The first panel of the third and final Commodity Futures Trading Commission (CFTC) hearing on potential position limits on speculative entities in the energy markets turned quickly into a debate on whether noncommercial traders -- i.e., funds -- were responsible for the price run-ups in crude and natural gas seen in recent years.
CFTC Chairman Gary Gensler started the meeting by asking how much concentration in a market by an entity is too much. "At what point of market concentration does a trader detract from liquidity instead of enhance it?" he queried. "I think we would all agree that if one party controls half the market, that party is more likely to lessen liquidity than enhance it. Position limits should enhance liquidity by promoting more market participants rather than having one party that has so much concentration so as to decrease liquidity."
Coming under fire from CFTC commissioners as well as other end-user panelists was John Hyland, CIO of US Commodity Funds LLC, which is the general partner for the United States Natural Gas Fund (UNG) and the United States Oil Fund (USO) (see NGI, Aug. 3a). He noted that USO and UNG are "highly transparent, unlevered passive index funds" that allow hundreds of thousands of retail and nonretail investors to access commodity exposure.
"In recent months, a number of reports have attempted to make the case that last year's run-up in crude oil prices and natural gas prices were the result of investments made in the futures market by large unleveraged and passive index funds such as USO and UNG," he said. "The management of USO and UNG believes these reports are completely inaccurate. Our data contained in our written filing clearly shows that USO was a seller of contracts in 2008 when prices were rising, a buyer when prices were falling and a seller again in 2009 as prices have been rising. The pattern is essentially the same for UNG as well."
Hyland said the claims linking his funds with the oil and gas price moves of the last year "amount to -- to be quite honest -- little more than self-serving statistical gibberish." He added that instead of disrupting the futures markets, the funds provided a "steadying force" by adding "significant liquidity to the market and potentially reducing the price volatility."
Hyland had recommendations for the CFTC if position limits are levied on energy markets. "If it is determined that limits are deemed appropriate for the energy markets, we believe the CFTC should extend futures position relief or a hedge exemption to exchange-traded commodity funds tracking single commodity benchmarks -- such as [UNG and USO], if as we believe our commodity funds are merely acting as highly efficient aggregators of investment demand...and not as agents of demand themselves," he said. "We believe it is in the interest of the markets that we be treated as such and dealt with as a flow-through vehicle that can provide liquidity without actually driving prices. Alternative approaches could have the unintended effect of reducing market liquidity while also harming our 600,000 shareholders."
While allowing that financial speculators have an important role, Paul Cicio, president of Industrial Energy Consumers of America, said speculative transactions need to be tied to the physical commodity, noting that "the creation of the futures market was not intended to be a substitute for a gambling casino for Wall Street banks, hedge funds, sovereign funds and index funds."
"Excessive speculation in the natural gas market is real and must be stopped immediately," he told CFTC commissioners Wednesday. "From January to August 2008 the price of natural gas more than doubled due to excessive speculation -- not supply-demand fundamentals. During that same time period the production of natural gas rose by 8%, inventories were well within the five-year average and demand was essentially unchanged from the previous time period. The result of excessive speculation cost consumers over $40 billion in that short period of time. We believe that speculative aggregate position limits are essential. Other forms of position limits will not work as well because traders will simply move to platforms and products to avoid them."
Cicio also took on UNG, noting that passive index funds undermine price formation. "[UNG] differs from the historic functioning of the futures market and how price formation occurs," he said. "Their objective is unrelated to financial risk management transactions of buying or selling the underlying commodity. Unlike other players, they roll their positions each month. The combination of their significant volume relative to other players and the size of the physical market -- plus everyone knowing when they are going to roll their positions -- damages price formation.
"Price formation is not 'passive,' it is dynamic," Cicio added. "It is a combination of reaction and pro-action and without a pattern. Price formation is unpredictable, not predictable and reflects changes in supply and demand to the underlying commodity. [UNG] is a 'long-only' fund and it does not contribute to the price formation dynamics, it undermines price formation."
Taking issue with a comment made by Cicio that "common sense" shows that excessive speculation was behind all of the large price moves of the last year or so, Hyland said, "Anytime anybody tells you 'common sense' is telling you something, it is just their way of saying they don't have the data to support it. We believe our data is crystal clear. We are not driving prices higher by our buying in the last run-up in natural gas and we are not driving prices lower in this current bout. The data shows that at best, you could make the argument that UNG and USO are acting to moderate price swings by being a seller when prices are rising and a buyer when prices are falling."
Hyland asked the Commission to ask itself, "Can you actually justify with data, not with common sense, what amount of the market can be held by passive indexers without having the benefit of additional liquidity be overwhelmed by some sort of distortion of price?"
There was near-unanimity during the three recent CFTC hearings that position limits are needed to curb excessive speculation in energy commodity markets (see related stories). 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 (see related story). 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.
Commenting on the string of CFTC hearings (see NGI, Aug. 3b), some energy market participants were weary of the Commission's potential action. "Any time the congress or the CFTC talk about reducing liquidity in the marketplace it is dangerous and they need to be very careful," Gene McGillian, a broker at Tradition Energy, told NGI. "With the price volatility we've seen over the last two to five years, the elimination of some of the people in the market will, in my opinion, worsen the volatility and the consequences will be even more dire."
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