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Hearing on Speculative Position Limits in Energy Futures Markets, July 29, 2009

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Donald Casturo, Managing Director, Goldman, Sachs & Co, in his opening testimony during the second day of hearings at the CFTC, blew into a familiar horn with respect to speculative actions in trading energy future contracts. Maybe so because of his position as head of trading and managing the commodity index business at Goldman or maybe it was just something that comes with the job as a trader.

In his defense Casturo referred to convergence at settlement of a future’s contract price with the spot price in a physically deliverable commodity like oil, as vital to well-functioning futures markets.Therefore prices in the future’s market are determined only by supply and demand fundamentals the same way spot prices are.

This makes a lot of sense under normal circumstances but we surely don’t live in normal times. The convergence argument does not take into account that fundamentals are not really that important considering the accommodative stance of the Federal Reserve. Who is going to take the other side when everybody and his cousin are assuming that the Fed will trash the dollar in order to revive an ailing financial industry? By doing so the Fed will increase commodity prices and inflation over the long run. After all that’s what they have done for the last thirty years.

From this it clearly follows that future prices can influence spot prices in such a way detached from market fundamentals. Excessive speculation therefore will drive the spot price in the direction of the shape of the futures curve. To pinpoint such a shift away from fundamentals is of course extremely difficult. Speculators seem to say we are innocent until proven guilty, and see their business in trading energy as legal.

CFTC and others might not be able to refute it but might recognize their illegitimate actions on the basis of common sense. I hope that the CFTC hearings will help them and the public to acknowledge today’s peculiar situation in energy markets and commodity trading in general and act accordingly as outlined in section 4a of the CEA  (Section 4(a) of the Commodity Exchange Act) to protect the public interest.

In order to illustrate this point I charted the monthly price of the front month WTI crude oil futures contract (CLU9) including FOMC decisions on the Fed Funds rate since 2006. The last of a series of restrictive steps was implemented in June 2006, FOMC raised interest rates by 25 basis points to 5.25 percent in that month. After that rates were kept steady at that level for more than a year. Over that time period the price of WTI oil was range bound between $60 and $80.

In September 2007, two months after two Bear Stearns hedge funds had defaulted, FOMC changed course and lowered their target rate by 50 basis points. During September for the first time ever the price of WTI cut through $80 threshold like a knife through butter. Unprecedented cumulative cuts of 125 basis points in January and 95 basis points in March and April the following year saw similar price jumps in WTI crude oil future contracts.

The price of oil kept increasing from about $85 at the end of 2007 to almost $150 in June of 2008 even though the economy was already in a severe recession as determined by NBER since the end of 2007. As one might argue that this was not recognized until many months later, unprecedented actions taken by the Federal Reserve should have proven otherwise. Speculators kept pouring money into commodities and were driving up prices to unsustainable levels.

During the CFTC hearing commissioner Bart Chilton was chastising the industry for their go slow attitude and reiterated CFTC’s commitment to swift action. He was particularly concerned with the London loophole and look-alike contracts traded on London futures markets. In the connection with hedge exemptions traders can buy and sell these OTC contracts on unregulated electronic exchanges with almost no position limits attached to them. These contracts were traded outside of the commissions oversight.

The policy debate according to Chilton is to find the right balance between the amount of commercial hedging and speculation. Within the CFTC he seems to be the driving force behind stronger regulation. In his statement he acknowledged the commission did not perform its due diligence function with as much zeal as it should have last year. No such words coming from chairman Gensler.

In fact there seems to be a rift between Gensler and Chilton on the role speculators played during the commodity bubble of 2008. In last years report CFTC blamed supply and demand fundamentals rather than speculators for the run up in oil prices. Chilton seemed to suggest that this year’s report would deviate from that view, but chairman Gensler merely talked about updating but not necessarily reversing the 2008 findings. CFTC will release the new report next month.

Tyson Slocum is Director of Public Citizen’s Energy Program, an organization that supports the public in helping to ensure households have access to competitive priced energy markets. In doing so they are vitally interested in functioning energy markets and fair prices. Public Citizen is neither funded by the government nor by the corporate sector.

Slocum’s independence represented the true public view on the issue of energy prices, which should be determined only by supply and demand fundamentals. He suggested to the CFTC to implement: 1) aggregate position limits across all energy products and markets for all index traders, swaps dealers and proprietary traders. 2) increased transparency of OTC contracts and clearing them through a CFTC controlled exchange. 3) investigation of potential market integrity concerns.

