is a big critic of the futures market though, and to be fair, the futures market is an entirely different animal than the oil exploration business, even though both involve oil. It is understandable that Hamm turns out to know little about futures, and a lot of people are in the dark when it comes to this form of financial trading, including plenty of his associates in the oil business.

Seeing oil futures drop all the way to minus $40 at one point on Monday and seeing the market close in that area was enough to bend all of our minds, including those who are very well versed in how futures markets work. The shock of something like this was simply enormous, and was felt by all, even though knowing how these markets work does allow us to make sense of this, but only if we do.

Hamm actually thinks the futures market hurts the oil business, and he’s not alone in this belief, so Monday’s trading really bent his mind. His immediate response was to accuse the CME, which operates the exchange where the futures contract that collapsed is traded on, of misconduct, because there must be misconduct to cause such a wild stampede, as he thinks that oil cannot go down into the negative like this otherwise.

The CME has responded to his accusations by sharing that this market was conducted in an orderly fashion and In full compliance with regulations, and the only real gap here is the one between the realities of futures trading and Hamm’s understanding of this, which was in full view prior to this based upon Hamm’s previous criticisms of futures.

In an interview on CNBC on Wednesday morning, Hamm shared his views surrounding this event as well as his general criticisms of oil futures, and he’s definitely a leading spokesperson for this. We’ve touched on this issue in previous articles about the futures market in general, sharing that these views are still out there in spite of their side ultimately losing this battle, but we now get to see that this view is definitely far from dead although not all that influential anymore.

They certainly were at one time, and futures trading was once in a very long and protracted war, where a lot of people who had very little or no understanding of the benefits that these markets provide just saw this as a form of gambling. Together with the view that gambling is not acceptable, this caused a wave of discontent that lasted throughout the better part of the 20th century and took a lot of time and effort to beat back these flames until the fire was finally put out enough that these views could be simply ignored, as they are today.

Even though some might wish to use the term gambling to describe futures trading, a better term would be speculation, which we can differentiate by defining this trading as gambling with the potential of a positive expectation, in contrast to someone who may blow their pay check at a casino without a positive expectation, for the thrill of the experience perhaps or by way of a distorted view of probability.

This doesn’t mean that we should take a derogatory view of this, as it is their money, and it still can be rational to engage in activities that have a negative positive expectation provided that its entertainment value is sufficient enough to justify this. There isn’t even a need for anyone to justify spending their money on the basis of rationality anyway, and people spend irrationally on all sorts of things, and cause themselves all sorts of economic harm by overspending on anything, but it’s their money and their decision.

Futures trading does not involve the exchange of assets by way of the trade itself, which distinguishes it from trading in assets themselves, like stocks or bonds. They involve entering into financial agreements that involve the obligation of buying or selling an asset in the future at an agreed upon price, when the contracts end up being settled.

All futures contracts are settled one way or another, either by way of delivering the asset itself to someone, in this case delivering oil to someone at a certain price, or settling based upon the cash difference. We’ve moved a lot more to settling with cash, even though physical delivery still occurs, but there is no difference other than in many cases it may be more efficient to just give the winning party the difference in cash where they may go out and buy or sell the oil on the spot market themselves if they wish, or not, according to their wishes, as we normally treat spending.

When you get paid from your job for instance, your employer doesn’t tell you how to spend it, or when you make money from an investment, you aren’t told where you have to put it next. It is therefore perfectly reasonable and natural that when you make money from a futures trade that you are left to decide what to do with it.

This is the actual foundation of both a free society and the benefits of using money as a means of exchange where we can convert the value received into what we want or need rather than be limited to exchanges of goods directly, the barter system that we stopped being limited to by the invention of money all those millennia ago.

Should we find it more expedient or desirable to choose to transact in oil or whatever commodity that is involved in a futures trade, it is reasonable to allow us to do so, as our needs and preferences dictate. If not, cash settlements allow us to do whatever else we may wish or need to do, and allowing us to choose this is not only reasonable but essential to preserve not only the efficiency of a market economy but the free choice that it also requires.

Requiring Physical Settlement of Futures Contracts is a Bad Idea All Around

Hamm believes that all futures contracts should involve physical delivery, not that he’s in any position to decide or even weigh in on this. This is amusingly ironic though, because it was the scramble with the contracts that were to be settled with physical oil that caused the spot market to panic so much, and not without reason.

