Eugene Linden
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Matt Taibbi, a journalist whose writing I admire, has joined the throng decrying the hypocrisy of pundits who write on the pages of the Washington Post (owned by a billionaire) that if billionaire Elon Musk buys Twitter it will be a threat to democracy. This is too glib. The problem isn’t b...



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Saturday June 16, 2007

[This is a slightly longer version of an essay that first appeared in Business Week]
Eugene Linden
With global oil production basically stalled for the past two years, the controversial prediction that the world is fast approaching maximum oil output is looking a bit less controversial. At first blush, those concerned about global warming should be delighted if this is the case. After all, what better way to prod the move towards carbon-free, climate-friendly alternative energy? Actually, the U.S. is completely unprepared for peak oil, as it's called, and the wrenching adjustments it would entail could easily accelerate global warming as nations turned to coal for energy. Moreover, regardless of the implications for climate change, peak oil represents a mortal threat to the U.S. economy. Peak oil refers to the point at which world oil production plateaus before beginning to decline, as depletion of the world's remaining reserves offsets ever increased drilling. Some experts argue that we're already there, and that we will not likely exceed the 84.5 million barrels per day production peaks reached in 2005 and 2006. If so, global production will bump along near these levels for some years before beginning an inexorable decline. What would that mean? With alternative energy still far too small to grow fast enough to make up the difference, global economic growth would slow, stop, and then reverse; international tensions would soar as nations sought access to diminishing supplies, enriching and enabling autocratic rulers in the unstable oil states in the process; and, unless some other sources of energy could be ramped up with extreme haste, the world could plunge into a new Dark Age. Even as faltering economies burned less oil, carbon loading of the atmosphere might accelerate as nations turned to vastly dirtier coal. Hmm, given such unpleasant possibilities don't you think this issue would rank a little higher on the radar screen? Actually, it's dumbfounding that Peak Oil isn't a day-in, day-out obsession for the press and policy makers. Picking a date for peak oil is exceedingly complicated, involving uncertainties ranging from how much oil might be recovered from unconventional sources such as oil sands to determining whether secretive oil exporting nations are telling the truth about their reserves. Even if proponents are wrong that the peak has already arrived, however, there are enough disturbing omens out there - e.g. declining production in most of the world's great oil fields and no new super-giant fields to take up the slack - to merit an intense international effort to understand the issue. For those interested in a robust discussion of the details, I'd highly recommend visiting, where some of the best minds in the business ventilate all these issues. Regardless of whether peak oil has arrived globally, the stark reality is that it will arrive much sooner for the United States -- in the form of peak global oil exports. Since we import nearly two-thirds of the oil we consume each year, oil available for export is the figure Americans should be concerned about. Fast-rising domestic consumption in the oil exporting nations, and increasing demands by big importers like China, means a scramble to maintain supplies to the U.S. unless world production rises rapidly. Production isn't rising, however; it has stalled. Call it de facto Peak Oil or Peak Oil Lite, but it means is that the United States is entering a brave new world in which we have to scramble to maintain levels of existing imports, much less increase the amount of oil we bring in. We will know soon enough whether the extra capacity to raise production really exists. If not, it's too late to avoid significant pain. Basic math and the clock tell the story. Taken together all alternatives - geothermal, solar, wind, etc. -- produce only 3% of the energy supplied by oil. If oil demand rises by 2% while production remains flat, production of alternative energy would have to grow by 60% a year - more than twice as fast as the growth of wind power, the fastest growing alternative energy -- and all this incremental energy would somehow have to be delivered to transportation (which consumes most of the oil produced each year) just to stay even with the growth in demand. Nuclear and hydropower together produce ten times the power of wind, geothermal and solar power, of course, but even if nations put aside environmental concerns, it takes many years to build either nuclear plants or dams, and it's getting harder to find un-dammed rivers. There are many things that we in the U.S. should be doing right now. If a tax on oil makes sense from a climate change perspective, it makes double sense squared from the point of view of extending remaining oil supplies. Improving efficiency and scaling up alternative sources must be a priority, but, recognizing that nations will turn to cheap coal (in recent years 80% of global growth in coal use has come from China), major efforts should be directed towards de-fanging this fuel, which produces more carbon dioxide per ton than any other energy source. If the peakists are wrong, we'll still be better off with these actions, but if they are right, major efforts right now may be the only way to avert a new Dark Age in an overheated world. Unfortunately, our collective policy on peak oil seems to be cross our fingers and hope it's not true. It that worthy of a great civilization facing a threat to the energy source that propelled much of its prosperity and growth?

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Short Take

HOW THE OPTIONS TAIL HAS COME TO WAG THE MARKET DOG: A Simple English Language Explanation of How Structural Changes in the Stock Markets Contribute to Whipsaw Movements in Prices.

Lately a string of violent price movements and reversals in the equity markets make it look like the markets are having a nervous breakdown. The last day of trading in April 2022 saw a 939 point drop in the Dow. The day before that, the Dow rose about 625 points, and two days before that it fell over 800 points. The very next week, after two quiet days, the Dow rose over 900 points after the Fed announced its biggest rate hike in 22 years (ordinarily a big negative for the markets), and then, the next day, fell over 1000 points (more on this later).  There have been plenty of headlines – about the Ukraine Invasion, inflation, the threat of a Fed caused recession, supply chain disruptions – to justify increased uncertainty, but the amplitude of the moves (and the sudden reversals) suggest something more may be at work. Here follows an effort to explain in simple language the significant changes in the market that have contributed to this volatility.


