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An excerpt from Kate Kelly's 'The Secret Club That Runs the World'

An excerpt from Kate Kelly's 'The Secret Club That Runs the World'

Andurand wasn’t worried. The  oil market was a volatile beast, he  knew, and  such  fluctuations weren’t  unprecedented. He’d  always played  them to  his  advantage,  even  awakening one  time from  surgery  to find  that  Brent  had  risen  $10, just as he’d  predicted. He  kept  chatting with the  writer,  telling  him  about his philosophy on trading and how he’d applied it at his hedge fund, BlueGold Capital  Management, which  had  been celebrated for having  predicted both  the  high  point and  the  low point of the crude-oil market in 2008.  It was a call that  had  established the firm as one  of the  most successful  commodity hedge funds  of all time.

E-mails  from   upstairs began  flooding  in.  The   Brent   drop had  widened  another fraction of a dollar, then another dollar. Andurand’s team  was scouring the  trader chat  rooms  and  the Internet for information that would explain the sell-off—a production  hike  by OPEC? A release  of the  U.S. Strategic Petroleum Reserve?—but there was none to be found. Meanwhile, BlueGold was losing  hundreds  of millions  of dollars.  Andurand  couldn’t focus.  “Why are  you looking at your  BlackBerry?”  the  writer  finally asked him.

Andurand  ended the  meeting and  rushed  upstairs. His  two young  traders, Neel  Patel  and  Sam Simkin,  were sitting  at their computers, looking anxious. Brent  futures had  fallen several dollars in an hour, and their downward spiral was weighing  on other parts  of the  market too.  It was a level of distress  the  thirty-four- year-old Andurand, who had  been trading energy  products daily for more than a decade, had  rarely  seen.  He  called  a few other traders  to  ask what  was happening. He  instant-messaged  a few more. Nobody  had  a clue.

Whatever it was, it was bad for BlueGold. Andurand and his partners had used complex trades to build a position three times as large on paper as the $2.4 billion in assets they were managing, and it was set to maximize profits as crude oil prices rose. But if crude fell sharply, as it did that day, it could have been disastrous for the hedge fund.

Andurand turned to his traders. “Sell a few hundred million worth!” he said. “See how the market takes it.”

Clicking  their mouse  buttons  furiously  to  finalize  trades  on their computer screens, Patel  and  Simkin  began selling  off futures  on  Brent  crude as well as its U.S.  counterpart, the  West Texas  Intermediate, or  WTI, oil contract, which  was pegged to physical  crude oil stored  in Oklahoma. Although crude was al- ways subject  to its own regional supply and  demand issues, jitters about the  trajectory of prices  tended to play out  publicly  in the futures markets, where  hedge funds  like BlueGold made  bets on whether prices  would stay low or high  in the months and  years to come.

Unloading a multibillion-dollar set of trades  was extremely difficult to do without  losing additional money  in the process.  On  a calm  day, sale orders  comprising large  numbers  of contracts— each  of which was linked to one  thousand barrels of actual,  phys- ical petroleum—could tip other traders off to the  idea that somebody had  a lot to sell and  prompt them to sell oil contracts themselves. The result was an even further price drop. On a rough day,  a  large  sale  could   prove  an  even  stronger  depressant on prices.

BlueGold’s  initial  sales on  May 5 seemed to worsen  the  mar- kets. Brent  continued falling, and the fund’s traders perceived an added drop whenever they  pressed the  sell button. A few hours into  the  rout,  Brent  was down  $6, then $7, with little  sign of settling.

But Andurand couldn’t afford  to stop.  He  told  the  traders to wait twenty minutes before making additional sales, hoping that would let the market calm a bit. It was chaos in their office. Land lines  and  mobile phones were ringing. Competitors and  friends wanted  updates and gossip. Was BlueGold collapsing? they asked. Reporters had  the  same question. Everyone  knew of Andurand’s appetite for enormous bets—and his reputation for relaxed risk management.

Brent  went  down,  down,  another dollar, another fifty cents, another dollar. BlueGold continued selling.  By 7:30 that  evening in London, as the  U.S. markets dwindled  to a close,  Brent  had fallen almost  $10.40 per contract, a historic move.

