The Secret Club That Runs the World: Inside the Fraternity of Commodity Traders (10 page)

It was a relatively simple concept with a complex execution, and it had a Seussian name to describe it: a “cap-swap double-down extendable.” There were layers upon layers of different trades between the parties, and no one bothered to track the amount of money one party had paid to the other overall. For Morgan Stanley, however, the “extendable” part was key. If the trade went well for the client—and it did for a number of years—it was simply rolled into the new year and reinstated at new price targets.

“For years and years, they were happy, and the firm was happy,” says a onetime Morgan official who was involved with the trade. Oil prices rose within the ranges expected, and Emirates effectively locked in cheaper fuel prices at just the right time. The carrier had recently initiated nonstop flights from Dubai to New York, and was planning to add a route from Dubai to San Francisco as well. The airline’s executives, led by Sheikh Ahmed bin Saeed Al Maktoum, whose nephew was the ruler of Dubai, were happy to remove some of the uncertainty from their biggest liability. Over time, the program saved the carrier at least a billion dollars on fuel; for the fiscal
year that ended in March 2008, Emirates reached a record profit of $1.4 billion.

Then things changed. In early May, West Texas Intermediate crude contracts—the standard oil contract in the U.S. at the time and the one Morgan had used to structure the Emirates hedge—soared past the $120 upper limit Emirates had imposed. That meant not only that Emirates was paying sky-high prices for jet fuel as cash prices moved higher, but that it was no longer protected by the hedges it had paid to create.

Oil’s $147 peak in July 2008 was an expensive miscalculation for Emirates, but its reverse was far worse. In five short months, West Texas contract prices collapsed from their height of nearly $150 to less than $70 and kept going. The floor of the Emirates trading range had now been pierced, and although the cost of West Texas crude was by now impossibly low—ranging in the $50s by November—the cost of the “swap” portion of the trade the airline had arranged with Morgan Stanley, which was repriced every day based on the latest market movements, was exploding.

At that point, Morgan made a massive “margin call,” or demand for additional cash as a down payment on the ongoing swap trade, to Emirates of more than $4 billion. The put options, or rights to sell crude, that the carrier had sold to Morgan were by now well below their “strike,” or target price. While the details of the paper transaction were confusing, the economic impact of it could be understood simply: if
Morgan Stanley had wanted to collect on the puts, Emirates could, effectively, have had to buy crude oil from Morgan for $70 per barrel and receive as little as $50 per barrel in return. Although Morgan had not yet invoked its right to sell the oil to Emirates at those inflated prices, it wanted reassurance that the money Emirates would owe it if it chose to use them would be there.
So, late in 2008, it issued the margin call, a demand for additional cash from the airline.

Emirates executives scrambled. They didn’t have billions of dollars in cash handy, so they had to source it from elsewhere. Letters of credit from various banks were issued, and at one point, Emirates put about $2 billion in cash in its margin account. But the full amount, of more than $4 billion, was not forthcoming, and West Texas prices were going even lower.

Some Morgan Stanley executives, who had reduced the overall margin demand thanks to their long-standing ties to Emirates, grew alarmed. True, the Emirates debt was unlikely to become an issue unless the airline suddenly went bankrupt. But they couldn’t rule out that possibility. The U.S. banking community had barely recovered from the financial crisis, even after a nearly $700 billion taxpayer bailout the October before, and cash was critical. The Federal Reserve’s office was asking questions, and so were Morgan Stanley’s board members.

“The psychology in those days was, if Lehman could fail, anything could happen,” says the Morgan official who was involved at the time.

Early in 2009, with West Texas contracts trading in the $40 range, John Mack and two lieutenants flew to Dubai to meet with Emirates management. They had been invited to see the city-state’s ruler, Sheikh Mohammed bin Rashid Al Maktoum, in his desert lodge, about 45 minutes’ drive from Dubai, for evening tea.

Using his limited Arabic, Mack greeted Sheikh Mohammed bin Rashid, nicknamed “Sheik Mo,” and his uncle, Sheikh Ahmed bin Saeed Al Maktoum, the Emirates chairman. Mack was warmly
received. In addition to their business dealings with Morgan Stanley, Sheik Mo and three of his sons had visited with the bank’s board during a scheduled gathering in Dubai in 2006 (designed, no doubt, to curry favor for the booming and increasingly indebted metropolis). They liked the firm, it seemed, and were impressed with its embattled chief executive, who, despite his modest grasp of Arabic, had Middle Eastern roots himself and took the time to call on them regularly.

The group settled into their seats, and coffee and tea were served. “Tell us what’s going on in the world and on Wall Street,” the ruler asked Mack. “When is all this going to end?”

