Let me start with what I understand the key aspects of the “Enron Loophole” to be.
Back in December 2000, Congress passed and President Clinton signed into law the “Commodities Futures Modernization Act of 2000 [CFMA]”. While the CFMA attempted to resolve the dispute over jurisdiction between the SEC and the CFTC, two elements of the bill appear to have a direct impact on the markets and the financial services industry, specifically investment banks and hedge funds.
I will save the second point for a later report, as it requires further research before I feel comfortable commenting on the derivatives portion of the bill. What I do want to get to is what has come to be known as the “Enron Loophole”, a provision that was slipped into the bill literally in the dead of night by then-Senator Phil Gramm [R – TX].
The provision, allegedly at the behest of Ken Lay of Enron, exempted from regulation energy trading on electronic platforms. This provision is believed to be the primary reason for the spike in electricity costs in California in 2001 and is at the heart of the debate re the speculation in oil prices today.
The most vociferous of the expert witnesses at last Tuesday's congressional event was I. Michael Greenberger, professor of law at Maryland University and former CFTC Director of the Division of Trading & Markets (1997 – 1999). Professor Greenberger argued that the “Enron Loophole” provision in the CFMA produced a change in the supervision of certain commodities (energy, for example) that had been in place since 1922 thereby enabling Enron to engage in their trading practices (with led to the electricity crisis in California in 2001) and the development of “dark markets” (Intercontinental Commodities Exchange in Atlanta, for example) enabling unlimited positions and limited transparency to be established by speculators. All outside the purview of the US regulatory bodies such as the CFTC.
Currently, an attempt to eliminate the “Enron Loophole” has been attached to the massive farm bill (amendment by Sen. Carl Levin) that was passed with a veto proof majority and has been threatened with a veto by President Bush for stated reasons that are suspect, at best.
There are several dimensions to this dynamic issue and they will be explored in the coming days. But let me leave you with a few initial observations:
1 - There is a real probablity that investment banks will be at risk as last week’s testimony makes abundantly clear. One point illustrates the danger – Professor Greenberger noted that the largest holder of heating oil for New England residents is Morgan Stanley. Related to this, George Soros and other panelists noted that hoarding is taking place, as the incentive to convert a rising and controllable asset such as heating oil to US dollars (which is in a structural decline in value and not controllable) is not in the investment banks' interest.
2 – The obvious direct economic impact cannot be overstated. From consumers to industries (airlines, for example) are being effected by the speculation of indexers and hedgies. With consumers stressed and industries on the verge of bankruptcy, the uproar in an election year will not go unnoticed. To that end, consider the following point re the upcoming presidential election.
3 – Former Senator Phil Gramm is acknowledged as the key economic advisor to Senator John McCain. Senator McCain has joined President Bush in opposing the current farm bill for the same apparent reasons. However, in Senator McCain’s case the reason may be more ignorance by relying on his economic advisor, Sen. Gramm, than the more nefarious supporting of the Enron Loophole. The bottom line is there is real risk that McCain will look more than a touch clueless on the key economic matter of the price of energy.
Investment Strategy Implications
At last week’s congressional hearing, several experts testified to what the fair value of oil might be – a subject that I wrote about last week, without knowledge of the actual testimony. It was interesting to hear that my rather simplistic calculation of where the fair value of oil might be (approx. $80) matched very closely to several expert witnesses’ estimates, as well as the more sophisticated analysis conducted by Exxon Mobil and Shell Oil.
The coming weeks will be telling as the farm bill works its way into law. And then we shall see if $130 oil is really only about real economy supply and demand and not the supply and demand of the speculators.