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Still Debated: Speculators' Vice/Virtue, CFTC Role

Anyone watching and listening to energy markets knows that with higher and more volatile commodity prices comes the more frequent utterance of words such as "speculation" and "manipulation," often in the same breath.

Over the last two years allegations of wrongdoing by speculative or noncommercial traders have often been on the lips of hedgers or commercial users of natural gas and other commodities. This is nothing new. How one feels about noncommercial or speculative traders depends more often than not upon where one sits in the market.

"Given that this debate has gone on for centuries, it's unlikely that we'll resolve it today," said Craig Pirrong of the University of Houston's Global Energy Management Institute (GEMI) at the beginning of the institute's fifth Energy Trading & Marketing Conference Thursday.

Accompanying the vice-or-virtue debate over speculators is the question of whether the oversight authority of the Commodity Futures Trading Commission (CFTC) should be expanded to give the commission the same enforcement abilities over over-the-counter (OTC) electronic exchanges, such as the IntercontinentalExchange (ICE), that it enjoys with the futures market of the New York Mercantile Exchange (Nymex). Similar to other foreign-based exchanges, the U.K-based ICE gets a pass from the CFTC because it is subject to rules and regulations in its home base.

The American Public Gas Association (APGA), Iowa Association of Municipal Utilities (IAMU) and more than 30 Iowa public natural gas systems Wednesday called on Senate Agriculture Committee Chairman Tom Harkin (D-IA) to press for legislation in the new Congress that addresses a "critical lack of transparency" in the over-the-counter (OTC) gas market (see Daily GPI, Jan. 25).

A similar push was made in 2005 and 2006 (see Daily GPI, March 4, 2005). U.S. Sen. Carl Levin (D-MI), chairman of the Senate's Permanent Subcommittee on Investigations (PSI), last year was co-sponsor of a bill, which, had it become law, would have expanded CFTC oversight to exempt commercial markets (ECM), of which ICE is one. It would not have covered voice-brokered transactions as other more expansive bills would have, but Dan Berkovitz, a PSI staff member, told his Houston audience Thursday that it was better than nothing.

"It's better than the current situation," he said. "It's not perfect," he admitted, saying that more aggressive legislation was seen as less likely of passage. As it happens, the more modest legislation didn't pass either, and it's likely to come back this session.

Berkovitz said the CFTC needs the expanded authority to monitor ICE and other OTC electronic exchanges proactively, rather than retroactively. "Manipulation retrospectively is incredibly difficult to prove," he said. "The potential club of six years of litigation after the fact..." is not as effective as proactive market monitoring.

The trouble is, Levin and other lawmakers are trying to give the CFTC an authority it doesn't want and says it doesn't need. At last year's GEMI conference, then-commissioner Sharon Brown-Hruska strenuously argued against the expanded authority (see Daily GPI, Jan. 27, 2006). And this year it was clear from remarks by Commissioner Walter Lukken that a lighter-handed, "principles-based" approach is what is favored at the CFTC, not expanded authority over OTC electronic exchanges such as ICE. ICE is a popular venue for trading natural gas swaps that are pegged to CFTC-regulated Nymex futures contracts.

"From a risk perspective, this competition raises the possibility that traders could take positions on one market in order to profit off positions on the other," Lukken said Thursday. "To address this concern, the CFTC has utilized its authorities to request information from ICE regarding trader position data for these pegged contracts on an ongoing basis similar to what we receive from large traders on regulated exchanges. This has allowed our surveillance staff a more comprehensive view of this marketplace."

Lukken said this "tailored" monitoring activity evolved from risk considerations stemming from the need to protect the financial integrity of the regulated (i.e. Nymex) marketplace and price discovery. "The flexible structure of the CFMA [Commodity Futures Modernization Act] has enabled this to occur without the need for additional legislative authority."

Last November the CFTC issued a policy statement, basically reiterating its policy of recognizing the jurisdiction of foreign-based regulatory regimes. It said it was addressing complaints that had arisen recently, particularly from U.S.-based exchanges such as Nymex, that foreign-regulated exchanges operate in the U.S. at a competitive advantage if overseas regulation is not as restrictive as the CFTC oversight. The agency said it was striving to regulate in a flexible manner in order to allow the U.S. futures industry to compete effectively in a global environment (see Daily GPI, Nov. 1, 2006).

While some at the conference argued against any nefarious activity by speculators and the need for more regulation, Berkovitz said a PSI report released last year outlined some bothersome conclusions. The PSI found that there had been a large increase in speculation in energy markets and this had contributed to increased commodity prices. Further, the increase in speculation shifted the traditional relationship between price and inventory, Berkovitz said.

Excessive speculation, he said, causes prices to deviate from levels dictated by industry fundamentals, increasing the cost of hedging by local distribution companies and other end-users and making it more difficult to determine when to hedge to begin with. Berkovitz said the CFTC has a mission to prevent "excessive speculation" and it needs authority over ECMs equivalent to what it has over Nymex.

"The markets are functionally equivalent," he said. "I don't see how that whole regulatory panoply can apply to one and not the other."

Kyle Dickard, Merrill Lynch managing director of commodity analytics, was one of the speakers arguing for the virtue of speculators and against the need for greater CFTC oversight authority. He said that CFTC data indicates speculators and hedge funds hold spread positions in the commodity markets and help keep those markets aligned with one another. In addition they inject liquidity, which, among other things makes transacting easier and absorbs price shocks.

While speculators have been accused of driving prices up, "they can equally drive down the price of the commodity," said Johnathan Short, ICE senior vice president. He said speculators cannot sustain a directional market move without the support of underlying fundamentals. "There's a bias toward thinking speculators can only drive prices up."

Short said the focus on speculators when prices spike is misplaced. Energy markets, for instance, have been plagued by a number of factors that drive commodity prices up, such as tight supply-demand balance, hurricanes, declining production, tight refining capacity and inelastic demand, to name a few. Without speculators, bid-ask spreads would widen and hedging would become more expensive. Without speculators, markets wouldn't work and someone else would have to set commodity prices, perhaps the government, perhaps producers, neither option likely to be appealing.

Short added, "Who is better to make that assessment about what the future price of a commodity ought to be other than a speculator?"

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