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On Energy Commodity Position Limits, Devil In the Details

There was near-unanimity last week at the Commodity Futures Trading Commission (CFTC) hearings on one point -- that position limits are needed to to curb excessive speculation in energy commodity markets. But the consensus unraveled when it came to the details -- who should set position limits, who should be exempted from the limits and at what level the position limits ought to be set.

Following back-to-back hearings last week, CFTC Chairman Gary Gensler appeared certain that speculative limits were in order in the energy markets (see NGI, July 27). "No longer must we debate the issue of whether or not to set position limits," he declared, but he acknowledged that the details still had to be ironed out. Energy users called on the CFTC to move quickly. "Rome is burning," they said, urging fast action on across-the-board hard position limits before the energy markets, particularly crude oil, take off again. Gensler has indicated that agency action on position limits may come in the fall.

The major exchanges -- Atlanta-based IntercontinentalExchange (ICE) and CME Group, which owns the New York Mercantile Exchange (Nymex), Chicago Board of Trade and the Chicago Mercantile Exchange -- agreed that position limits were necessary in the energy commodity markets, but they were split over the issue of who should set the position limits -- the CFTC or the exchanges.

"We think that any aggregate position limits, accountability levels and hedge exemptions should be set and administered by...the CFTC and not by the exchanges," said ICE CEO Jeff Sprecher. "Only the CFTC has the placement to view a trader's positions across all venues to observe true position size -- no single exchange or venue is in such a position."

While supporting position limits, Sprecher said, "we...have not seen a quantitative study that shows speculation in the futures market was the cause of the increased energy commodity prices that we've seen over the last year."

But CME Group CEO Craig Donohue said he believed exchanges were best suited to impose position limits. "We believe that CME Group is in the best position to impose and administer position limits and hedge exemptions regarding the energy commodities, and are therefore prepared to act in the near term before the Commission or Congress [acts]" on position limits.

He told CFTC commissioners that "efforts to control price volatility by position limits is generally a failed strategy." But due to concerns over the role of index funds and swap dealers in the futures markets and the impact of their participation on energy prices, he said CME was "prepared to respond to those concerns by adopting a hard limit regime for those [energy] products, including single-month and all-months combined limits, in addition to current limits that apply during the final three days of trading of the expiration month.

"This modified regime will include the administration of tailored hedge exemptions for swap dealers and index funds, and as a whole should alleviate the external concerns that positions held by these investors and hedgers will increase price volatility or artificially inflate or deflate prices," he said. Energy customers blamed index funds, swaps dealers and the big Wall Street firms for the run-up in oil and natural gas prices last year.

Action by the exchanges, while welcomed, won't deter the CFTC. The agency can establish position limits on energy traders, even if an exchange already has established its own position limits, said CFTC General Counsel Dan Berkovitz. And he noted that the CFTC can take this action even if there is no finding of excessive speculation. "The Commission has been able to set position limits without such a finding."

Currently the major exchanges set energy position limits only in the last three days of trading to address manipulation and congestion, according to the CFTC. The exchanges, however, are not required by statute to set and enforce position limits to prevent excessive speculation in energy futures markets.

The exchanges also set position accountability levels and issue early warnings to traders when they are near or have exceeded that level. But CFTC Commissioner Bart Chilton said accountability levels were about as effective as "speed limits on a dark desert highway."

Nearly 70 traders in four Nymex single-month energy contracts (crude oil, natural gas, gasoline and heating oil) exceeded the accountability level during the last 12 months, Gensler noted. For the Nymex natural gas contract, 40 traders exceeded the single-month accountability level of 6,000 contracts for an average of 84 days. Three-quarters of the time traders were issued a simple notice for the overage. "So it wasn't a stop sign or a yield sign. It was sort of honk if you go past this?" Gensler asked Donohue.

"Yes. That's as it is intended and designed to be," Donohue responded.

From a legal standpoint, "the Commission's authority to establish position limits only goes to designated contracts, designated derivative transaction and execution facilities or where there's a significant price discovery contract [in] exempt commercial markets," Chilton said. "So we do not have statutory authority to post position limits in the over-the-counter [OTC] markets or other markets." Both Congress and the CFTC are working together on legislation to give the agency authority in OTC markets (see related story).

Several at the hearings expressed concern that restrictive position limits could force traders into the unregulated OTC markets. To prevent this, Gensler said, "the CFTC must be able to set aggregate limits on all persons trading OTC derivatives that perform or affect a significant price discovery function with respect to regulated markets that the CFTC oversee."

This would "ensure that traders are not able to avoid position limits in a market by moving to a related exchange or market, including international markets."

Another key issue is "whether or not we should grant exemptions from position limits to persons using the futures markets to manage purely financial risks rather than risks arising from the actual use of a commodity," Gensler said. "Although our statute directs the Commission to set position limits as necessary to prevent undue burdens on commerce, Congress [has] made it clear that position limits would not apply to bona fide hedgers."

Toward this goal, Gensler said the CFTC will take a close look at whether to eliminate the hedge exemptions for certain swap dealers and possibly create a new risk management exemption.

Sen. Bernie Sanders (I-VT), who had blocked Gensler's confirmation to lead the CFTC for months, blasted the CFTC for granting bona fide hedging exemptions to Wall Street firms, such as Goldman Sachs, to "do as much oil and gas trading as they want."