Andurand, finally able to pause,  was in a state of shock.  Blue-Gold  had  managed to sell off $3 billion  worth  of positions, far more than he  had  expected they  could  under such  duress.  But the  firm’s losses for the  day were a half billion  dollars,  and  it still had  $5  billion   invested   in  the  markets, betting that  crude-oil would rise.

Andurand’s day that  May was the  sort  of experience that  would humble any good  trader. But in the world of commodity trading, where  a relatively small circle of powerful players take enormous risks gambling on the  future price  of physical raw materials like oil, corn,  and copper, huge  market moves and the resultant gains and  losses are incredibly common.

“Commodity” is an overused word that  in colloquial terms  applies to things so widely available—toilet paper, milk, dry cleaning— that they are bought and sold almost solely on the basis of price.  In the  context of the  global  markets, physical  commodities serve  a crucial  purpose, however: they are the basic building blocks of agriculture, industry, and  commerce. The  reason Brent  crude oil or the  widely grown  grain  known  as number two yellow corn  are called  commodities—a term  that  brings  to mind  things  that  are easily found and not overly valuable—is that their structural, chemical makeup is the same no matter where in the North Sea they are drilled or in what field they are harvested. Like toilet paper and dry cleaning, those  commodities also trade on the  basis of price.  But price in their case is an outgrowth of a long list of what traders call “fundamentals”: the  cost of actually getting the  commodity out of the  earth, the  cost  of moving  it from  its source  to  a buyer,  how many  people want to buy it at a given time,  how plentiful it is in other locations, and at what price,  at that particular time.

Commodities may sound like an esoteric market, but everyone has heard of at least  some  of them. Gasoline and  crude oil are important ones, and copper, which is used in the wiring of iPhones and air conditioners and maintains a minor presence on the U.S. penny (which at this point is mostly zinc), is another. Corn,  wheat, and  cotton are consumed or worn by almost everyone. Other commodities, such  as the  element cerium, referred to as a “rare- earth” commodity because of its elusiveness, are obscure—although cerium too is put to work in mundane products like cigarette lighters and  movie-projection bulbs.

The practice of gaming out commodity price changes through financial bets—the subject  of this book—is  believed  to be quite old. More  than three thousand years ago, Sumerian farmers promised a portion of their harvests  in  exchange for  silver up front. Those agreements, known to modern traders as “forwards,” were memorialized in the  first written  language, a body of symbols known  as cuneiform.

The  trading of commodities based  on  future deliveries  persisted  for centuries, from  ancient Rome  to the  Italian  merchant cities  to  the  Dutch  traders  who  exchanged tulips  in  the  1630s. Commodity trading came  to the  U.S. with the  British  colonists, and was formalized by the opening of the Chicago Board of Trade in 1848, spurring a century and  a half of more sophisticated virtual trading by a group of more dedicated practitioners. Eventually, commodity trading became its own dedicated niche. Farmers uncertain of the  next  year’s crop  wanted  to ensure that  they had a reliable amount of income, even in a bad  year, and  companies dependent on a certain metal  for manufacturing wanted  to lock in lower prices in advance to guard against a huge  price spike that could  erase  their profit  margins. Over time,  additional commodity exchanges opened in the  cities that  most  needed them, and entire companies grew up around the need simply to hedge commodities.

During the  2000s,  however,  commodity  trading became the new fad. Volume and volatility in the commodity contract markets exploded, propelled by a massive influx of both  everyday and professional investors.  In the “listed” markets, where contracts traded at places like the New York Mercantile Exchange and the Intercontinental Exchange in Atlanta,  volume  shot  from  roughly 500 mil- lion contracts per year in 2002 to nearly 2 billion contracts in 2008.

Meanwhile, in the over-the-counter market for commodity contracts,  where  an  array  of exotic  financial products connected to physical commodities was traded party-to-party by phone and computer (in other words,  off the  exchange), the  total  value on paper of the trades  outstanding spiked  from about $800 billion  to more than $13 trillion over  roughly the  same  period. Suddenly, commodity contracts, once  a rounding error in the world of tradable products, were all the rage.

