The Proposal to Limit Commodity Positions Will Hurt Free Markets and Economic Growth

It’s a busy day for the Commodity Futures Trading Commission (CFTC) as testimony is heard regarding the controversial proposal to limit position sizes on all finite commodities. The two primary investments affected by this discussion are IntercontinentalExchange (ICE), CME Group Inc. (CME). Earlier this month, ZachStocks discussed how further limits to position sizes could have unintended consequences and actually increase volatility instead of helping to stabilize wildly swinging markets.

Jeff Sprecher, the CEO of IntercontinentalExchange voiced a similar perspective in his remarks to the committee today:

While well intentioned, these measures often fail to achieve their desired objectives or, worse yet, lead to unintended consequences … that would otherwise be discovered in properly operating markets

The primary evidence presented by the pro-regulation side of the argument is the drastic swings in energy prices over the last 18 months. But extreme volatility in energy markets is much more affected by economic concerns (which have been more volatile in recent quarters than any time in the last 70 years) than by manipulative trading practices.

Consider the “peak oil” arguments from just over a year ago. Oil companies were finding it more and more difficult to produce oil and natural gas with the same cost structure. As low hanging fruit (or easy to drill fields) were slowly bled dry, the cost to discover and produce each marginal barrel of oil (or gas equivalent) was rising. Technology advances and alternative energy helped to offset this some, but the evidence pointed to rising costs (and therefore higher prices) for traditional energy sources. It was only natural for energy prices to skyrocket.

Then came the most devastating global economic recession seen in decades. Growth assumptions were severely cut (partly as a function of higher prices of commodities such as energy - and partly because of unsustainable growth assumptions in the first place). As consumption, and by extension the future estimates for consumption, dropped, the price of energy products came crashing back to earth. Fundamental economic laws state that when demand for a product decreases, the price will naturally fall. So once again, the price of traditional energy products declined sharply - but more as an extension of global economic forces than due to “evil speculation.”

Now I’m not claiming that prices are always accurate or that traders had no part in pushing prices higher or lower. But an active market with heavy interest on both the buying and selling side will by definition lead to efficient prices given the information that is available at the time. Traders with keen foresight or better information need only to take the other side of a trade in order to profit from their perception (from both a long-term and a short-term perspective). So if prices really are out of line with reality, then it would behoove a large trader to begin building a large position which will profit when prices move back to sustainable levels.

CFTC Chairman Gary Gensler stated that Congress should move “urgently” to prevent market players from moving to the over-the-counter (OTC) market or to foreign exchanges. Yet, increasing regulations by capping position size will likely create an even greater incentive for participants to create their own “side bets” or off-balance sheet agreements in order to profit from price movements, or hedge financial risk.

The assumption that the government can accurately determine value or steer prices towards a “correct” range is absurd. While it is important to make sure that one player or group of players cannot buy up all of the supply and then hold resources hostage (known as “cornering” a market), the oil and natural gas market is large enough to make this virtually impossible. Instead, regulators appear to be using fear as a tool to argue for heavily regulated markets. The anti-business, anti-capitalistic bent of the current administration is sobering and could cause much more harm to free markets and economic growth.

Disclosure: Author has a long position in ICE in the ZachStocks Growth Model

Comments

[Chris Cook:]

Zachary, you ignore the fact that the futures markets are the visible tail of the OTC market dog.

The small clique of trading intermediaries kick around the North Sea BFOE complex (which now actually prices crude oil globally directly and indirectly) like their own private football and they both created and control ICE as I set out at length here

seekingalpha.com/artic...-

As Izabella Kaminska put it memorably today

ftalphaville.ft.com/bl.../

there is in fact not so much a London Loophole (ICE Europe's WTI isn't even delieverable) but a "Physical Loophole", which canny operators like GLG are racing to exploit.

None of that detracts from the fact that in the long term the oil market price is a function of supply and demand.

But in the short and medium terms, trading intermediaries are pillaging billions at the expense of producers and consumers alike through the creation of unnecessary volatility exacerbated by the gearing effect of derivatives and borrowing from credit institutions.

Jul 29 08:28 AM

[Venetian Poker:]

Speculators are needed in the commodity futures markets to provide liquidity so that hedgers can manage their income or expense. However, speculators should not have the power to set the prices artificially.

The price of oil and gasoline should be based on the demand for those products by those who actually buy and use them, not the demand for their underlying futures contracts.

Does anyone really think that the "real market" for oil pushed it to $140 followed by a $100 drop? Nonsense.