The Intercontinental Exchange (ICE) according to Slocum operates OTC and Exempt Commercial markets (ECM), both are not effectively regulated by CFTC, yet their overall market penetration has exploded in the last couple of years. ICE’s electronic exchange volume increased 567% from 2004 to 2008 (from 35 million contracts to 237 million) and the company’s OTC platform has seen volume grow 700%, from 31 million contracts in 2004 to 247 million in 2008.

Major investment firms like Goldman Sachs, JP Morgan Chase/Bear Stearns, Morgan Stanley, Citigroup and Bank of America/Merrill Lynch invest in commodity index funds by buying huge amounts of energy and other commodities future contracts in OTC markets. The same firms hedge their exposure to these markets in offsetting portfolios of future contracts on regulated exchanges. These hedges are very often exempt from position limits. Since many firms operate index funds and at the same time function as swap dealers they manage to evade CFTC regulation not once but twice through OTC markets and hedge exemptions.

GS operates the long only GSCI index fund, with 65% of its 24 commodities being in the energy space and only 25% in agricultural commodities. The CME has a 20000 contracts hedge exemption on the GSCI index fund. When GS radically changed the weighting of the index in the summer of 2006, selling about $6 billion worth of gasoline futures contracts, future prices fell by nearly 10 percent.

To gain inside into physical movements of energy products large energy traders like Goldman Sachs are acquiring energy infrastructure assets like pipelines and storing facilities or in some cases even outright oil and gas fields. Highbridge Capital Management, a hedge fund controlled by JP Morgan Chase, bought a stake in oil and natural gas trader Louis Dreyfus Group. As of November 2008  Morgan Stanley paid $452 million to lease storage facilities for 2009. In January 2009, investment banks like Morgan Stanley and Citigroup stored about 80 million barrels of oil in takers at sea. According to a Wall Street Journal report financial speculators were snapping up leasing rights in Cushing, the most important delivery point of physical crude in North America.

In August 2006, Goldman Sachs, AIG and Carlyle/Riverstone took over pipeline operator Kinder Morgan for $22 billion, thereby controlling 43,000 miles of crude oil, refined products and natural gas pipelines, in addition to 150 storage terminals. In 2005, Goldman Sachs and private equity firm Kelso & Co. bought a 112,000 barrels/day oil refinery in Kansas operated by CVR Energy. In May 2004, Goldman spent $413 million to acquire royalty rights to more than 1,600 natural gas wells in Pennsylvania, West Virginia, Texas, Oklahoma and offshore Louisiana from Dominion Resources.

Goldman Sachs owns a six percent stake in the 375-mile Iroquois natural gas pipeline, which runs from Northern New York through Connecticut to Long Island. In December 2005, Goldman and Carlyle/Riverstone together invested $500 million in Cobalt International Energy, an oil exploration firm.

During yesterday’s hearings senator Sanders characterized the situation in the financial industry as heads, bankers win; tails, everyone else loses. Looking at the vast increase in scope of energy specs, their many loopholes in electronic exchanges where thousands of contracts are evading CFTC regulation with the speed of light, or the explosion of hedge exemptions to those very same traders that are fleeing into the dark pools of OTC markets, makes me think he is on to something.

The goal has to be to avoid extreme volatility in energy and other commodity prices for the sake of the common good. To achieve this we must implement Tyson Slocum’s suggestions and constitute strict aggregate position limits, close all possible loopholes and absolutely assure market integrity. In the nearby future big investment firms like GS and Morgan Stanley have to make a decision, whether they want to continue their lucrative trading venues or switch to the physical part of the commodity business. Either commercial or non-commercial, we should not allow this huge firms to be both at the same time.

Hearing on Speculative Position Limits in Energy Futures Markets, July 28, 2009

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British Petroleum reported second quarter results with earnings off 53 percent compared to the same period last year. The company still earned $4.39 billion compared to $9.3 billion a year ago, but during the quarter the price of oil had averaged $59.13 a barrel compared to a stunning $121.18 in the second quarter of 2008.

Several industry insiders and analysts have stated time and again that based on fundamentals of supply and demand the price of oil should not exceed $60 per barrel and yet in the last 12 months we have seen prices spike to $150, to fall back to about $30 and to rise again to about $70 in the first half of 2009. Even the staunchest free market defendants will have a hard time to explain these prices swings.

