Thoughts on Energy Trading Position Limits

CFTC Chairman Gary Genlser continues to make concentration and diversity his primary justifications for expanding position limits:

I believe we should consider setting position limits to guard against excessive concentration in the energy futures market,’ said Gensler at a luncheon held by the Natural Gas Roundtable, a nonprofit organization.

The CFTC is weighing whether to set position limits — a maximum market share — for oil and other energy products. The agency already sets limits on agricultural contracts.

‘When the CFTC set position limits for certain agricultural commodities, the agency sought to ensure that the markets were made up of a broad group of market participants with a diversity of views,’ said Gensler.

This raises several questions.

First, what is the statutory basis for position limits designed to reduce concentration and increase diversity? I see none whatsoever.

The relevant statute–available right there on the CFTC’s website–makes it clear that position limits are for the purpose of reducing “excessive speculation” that causes unwarranted price changes:

Excessive speculation in any commodity under contracts of sale of such commodity for future delivery made on or subject to the rules of contract markets or derivatives transaction execution facilities causing sudden or unreasonable fluctuations or unwarranted changes in the price of such commodity, is an undue and unnecessary burden on interstate commerce in such commodity. For the purpose of diminishing, eliminating, or preventing such burden, the Commission shall, from time to time, after due notice and opportunity for hearing, by rule, regulation, or order, proclaim and fix such limits on the amounts of trading which may be done or positions which may be held by any person under contracts of sale of such commodity for future delivery on or subject to the rules of any contract market or derivatives transaction execution facility as the Commission finds are necessary to diminish, eliminate, or prevent such burden.

It couldn’t be much clearer. Congress has authorized the CFTC to fix trading limits

for the purpose of diminishing, eliminating, or preventing such burden [of "sudden or unreasonable fluctuations or unwarranted changes in the price of such commodity"].

Period. Full stop. Not a word about “concentration” or “diversity.” Like Bart Chilton’s musing about “unintentional manipulations,” Gensler’s advocacy of position limits based on these concepts is completely unmoored from the law.

That is, “excessive speculation” that distorts prices can provide a legal basis for position limits; Gensler’s “excessive speculation” (with no attempt to connect such concentration to price distortions) cannot.

Second, what is the evidence that variations in concentration across markets affect market quality? I am not aware of any. That is, what constitutes “excessive” concentration? How would we know when this level is reached?

Third, what does Gensler believe causes variations in concentration across markets? Could there be fundamental economic considerations that affect the level of concentration? Could it be that trying to micromanage concentration through position limits would impose costs because these limits conflict with these fundamental economic considerations.

Fourth, more generally, what are the costs of position limits (e.g., in terms of constraining risk transfer)? Has Gensler made any effort to weigh the costs against his estimates of the benefits?

Fifth, what levels of concentration are problematic? Under what theory? What is the evidence that supports this contention?

Sixth, are there any markets that have reached this level of concentration?

Seventh, is there any evidence that position limits materially impact concentration?

In terms of what concerns concentration poses, concentration levels (per CFTC data) are not large as compared to, for instance, industrial concentration in most markets. In crude and nat gas, 4 firm concentration ratios range between 25 and 40 percent, while 8 firm ratios are in the 30-50 percent range.

I think that Gensler’s clear desire to shift the grounds of the debate from the (legally required) “excessive speculation” issue to something else (the legally meaningless idea of “excessive concentration”) reflects the fact that there is clear lack of both logic and evidence to support any claim that “excessive speculation” has, in fact, caused “unwarranted” price fluctuations. Lacking such evidence, Gensler is attempting to hitch a ride on the financial crisis. As the article quoted above says,

Chairman Gary Gensler of the Commodity Futures Trading Commission said the financial crisis last fall showed the risk posed by ‘large concentrated actors on the financial stage’.

He provides no evidence that this concentration caused problems in the futures market even during the height of the crisis (which would, interestingly, undercut his argument that clearing is a panacea to systemic risk). And even if it did, it still provides no legal basis for position limits, which must as noted above, can be imposed only “for the purpose of diminishing, eliminating, or preventing” undue price fluctuations caused by excessive speculation.

By repeatedly invoking “concentration” and almost completely ignoring the sole legal basis for position limits, Gensler may actually call into question the legitimacy of any position limit regulation the Commission does pass. If Gensler really believes that concentration is a problem, he should advocate amendment of the Commodity Exchange Act to make concentration a justification for imposing limits. By straying from statutory authority in his advocacy for position limits, Gensler risks becoming another out of control regulator attempting to ensure that no good crisis goes to waste. He has a lot of company in that, but that’s no excuse.

Comments

[Elliott:]

I disagree -- "excessive concentration" and "excessive speculation" are part and parcel of the same thing, both of which are activities that damage the futures markets. Futures markets are fragile and they work best as a price discovery mechanism when both sides have an actual interest in the physical commodity. I guess the author forgot we paid $4 per gallon for gasoline in 2008 not because oil was scarce -- inventories were very high -- but because hedge funds and big banks bid up the futures and had no intention of ever taking physical delivery of oil nor gasoline.

Nov 02 11:43 AM

[Chris Cook:]

@Elliott

"but because hedge funds and big banks bid up the futures and had no intention of ever taking physical delivery of oil nor gasoline."

I have difficulty with that. I think the market spiked because the investment banks were able to control the physical and forward markets in Brent/BFOE crude oil, and hence the global benchmark price, through the aptly named Brent/BFOE complex of contracts.