Oil producers were delighted to have people take oil off of their hands at prices far higher than zero, and while they were happy enough to settle for cash, making deliveries would be even better given the massive excess inventory they hold these days. Normally, this wouldn’t be a big problem, and while in a lot of cases it’s still preferable for counterparties to settle in cash, there normally is enough demand in the market that they may want the oil anyway, and enter into these contracts often times with the full intention and need to do so to settle the contract.

With demand dropping so much, enough that the oil in the market is well in excess of demand already, they not only don’t need the oil now, they don’t even have a good place to put it. This is like our having regular deliveries of oil to fire our furnaces, where we have a tank and have it filled periodically, but if our tank is full and there’s a truck parked in our driveway looking to unload, we just can’t use it or even take it.

If we are forced to buy it anyway, taking physical delivery of this contract for the oil, we need to find somewhere else for it to go, and we don’t really have the capacity so that means selling it to someone else in turn. No one wants it though so you may even have to pay someone to take it off your hands if the demand for it dries up enough, and this is exactly what has happened. The delivery of physical oil from this contract therefore served to worsen this problem, and put a scare not only into the futures market but the spot market as well, where this oil that is delivered by way of these contracts being settled in physical oil ends up.

If we need any regulation at all as far as physical delivery versus cash settlements goes, we might want to consider requiring cash settlements, not doing away with them, to avoid the element of regret and the ensuing market crisis that changes in demand like this can cause. The sole purpose of these contracts is to cover off the financial consequences of changes in price of the commodity, and not to facilitate the exchange of oil between parties, as they can do that themselves perfectly well without the influence of futures markets.

If your side of the contract ends up netting a loss of $10 a barrel, where the price went from $30 that you contracted it to buy at and the $20 that it costs now, you can just give the producer the difference, the $10 a barrel. If the company wishes to sell this oil on the spot market for the $20, they end up in the same place, getting this $20 plus the $10 you gave them and end up with $30 in total.

They did this because they wanted to know that the oil they are producing today will provide them with $30 a barrel down the road, at contract expiration, and perhaps it is costing them $25 a barrel to produce it right now and they want to make a profit and not be subject to a loss by the time this oil gets to market.

If the market goes down to $20, they may not wish to sell their oil for that, although the futures contract covers their loss that they experienced by way of the price going down this much. Perhaps they will still hang on to it, storing it with the expectation that the price may rise, especially in a situation where demand has declined so much. Forcing them to sell it anyway because people think that they should, and especially forcing them to flood an already flooded market even more, is not only not necessary, it is foolish.

The party on the other side of this contract may have originally thought that they needed this oil, but circumstances change, and they sure have now. The last thing they may need is more oil, as they may already have all they can use and then some, and being able to just settle up the difference allows them to make good on their financial obligations without further burdening them and the market with needing a way to sell this oil to another party and suffer further problems in doing so.

When a bunch of people are forced to take delivery this way, by way of contractual obligation, this can create a big mess indeed, as all of this oil hits the market at the same time, at a time that the capacity is so limited and is expected to continue to be limited in the coming weeks. This is where the real battle was fought, and what caused the bizarre anomaly of seeing oil drop so low below zero, from these folks having to pay so much to be rid of the oil they are now stuck with.

This doesn’t necessarily mean that we need to regulate physical delivery requirements away, as the market generally will work these things out for themselves, and it’s only when their interests and collective interests collide so much that we need to step in. We still may want to seriously consider this anyway because leaving it up to the kids doesn’t always work out too well as we just saw.

It’s Understandable that We Did Not See This Coming, But This Needs to be Hedged Too

The problem here arose from the risk of the current situation not really being that foreseeable, as who would have thought that we would have shut down most of the world’s economy for any reason. We didn’t even do anything close to this with the Spanish flu, which in spite of what some mistakenly believe, was immensely more tragic than this one.

The media back then took a different approach though, and kept the truth from the people. This virus actually started in the United States, and was only called the Spanish flu because the Spanish media were the only ones that were talking about their experience with it. Spain was neutral in this war, with other countries worried that people finding out about this would hamper the war effort so they hid it from their people.

It started on a pig farm in Kansas, which is why it is also called the swine flu. When the boys who worked on the farm volunteered for the war, they infected the barracks they were sent to, which then spread to several other military camps that were holding troops to be sent to battle soon.

This had such an effect upon these barracks that patients were piled up on the porches, there we so many. The ones that didn’t die and weren’t too sick to go were then sent to the front in Europe, because this was felt to be needed to fight the enemy, and this infected Europe, then the whole world, and caused up to 100 million deaths, with the manner of death from this being far more hideous, similar to Ebola but on a scale ten thousand times more massive.