Jul 29 09:09 AM

[nkbay99:]

As long as speculators simply play their games and it only affects them, no problem. however, when the games they play drive prices that consumers pay way beyond what the "normal" laws of supply and demand would dictate, it is time for the "games" to stop. How is it that supply is way up; demand is way down; and oil prices have doubled this year? It is time for the speculators to pick up their marbles and take their game elsewhere.

Jul 29 09:13 AM

[Chris Cook:]

Most ETFs are explicitly sold as a "hedge against inflation" -surely the anthesis of speculation. IMHO they are in fact bringing much needed liquidity as counterparties to genuine producer hedgers at prices acceptable to both. Such risk transfer is what a futures market is for.

The effect is akin to ETFs loaning money interest free to producers, and producers loaning oil to ETFs.

I would argue that it is the hedge funds and proprietary traders (the ICE owners club) who are the only "speculators" in the market.

And they are brilliant at what they do.

But in the same way that a submarine is a beautiful piece of engineering with a malign purpose (sinking ships) , these cleverest guys in the room operate with the (IMHO malign) purpose of extracting profit by whatever means possible from producers, consumers and genuine investors alike.

Jul 29 09:25 AM

[lookit:]

hey, Zach - aren't you making a good six figures working in that murky speculative world you're now saying the government shouldn't regulate? Real people (i.e. consumers) are FED UP with artificially high oil prices due to rampant speculation. Your gravy train is about to come to a screeching halt, and I think you know where you can stick your commodity trading profits...

Jul 29 09:28 AM

[IndidnaJohn:]

Zachary, you ain't nothing but a blabberbox. But you can still prove that you know something about economic growth; go produce something that has value in the export markets.

Jul 29 09:40 AM

[Zachary Sch...:]

well obviously this is a highly debated topic and I'm glad we could discuss in a (somewhat) orderly fashion.

We talk about the "real" market as if there were two different forces at work. In actuality, the market is made up of buyers and sellers - plain and simple. The oil market is just too big and fluid for anyone to "corner" or artificially move prices to any significant degree. Producers and consumers need speculators to offer liquidity. If the price is "artificially" high, you will see speculators "regulate" the market by selling. And I don't hear anyone complaining about prices being too low in the early part of this year.

One thing that always drives me nuts is that Goldman gets so much criticism even though they are a publicly traded company... Sure, their executives and traders are richly rewarded. But so are their shareholders. And who are these shareholders? The Investing Public! If you're jealous of the profits Goldman is booking - go buy their stock! Then they can be YOUR profits.

For whatever it's worth, and as an aside note, I may pull in six figures, but that only happens when I'm providing seven for my investors. I'm a big fan of the "eat what you kill" setup which is why I have my own company and live and die by my ability to keep my clients happy. It's more risky, yes - but then so is counting on an employing firm to stay in business and continue making payroll...

I appreciate the spirited debate, and I'm sure I'll get dinged on the "positive / negative" comments for this one, but honestly I can't make an argument against a freely operating market. Manipulation by the Government, Goldman Sachs, LTCM, or any other institution should be fought. Unfortunately, few see this move towards stiffer regulation as the manipulation that it truly is.

Zach
zachstocks.com

Jul 29 11:35 AM

[China Expert:]

Are you trying to imply that oil hit $140 because of supply and demand ? What a joke ! I sympathasize with the average family who suffered because of this fiasco and the many companies that suffered because a few well healed players wanted to "play in their sandbox" and makes themselves a ton of money at the expense of the innocent. They should be lined up against the wall and shot on national televsion.

Jul 29 12:06 PM

[tonym:]

Socialists don't do this on television anymore.



> Are you trying to imply that oil hit $140 because of supply and demand
> They should
> be lined up against the wall and shot on national televsion.

Jul 29 12:21 PM

[bernie bicoy:]

Really? Then how do you explain the fact that non end users of commodities like oil were prohibited from engaging in speculation up until 2000, when the market was 'deregulated' allowing spec trades by non end users, at the specific instigation of Enron?

Are you saying that the market didn't work so well prior to that? Or are you saying ''this is such a neat way for speculators to make money wouldn't be a shame to limit it for something as silly as the public good?"

Jul 29 12:35 PM

[Chris Cook:]

"The oil market is just too big and fluid for anyone to "corner" or artificially move prices to any significant degree."

Zachary, there are less than 70 cargoes of BFOE quality oil coming out of the North Sea each month. At current prices that's about $3bn.