“This time it’s different” is perhaps the most dangerous phrase in finance as usually it’s uttered by market cheerleaders just before a bubble bursts. That said, markets do change, and those changes have their impacts. One change in the markets has been the shift from intermediaries (such as brokers) to direct electronic trading, a shift that has made the markets somewhat frictionless, and allowed computer driven funds to do high speed trading. This shift began a couple of decades ago. Today’s markets can move faster than a human can react.


Another shift has been the degree to which passive investing through index funds and algorithmic trading through various quant funds have come to eclipse retail investing and dominate trading. A consequence of this is that to some degree it has mooted individual stock picking because when investors move in or out of index funds, the managers have to buy or sell the stocks held on a pro rata basis and not on individual merit. This change too has been developing over recent decades.


A more recent and consequential shift, however, has been the explosion in the sale of derivatives, particularly options (the right to buy or sell a stock or index at a specified price on or before a specific date). Between 2019 and the end of 2021, the volume of call options (the right to buy a stock at a specified price on or before a particular date) has roughly doubled. During times of volatility, more and more retail and institutional investors now buy calls or puts rather than the stocks. 


Today, trading in options has reached a scale that it affects market moves. A critical factor is the role of the dealers who write options and account for a significant percentage of the options issued. Dealers have been happy to accommodate the growth in option trading by selling calls or puts. This however, makes them essentially short what they have just sold. Normally, this doesn't matter as most options expire out of the money and worthless, leaving the happy dealer to book the premium. Being short options, however, does begin to matter more and more as an option both moves closer to being in the money and closer to expiration. 


This situation is more likely to occur when markets make large and fast moves, situations such as we have today given the pile of major uncertainties. Such moves force dealers to hedge their exposure. 


Here’s how it works. If, for instance, a dealer has sold puts on an index or a stock, as a put comes closer to being in the money (and closer to expiration), the dealer will hedge his short (writing the put) by selling the underlying stock. This has the combined effect of protecting the dealer -- he's hedged his potential losses – while accelerating the downward pressure on the price. In other words, this hedging is pro-cyclical, meaning that the hedging will accelerate a price move in a particular direction.


Traders look at crucial second derivatives of stock prices, referred to by the Greek letters delta and gamma to determine exposure to such squeezes. As an option moves closer to in the money it's delta -- it's price movement relative to the price movement of the underlying, and its gamma -- the rate of change of the delta relative to a one point move in the underlying, both rise. The closer to both the strike price and expiration date, the more the dealer is forced to hedge. The result is what’s called a gamma squeeze. Once the overhang of gamma exposure has been cleared, however, the selling or buying pressure abates, and gamma may flip, with new positioning and hedging done in the opposite direction. The result can be a whipsaw in the larger markets. This same phenomenon can happen with indexes and futures.


How do we know that the hedging of option positioning are contributing to violent price changes and reversals in the market? While not conclusive, perhaps the strongest evidence is that large lopsided agglomerations of options at or near the money have been coincident with surprising market moves as expiration dates approach. In fact, some market players use this data to reposition investments, in effect shifting investment strategy from individual companies to the technical structure of the markets. This is what Warren Buffett was referring to when, at his recent annual meeting, he decried the explosion of options and other Wall Street fads as reducing companies to “poker chips” in a casino.


The week of the May Fed meeting gave us a real-time example of how a market move that looks insane on the surface reflects the underlying positioning in various derivatives. To set the stage: ordinarily, given debt burdens and the threat of recession, the markets would be expected to react badly to a Fed tightening cycle that is accelerated by the biggest rate hike in 22 years. On Wednesday, however, market indices began to soar on Wednesday when Fed Chairman Powell, one half hour after the Fed announced it 50 basis point raise, suggested that the Fed was not considering larger 75 basis point hikes during this tightening cycle. Traders interpreted this as taking the most hawkish scenario off the table. Up to that point, institutions were extremely bearish in their positioning, heavily weighted to puts on indexes and stocks, and also positioned for future rises in volatility in the markets. Right after Powell made his comments, investors started hedging and unwinding this positioning, and all the pro-cyclical elements entailed in this repositioning kicked in. By the end of the day, the technical pressures producing the squeeze had largely abated, setting the stage for a renewed, procyclical push downward the next day, as the negative aspects of the tightening cycle (and other economic headwinds) came to the fore. 


What these violent moves in the market are telling us is that while in the broader sense, this time is not different --the overall sine wave of the market is still that bubbles build and burst -- how the present bubble is bursting may be following a different dynamic than previous episodes. The changes since the great financial crisis-- the rise to dominance of passive trading through indexes and algorithmic trading through various quant strategies – reduced the friction in the markets as well as the value of picking individual companies. Now, the more recent explosion of option issuance, further accelerates market moves, and leads to unpredictable reversals that have to do with option positioning rather than fundamentals such as earnings, politics, or the state of the economy. 


The tail (the options and other derivatives markets) now wags the dog (the equities markets).



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