While the oil industry is still coping well with the current situation others are more unfortunate. In a recent CFTC testimony Ben Hirst on behalf of the Air Transport Association of America outlined that airlines consumed 5 percent fewer fuel in 2008 yet their fuel costs went up by $16 billion. According to Hirst who is also senior vice president of Delta Airlines fuel expenses consumed 40 percent of Delta’s total revenue in 2008, forcing the company to lay off about 10000 employees. A price swing of $1 had an annual impact of $100 million to Delta’s bottom line.

This reminiscent of beg-thy-neighbor policy where some are profiting handsomely at the expense of others has now become the subject of a series of hearings by the Commodity Futures Trading Commission (CFTC). The hearings are scheduled to be held between 9:00 a.m. EDT and 1:00 p.m. EDT on Tuesday, July 28, Wednesday, July 29, and Wednesday, August 5, 2009. In the spirit of transparency all hearings will be live webcast and testimony and statements as well as supplementary material will be available till August 12, 2009.

The subject of the hearings concerns the recent price volatility in energy futures trading and their impact on the spot price for this diverse class of commodities. Chairman of the CFTC Gary Gensler laid out the primary objective to gather information from a wide-range of industry participants and academics in several points. The most important are 1) how to apply aggregate position limits consistently across all markets and participants and 2) how to deal with exemptions from position limits by bona fide hedgers and others.

As chair Gensler pointed out in his statement 37 exemptions were granted to NYMEX spot month speculative position limits for crude oil as of July 21, 2009. The average size was 5.639 contracts, almost 2 times the size of the 3000 contracts set as position limit. A survey conducted by the CFTC from July 1, 2008 to June 30, 2009, found that in the nearby NYMEX futures contract for WTI crude oil 2 traders exceeded 10% or more of open interest in all futures and options combined. The largest trader’s position held 14% of OI total. In the first deferred month 5 traders exceeded 10% of OI with a maximum of 18% OI, and in the second deferred month 6 traders held more than 10% with a maximum of 19% OI. This of course does not include bilateral swap trades because CFTC does not have regulatory oversight within the dark pool of OTC markets.

For senator Bernard Sanders Rome is burning, using his words to characterize the current situation in the energy markets. As the first one to testify in this most recent hearing he demanded that the CFTC takes urgent action and puts an end to heads, bankers win; tails, everyone else loses.

Last year Sanders introduced S.1225, the Energy Markets Manipulation Prevention Act, to address rampant speculation. Last July the House of Representatives overwhelmingly passed similar legislation by a strong bipartisan vote, yet S.1225 did not become law. Congressman Bart Stupak also introduced legislation included in the American Clean Energy and Security Act (ACESA), which recently passed the U.S. House of Representatives and is now pending in the Senate.

In his testimony Stupak emphasized the influence index investors have on price developments. From January 2008 till the end of June 2008 index investors were responsible for $55 billion of hot money inflows driving the price of oil from $99 to $140 per barrel. A massive financial crisis caused investors to withdraw $73 billion over the next six months, and the price collapsed to about $30 per barrel. Since the end of 2008 index investors have again increased their holdings of future positions by 30 percent to the equivalent of more than 600 million barrels of crude oil.

During his testimony he also addressed the issue of non-commercial traders, namely those banks, hedge funds and large institutional investors who qualify as speculative traders and yet are able to operate under almost unlimited conditions. As of June 30, 2008, at the height of the commodities bubble, non-commercial traders held about 60 percent of the open interest in natural gas markets, and 75 percent of the West Texas Intermediate crude oil market. At the same time commercial traders, who actually take delivery of physical oil because they need it to operate their businesses, held only about one third of the long positions in OTC markets.


The CFTC is an independent agency of the United States government and operates under the regulatory powers of the Commodity Exchange Act (CEA) enacted June 15, 1936. In 1974, congress amended the Act in an attempt to provide more comprehensive regulatory oversight for the trading of future contracts, and created the Commodity Futures Trading Commission. Since then the commission has fine tuned its regulatory framework but many including Sanders and Stupak urge CFTC to take more decisive steps towards regulation of future markets.