These cargoes form the base of global oil prices, and WTI has next to nothing to do with it other than to follow the BFOE lead via the arbitrage on ICE.

Are you seriously suggesting that (say) a major oil company and major investment bank working in tandem couldn't artificially move global oil prices at will?

If so, I have a bridge to sell you.

Jul 29 12:37 PM

[awake09:]

Zachary, these old timers are just jealous because you look like a young, handsome Republican. Nothing wrong with that.

Other than that, this is all over my head-- Out.

Jul 29 01:36 PM

[RiskAverseA...:]

"But extreme volatility in energy markets is much more affected by economic concerns (which have been more volatile in recent quarters than any time in the last 70 years) than by manipulative trading practices."

YOU LIVE IN A FANTASY WORLD!

What's Goldman paying you to write this crap?

Jul 29 01:38 PM

[MSimon:]

"limit position sizes on all finite commodities."

Evidently there will be no limit on stupidity.

Jul 29 02:40 PM

[Ferdinand E...:]

Just another anti-present government (i.e. Obama) thing. The economic content might go over good in the freshman class at Boston Public, but as far as this great teacher of economics is concerned it doesn't wash.

Jul 29 02:48 PM

[JBELL:]

Sorry, but I have heard this free market babble for over 60 years and there was a time I bought almost all of it. Not anymore.Seems business folks want free market conditions until government has something to hand out; then all principles are cast aside and the arms are extended. Regarding Zach and the CFTC, I too want a minimum of interference in the private sector, especially in setting prices for anything. But if the government tries to fiscally stimulate the economy through the infusion of 2 plus trillion dollars and a small group of speculators drive up the price of oil to $350.00/barrel which tanks the economy further, we are suppose to sit back and accept that's how capitalism works? I don''t think so.. Zach your mantra is out of step. I recommend your energies be invested in preventing a repetition of what we are currently going through.

Jul 29 03:01 PM

[MSimon:]

" Sorry, but I have heard this free market babble for over 60 years and there was a time I bought almost all of it. Not anymore.Seems business folks want free market conditions until government has something to hand out;"

You are confusing free market with self interest. A common affliction.

Buyers and sellers are always trying to get the guys with guns on their side of a deal.

The answer to your conundrum is not more government. It is less.

You might want to look up regulatory capture. Some guy got a Nobel for it.

Jul 29 03:20 PM

[MSimon:]

What a young crowd here.

No one remembers the Hunt Brothers going broke cornering the silver market.

Jul 29 03:39 PM

[MSimon:]

"A common sense observation is that those who take outsize positions in futures markets are operating at the same advantage as a poker player who has more chips than anybody else at the table: he throws his weight around and eventually cleans everybody else out."

I know how to fix that. No one with a net worth of more than $1,000 or an income of more than $10,000 a year ought to be allowed to trade in futures. That will minimize speculation.

Me? I speculate a tank of gas (or less) at a time when I pay at the pump. If I think the price is going down I buy less. Going up I buy more. Staying the same? I buy what I need.

If I want to hedge on future prices I buy a gas can.

Jul 29 03:51 PM

[pater_teneb...:]

Circumscribing speculation in futures markets in order to 'control' prices (in the case of commodities, downward - in stock markets, restrictions are mainly aimed at short selling in order to manipulate prices upward) is bound to backfire. It may well lead to lower prices in the near term, as speculators exit the futures markets, but these lower near term prices are practically guaranteeing higher long term prices, as the incentive to invest in the production of the commodities concerned will be lessened. Furthermore, the government can not stop speculators from continuing to speculate, short of instituting a complete command economy. In all likelihood, restrictions in futures trading will lead to accumulation of physical product off-shore. This will then drive prices even higher, as real shortages will eventually ensue.
Price volatility in commodities is a poor argument for intervening in these markets by restricting access to them. Commodities have always, and will always be volatile. No government edicts will change this - the end result of restricting access for speculators will be a long term decline in living standards as thinner markets make it more difficult for producers to hedge, and both long term prices and price volatility will likely increase rather than decrease.
Markets often overshoot or undershoot the prices that would be justified by fundamentals, but this is in the nature of price discovery, which is a process, not an event. The idea that government can 'force' markets to conform to a more 'reasonable' manner of pricing is laughable in the extreme.
The main reason for rising prices is of course monetary inflation - and yet, the government is not abolishing the Federal Reserve, which is the cause of this inflation. So what this is really about is trying to control what is allowed to feel the effects of inflation - but it is an impossible task.

Jul 30 04:44 PM