Nonetheless, commodity investing was small compared to stocks, bonds,  and  currencies. Until  the  mid-2000s,  most  investors  had never  seriously considered adding commodities to their individual portfolios, which  tended to favor simple,  easily traded things  like stocks and  U.S. Treasury bonds. But something happened to commodities in the  2000s to change their minds:  a huge  increase in prices and an especially convincing sales job by Wall Street.

Between the early 2000s and the middle of 2008, before the U.S. financial crisis hit,  the  contracts tracked by the  Goldman Sachs Commodity Index, known as the GSCI for short—the commodity equivalent of the Standard & Poor’s 500 Index—nearly tripled in price.  (S&P, in fact, bought the index and  added its own name to the  title  in 2007.) Crude oil futures rose  three and  a half times their earlier levels. Corn  futures also tripled. Even gold,  an odd- ball commodity because it often  performs better when  the  stock markets fall—and in this case stocks were on fire—nearly doubled.

It was a period of easy money,  and  the  benefits were  felt all around, from state pension funds that had added commodities to their investments  in  order to  mitigate their exposure to  other, unrelated markets, to individual investors,  who had  dipped into commodities as a way to make money off of skyrocketing oil prices even  though their gasoline was so much more expensive at the pump. Salesmen for the  GSCI and  other commodity indexes ar- gued  that  their products were an  important way to diversify in- vestment  portfolios. An array  of new securities that  traded like stocks but  tracked precious metals  like gold and  silver had  made commodity investing  easier  for regular people than ever before, and the commodity market’s inexorable upward movement meant that  they’d be crazy not to buy in.

“Wall Street did a nice job of marketing the value of having the diversification of commodities in your portfolio,” says Jeff Scott, chief investment officer  of the  $74 billion  financial firm Wurts & Associates. “I don’t  mean that  sarcastically.  And there is value to having certain commodities in your portfolio. Unfortunately, the return composition changed.” In other words, at a certain point the money  wagon stopped rolling  along.

Until  2008, there were plenty  of reasons to like commodities, most important of which was the  torrid pace of demand in India and  China. Those  economies, which were driving  up the price  of raw materials around the  world,  were widely seen  as the  harbingers  of what  the  buzzier  banking analysts  referred to  as a new “supercycle,” a period of sustained world growth the likes of which had not been seen since World War II. There was also a prevalent theory  known as “Peak Oil” suggesting that the world’s petroleum supplies were well on their way to being  tapped out—a  situation that  would  make  crude oil,  the  engine of so many  economies, frighteningly   scarce.   Both   hypotheses   augured  a  continuing climb in the price  of oil.

But during the  second half of 2008, the  belief  in higher com- modity prices vanished. Like stocks and bonds, commodities were roiled by the  financial crisis in  the  U.S. The  main  commodity index plummeted, and  crude-oil contracts sank  to a fraction of their record high  of $147.  Underlying their sudden drops  amid volatile  times  in the  market was a broader story line:  the  whole commodity craze had  by then begun to fizzle.

Throughout the bubble in commodities, a core  group of traders were siphoning much of the  profit.  They were industry veter- ans  who,  like Pierre Andurand,  used  a combination of strategy and  heft to play the markets to their benefit. Along the way, their bets  that  commodity  prices  would  rise  had  the  ability  to  move markets upward, and  their bets that  prices  would fall, the  opposite. For the most part,  they weren’t  manipulating prices  by hook- ing  up  with  fellow  traders  to  orchestrate  group decisions, nor were they buying physical commodities to constrict supplies while collecting money by betting that the futures prices would go up, a classic commodity swindle known as cornering. But their intimate knowledge of nuanced industries, their access to closely held  in- formation, and  their enormous resources gave them tremendous advantages that  few others had.  And even when  they bet  wrong, they were still so rich  and  well connected that  they could  usually return the next  day and  begin  to make  their money  back.

