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The Real Reason For Rising Margin Requirements for Silver Commodity Futures

Commodities / Gold and Silver 2011 May 18, 2011 - 07:36 AM GMT

By: Money_Morning


Best Financial Markets Analysis ArticleJon D. Markman writes: CME Group Inc. (Nasdaq: CME), which provides an electronic exchange for commodity futures, raised margin requirements for trading silver futures contracts on May 4 - resulting in a steep drop in silver prices.

A similar thing happened last week in the oil futures market when the CME Group last Monday raised margin requirements on oil contracts by 25%.

While the impact of that decision was not immediately felt, it seemed to have a delayed effect on the futures market. By Wednesday, there was so much selling that the exchanges had to close trading in oil and gasoline to chill everyone out for a while.

Of course, the CME did not need to do this, as there are no set rules for raising margins and oil prices were already coming down.

So what exactly was the motivation? And why start with a 25% hike, which was much larger than the hike in silver margins?

One reason that was a bit hidden was a letter sent jointly by 17 U.S. senators to the U.S. Commodity Futures Trading Commission (CFTC) that demanded that position limits be put on speculators in energy futures and derivatives by May 23. The Dodd-Frank Act had already required position limits but had not yet implemented them.

Senators were apparently of the belief that the surge in oil prices last month was caused by speculators.

But the reality is that most energy trading is done by commercial hedging operations in which the owners of crude oil assets - basically oil companies like Whiting Petroleum Corp. (NYSE: WLL) - make deals to sell, say, half their production for the quarter at $90. Another party takes the other side of that trade. If oil is higher than $90, the hedger wins.

You could say that is speculation, but in reality it is providing a service to the oil company, allowing it to lock in prices at a level that will ensure a profit and the ability to keep up its drilling program.

Some analysts are now suggesting that a lot of the big commercial hedgers are going to simply pull up stakes and move their business offshore to other exchanges. That would be a shame, because without their speculations, our markets will face fewer ways to reduce their risk. It would be an unintended - albeit ironic - consequence that Congress' attempt to cut risk would end up increasing risk.

At the same time, it's apparent to some veterans that the government is trying to tell the public that investing in commodities is too volatile and that they should focus on buying stock and government bonds. If that's true, officials are playing a dangerous game, and I doubt they fully understand the potential consequences of their grandstanding.

Meanwhile, is it perhaps an odd coincidence that this measure was taken just before oil executives were due to be hauled up in front of Congress this week for their semi-annual flogging? I don't think so.

This politicization of markets can only work for a brief period. What happens when the oil price takes off due to the next Middle East war or a supply interruption? It is very doubtful that CME can control the global price of oil, and any attempt to do so will have unexpected consequences down the line.

We are at the threshold of a change of eras. For years, commodity prices were very sensitive to the actions taken at the U.S.-based exchanges because they all traded exclusively in dollars. That sensitivity will continue, but will diminish as demand shifts toward Asia. As that happens, the currency with which buyers pay for oil will increasingly not be dollars.

India is already paying for oil in rupees and China is paying for Russian oil in yuan. Some analysts argue that the commodity exchanges may be surprised by how high they have to raise margins in order to bring prices down. They may also be surprised by how fast markets snap back.

The real problem for all of us who trade stocks and not commodities is that futures traders react to the need for more margin in one of two ways: either by selling contracts to get their portfolios in line with the new requirements, or raising capital via the sale of other positions in commodities like corn or equities.

And that is the slop-over effect that we saw last week.

Yet looking down the line over the next few weeks, once that offloading of positions is complete, it may create a vacuum in which there are no more sellers. The silver debacle a few weeks ago reminded some analysts of the October 1987 stock market crash in that all the damage was done in one week. Following that 1987 crash the next up-phase started just six to eight weeks later in December.

So the question we're now left with is: If silver and oil are crushed now due to the CME action, will they stabilize and start to move much higher in a new up leg in July or August?'

My guess at this point is that they will, if for no other reason than that new turmoil is likely to arise in the Middle East and North Africa to threaten supply again. If so, we will be able to buy a lot of great energy companies cheap over the summer in anticipation of higher prices in the fall.

I will make sure you are ready for that.

[Editor's Note: Money Morning Contributing Writer Jon D. Markman has a unique view of both the world economy and the global financial markets. With uncertainty the watchword and volatility the norm in today's markets, low-risk/high-profit investments will be tougher than ever to find.

It will take a seasoned guide to uncover those opportunities.

Markman is that guide.

In the face of what's been the toughest market for investors since the Great Depression, it's time to sweep away the uncertainty and eradicate the worry. That's why investors subscribe to Markman's Strategic Advantage newsletter every week: He can see opportunity when other investors are blinded by worry.

Subscribe to Strategic Advantage and hire Markman to be your guide. For more information, please click here.]

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