Commodity Trading Probes Target Wall Street, Organized Crime

Are the financial markets underestimating the ongoing investigation into manipulation in the commodity markets? The recent decline in crude oil (USO-AMEX) might have been, in part, due to the unwinding of speculative long positions. But with financial concerns in control of much of the storage and distribution infrastructure, ongoing investigations are about much more than mere leveraged long positions in the futures markets.

Bloomberg is reporting that the CFTC might release results from its investigation into the cotton market as early as June 3rd, and the rumor mill is running full tilt over their recent probes into the energy markets, which is now in its 6th month:

The regulator, which generally keeps its inquiries confidential, didn't say when the oil-market probe will end and didn't name any companies being targeted. The details of the investigation were confidential, it added. Bloomberg

Confidential or not, it is not good news Goldman Sachs or Morgan Stanley, who have built large commodity trading segments, and have much more to lose from a slowdown in commodity trading than their Wall Street rivals:

The brokers are busy fending off financial market regulators, who are seeking to impose new capital adequacy standards, among other things. But fighting a two front war, and fending off regulators in their commodity businesses, would be another blow, severely crimping their earnings power going forward. Bad news for their stocks?

And while the investigation might not be specifically targeting the two bulge brackets, they have the most to lose if the speculative juices begin to wane. A Wall Street Journal article in March of 2005, noted the growing appetite, and dominance of Goldman and Morgan Stanley in energy trading as they filled a vaccum in the wake of Enron’s implosion:

March 2005
Wall Street played the energy markets actively before—notably through Salomon Brothers’ Phibro unit in the go-go 1980s—but most firms cut way back as oil cratered and stocks soared in the late ‘90s. Then Enron Corp.’s seeming success inspired a spate of trading by power providers, such as Dynegy Inc. and Mirant Corp.—followed by a lull after Enron blew up. Throughout, Morgan Stanley and one other bank, Goldman Sachs Group, stayed the course.

Today, others are rushing to follow them. Merrill Lynch & Co., Credit Suisse First Boston and Citigroup Inc., among others, are stepping up their activity. Hedge funds—investment pools for institutions and the rich—leapt into commodity trading a year or more ago. WSJ

Energy traders have had some time to circle the wagons, perhaps the sunlight that will soon disinfect the cotton market will provide a clue to the regulators intentions.

Cotton was rockin’, trading at 10 year highs earlier in 2008

The issues in the energy markets mirror what has been transpiring in the grain markets, where hedge funds have been gaining control of physical commodities by buying grain elevators:

February 2007
Packaged-food maker ConAgra Foods Inc. (CAG) this month confirmed it had sold two grain elevators in Minnesota, and grains sources said the buyer was a Minneapolis-based hedge fund, Whitebox Advisors LLC. Whitebox Advisors would not comment.

“Hedge funds in the commodity space and hedge funds in commodities are getting bigger,” said Brad Cole, president of Cole Asset Management, a Chicago-based firm that manages a fund of hedge funds focused on the natural resources sector. “If they find (buying physical assets) to be an advantage, then it’s probably going to happen more and more.” Dow Jones

Indeed, hedge funds have been diversifying into new businesses to get a trading edge, as evidenced by Ospraie Management’s move to buy Con Agra’s commodity trading and merchandising operation earlier this year.

``Buying such assets gives a greater insight into the entire supply chain and helps to complement trading activities,’’ said Christopher Peel, chief executive officer of London-based Blacksquare Capital LLP, which invests in hedge funds. ``You get an edge over those that don’t have access to the information”

While the Fed Reserve might eventually have some success regulating Goldman Sachs and their brokerage peers, commodity market regulators have their work cut out for them given much of the activity takes place away from prying eyes in the OTC market.

Money has poured into speculative positions from the hundreds of hedge funds that have cropped up in recent years to trade these markets, in what amounts to a game of high stakes poker, as Amaranth’s $6 billion loss in the natural gas markets illustrates.

With pension and endowment funds increasing the funds allocated to commodity strategies, and other strategies, such as Global Macro hedge funds, getting in on the action it is easy to see the funds allocated to these positions can swamp the physical markets. Ospairie’s costly short position in copper two years ago, which seem to be fundamentally a sound trade based on historical precedents, taught them an expensive lesson; that the game had indeed changed.

Of course, with the traders beginning to smell blood in the water, it is possible the market sorts this out on its own. Leveraged long speculators have built up huge positions due to skimpy margin requirements; it is possible that further declines will lead them to liquidate positions as weak hands panic, margin calls accelerate, and the speculative trades are unwound..

But this time it has been different.  Normally a slowdown the U.S. housing market would send shivers into the copper marketl; and while housing construction has seized up, copper has not sold off like you would expect. While construction in the BRIC countries explains some of the bull market move in copper, manipulation via hoarding and “hidden stocks” are being bandied about to explain the divergence from historical norms.
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Housing bad, Copper good. It’s different this time.

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While the head of the CFTC, Walter Lukken, might not scare the hedgies, other government agencies are also poking around in the shadows, one part of the story the markets are just beginning to come to grips with.

A correction in the price of crude might set off a a series of dominoes, quickly toppling other commodity marts as well. David Threlkeld, a veteran trader who helped expose a Sumitomo trader who lost nearly $3 billion in 1996, has been blaming a number of New York and London hedge funds for our current straits. While it has fallen on deaf ears, if he is eventually right, the rout could begin. In a presentation to the the World Bank, authored by Frank Veneroso, the former partner at Omega Advisors responsible for global investment policy, Threlkeld was quoted as follows:

“This is a perfect storm. If oil takes a dive, there are going to be a chain of margin calls going through the copper market, and then we will find out there are no buyers.” he said. “Copper will implode overnight, This is like flipping condos in Miami, the last one holds the bag.”

Now that is a scary thought.

While speculation and price discovery have their place in the pits, the probe is about manipulation, pure and simple.

And with Attorney General Michael Mukasey sniffing around, this could blow up into the mother of all scandals, as he seemed to suggest five weeks ago:

Attorney General Michael Mukasey warned Wednesday that organized criminal networks have penetrated portions of the international energy market and tried to control energy resources.

In a speech at the Center for Strategic and International Studies in Washington, he said similar efforts have targeted the international financial system by injecting billions of illicit funds to try to corrupt financial service providers. Mukasey then vowed to beef up U.S. efforts to fight international organized crime, which he called a growing threat to U.S. security and stability. CNN

And if that is not enough, the FBI is on the case:

“The activities of transnational and national organized criminal enterprises are increasing in scope and magnitude as these groups continue to strengthen their networking with each other to expand their operations,” said FBI Deputy Director John Pistole.

Officials declined to discuss specific cases because the information remains classified, and disclosure could jeopardize ongoing investigations.

Connecting the dots suggests that this is much more than a routine CFTC investigation, and Wall Street’s miserable year is about to get a lot worse.

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Walter Lukken, CFTC Chairman, on CNBC Friday:

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CFTC Probes Possible Manipulation in Cotton Market, People Say
Bloomberg

Morgan Stanley trades energy in barrels
WSJ/Commodity Trader

Hedge Funds May Look To New Assets For Grains Exposure
Dow Jones/Cattle Network

Ospraie’s Special Opportunities Fund Buys an Edge
1440 Wall Street

Criminals target energy, financial markets, Mukasey says
CNN

The Commodity Bubble, The Metals Manipulation, The Contagion Risk to Gold and the Threat of the Great Hedge Fund Unwind to Spread Product
Frank Veneroso’s presentation to the Global Central Bankers at the World Bank, April 2007 (PDF)
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