For any additional regulation to be successful it will be necessary to close loopholes many energy traders are using today to circumvent existing regulation. Most importantly 1) swap exemptions included in the CEA, 2) Foreign Board of Trade no Action letters, and 3) general swap loopholes which allow swap dealers to circumvent position limits. Hopefully the hearings will help to deal with these very issues, since they are crucial to any successful attempt to reign in rampant specs in energy markets.

The Intercontinental Exchange (ICE) is under the supervision of authorities in the UK although it is based in Atlanta, U.S.A. ICE is the largest internet market place to trade futures and OTC energy and commodity contracts in the world and as such detrimental to price developments in energy markets. The exchange cooperates with the CFTC though a no-action letter prevents the commission to impose tough regulation on foreign markets. This loophole has to be closed.

Similar to ICE the Dubai Mercantile Exchange (DME) is a fully electronic exchange with its contracts listed on CME Globex and primarily offers energy futures contracts. The DME is regulated by the Dubai Financial Services Authority and can serve as another loophole for trigger happy energy traders. In August 2008 the CME has acquired a 32.5% stake in the DME from NYMEX. In addition about 20% belong to Goldman Sachs, Morgan Stanley, Shell and JP Morgan.

In 1991, CFTC authorized the first bona fide hedging exemption to a swap dealer, since then 15 different investment banks have taken advantage of this exemption. Since 2006, NYMEX has granted 117 hedging exemptions for West Texas Intermediate crude contracts, many of which are for swap dealers without physical hedging positions. These exemptions have to end and swap dealers need to come under the umbrella of conventional regulation by the CFTC.

Craig Donohue, Chief Executive Officer of CME, admitted that future exchanges took disciplinary actions in 1,334 cases, levying fines and restitutions of $10.3 million, suspending traders for a total of 3,414 days and barring 22 traders from trading at the exchange for at least a year in some cases. According to his testimony he is ready to adopt a hard limit regime to regulate energy future contracts that will include all-months combined limits and tailored hedge exemptions for swap dealers and index funds.

But that’s about as far as Donohue goes. During his testimony he defied any involvement of speculation in the recent volatility in energy prices. As much as he condoned this unfortunate development supply and demand remained as the sole culprit. To support his thesis he cited research that used quantitative evaluations rather than qualitative ones from his opponents. In January this year a GAO report did not grant conclusive evidence to some of those qualitative studies which designate speculators as being responsible for the price swings in energy markets. A Wall Street Journal survey of 53 economists agreed and found that market fundamentals were driving prices of food and energy.

Donohue confronted the issue of causation by citing evidence that net long exposure of futures-equivalent swap positions declined by 11% in the first half of 2009, refuting the fact that speculators were behind the run up in energy prices during this time period. This somehow neglects the issue of absolute positions in a sense that even less of something can still be a lot, and I do not think it can be used as an effective argument against a casual relationship between speculators and excessive price movements in energy futures and spot prices.

According to Donohue an exchange and not the CFTC is best suited to police activities in its markets. This is very reminiscent of what Siebel Harris, then vice-president of Chicago Board of Trade, said to senator Capper in a 1936 hearing about the establishment of the CFTC. Capper responded: “I take it that your position all hangs on this point, that you want the board of trade to make all the rules and regulations governing the grain trade rather than an impartial agency of the Government that will function in the interest of all parties interested?”

The most compelling argument of those who support speculation has historically been to provide liquidity to the market and in doing so helping to find the real price for the underlying commodity. For them the logic followed the more speculation in the markets the better for transparency and price discovery. Granted the mediators in this process were the regulators but markets worked best with the least amount of regulation possible.

Senator Saunders begged to differ and saw Rome burning with respect to modern day players in the field of energy speculation. He therefore suggested three swift and unmitigated actions. 1) Immediately classify all bank holding companies and hedge funds engaged in energy futures trading as noncommercial participants and impose strict positions limits on them. 2) Eliminate the conflicts of interest between Wall street’s trading desks and their internal research departments. 3) Revoke all staff no-action letters for foreign boards of trade that have established trading terminals in the United States.

Were CFTC to follow these three simple rules excessive volatility in energy prices would almost certainly be a relict of the past. The question is not will it be effective but rather will regulators have what it takes to pierce the zone of influence of powerful financial institutions. Since the necessity to act is so urgent, by no means is it trivial anymore to be complacent and ignore the call for action, there is a good chance we might get tougher regulation this time, even though traders will explore all possible venues to avoid it.