Mack and Sheik Mo commiserated over their respective dilemmas. Mack had narrowly avoided a bank failure in September, and Dubai, which had become an international hub for real estate, finance, and tourism under Sheik Mo’s watch,
was being criticized for overbuilding and amassing huge debts. Perhaps more embarrassingly, the arrest of
two drunken British travelers for having sex on a local beach had brought months of headline damage to Dubai, where people took offense at such vulgar public activities.

The sheikh seemed incredulous about the sex scandal. “If you, in the U.S., find two people on the beach who are not married having sex, and the policeman tries to tell you you cannot do this and the woman gets up and slaps the policeman, would you arrest them?” he asked.

“Of course,” said Mack sympathetically. It was a no-win situation, he added.

Mack soon turned the topic to the financial struggles in Dubai. “How are you getting through this?” he asked gently.

“We’re suffering the same issues as everybody else and we’re
going to walk through them,” the ruler replied. “We are one country, we are one state, and if we need to financially assist institutions, we will do that. Nobody will ever lose a dollar in Dubai.”

It wasn’t a clear promise of money in the bank, but it was as strong a reassurance as Morgan Stanley was going to get that Emirates was good for its money.

Morgan reported profits for that year of just $1 billion. Commodities results, the company noted, were affected by a lack of client business and a weak economic environment. Emirates Airline, whose fiscal year comprised the worst possible period for the contracts it had bet with—the latter half of 2008 and the first half of 2009—reported fuel-hedging losses of $428 million. Its fuel hedges had met with “challenges,” the carrier noted, and had protected it only in a certain price range.

Jennifer Fan sensed internal change coming that winter. She was friendly with Jean Bourlot, who had moved on from trading jet fuel to develop a new agricultural-commodity trading desk, and who had heard rumblings of the Emirates problem. Moreover, since the credit crisis, Morgan was being more frugal in deploying its cash for house trading, and it was having some difficulties in getting credit from market counterparts, making it tougher to trade.

Fan, who had married Morgan Downey the year before and was still living in Tribeca, had never been good at artifice. She said what she thought most of the time, and what she didn’t relay verbally was usually made clear by her body language. She wasn’t above rolling her eyes during a boring speech at a public meeting, and her terse e-mails made it clear when she thought she was fielding a stupid question. Long silences in conversation with her
weren’t unusual, nor were boasts about her trading prowess in the company of rivals.

By early 2009 at Morgan Stanley, she was mostly frustrated with her annual bonus, which had been in the low millions despite her trading profits for the year of $35 million. Standard pay for a hedge-fund trader was 10 to 15 percent of the P&L, or profit they made in a year, so she figured she was entitled to at least $4 million, if not substantially more. Morgan Stanley had never paid its young commodity traders terribly well, and Fan was getting the usual treatment.

One day that May, she walked into the Purchase office and gave notice of her resignation. She’d been offered her own portfolio to manage at a newly formed commodity hedge fund in Stamford, Connecticut, and at twenty-five, she planned to take it.

E
arly in 2009, Carl Levin, the powerful Democratic senator from Michigan, met with Gary Gensler, the former investment banker who had been named to run the Commodity Futures Trading Commission. Established in 1974, the CFTC was a somewhat overlooked sibling agency to the Securities and Exchange Commission. Its responsibility was to regulate the nation’s swelling commodity and futures contract markets, but it barely did.

Commodity trading oversight, despite being an unloved agenda item in Washington that was handicapped by a modest budget from Congress and protective laws set during the Clinton era that walled off big sections of the markets from regulation, was a huge concern to Senator Levin. Gyrations in oil and gas prices were hurting consumers in Michigan, the home of the big three automakers, and beyond, and the
demise of the energy trader Enron in 2001 had exposed manipulative activity in the natural-gas and power markets. About to serve his last term before retirement at the time of Barack Obama’s election in the fall of 2008, the smiling, portly senator, who had no problem interrogating the titans
of Wall Street with hours of embarrassing questions, was determined to address runaway commodity trading.

During the 2000s, the septuagenarian senator’s Permanent Subcommittee on Investigations—a panel of a dozen or so publicly funded detectives who used cajoling and, occasionally, subpoenas to gather information then used in televised public hearings and excoriating reports the size of coffee-table books—conducted five different inquiries into commodity markets.
Its seminal report, issued in 2006 as the commodities bubble was building, found that speculative trading was affecting commodity prices greatly, perhaps padding the price of oil by as much as $20 for every $70 barrel of crude.

Levin knew that a Goldman alumnus like Gensler would face a tough confirmation process before he could start the job, and that demands for tighter oversight of speculators after a period of witheringly high energy prices would inevitably arise. He thought it might be his moment to steer the CFTC toward neutering some of the commodity traders whose behavior he considered most abusive.