It was an  industry  of optimism, peopled by wealthy,  focused traders who were not  afraid  of an occasional setback.  Some  had absentee fathers whose  gaps  they  longed to fill with power  and money,  some  were simply more comfortable with risk than their counterparts. After all, commodities were  an  area  in which  the market swings in a given  day could  be  exponentially greater in size than the typical moves in stock or bond markets.

“When  you trade commodities, you realize  really quickly that markets can do anything,” explained Gary Cohn during an inter- view in Goldman’s sleek  New York  corporate offices  one  day in 2012. “So I love when I sit there with guys who say, ‘that would be a three-standard-deviation move,’ ” that is, a shift in market prices that  was three times  as great  as the  typical one  would  be—as  if that  notion should come  as a shock to the  listener, he added: “In commodities, we have three standard-deviation moves in a day.”

Commodity  players  can  appear pampered, even  lazy. Maybe they spend half the  summer in Provence or Nantucket, working remotely from  a Bloomberg terminal in their home office while their kids are minded by a live-in nanny. They might  piddle away a serious  investor  meeting talking  martial arts, move a long- scheduled international appointment just days in advance, refuse to take  a view on  the  markets, or be too  busy grouse-hunting in Norway to answer a couple of questions about the  crude-oil business. All of the  above happened with people interviewed for this book.  But  when  it  comes  to  trading raw  materials, they  are  a shrewd  and  indomitable lot, and,  at least for the moment, the contracts they trade are still so loosely regulated that  the  correct combination of money  and  skill creates  irresistible opportunity. That’s why I am only half-joking when I call them the secret  club that  runs  the world.

In  BlueGold’s  prime, it had  several  hundred  competitors in the hedge-fund business,  each  of varying size. Commodity hedge funds,  typically based in London, Greenwich, or Houston, picked one  or  more raw materials they  understood  well, then made  a business  of trading in the  related contract markets. Their inves- tors,  usually  a combination of larger  money-management  firms and  wealthy individuals, presented them with billions  of dollars to trade. There were many winners,  but  John  Arnold, a onetime Enron trader who went into  business  for himself  after  it folded, did the best of all; his natural-gas-focused hedge fund,  Centaurus Energy, generated 317 percent returns in 2006. Several years later, Arnold  retired, a billionaire at the age of thirty-eight. He became a philanthropist.

Prodigies like Arnold  were the superstars of the industry, com- manding respect as a  result  of  the  enormous  sums  of  money they’d  made. Andurand, who generated 209 percent returns in 2008,  was in  there too.  But  few hedge-fund  traders  were  quite that  accomplished. The  rest of the  commodity-trading hierarchy was topped by the  large,  multinational brokers involved  in every single aspect  of commodity harvesting and  trading, from extract- ing the coal out of Colombian mines to hiring massive cargo ships to move them to Singapore while hedging the future price of coal as it was transported. Those  companies, based  largely outside of the  U.S., had  a long  and  sordid history  of doing backroom deals with shady  politicians, flouting international trade and  human- rights laws, and engaging in tax dodges, pollution, even, allegedly, child  labor.  The  big players  in the  industry were companies like Glencore and Trafigura, and their founding father was the Amer- ican  fugitive Marc Rich. Other parts  of the  commodity business feared their aggressive approach to business,  given that  they transacted with parties with whom  the  majority  of the  business world feared to work.

But their scope and sheer  manpower helped them understand tiny regional discrepancies in the  price  of oil and  other goods, allowing them to source  commodities more cheaply and sell them at a premium. That  process  generated tens  of billions  in profits. “This is off the  record,” or at least it has to be anonymous, one industry analyst told me, before describing one of the companies, because  he  didn’t  want  the   subject   of  his  comments  “to  be blowing  up  my car.” Many investors  and  even  other traders had reservations  about  the   international  trading  houses. But the comprehensive approach taken  by Glencore and  others, helped by a creative  use of corporate regulatory havens,  had  given them elite status in certain commodity markets and  made  their execu- tives exceedingly wealthy.

