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CFTC Considers Speculative Limits for Energy, Other Commodities

July 27, 2009
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In the first of a series of hearings this month and in August, the Commodity Futures Trading Commission (CFTC) will focus on whether federal speculative limits should be set by the agency on all "commodities of finite supply," particularly energy commodities such as crude oil, natural gas, heating oil and gasoline, Chairman Gary Gensler said.

"The CFTC currently sets and ensures adherence to position limits with respect to certain agriculture products. This is not the case for energy markets. For energy commodities, futures exchanges set position limits and accountability levels to protect against manipulation and congestion," but they "are not required to set and enforce position limits to prevent the burdens of excessive speculation," he said.

The hearings will explore whether the CFTC, rather than exchanges, should set limits on the number of contracts that a single company or fund can hold to crack down on speculation in the energy futures markets. A CFTC spokesman said no dates for the July-August hearings have been set.

"This different regulatory approach to position limits for agriculture and other physically delivered commodities deserves thoughtful review. The [CFTC] will be seeking views on applying position limits consistently across all markets and participants, including index traders and managers of exchange traded funds; whether such limits would enhance market integrity and efficiency; whether the CFTC needs additional authority to fully accomplish these goals; and how the Commission should determine appropriate levels for each market," Gensler said.

"While the Commodity Exchange Act provides for exemptions from such limits for 'bona fide hedging transactions or positions,' the CFTC is currently reviewing the manner in which this exemption has been implemented."

Gensler said the CFTC also seeks to increase the transparency of market data in the weekly Commitments of Traders (COT) report, which is released each Friday. The report includes the aggregated positions of noncommercial and commercial traders and has been an important tool for market participants and the public to track the changing positions and investments of important groups of market players.

"I have directed staff to improve our COT reports in four ways. First, we will disaggregate the current commercial category separating out and categorizing swaps dealers. Second, we will disaggregate the current noncommercial category by separating out and categorizing the professionally managed market positions, such as hedge funds. Third, we will incorporate data the CFTC receives for all foreign contracts linked to domestic contracts. [And] fourth, we will incorporate data of contracts determined to perform a significant price discovery function," Gensler said.

In September 2008 "the CFTC published a Report on Swap Dealers and Index Traders based upon our special call authority. The Commission will continue this special call, enhance the information disseminated in this report and release it on a quarterly basis," with a goal of moving it to monthly in the near term, he said (see NGI, Sept. 15, 2008).

CFTC Commissioner Bart Chilton called the hearings an "excellent starting point" to ensure that speculative activity in the marketplace does not distort prices. "First, we need to look at the issue of spec limits generally; we've got federally set spec limits in ags [agriculture] but not in other physically delivered commodities, like oils and metals, and we need to see if it's appropriate for the CFTC to set limits in those commodities as well."

Chilton noted that oil, for example, is certainly as important a commodity as wheat, "and, as we saw last summer when the price of oil skyrocketed out of control, federally set spec limits may have been able to provide some needed speed bumps." He said the CFTC also needs to look at whether exemptions that have been granted to these limits are appropriate. "This involves a review of our fundamental concept of 'ona fide hedging;' specifically, should that include entities that are primarily involved in financial hedging and not in the actual commercial dealings in underlying commodities? We need to drill down on this issue, and figure out how best to craft this definition to protect consumers and markets."

Chilton supported Gensler's plans to revamp the commission's COT reports, which he called "long overdue" in the effort to increase transparency. "I look forward to getting comment from the public as to what they think of this new report and whether additional improvements can be made," Chilton said. "Lastly, until we have authority granted by Congress increasing our ability to look into 'dark markets,' I think we need to continue to improve our information gathering related to our swaps 'special call;' this information is only as useful and reliable as the data we receive, and I believe we must also continue to improve our scrutiny of this information to ensure its utility to us and to the marketplace."

IntercontinentalExchange (ICE), a major energy trading platform, last Thursday said it welcomed the opportunity to participate in the CFTC's upcoming hearings on position limits in energy trading markets, noting it has been an area of concern for some time. Independent oil and natural gas producers, however, were less receptive, warning that dramatic changes by the CFTC affecting their hedging activities could cripple development.

"ICE has expressed concern to the CFTC about the process in place today for establishing position standards in the U.S. energy markets. We look forward to participating in the Commission's hearings and believe they will provide a venue for the open...dialogue necessary to consider market impacts of the needed changes to the existing position position management regime," said Atlanta-based ICE. Competitor CME Group, the world's largest derivatives exchange, said it would withhold comment until more details about the hearings are released.

"Current regulation by the CFTC mandates that ICE adopt the position and accountability limits that its competitor, Nymex [New York Mercantile Exchange], is presently responsible for establishing," ICE noted. The hearings will examine whether the current process -- with exchanges setting position limits -- goes far enough to check excessive speculation.

"Although attacking so-called speculation is a popular program for some who may not fully understand its full market function for America's small and independent natural gas and oil producers, it's an incredibly valuable tool for managing risk and keeping operations engaged and intact at the well site," said Barry Russell, president of the Independent Petroleum Association of America.

"If the CFTC and Congress obstruct commonsense market activity, independent energy producers will not be able to hedge their production. Without hedging, companies will be unable to protect their cash flow to maintain exploration and production budgets and retain employees when prices drop...With less production comes higher prices," he said.

ICE cited flaws in the current system for setting trading position limits. "ICE is provided no access to the information needed to judge the suitability or size of these limits [set by Nymex], nor does it have access to the methodology or determining factors that Nymex used in deciding to grant [more than] 115 hedge exemptions since 2006.

"Despite the substantial increase in the size of the energy markets -- including growth in contract volume, participants and physical production -- position limits in U.S. energy markets have remained unchanged for years. Therefore, it appears that hedge exemptions have been increasingly granted to meet the needs of market participants in today's large, global markets," it said.

ICE warned that strict position and accountability limits could send traders to bilateral, off-exchange markets where neither limits nor reporting exist. This "shift backward to opaque, bilateral markets decreases market transparency and increases counterparty risk, both of which run counter to proposals by the [Department of Treasury] to bring bilateral positions into clearing houses," ICE said.

"The hearing process will allow the industry to examine how needed modifications to the current position management regime might be better structured, including how changes might affect volatility, prices, market concentration and the prevention of settlement prices manipulation."

With respect to the CFTC's plan to focus on index funds and exchange-traded funds (ETFs), ICE said they accounted for an "immaterial amount" of its revenue. "Index funds typically execute their trades in the OTC [over-the-counter] broker markets rather than in ICE's markets -- using ICE only to clear their bilateral positions -- and thus they pay limited fees to the exchange. Because trading activity generated by index funds and ETFs generally is not part of the on-exchange price discovery process, they typically do not provide volume interaction with other participants in ICE's electronic execution markets."

The CFTC's regulatory grip on ICE's energy markets has tightened within the past year. With the passage of the farm bill in 2008, ICE's OTC energy markets became subject to increased CFTC regulation for key contracts, such as the Henry Hub natural gas swap, which perform a significant role in price discovery.

Also in 2008, the CFTC amended ICE Futures Europe's no-action letter to require the foreign exchange to adopt U.S.-style reporting, position limits and position accountability levels for its energy contracts and reference the settlement price of a U.S. designated contract market.

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