100 years later, we’re making up for this by having our media and officials trumpeting up this one to the point where it’s held to be even worse than the Spanish flu, setting a new standard for both absurdity and the effectiveness of the media to promote it.

The outbreak itself may not have been a black swan event like the Spanish flu, but the response sure has been. We don’t usually prepare very much for black swan events, events that are extremely dangerous but extremely unlikely, but sometimes swans do turn black. Sometimes we blacken them ourselves.

What evidence we do have on the effectiveness of this shutdown on containing this outbreak has not even shown it to make any difference, as we continue to study how this virus has progressed in areas that have locked down their economies versus areas who have not, including 8 states in the U.S. When we are in the grips of paranoia though, perhaps it is too much to expect us to even wonder about such things, and we may even wonder whether the truth will matter even after this is all over.

Given that the specter of economic shutdowns like this will now be seen as far more likely than we saw them up to now, this will no doubt cause oil consumers much more pause, and this should make cash settlements even more popular, as we can no longer assume that we will need this oil with the same certainty as we used to.

While this did contribute significantly to this crash in oil futures, when you have demand cause the spot oil price to drop as much as it did, albeit nowhere near as low as this extra supply hitting the market on the expiration of this contract caused, a crash was in our future regardless. The price of a futures contract at expiration will always converge with spot prices, which is what determines the value of the contract when all of the trading ends, and there was a big gap that did need to be filled regardless, as the cash settlement price converges as well.

Hamm’s insistence on all participants in futures contracts needing to deliver or take delivery of oil is more problematic than just creating inefficiencies, forcing the hand of these participants to act against their interests, and even causing a panic in the spot market when they can’t handle this.

Companies have always been able to enter into private contracts involving the future delivery of oil and other commodities, or anything else for that matter, yet they trade widely on the futures market anyway. This is because there are additional benefits to them, just like there are with people who own private stock which is illiquid, versus stock on public exchanges, which is far more liquid.

You can still buy and sell privately held stock, but it is far more difficult and far less efficient. You need to find someone to sell your stock to, which your best efforts may not even be enough to produce a satisfactory result or even do this at all, and there’s also the lack of price discovery, where someone may have paid you more but you don’t know because they are not participating in the price discovery, what people would pay if given the chance,

Exchanges, like the stock exchanges and the futures exchanges, bring buyers and sellers together. It just doesn’t bring producers and consumers of oil together, it brings everyone interested in oil together, and the additional participants that the futures market brings in, the ones that Hamm wants excluded, are what exchanges add to the mix and what distinguishes this completely from private deals which companies are still free to engage in to their heart’s content.

This is all well known by those who have a basic understanding of futures, but many do not. In the CNBC interview, when presented with the obvious issue of excluding the people from futures trading, Hamm responded that hedging and speculating are somehow different, and preferable, even though this left the lack of liquidity problem unaddressed.

Seeking to hedge and seeking to make a profit are certainly different, but it’s all speculation really, it is all wagering upon the future price of something, even though the risk for the hedgers is not doing it and the risk with speculators is if things don’t go their way and they lose money.

Hedging is plenty important to these companies, but the added liquidity of having people involved in these markets that have no desire or intention to ever touch a drop of oil helps companies hedge better, and this is very clear and cannot even be intelligently disputed. We also need to remember the purpose of exchanges, which is not directed at helping certain companies, but only to allow those with an interest in a market to freely participate, to bring the trading to the public, to allow these other parties into the game.

Doing this would dry up a lot of liquidity and make it a lot more difficult for companies like his to hedge, and basically turn futures trading into the world of private deals, removing not only the benefits of futures trading but the very reason why they exist.

It was the hedgers that were on the run on Monday, not the speculators, even though speculators made a lot of money on that day. The panic in this market was people scrambling to get out of physical delivery obligations, and if any fingers need to be pointed, people like Hamm need to point their fingers at themselves instead.

This is just the nature of the mechanism of free exchange, but we would be better served if we just rid ourselves of the remaining effects of the idea that we need an exchange of a physical asset to settle these financial interests. Old ideas often die hard though, as do old misconceptions.

Monica

Editor, MarketReview.com

Monica uses a balanced approach to investment analysis, ensuring that we looking at the right things and not confined to a single and limiting theory which can lead us astray.

Contact Monica: monica@marketreview.com

Topics of interest: News & updates from the Office of the Comptroller of the Currency, Forex, Bullion, Taxation & more.