Levin, two of his senior staff members, and Gensler met in mid-January 2009. Sitting on a couch in his Senate office at a right angle to the CFTC designee, Levin got immediately to the point. “Does speculation affect prices?” he asked.

“Yes,” said Gensler.

There was a long silence. The answer had come with astonishing ease; this was not the sort of frankness previous CFTC chairs and commissioners had given. Levin and his aides, staff director Elise Bean and a lawyer named Dan Berkovitz, both of whom had been deeply involved in the subcommittee’s commodity research, looked shocked.

Gensler, whose confidence was not easy to dent, glanced around the room. “Why is my answer having this effect?” he finally asked.

“It’s not what we’ve heard before from other people at the CFTC,” Levin answered. He repeated the question: “Does speculation affect prices?”

Gensler repeated his answer. “It’s what I feel,” he said. “We had an asset bubble in housing, and we also had an asset bubble in physical commodities,” he added. He spoke about how in the mid-2000s, commodity contracts had become a product for the masses, not just the professionals, drawing in large volumes of investments betting on a rise in prices that, in fact, pushed prices higher. “We saw that bubble burst in 2008,” he said, referring to the steep crash that had sliced crude-oil prices from nearly $150 per contract to a $40-per-contract level, where the market was still trading that January.

To Levin and his team, Gensler’s answer provided some hope. Here was a potential CFTC chairman who actually agreed with some of the subcommittee’s conclusions—and might even construct policy to combat the more harmful behavior in the market.

Levin said he would follow up with a list of written queries that he wanted Gensler to answer before his confirmation hearing.

“I look forward to reading them,” Gensler replied. Levin, who was accustomed to battling unenergetic market regulators, seemed to find that humorous.

Speculators had had a bad reputation in the commodity markets long before traders like Andurand, Glasenberg, or Fan came onto the scene. In fact, it was concern that speculators were manipulating raw-material prices that had led to the founding of the Commodity Futures Trading Commission a quarter-century before.

Congress established the CFTC the same year Marc Rich & Co. opened for business in Zug. Commodity contract trading around the world had grown dramatically, and so had big fluctuations in commodity contract prices. The lines were blurring between the so-called hedgers—farmers, corporations, and ranchers who traded futures to help manage the risks associated with their physical positions—and speculators, who made bets on the future of prices without the underlying physical positions. Back then, market watchers made a sharp distinction between the two.

By the terms of the Commodity Futures Trading Commission Act of 1974, the CFTC was meant to oversee the trading of all commodity contract products, which by the 1970s tracked a large array of physical commodities, from silver to Maine potatoes. The agency would crack down on any violations of trading laws, including manipulation. It would have enforcement capabilities and emergency powers allowing it to step in and halt trading during especially trying market circumstances.

In 1975, it opened for business in the basement offices of the U.S. Department of Agriculture. The nascent CFTC had desks, typewriters, and a small staff with little or no direction. William Bagley, the chairman, had no background in the commodities industry at all, but he had recently lost the California state controller’s race and was an acquaintance of President Gerald Ford. “You can be the Joe Kennedy of the CFTC,” joked the presidential staffer who offered Bagley the job, referring to the Kennedy patriarch who had been the Securities and Exchange Commission’s first chair.

Building a culture of openness and tough regulation proved arduous for Bagley. In short succession, his CFTC faced
a soybean-market manipulation by the Hunt brothers, a wealthy family of
Dallas commodity traders who tried to corner the market for soybeans by buying an enormous number of physical bushels in hopes they could drive prices higher. It also faced
a group of con men that were selling phony contracts in the London commodity markets to unwitting Americans. By then situated in its own offices on Twenty-First and K Street, the CFTC jumped to stop the London swindles, which had been perpetrated from the U.S., but found it had essentially few tools at its disposal. “We had no body of law,” Bagley says, “no precedents.”

New as it was, the CFTC was already crippled by a bureaucratic Washington mentality—as Bagley discovered when he realized how many CFTC documents were stamped “confidential” in red ink. Since there were no established rules around the secrecy of documents, Bagley considered the stamps unnecessary, and he sent an employee around the office to collect them all so he could toss them into the Potomac River. Bagley had hoped the photographer he’d invited along for the purge would promote it as a needed push for transparency. Instead, Bagley was chastised for polluting local waterways.

By the 1980s and early 1990s, a new breed of trader was trickling into the commodity contract markets, where products tied to West Texas Intermediate and Brent crude oil were taking off. Refineries and other energy buyers were experimenting with oil contracts as a way to hedge their risk of rising prices, and independent money managers were betting on commodities.

