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House Urges CFTC to Restore Order to Energy Markets

June 30, 2008
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As the price of crude oil steadily climbed last week, eclipsing $140 a barrel on Friday, Capitol Hill's focus was on whether the Commodity Futures Trading Commission (CFTC) was doing everything in its power to police the energy futures markets. The consensus was "no," which lead House Speaker Nancy Pelosi (D-CA) last Wednesday to ask President Bush to direct the CFTC to use its emergency authority to restore order to the oil and gasoline markets, and the House of Representatives one day later to overwhelmingly pass a bill directing the CFTC to draw on all of its powers, including its emergency authority, to immediately curb excess speculation (see related story).

"Despite growing reports of excessive speculation in energy markets, the CFTC has refused to act," Pelosi wrote in a letter to the president. "The CFTC's prompt action would send a strong signal to the market that [the] CFTC will be both a 'cop on the beat' and be prepared to use its power to address systemic weaknesses that are contributing to market instability."

The CFTC responded that since its creation in 1976, it has used its emergency authority only four times -- and it was in response to extreme events, such as manipulation or a specific distrubance that cause a sudden shock to the markets. It said it has never exercised its emergency power based on price trends that have developed over months or years.

At a press briefing last Wednesday, Pelosi said, "Today we are putting oil speculators on notice...Eight years ago, before another Congress made the Enron loophole law, 70% of the energy futures market trades were made by the industry -- only 30% by speculators. Today those numbers are reversed -- and trading volume has increased six-fold."

The overwhelming vote (402-19) in favor of the House CFTC-related bill signaled that both Republicans and Democrats believe the agency needs to do a better job of overseeing the energy commodities futures markets. Whether this bill or other proposed CFTC measures will become law still is an unknown. "If addressed separately (something we think is increasingly likely), changes to how the Commodity Futures Trading Commission supervises markets may happen this year," said energy analysts Christine Tezak and K. Whitney Stanco of Stanford Group Co.

"We currently expect legislation to move through both chambers through the month of July, and possibly move toward enactment in September. That's the easy part to anticipate -- but what exactly might wind up in that bill is far from clear," they said.

The commodities futures markets were the target of several Capitol Hill hearings last week. A top executive of a global investment firm told a Senate panel last Tuesday that if the futures markets lose one or both of their key functions, price discovery and risk hedging, "the physical hedgers will abandon the futures markets and they will become little more than high-stakes casino."

Because of the "disassociation between futures prices and the supply and demand realities in the physical markets, the futures markets are no longer able to serve the only constituency they were ever intended to service -- bona fide physical hedgers," said Michael W. Masters, managing member and portfolio manager with Masters Capital Management LLC, during a hearing before the Senate Homeland Security and Governmental Affairs Committee.

"If this trend continues, we can expect to see many physical commodity producers and consumers abandon the futures markets entirely as a vehicle for hedging purposes and price discovery. At that point, the futures markets' destruction from excessive speculation will be complete," he said.

"Physical commodity producers and consumers trust and rely upon the price discovery function of the commodities futures markets to accurately reflect the overall level of supply and demand, pricing their spot market transactions directly off the applicable futures price. For many years, spot market traders have trusted the veracity of futures prices."

But "unfortunately, this has changed in the last few years. This trust has been betrayed, and many physical commodity market participants are now losing faith in the futures price as a benchmark for their transactions."

The hearing was called to hear testimony on proposals by Committee Chairman Joseph Lieberman (I-CT) and Sen. Susan Collins of Maine, the ranking Republican on the panel, to curb speculation in the commodities markets, including:

Lieberman and Collins are expected to introduce legislation, incorporating some of the proposals, following the July Fourth recess.

Masters called on Congress to take several steps to address speculation in the commodity markets, including convening a panel composed exclusively of physical commodity producers and consumers to set "reasonable speculative position limits" in the spot month as well as in all other individual months, and as an aggregate across all months.

"As part of this first step, speculative position limits must apply to every market participant (exempting bona fide physical hedgers) whether they access the futures markets directly or trade in the [OTC] markets through swaps and other derivatives," Masters said. "This means effectively closing the swaps loophole and ensuring that position limits 'look through' the swap transaction to the ultimate counterparty. It is essential that swaps deals report all their positions to the CFTC so that positions can be aggregated at the control entity level for purposes of applying position limits."

As a second step, Congress should instruct the panel of physical commodity producers and consumers to determine, based on a percentage of open interest, what constitutes "excessive speculation" in the futures market, Masters said. For example, the physical crude oil producers and consumers may decide that the crude oil futures markets should never be more than 35% speculative (not including spreads) on a percentage of open interest basis.