Investment banks JP Morgan and Goldman Sachs, who deal in swaps, support the CFTC imposing federal position limits in the energy futures market to clamp down on excessive speculation, but with one caveat -- the limits should be on the ultimate holder of a contract, not the swap dealer when it acts as an intermediary between buyer and seller.

Blythe Masters, head of the global commodities group for New York-based JP Morgan, called on the CFTC to focus on end-use customers when imposing position limits across all markets -- both over-the-counter and exchange-based markets. "In effect the CFTC should look through the swap dealers and apply position limits at the market participant level. This would eliminate the ability to use the OTC markets to exceed positions that would otherwise apply if the participant had transacted on regulated exchanges, furthering the mission of preventing excessive speculation," she said.

"My layman's read of your existing authority would suggest you have the power to do this. And if not, we would be supportive of legislation needed to achieve this," Masters said.

Don Casturo, a managing director with Goldman Sachs, agreed that the CFTC should "[look] through the swap dealers to apply limits at the end-user [counterparty] level across derivatives and futures" markets.

"While it might often appear that a swap dealer has taken a large position in the futures market, in reality the swap dealer is using the exchange to manage the risk incurred in the capacity as an important intermediary in the OTC markets," he said. "We're just a passer."

Tyson Slocum, director of the energy program for public watchdog Public Citizen, called for the CFTC to establish "strong effective" position limits across all markets and for all products, reaching into swap dealers and index funds. He emphasized that the CFTC, not the energy exchanges, should impose position limits.

"We believe that the lack of effective position limits [in energy markets] has allowed the accumulation of too much market power and has limited effective competition in these markets, and allowed a handful of very powerful entities -- two of which are seated here at the table today, Goldman Sachs and JP Morgan -- to take very large positions in underregulated format," he said.

"We are aware of no credible academic study or analysis that demonstrates the presence of noncommercial interests in commodity markets has been detrimental," quipped Masters.

Slocum urged the agency to "only provide exemptions [from position limits] for bona fide commercial interests...folks that can demonstrate they have a direct financial interest in hedging their risks."

Petroleum marketers, representatives of the airlines and municipal members of the American Public Gas Association (APGA) were unanimous in calling for unified hard position limits across all markets. This would include bilateral non cleared OTC contracts and economically linked contracts, Laura Campbell with Memphis Light, Gas and Water testified.

All months should come under regulation, as is done in the agricultural markets, said Sean Cota of Cota & Cota fuel oil dealers, representing the Petroleum Marketers Association. He noted that failed hedge fund Amaranth Advisors, which crashed and burned on a huge hedge position, did a lot of trading in the outer months as well as the front month. Passive hedgers need to have much smaller limits, and noncommercial traders should hold no more than 30-40% of the market. Limits on a single company's trading should include all of a company's funds, subsidiaries and other appendages, Cota said.

Exemptions to the limits should be available only to those who produce, process or consume a commodity, said a Delta Airlines witness, testifying on behalf of the Air Transport Association. Fuel is the airlines' largest single expense, Delta's Ben Hirst said. He noted the spike in market speculation for jet fuel, which went from a $15 billion market in 2003 to $200 billion in 2008. He estimated that Delta lost $1.7 billion over the last year from excessive speculation. Questioned by Gensler as to how to go about setting position limit levels, Hirst suggested the Commission look back at trading patterns before the "speculative explosion," which started in 2007.

While the Commission dithers over exactly what markets it should get into and how far position limits should go, "Rome is burning," both Cota and Hirst said, urging the CFTC to "act now before we see a repeat of last year's oil bubble." Under its current authority, the agency can make rules and revise them whenever it needs to, the commercials advised. This is not like legislative action, which is set in cement. "You can always make mid-course corrections," Cota said. It may take legislation, however, for the CFTC to get into the OTC markets, although there could be ways to pursue their authority even there.

Cota said that where the cost of fuel oil hedging for residential customers used to be about 6 cents/gallon, that has gone as high as $1/gallon and is in the range of 60-70 cents now. Those costs are passed on to the consumers.

The energy users called for a lot more detailed information or transparency in the Commitment of Traders (COT) reports. "We want to see who is a physical trader and who is not," Cota said. Responding to a question from Gensler about his reference to a "bona fide speculator," Cota said he meant the kind of trader "who used to be in the pits at Nymex" compared to "a lot of big, dumb money" from index funds.

Gensler said the CFTC is working on more transparency, for instance the possibility of having four categories of traders in the COT report, having the swaps dealers report quarterly and then eventually monthly, having a thorough index investor report, including having gross longs and gross shorts instead of just nets. These, however, are just in the discussion stage and have not been circulated to the other CFTC commissioners.

Todd E. Petzel, chief investment officer of Offit Capital Advisors in New York and a member of two futures industry groups, warned against interfering in the futures markets, advising that would-be hedgers always will find other ways to their goals, such as going to foreign markets. Petzel said a lot of recent activity in the energy commodity markets is aimed at hedging the U.S. dollar. "Over the last 10 years in particular, there has been an increasing awareness of the role commodities can play in a portfolio," he said, acknowledging that commodities can be considered a general inflation hedge.

The third and final CFTC hearing on the need for position limits on speculative trading in finite commodities markets, such as energy, is scheduled for Wednesday (Aug. 5).

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