The Energy Markets According to Stupak

By Brad Zigler

It's never been easy for speculators.

First, there's that pesky little problem of correctly forecasting price movements. Then there's the wrath. Lately, market participants and legislators have been trying to pin the blame on speculators for the price contortions that have roiled the energy markets.

Last year's congressional hearings (see "Congress Blames Index Speculators") put the Commodity Futures Trading Commission [CFTC] in the hot seat, as lawmakers wagged their fingers at the agency for failing to rein in the seemingly indiscriminant buying of energy futures by hedge and index funds, as well as the loophole-diving of swaps dealers. Leading the charge for tighter regulation was Rep. Bart Stupak (D-Mich.), chair of the House Energy and Commerce Subcommittee on Oversight and Investigations.

Under pressure from Stupak's subcommittee, the CFTC set to work studying the influence of these speculators on energy prices. Analyzing market data from the first half of 2008, the commission determined the sharp rise in the value of crude oil index positions had not resulted from hand-over-fist buying, but rather from supply constraints in the underlying market. Additionally, the CFTC study found that over-the-counter swap transactions - even when aggregated with on-exchange futures - hadn't influenced oil prices.

But Stupak was singularly unconvinced by the commission's analysis. The Michigan congressman got another chance to take a swipe at speculators when he testified, oddly enough, before the very agency he excoriated last year in the round of CFTC hearings that concluded Wednesday.

The commission has solicited testimony to suss out market participants' views on a number of potential regulatory reforms. Paramount among them: the establishment of federally mandated position limits for speculators in the energy markets.

Under current law, the CFTC sets limits for only certain agricultural commodities, leaving it up to the exchanges to control the size of speculators' holdings in other futures. Exchanges impose so-called accountability levels to identify and control traders with large positions. But unlike the hard limits imposed under federal regulations, these accountability levels are porous, prompting CFTC Commissioner Bart Chilton to describe them as "suggested speed limits."

CFTC chairman Gary Gensler has called on his agency to "seriously consider setting position limits in the energy markets" and vowed that the agency would "urgently work with Congress to secure additional authorities" to strengthen oversight over other derivatives trading.

Gensler also pooh-poohed reports that a new CFTC analysis of index trading, due out later this month, would reverse the commission's view on last year's speculation.

For his part, Stupak wants position limits, but not just at the exchange level. He wants aggregate position limits set across all exchanges in which a commodity may trade. That way, he says, traders can't play one exchange against another to build massive positions.

However, Stupak doesn't want to eliminate speculation - just to curtail it. In fact, he acknowledges the necessity of speculators as a source of liquidity. "Speculation is OK, I understand that," Stupak told the Detroit Metro Times last year. "You're always gonna have speculation. But excessive speculation by those who have nothing to do with the oil industry is driving up energy costs for families and crippling our economy."

The folks Stupak believes have nothing to do with the oil industry are commodity fund investors. By closing several loopholes in the Commodity Exchange Act, Stupak hopes to squeeze out these so-called index speculators.

One such loophole provides a "bona fide hedge" exemption to over-the-counter energy swaps dealers who provide index fund and note managers potentially unlimited exposure to futures. In a swaps transaction, an index investor obtains a commodity return from an investment bank in exchange for a stream of interest payments, tied typically to the London InterBank Offered Rate (Libor). With a swap, the index trader doesn't go to the futures market itself, but the dealer selling the swap might, in order to hedge its resulting exposure. If a swap dealer can establish that a genuine risk is being hedged through futures, it's exempted from any speculative position limits imposed by the CFTC or the exchanges.

Stupak also wants the CFTC to extend its jurisdiction over foreign commodity exchanges that offer contracts on U.S. goods, specify a U.S. delivery point or are accessed through dedicated computer terminals in the U.S. Specifically, he's cast the stink-eye on London's all-electronic Intercontinental Exchange (ICE), which trades, among other things, a contract on West Texas Intermediate crude oil. ICE's petroleum trading is regulated by the U.K.'s Financial Services Authority [FSA], a regulator even more lax than the CFTC; FSA imposes no position limits on futures trading within its purview.

Whether or not Stupak's notion of regulatory reform becomes the law of the land remains to be seen. But the fact that the CFTC is revisiting the speculation issue is another indicator of the change in the political winds this year. Since Gensler was appointed by President Obama, the CFTC has been expected to take a more aggressive regulatory stance than the agency's laissez faire approach exhibited during the Bush administration.

Whatever regulatory changes come from these hearings, Gensler and the commission will have to deal gingerly with industry participants, who are particularly concerned that a drastic transformation could force liquidity onto unregulated OTC markets or dark pools.

But changes wrought in the energy markets are likely to serve as templates for modifications elsewhere. According to Chairman Gensler, "the Commission intends to further review other commodities of finite supply in future hearings."

Comments

[mekats:]

Speed limits is something Rep Stupak knows something about. He'a former state policeman. Believing he can come up with the right regulatory structure for commodity trading is a frightening thought.

Aug 09 08:57 AM

[mc2406:]

Another professional pol in over his head with the "doing something is better than nothing" mantra to feed his unknowing constituents.

Aug 09 11:10 AM

[5142152-337:]

I don't have a clue what Obama has up his sleeve naming Gensler as Chairman of the CTFC, but, who knows, it could be the ONLY thing Obama does in his presidency that is a plus for the people--the common Joe Sixpack--.

Gensler does appear hell-bent on capping position limits, maybe a maximum of 1000-1500 which will FINALLY kick the snot out of the JPMorgans of the world. God, it serves them right! Those elitist greedy bastards (EGBs) have run amok for decades. Now, its time for us little guys that have seen the handwriting on the wall (silver investors) to get a piece of the action.