"Next the CFTC should be instructed to establish 'circuit breakers' (a concept familiar to equity market participants) that adjust individual speculative position limits downward in order to prevent any commodity futures markets from reaching the overall limit established by the panel," he said.

Masters also called for the elimination of the practice of investing through passive commodity index replication. "Index speculators have no sensitivity to supply and demand in the individual commodities because of the nature of passive indexing. This practice should be prohibited because of the damage that it does to the price discovery function."

In addition, "Congress should actively investigate the practice of investors buying physical commodity inventories. It has come to my attention that some Wall Street banks are offering commodity swaps based on actual physical commodities. This is a distressing development because it means that investors are directly competing with American corporations for natural resources and thereby competing with American consumers," he said.

To deal with high energy prices in the here and now, Congress should give the CFTC the powers and resources needed to regulate close substitutes to exchange-traded products, said James J. Angel, associate professor of finance at Georgetown University.

"If there are abuses going on in the OTC markets that are affecting the regulated markets, our regulators need the powers to deal with it. These powers would include the ability to gather information [and] provide transparency, as well as set position limits and margin limits when necessary in the public interest. This should apply to all contract markets, not just energy and agriculture," he said.

In a related development, Sen. Byron Dorgan (D-ND) last Tuesday offered legislation aimed at shutting down excess speculation in the energy commodity futures markets. The bill would require the CFTC to classify all trades as either "legitimate hedge trading" by commercial producers and purchasers of actual physical petroleum products, or as "nonlegitimate hedge trades."

It also proposes that the CFTC increase the margin requirements to 25% for trades classified as nonlegitimate hedge trades. "There is a 50% requirement for people when purchasing stocks, but only a 5% to 7% requirement for those speculating to buy oil they'll never use...and the American public gets stuck with the bill every time we fill up our tank," Dorgan said.

In addition, Dorgan's measure calls on the CFTC to revoke or modify all prior actions or decisions that prevent the agency from protecting legitimate hedge trades and discouraging speculative trades. It also proposes that the CFTC convene an international working group of regulators to ensure the protection of petroleum futures market from excessive speculation and worldwide forum shopping.

Another Democrat, Sen. Bill Nelson of Florida, has introduced legislation (S. 3134) to ban unregulated speculative trading of crude oil futures and other energy commodities in an attempt to curb the "unchecked run-up" in oil and gasoline prices that he claims took off after Congress deregulated electronic trading of energy futures in late 2000.

The measure is based on the testimony of University of Maryland law professor Michael Greenberger, a former government commodities regulator who recently told the Senate Commerce Committee, on which Nelson sits, that the record-shattering price run-up began when Congress exempted trading of energy and metals from CFTC oversight with the passage of the so-called Enron loophole in December 2000.

The farm reauthorization bill, which became law on June 18, was intended to have completely closed the Enron loophole, which exempted large electronic trading platforms from the full oversight of the CFTC. But critics, such as Greenberger, said it did not go far enough to regulate the OTC markets in energy futures.

While Nelson and other lawmakers are convinced that trading speculation is driving the prices for oil and other energy commodities, CFTC Acting Chairman Walter Lukken told a joint Senate committee hearing earlier this month that the agency has uncovered no evidence of excessive speculation in the crude oil market. But he said he could not rule out the possibility of manipulation.

"We have not seen evidence from our data" of speculation driving oil prices, he said during a recent joint hearing before the Senate Agriculture Committee and the Senate Subcommittee on Financial Services and General Government (see NGI, June 23). "We have not [found] a smoking gun." Lukken said that "hopefully soon" the CFTC will release the results of its six-month investigation into crude oil markets (see NGI, June 2).

Lukken also appeared before Lieberman's committee last Tuesday (June 24). Lieberman chided the CFTC acting chairman for not addressing the issue of speculation in his prepared testimony. "This is a crisis...The problem is urgent," the senator told Lukken.

On the campaign trail, Sen. Barack Obama of Illinois, the presumptive Democratic candidate for president, outlined a four-point plan to crack down on the "excessive" energy speculation that he claims is driving up the prices of crude oil, gasoline and other energy commodities.

If elected in November, Obama said he would go beyond the changes included in the recently passed farm reauthorization bill and fully close the Enron loophole by requiring that U.S. energy futures trade only on regulated exchanges. The loophole exempted large electronic trading platforms from the the full oversight of the CFTC.

Obama also advocated new, disaggregated data on index fund and other passive investments to increase transparency and oversight of the growing number of institutional investors participating in the commodities futures markets. And he said he would support legislation directing the CFTC to investigate whether additional regulation is needed to eliminate excessive speculation in U.S. commodities markets, including higher margin requirements and position limits for institutional investors.

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