Expensive oil pretty soon leads to expensive gasoline in the US at least.

The point is that the futures markets are the tail, not the dog.

The investment banks were able to achieve that outcome essentially with money borrowed from funds invested in the market.

The outcome was that the funds loaned money to the producers and the producers loaned oil to the funds via an arbitrage in which I think BP/Goldman were key, but with many camp followers. Once funds were pulled out of the market it collapsed, in much the same way the tin market did in 1985.

I think the current bubble may well be a minor league replay of last year's events.

Nov 02 03:28 PM

[Elliott:]

Chris Cook: "I think the market spiked because the investment banks were able to control the physical and forward markets in Brent/BFOE crude oil, and hence the global benchmark price, through the aptly named Brent/BFOE complex of contracts."
===

OK, well, I've never seen evidence of banks in "control" of the markets. In Congressional testimony, a hedge fund manager pointed out that hedge funds, pension funds, ETFs, etc., increased their positions in futures contracts from $13 billion to $260 billion from 2003 to 2008. It was a huge momentum trade, making a profit on the rollover from one contract to the next, and never taking delivery of the oil.

So much money poured in that the price got disconnected from the actual demand for oil.

In a normal free market, prices are high when goods are scarce. When the price of oil hit the peak, world oil storage was full. America's top oil storage facility, Cushing Oklahoma, was turning away oil. The fact that prices were high while oil was in surplus -- is strong proof that the oil futures market was distorted and unbalanced by financial players.

People need to understand that if you truly want the free market to exist in the futures markets, we need to limit participation to professionals who actually produce and consume the commodity at the wholesale level.

Nov 02 04:43 PM

[dingding:]

Those money managers and financial investors who genuinely believe in long term investment in oil can buy the equity of the oil majors instead of distorting the physical oil markets through speculation in oil futures. For this reason alone, position limits are justified.

Nov 03 03:34 AM

[Chris Cook:]

@Elliott

In case you were unaware, over 60% of global crude oil is priced directly against the price of North Sea Brent/BFOE crude oil, and specifically the assessment by Platts of the 'dated' BFOE price. The ICE Brent/BFOE futures contract is cash settled and could no more have an effect on the physical market price than if you and I bet on it. As for WTI, it is not what it was , and through massive arbitrage, much of it on the ICE platform, the WTI price is these days more or less ancillary to the Brent/BFOE price.

In any event for six years I managed - as Head of Compliance & Market supervision of the IPE - a deliverable oil product contract - the IPE's Gas Oil contract. I can tell you that position limits are entirely irrelevant in energy markets other than in the spot month, with a view to orderly deliveries. In order to manipulate the market price market participants have to be able to make and take delivery, and ETF's are unable to do either.

Markets such as precious metals, and those softs where there is plenty of storage relative to consumption, are a different issue for reasons I will not bore you with.

The fact of the matter is that the oil futures markets have little or no effect on the physical market price, and it is routine, and systemic, manipulation of the physical/OTC market that is the problem.

That is why GLG are getting into the physical market, why it was Oxy who bought Phibro, why Vitol are acquiring Petroplus assets, and why we can expect more similar transactions.

@ding ding

ETFs buy energy futures in order to take on long term energy price risk and offload the price risk of fiat money. They do not distort the futures market, but enhance it, because they take the other side against selling hedgers who wish to offload energy price risk.

The futures market is routinely distorted - through manipulation occurring off exchange - by those who have an interest in volatility, and that is energy traders generally and investment bank "wall street refiners" in particular. .

Nov 03 09:32 AM

[G. L. Turner:]

I listened intently to this financial geek's Congressinal Testimony and read his reports.

Bottom line: University of Houston ...Hmmm (Sounds like Big Oil's Hihgh School.) and I wonder how much Wall Street Endowment also flows into the U of H. To the point, it was obvious just listening to hiim that he was working overtime then, to try and prove what he was to prove...that there was not such thing as TOO MUCH FINANCIAL SPEC money in the energy markets last year...yeah, when oil normaly would trade 10x normally, was was at the time trading 28 x in 30 days...Nah, it was all S/D, jsut like now!

How do you spell 'SHILL"?

Nov 03 10:53 PM

[Gangy:]

If I was to buy all the oil in the market and sell it at my own price. I would be called a hoarder and the govt. would come and shoot me down in a second.
Then why do we allow 70% of oil markets to be controlled by banks, investment parties, ETF's etc. That's not 100% hoarding. Its only 70% hoarding. Call it whatever you want. It is hoarding none the less. They will not let the price of oil come down in-spite of the glut in the market.
It is for this reason that these investment parties should be discouraged from having concentrated positions(70% is a highly concentrated position).
Therefore the "position limits" Mr Craig. I don't need to tell you what happened when Hunt Brothers cornered the silver market by purchasing most of the available silver (Google silver, Hunt Brothers).
Oil companies (Hand in hand with banks) do not want the price to come down. Because their production costs are pretty much the same, but with record high oil prices they are raking in Billions.

Ah-ha university of Texas and big oil. Therefore the legalese about "concentration of positions".

The "investment funds" have caused massive fluctuation in oil markets. That is reason enough for CFTC to take action. The Harbingers of public interest slept under the previous Bush Administration. Bush, Cheney, Texas and big oil suckered the American public.

Nov 09 04:51 AM

[mn33:]

great article. lol at babbling bart chilton.

Nov 12 02:54 AM