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 casinos,” a top executive with a global investment firm told a Senate panel Tuesday.

“Because of this 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.

Masters warned that “many of the people who are profiting from the practices outlined in my testimony will try to scare you into believing that futures trading in U.S. commodities will simply move offshore” if Congress passes legislation to restrict trading practices. “This is an empty threat.”

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.

Congress also must pass a credible “petroleum and carbon phase-out plan” that creates the right incentives for alternative fuels, Angel noted. “Merely tinkering with CAFE [corporate average fuel economy] won’t fix the problem. A credible plan involves investment in research into alternative energy sources and investment in energy conservation. We need to clear the path for wind, nuclear, geothermal, tidal, solar and appropriate biofuels.”

When markets see that the “U.S. is serious about recovering from its addiction to petroleum and other carbon-based drugs, then the prices of those pollutants will drop like a rock,” Angel said.

In a related development, Sen. Byron Dorgan (D-ND) 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 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.

Nelson’s bill came on the heels of the defeat of Democratic energy legislation that sought to revoke $17 billion in tax breaks for energy companies and impose a windfall profits tax on oil and natural gas producers that don’t invest in renewable energy sources. The Democratic setback was a major victory for the oil and gas industry, as well as the New York Mercantile Exchange (Nymex), which had serious concerns with the legislation. It also was a big win for Senate Republicans (see Daily GPI, June 11).

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 last Tuesday 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 the hearing before the Senate Agriculture Committee and the Senate Subcommittee on Financial Services and General Government (see Daily GPI, June 18). “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 Daily GPI, May 30).

Lukken also appeared before Lieberman’s committee on 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.

In making a case for greater oversight of energy trading, Nelson cited a June 2006 report by the staff of the Senate Permanent Subcommittee on Investigations, which characterized the CFTC as a crippled agency in its oversight of the energy commodity markets due to a gap in its authority to monitor OTC electronic energy trading and its failure to keep track of U.S. energy trades on foreign exchanges.

While the CFTC oversees energy futures that are traded on regulated exchanges, such as Nymex, it does not regulate the trading of energy commodities on the OTC electronic exchanges as a result of a loophole in the Commodity Futures Modernization Act of 2000 that Enron Corp and other large energy traders lobbied for and won. As a result, there has been “tremendous growth” in the trading of unregulated OTC contracts in recent years, said the subcommittee staff report.

“The CFTC’s ability to monitor the U.S. energy commodity markets was further eroded in January [2006] when the CFTC permitted IntercontinentalExchange (ICE), a leading operator of electronic energy exchanges, to use its trading terminals in the United States for the trading of U.S. crude oil futures on the ICE futures exchange in London — called ‘ICE Futures,'” according to the report. Unlike Nymex, ICE is not fully regulated by the CFTC.

With the suite of energy speculation measures being introduced in the Senate and House, it’s not clear if or when any of the bills will make it to the chambers’ floors. The House Agriculture Committee was scheduled Tuesday to mark up a bill as part of a package of energy initiatives that Democratic leaders are trying to push through this week, but it was postponed until after the July Fourth recess, according to CQ Today Midday.

The House bill calls for enough funding for the CFTC to hire 100 additional employees in fiscal year 2009 to oversee increased trading in the commodities futures markets, particularly the energy and agriculture markets.

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