The growing alarm about the impact that hedge funds are having in the natural gas futures market is largely unfounded, FERC Chairman Pat Wood, CFTC Chairman Sharon Brown-Hruska and Nymex Chairman Mitchell Steinhause said recently in three separate letters to Rep. John D. Dingell (D-MI), ranking member on the House Committee on Energy and Commerce.
All three dismissed the notion that rising participation by hedge funds has increased gas prices and market volatility. Dingell had asked for their opinion on the matter after receiving a letter from Stephen R. Etsler of Stand Energy Corp., a retail gas marketing company, that included an article on hedge funds in the gas market by Peter Fusaro and Gary Vasey of Global Change Associates.
Steinhause told Dingell that Nymex is about to complete a detailed review of futures trading volume last year from Jan. 1 through Aug. 30. Preliminary data show that hedge funds accounted for "only 9.56% of all months trading during that period," said Steinhause. He also said the exchange determined that hedge funds accounted for only 9.06% of near-month futures contract volume during that period, indicating that was hardly enough to cause continuing volatility and price spikes.
Using a technique developed by C.W. Granger to examine the causal relationship between hedge fund open interest and market volatility, the exchange found that "volatility appears to lead hedge fund participation into the natural gas market rather than hedge funds leading to more volatility," said Steinhause. "For open interest there is only a 9% chance that volatility does not entice hedge funds into the market, whereas there is better than an 86% probability that hedge fund activity or open interest does NOT lead to higher volatility."
Nymex believes that hedge funds serve a "constructive role in our futures markets, and while their participation has not been substantial to date we will nonetheless continue to monitor it closely," he told Dingell, adding that the exchange is planning to release a final report on the matter soon.
Brown-Hruska told the Congressman the CFTC has been conducting routine surveillance of hedge fund trading for some time and found several other interesting facts about their participation in the gas futures market, but nothing to show that they have increased price volatility or driven up prices.
"Individual hedge funds' net positions generally are not large compared to total open interest in the futures market," she said. "Most hedge funds normally roll their positions into forward contract months well before expiration... Commission staff has also observed that hedge funds generally seem to trade in the opposite direction from commercial traders." She indicated that these behavioral tendencies should not cause concern, and in fact they may help support trading by commercial market participants.
Brown-Hruska also said the CFTC believes it already has the tools it needs to monitor trading activity by hedge funds in the futures market. She said that hedge funds are routinely tracked using the CFTC's large trader reporting system, which "has not identified these traders as a particular source of concern...
"The staff is continuing to study hedge fund trading activity in the natural gas market...but at this time does not believe that hedge funds are the major source of price volatility in the natural gas market," she said.
Etsler had expressed concern to Dingell that hedge funds traded gas futures with no intention of taking delivery of gas, and as a result there have been these "wild" swings in prices to the detriment of traditional gas users.
However, both Brown-Hruska and Wood noted that gas futures are rarely taken to delivery. "Physical delivery usually is not contemplated by either hedgers or speculators in those contracts that provide for physical delivery," said Brown-Hruska. She explained that the purpose of leaving open the possibility of physical delivery is to ensure that gas futures prices converge with physical gas prices.
Wood and Brown-Hruska also both pointed to inherent supply and demand factors as the likely root causes of market volatility. Demand for natural gas has been steadily increasing because gas is an environmentally clean fuel, Brown-Hruska noted. Meanwhile, the costs of producing gas and of competing fuels have increased.
Wood said that part of the reason for recent market volatility has to do with the lack of available real-time information on "gas production and production potential, or on gas usage or latent demand... In my view, price swings in natural gas markets have been driven by market fundamentals, but these swings may have been exaggerated by the paucity of statistics on gas supply and demand and the over reliance on gas storage as an indicator of supply and demand," he said.
FERC has considered requiring daily storage reporting. But if a full picture of national storage inventories is desired, the Commission would face jurisdictional issues over requiring some storage companies, such as local distributors and intrastate pipelines, to report storage data, said Wood.
He also noted that gas price volatility also may increase when traders follow price trends rather than independently verify gas market fundamentals. "This strategy can contribute to prices overshooting levels otherwise indicated by market fundamentals."
In a response letter, Dingell said that despite the conclusion that hedge funds pose no problem for gas markets, he promised to "monitor this matter closely."
"Last year's conference report on H.R.6, the energy bill, did not provide gas consumers with any meaningful relief, and this year's legislation is likely to be similar, so the integrity of the pricing markets takes on increased importance."
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