Most hedge-fund traders sat somewhere in the  middle of the totem pole. In the larger  scheme of commodity trading, they were essentially  money  changers, pooling other people’s cash to try to outmaneuver  the  markets, placing bets  on  where  prices  would go, and skimming profits  off the top of whatever  they made  when they  were  right—generally  20 percent of a year’s earnings and about 2 percent of the  money  investors  gave them. A Frenchman who had  socialist  influences growing  up,  Andurand  considered the  physical oil business  to be dirty and  distasteful, and  told  me at one  point he would never  consider taking  delivery of an actual barrel of crude. He  was just  a trader, and  although he  had  an £11 million  house near  Harrods in London, a customized Bugatti sports car, and a gorgeous Russian wife, he would never attain  the sort  of riches  and  power  that  his counterparts in the  corporate commodity logistics business  would.  He  was a mere  millionaire, not a billionaire.

Still, Andurand had something others lacked:  fearlessness. He traded billions of dollars’ worth of oil contracts in the markets daily, exposing himself to potential losses that many traders couldn’t stomach. Commodity hedge-fund traders talked often about their daddy issues and  other insecurities and  how they had learned to compartmentalize their financial woes without  bringing them home at night. “My wife couldn’t tell you if I had a good day or a bad day—ever,” one  Greenwich-based oil trader told me late  in  2011.  Andurand  shared  that  thinking; he  preferred to spend tens of thousands of euros  on a bespoke wedding gown for his fiancée than to acknowledge his setbacks  to her  directly.

The  international banks  that  dabbled in  commodities were lower  in the  pecking order. In  better days, Goldman Sachs and Morgan Stanley  took  in more than $3 billion  apiece  in revenue from buying and selling oil, gasoline, copper, and other commodities. They arranged elaborate hedging strategies for airlines  de- pendent on cheap jet fuel, charging fees for their advice along the way, and  they lent  capital  to hedge-fund traders, pocketing inter- est  and  fees  in  return.  Sometimes they  profited from  trading directly  with  those  clients,  buying  a commodity  the  client  was selling, for instance, and making money  unexpectedly when markets moved  against  that  client.  But the  real  money  was made  in trading for  the  house—turning their  commodity  traders  into mini-Andurands  with purses  provided  by the  bank’s  shareholders. In 2008, for instance, two of the  best-paid employees at the Swiss firm  Credit Suisse were  a pair  of commodity  traders  who took home a combined $35 million  after betting correctly on the crude markets. Their role was effectively eradicated in 2010 when a new law in the U.S. barred bank employees from trading for the house, prompting them and many of their counterparts to flee to less regulated parts of the industry. But the banks continued nos- ing around the  regulatory margin, looking for ways to optimize their commodity-trading chops,  and  the  Credit Suisse traders simply  quit  the  bank  and  started their own  oil-focused  hedge fund.

Lying miserably at the bottom of the commodity-trading power structure  were  the  individuals  and  corporations  that  depended on  physical  commodities—the Coca-Colas, Starbucks, Delta  Air Lines, and  small farmers of the world. Those  actors were paralyz- ingly dependent on aluminum, sugar,  coffee,  and  jet fuel for sur- vival, but were, almost  without  exception, unable to keep  up with the  commodity traders at banks  and  hedge funds.  Conservative- minded by nature, and  loath  to use the exotic  financial products or fast-moving trading strategies that  professional commodity traders employed, they lacked  the expertise to game  the markets and  felt it wasn’t their job to try, anyway. After all, they were sell- ing  lattes  and  airline seats,  not  risky commodity  contracts that required multithousand-dollar down payments. Still, with the prices of many commodities climbing, the companies couldn’t ac- commodate price shocks, so they often  wound  up hiring banks to hedge their vulnerability to volatile product markets. The  result could  include added fees, bad  quarters—even potential bank- ruptcy,  if large  demands  from  banks  or  other trading counter- parts for extra  cash or collateral became too much to bear.

And if their limited knowledge and  power  were not  enough of an  obstacle, these  companies and  people were  also damaged by sleaze in the  brokerage business.  Twice in the  aftermath of 2008, middleman firms  that  lent  money  to commodity-contract buyers and  sellers to make  trades  and  then finalized them on exchanges failed due to the mishandling of funds, wiping out customer money in the process.  One  of them, MF Global, was run  by Jon Corzine, a former head of Goldman Sachs in the 1990s and later the governor of New Jersey, who at MF used  small investor  money  to pay debts from  a side bet on European bonds that  had  gone  bad.  The  case against  him  is still cycling through the  courts,  and  it took  more than two years for MF Global’s customers to be made  whole.