The CFTC had strengthened during its first three decades, but it was still considered very cozy with the commodities industry. CFTC commissioners, the body of five appointees with ultimate authority over the agency’s actions, spanned a mix of backgrounds and agendas—often with connections to physical commodities.
Farmers and industry lawyers were common, as were politically advantaged figures with no background in commodities at all, such as the wife of a prominent Washington arms negotiator who served during the 1990s. At one point, the group even included a veterinarian. Yet the Commission’s presence in the President’s Working Group on Financial Markets—a board, sometimes referred to informally as the Plunge Protection Team, established by President Reagan after the market crash of 1987 to invite discussion between representatives from the Federal Reserve, the Treasury, the SEC, and the CFTC—gave it access to the White House. “It was a quirky place,” said a lawyer who worked there in the 1990s, recalling a female commissioner once wearing a spaghetti-strapped evening dress to a Working Group meeting and a narcoleptic commissioner who nodded off at some of the worst possible times.

Perhaps unsurprisingly, the CFTC was not prepared for the public backlash it faced in the late 2000s as the prices of major commodities swung higher. By June 2008, the price of West Texas crude contracts had soared into the $130 range, and gas prices were reaching $
4 per gallon in some parts of the country.

Voters were outraged. During that summer, Congress held dozens of hearings on energy-related issues. Notwithstanding the Levin subcommittee report from 2006, there was scarce hard evidence to show who, exactly, was responsible for the astonishingly high prices. But in the few years before 2008, speculators as a percentage of the market had rocketed higher as more passive investors piled into commodity indexes on a large scale. Commodity prices surged accordingly, with the empirical data arguing strongly that speculators could be partly responsible. Many motorists and corporate fuel buyers thought so, and were demanding that the government somehow put a stop to their influence.

Inside the CFTC, the general assumption was that the basic realities of finite supply and increased demand were the reasons for triple-digit-per-barrel oil. It was essentially the same “Peak Oil” theory that Andurand had spotted in the contract markets, that crude oil deposits around the world were soon to run out, driving prices for what still existed to nosebleed levels.

That attitude struck CFTC commissioner Bart Chilton, who had been sworn in in 2007, as far too blasé. Chilton, a Indiana-born Democrat who sported a long, blond mane reminiscent of a hair-band rocker, had never traded commodities himself. But he had worked for a family farm union and spent time at cattle auctions as an advisor to Tom Daschle, the onetime Senate majority leader from South Dakota, where, after hearing a series of public bids, the price of a head of cattle was settled by a couple of guys whispering to each other at auction. Even on that tiny scale, the fact that a private oligopoly could decide cattle prices had always bugged Chilton, a die-hard liberal who loved to wax outraged about the travails of plain folks while clad in his signature cowboy boots. Now he believed a cabal of traders were pushing around commodity prices in the oil and agriculture markets to benefit their own bank balances.

During a meeting with one of the agency’s senior analysts in 2008, Chilton brought up the cattle-auction anecdote as a possible explanation for rising oil.

“It’s nothing like that,” the analyst told him. “You don’t understand it.” For every buyer there was a seller, he added, and speculators simply couldn’t move prices around willy-nilly.

Chilton was miffed, but gave the staffer the benefit of the doubt. Bombastic as he could be at times, Chilton knew his limitations. After all, he lacked the education to back his claim about
speculators and commodity prices; whereas the analyst in his office had been studying the markets for thirty years. Still, Chilton couldn’t help thinking there was something strange about what was happening to oil.

“The staff was writing me off,” he remembers, “trying to tell me to go in a corner and hush up, and ‘you don’t understand it, Bart,’ and oil prices started going higher and higher, and I kept saying to the staff, ‘Really? Really?’” The only encouragement he got came from his own staff lawyer. “Just keep asking the question,” she said.

Chilton was not without support on Capitol Hill, where a number of legislators had been promoting bills to curb speculation in the energy markets. Late that July, not long after oil reached its zenith of $147 a barrel, the Senate passed a motion to proceed with a vote on an antispeculation bill that Senate Majority Leader Harry Reid of Nevada had been promoting.

Chilton was pleased. But on July 22, while grabbing a bite at the M Street Grill near the CFTC, he read on his BlackBerry that the agency had issued a press release on its oil-price task force’s preliminary findings. “Fundamental supply and demand factors provide the best explanation for the recent crude oil price increases,” the statement read.

Chilton nearly choked on his Cobb salad. This was politically motivated, he was sure. The CFTC’s task force, convened in June 2008 under pressure from Congress, had only been meeting for a few weeks and had barely any data to go on. Among other things, the CFTC had issued a special request to certain market participants to share their “swap” or bilateral commodity trading contracts as part of the study, and only a handful of parties had even responded.