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CFTC Chief: Hedge Funds Have Not Increased Energy Price Volatility

A new study by the Commodity Futures Trading Commission (CFTC) looking at oil and gas prices and trading on the New York Mercantile Exchange (Nymex) found that managed money traders (MMTs), such as hedge funds, were not driving prices, "but rather the higher prices and their associated volatility were attracting those traders," said Sharon Brown-Hruska, acting chairman of the CFTC, last Tuesday.

"Rather than increasing volatility, the hedge funds were found to be dampening market volatility by providing liquidity to the commercial hedging community," she told the National Energy Marketers Association's 2005 annual membership meeting in Washington, DC.

Speaking to reporters following her prepared remarks, Brown-Hruska noted that in the U.S. market, "we've seen that hedge funds have actually shifted from purely technical trading activities to more fundamental trading activity. In other words, they actually collect information and are actually professional power and gas and oil traders."

She said the CFTC, through its study, has "actually done some fairly sophisticated analysis of managed money traders and hedge funds to determine whether or not the volatility that we see seems to increase when they're actively trading in the market."

What the CFTC has seen is "when volatility starts to go up, speculators start to come in. So the hedge funds are actually in many ways reactive to volatility, rather than vice-versa," the acting CFTC chairman noted. "It's sort of a chicken-and-egg problem and this is a case where the volatility actually attracts greater hedge fund activity."

The CFTC at the end of the week said that its staff studied the relationship between futures prices and the positions of MMTs for the natural gas and crude oil futures markets. The staff also examined the relationship between the positions of MMTs and positions of other categories of traders (e.g., floor traders, merchants, manufacturers, commercial banks, dealers) for the same markets.

According to the CFTC, the results suggest that on average, MMT participants do not change their positions as frequently as other participants, primarily those who are hedgers. The staff found that there is a significant correlation (negative) between MMT positions and other participants' positions (including the largest hedgers), and results suggest that it is the MMT traders who are providing liquidity to the large hedgers and not the other way around.

In a report, "Price Dynamics, Price Discovery and Large Futures Trader Interactions in the Energy Complex," CFTC also found that most of the MMT position changes in the very short run are triggered by hedging participants changing their positions. That is, the price changes that prompt large hedgers to alter their positions in the very short run eventually ripple through to MMT participants who will change their positions in response. The staff also found no evidence of a link between price changes and MMT positions (conditional on other participants trading) in the natural gas market.

The findings of the CFTC follow on the heels of a study issued in March by Nymex (see NGI, March 14). Nymex's 2004 Market Participants Study found that hedge funds, or private investment funds, represented about 9.05% of natural gas futures trading volume in the first eight months of 2004 and 20.4% of gas futures open interest, but their market participation actually appeared to "dampen" price volatility rather than cause it or increase it.

Meanwhile, Brown-Hruska noted that the CFTC has completed 97% of the energy-related probes that the agency opened in 2002. Addressing the remaining 3% of the investigations, she told reporters that the CFTC is "still negotiating with some companies" and the agency "still has a couple of cases pending, I think, in court that we're waiting for the judges to resolve."

The agency has also filed cases against individual traders in the last month or so, she noted. The CFTC in April announced the filing of a civil injunctive action against a former director of marketing at Western Gas Resources Inc. for pressuring subordinates to report false price information to a price index publisher over almost a year between April 2000 to February 2001 (see NGI, April 18).

"So those are the cases that are still outstanding," Brown-Hruska said. She said that "even recently, we've gotten new information that, even though the conduct occurred in the same time period in our investigations, we hadn't uncovered that conduct until we just received the new evidence. So we at least have to follow up on it. Is it going to lead to any actions? That's still yet to be determined, but we still receive information that we follow up on."

In her prepared remarks, Brown-Hruska also noted that "there have been a lot of calls for an invasive government presence in the price reporting business," citing by way of example a proposal to create a centralized data hub in which all natural gas and electricity prices would be reported.

"I don't believe that the government should be in a business of picking of winners and losers, and this is also true of market data," she said.

"The incentives of government data collectors to produce accurate and high quality data really aren't that well aligned -- or at least as not as aligned as those who are in the business of doing it; who have to do it for a living, sell that data, ensure that the users of their data are happy."

She applauded industry initiatives proposed by the Committee of Chief Risk Officers to establish guidelines for price reporting. "I believe that these kind of industry initiatives can be effective in stemming the price reporting problem," Brown-Hruska said. "I also believe that it does that on a less costly fashion than by interposing a regulator into a job that the markets can perform themselves."

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