The astonishing wealth of commodity trading’s inner circle was created in near-total obscurity.  Because  it operated within  either closely held  companies that  didn’t trade on  public  exchanges or deep within large banks and corporations, where commodity prof- its and  losses weren’t  disclosed separately, the commodity-trading power elite has enjoyed utter anonymity. But if the individual par- ticipants in the  boom went unnoticed, their impact  did not.  The commodity market’s sudden growth  in volume,  and  the  parallel surge  in commodity prices,  along  with the  entrance of public  in- vestors such  as the  California Public  Employees’  Retirement Sys- tem,  raised  serious  questions about whether traders were jacking up the prices paid for commodities by average  citizens.

In  the  United States,  where  so many  people depend on  car travel, fuel was an especially charged issue. During the commodity price  spikes of 2008, the  resultant $4-per-gallon price  of gasoline sparked an outcry  in the  U.S., where  members of Congress held forty hearings on the topic in the first half of that  year alone.  Motorists,  trucking companies, and  other fuel  buyers  blamed commodity speculators for driving up prices,  and  they wanted  the government to rein things  in. Under intense public  pressure, Congress and  the Commodity Futures Trading Commission vowed to scrutinize the speculators, who their own records showed were accounting for a much larger  portion of the  markets. But the  brewing  financial crisis  and  an  ongoing political   struggle between those  in Washington who believed  speculators affected commodity prices and those  who didn’t made  the CFTC slow to act.

Overseas and in the States, the cost of food was another red flag. Food  prices  had  risen  during the  market boom of the  mid-2000s, but the concurrent inflation of home prices  and  the availability of cheap credit had blunted the impact on consumer spending. In the years after 2008, the price of staple grains like corn, wheat, and soybeans  hit  all-time  highs,  making food  products  costlier,  even unaffordable. Some  analysts believed  that  grain  prices  were caus- ing  revolution  in  already-stressed  places  such  as  Egypt,  which played a pivotal role in the 2011 uprising known as the Arab Spring. And while unpredictable weather, poor crop  yields, and  a rise in demand were  certainly  influences, some  academics also  argued that  commodity indexes like the  GSCI were to blame,  saying that the structure of those  investments, which was to bet over and  over again  that  prices  would rise, actually caused  such  rises to happen in the physical and futures market.

They had a point, as an academic paper published in 2010 later proved. But the  clear  evidence of causation was still hard to find; even when a connection appeared obvious, the support for the theory tended to be largely anecdotal. Andurand estimates that during that  fateful  day in May 2011,  BlueGold moved  the  Brent  futures market down an additional $2 or $3—exacerbating by up to 33 per- cent what was already a huge, $10 down spiral in the crude market. Negative headlines about a lawsuit implicating the hedge-fund manager John Paulson, a large holder of the physically backed gold security  known  as the  GLD, appeared to force  gold  futures down nearly 2 percent on a single day in 2010—a considerable move in a very large market that is difficult for any single party to affect. The idea that there is a connection in both  cases is powerful, and likely accurate. But because the impact  of market sentiment is impossible to document, we’ll never completely know.

What is clear is that the last decade in commodity trading had a unique impact, both  on  the  market itself and  the  public’s  perception of commodities as a compelling investment.  The  abundance of new speculators, the  meteoric growth  of the  GSCI and other, similar  investment  vehicles,  and  the  general ebullience about the  supercycle and  its implicit  effect  on  raw materials all made  the  market’s shifts more dramatic. That  volatility created kings  in  the  trading world’s  empowered  class, and  drove  other people and companies into financial ruin.  The commodities bubble of the  2000s is a snapshot of one  of the  most  extraordinary periods in American finance, providing an object  lesson  on  the role  of markets, regulators, and  how the  money  world can sometimes lose its connection to the real one.