Go Gensler!

Aug 09 06:40 PM

[E.D. Hart:]

and while he is at it maybe he can look into massive shorts controling the gold and silver market?

Aug 09 07:14 PM

[Kalani Martin:]

I'm not quite sure what 5142152-337 is talking about when saying:

"Gensler does appear hell-bent on capping position limits, maybe a maximum of 1000-1500 which will FINALLY kick the snot out of the JPMorgans of the world. God, it serves them right! Those elitist greedy bastards (EGBs) have run amok for decades. Now, its time for us little guys that have seen the handwriting on the wall (silver investors) to get a piece of the action."

Gensler is a former Goldman Sachs executive. He's one of those EGB's that you describe. His appointment to the CFTC will only help the JP Morgans and Goldman Sachs of the world. You have no idea what you're talking about!

Aug 10 12:54 AM

[a3A:]

have you listened to bart chilton? he's a meathead. and stupak is a former cop? cops in general are meatheads too. pretty scary.

Aug 10 02:37 AM

[A Barrel Full:]

One question I would like to ask of politicians like this is:
Do you support cap & trade?
If the answer is yes:
Why are high prices good when caused by politicians, but bad when caused by speculators?

Surely both would lead to lower CO2 emissions.

Aug 10 07:36 AM

[elliot_mllr:]

Has anybody explained to Stupak that commodities are traded world-wide and that restrictions on US trading will simply redirect trading to London, Hong Kong, Singapore, Malaysia, etc?

Aug 10 10:03 AM

[Jack Walker:]

Brad,

Thanks for keeping us up to date on these important developments.

It sounds like Rep. Stupak has it about right.

As previously expressed we view long term investment in commodities by non commodity participants as price distortion sending the wrong pricing signals to producers and user alike thereby providing incorrect data on which they base long term capital commitments distorting the entire capital allocation process in the industry.

Secondly, it the “bona fide hedge” exemption was eliminated perhaps the swap market would be curtailed thus reducing this activity which could prove to be beneficial for some price stability.

Jack

Aug 10 10:54 AM

[adamnb:]

No comprende: Please explain following for the future's-market-challe...
"One such loophole provides a "bona fide hedge" exemption to over-the-counter energy swaps dealers who provide index fund and note managers potentially unlimited exposure to futures. In a swaps transaction, an index investor obtains a commodity return from an investment bank in exchange for a stream of interest payments, tied typically to the London InterBank Offered Rate (Libor). With a swap, the index trader doesn't go to the futures market itself, but the dealer selling the swap might, in order to hedge its resulting exposure. If a swap dealer can establish that a genuine risk is being hedged through futures, it's exempted from any speculative position limits imposed by the CFTC or the exchanges."

Aug 10 01:19 PM

[Brad Zigler:]

An investment bank offers a fund a commodity return above a certain benchmark in exchange for a stream of interest payments. The fund, then, can obtain potentially unlimited exposure to the commodity (subject to the size of the market quoted by the swap-dealing investment bank). Thus, there are no speculative position limits hemming in the fund.

For its part, the swap dealer offsets as much of the resulting swap exposure against other (opposite) transaction in its risk book, i.e, swaps in which it receives the commodity return, or other long positions. The net residual risk can then be hedged in the futures market. If the swap dealer is short after netting, it'll be a buyer of futures. If long, it'll sell futures.

Those futures transactions, since they offset business risks, can claim a bona fide hedge exemption to position limits.

Aug 10 02:03 PM

[SeekingTruth:]

Brad, what instrument typically generates the interest payments, and how "secure" are they?
There are so many more arcane variables here than meets the eye, that many real world examples would have to be illustrated for the layman to grasp this all in depth. But you have given a good definition for those already familiar with the nuances of these techniques.
I believe that at certain times, under certain conditions , speculation can have a tremendous and disruptive effect on the markets, i.e. certain people get filthy rich very quickly and others are sent to the poor house for reasons that have little to do with the consumption element of demand (or legitimate hedging or investment either), and some rational rules for better keeping orderly markets are wise, and necessary.
Stupak is making an effort to determine what these rules should be, and with the help of some honest experts, maybe he can accomplish something. He has my best wishes for this daunting task.

Aug 10 05:14 PM

[Northstar10000:]

Yes stocks are due for a correction of epic proportions. You started to think another small correction forecast from a green shooter.
Sorry, you found a straight shooter. Buy SDS NOW.

Aug 10 09:50 PM

[Brad Zigler:]

They're swaps. These are over-the-counter (OTC) contracts typically tied to LIBOR (London InterBank Offered Rate) on the side opposite the commodity return.

Non-cleared OTC contracts are entered into by participants in reliance on the faith and credit of the counterparties. In other words, each party investigates the creditworthinessness of its opposite and looks only to that party for performance.

Some swaps nowadays, though, are guaranteed by third-party clearinghouses.


On Aug 10 05:14 PM SeekingTruth wrote:

> Brad, what instrument typically generates the interest payments,
> and how "secure" are they?
> There are so many more arcane variables here than meets the eye,
> that many real world examples would have to be illustrated for the
> layman to grasp this all in depth. But you have given a good definition
> for those already familiar with the nuances of these techniques.
>
> I believe that at certain times, under certain conditions , speculation
> can have a tremendous and disruptive effect on the markets, i.e.
> certain people get filthy rich very quickly and others are sent to
> the poor house for reasons that have little to do with the consumption
> element of demand (or legitimate hedging or investment either), and
> some rational rules for better keeping orderly markets are wise,
> and necessary.
> Stupak is making an effort to determine what these rules should be,
> and with the help of some honest experts, maybe he can accomplish
> something. He has my best wishes for this daunting task.

Aug 10 10:05 PM