Speculation and Energy Prices: Legislative Responses
Released: 2008-08-06T00:00:00

Overview

Are oil speculators the messengers bearing bad news, or are they themselves the bad news? The Commodity Futures Trading Commission (CFTC), which regulates speculative trading in energy commodities, has found no evidence that prices are not being set by the economic fundamentals of supply and demand. Many analysts agree, arguing that long-term supply growth will have difficulty keeping up with demand. Others, however, believe that changes in the fundamentals do not justify recent increases in energy prices, and seek the cause for soaring prices in the futures and derivatives markets, which are used by financial speculators as well as producers and commercial users of energy commodities.

The energy futures markets, which date from the 1980s, involve two kinds of traders. Hedgers—producers or commercial users of commodities—trade in futures to offset price risk. They can use the markets to lock in today's price for transactions that will occur in the future, shielding their businesses from unfavorable price changes. Most trading, however, is done by speculators seeking to profit by forecasting price trends. Together, the trading decisions of hedgers and speculators determine commodity prices: there is no better mechanism available for determining prices that will clear markets and ensure efficient allocation of resources than a competitive market where hedgers and speculators pool information and trade on their expectations of future prices.

Since many transactions in the physical markets take place at prices generated by the futures markets, speculators clearly play a large part in setting energy prices. In theory, this should not drive prices away from the fundamental levels: if financial speculators trade on faulty assumptions about supply and demand, other traders with superior information—including those who deal in the physical commodities—should be able to profit at their expense. In other words, there is no reason why speculation in and of itself should cause prices to be artificially high.

Theory says increased speculation should produce more efficient pricing. In practice, however, some observers, including oil company CEOs, OPEC ministers, and investment bank analysts, now speak of a "speculative premium" in the price of oil. This view implies that without speculation, prices could fall significantly without disrupting current patterns of consumption and production. How could the price discovery function of the energy derivatives market have broken?

Several explanations are possible. First, the market could be manipulated. Price manipulation, which is illegal under the Commodity Exchange Act, involves deliberate strategies by a trader or group of traders to push prices to artificial levels. Since derivatives markets reward correct predictions about future prices, manipulation can be very profitable. Most manipulations in the past have involved short-lived price spikes, brought about by spreading false information, or concerted buying or selling. Since 2002, the CFTC has brought 40 enforcement cases involving manipulation, but these usually have involved attempts to generate short-term price spikes, which may be very profitable for the manipulators, but do not appear to explain the long-term energy price trends observed in recent years.

It is rare, but possible, for a market to be rigged over a longer period of time when a single trader or group amasses a dominant position in both physical supplies and futures contracts and obtains enough market power to dictate prices. Examples include the Hunt brothers' attempt to corner the silver market in 1979-1980 and the manipulation of the copper market by Yasuo Hamanaka of Sumitomo in the mid-1990s. The CFTC has not produced any evidence that such a grand-scale manipulation of energy prices is underway and has testified before Congress repeatedly that prices are being set competitively.

In the absence of manipulation, another explanation for prices above fundamental levels is a speculative bubble. If, as was the case in the dot-com stock boom, a majority of traders become convinced that a "new era" of value has arrived, they may bid up prices sharply in defiance of counter-arguments based on fundamentals. Eventually, prices return to fundamental levels, often with a sudden plunge. This is what many forecast for energy prices, including George Soros, perhaps the best known speculator of the day.

The bubble explanation is the same as the speculative premium argument. If market participants are trading on mistaken ideas about the fundamentals, they may set a price that is above the true price (which is the current market price minus the speculative premium). However, there is no sure method for determining what the true price is; the only observable price is the one the market generates.

Policy options to discourage speculation driven by irrational exuberance are limited. Actions to reduce the amount of speculative trading, such as increasing the margin requirements on futures contracts or restricting access to the markets, may not produce the desired outcome. Higher margins raise trading costs, which should reduce trading volumes, but the final effect on prices is uncertain. Empirical studies have not found a link between higher margins and lower price volatility, or any evidence that would suggest that prices would fall.

Apart from the possibility that traders in general are getting the price wrong, there is an argument that prices have been driven up by a change in the composition of traders. In recent years, institutional investors—like pension funds, endowments, and foundations—have increasingly chosen to allocate part of their portfolios to commodities. This is rational from the point of view of the individual fund, as it may increase investment returns and diversify portfolio risks; but when many institutions follow the same strategy at the same time, the effect can be that of a bubble. A number of bills are aimed at reducing the incidence or impact of institutional investment on the energy markets. These, and other proposals to improve the regulation of derivatives markets, are summarized below.

Legislative Proposals: Closing Loopholes

Legislative approaches to ensuring that commodity prices are not manipulated or distorted by excessive speculation focus on (1) extending regulatory control to previously unregulated markets, (2) ensuring that speculators cannot use foreign futures markets to avoid U.S. regulation, and (3) restraining the ability of institutional investors (and others who do not deal in the physical commodities themselves) to take large positions in commodities. These three areas are known respectively as the "Enron loophole," the "London loophole," and the "swaps loophole."

The Enron Loophole

The "Enron loophole" refers to a range of transactions that occur off the regulated futures exchanges, in an "over-the-counter" (OTC) market where the CFTC has had little regulatory jurisdiction, and from which it does not receive comprehensive information about who is trading, in what volumes, and at what price.

The Commodity Futures Modernization Act of 2000 (CFMA, P.L. 106-554 ) created a statutory exemption from CFTC regulation for certain contracts based on "exempt commodities," defined in the legislation as commodities that are neither agricultural nor financial. Two types of energy derivative markets were thereby exempted: (1) bilateral, negotiated transactions between two counterparties that are not executed on a trading facility, and (2) trades done on an "electronic trading facility." The CFMA specified that these markets must not be accessible to small investors; all traders must be "eligible contract participants" (financial institutions, units of government, or businesses or individuals with substantial financial assets) or, in the case of the electronic trading facility exemption, "eligible commercial entities" (eligible contract participants who either deal in the physical commodity or regularly provide risk management services to those who do).

A substantial volume of over-the-counter energy trading makes use of these exemptions. There is a large market in energy swaps, where investment banks like Goldman Sachs and Morgan Stanley offer contracts linked to energy prices. The OTC market in swaps has also evolved towards an exchange model, where contracts are traded rapidly over an electronic network, and may be backed by a clearing house. The best known of these electronic trading facilities is operated by Intercontinental Exchange Inc. (ICE). The ICE over-the-counter market handles a volume of natural gas contracts roughly equal in size to that handled by Nymex, the largest energy futures exchange.

A Government Accountability Office report in October 2007 noted the growth of the OTC market and raised questions about whether the federal regulator had the information it needed to ensure that markets were free of fraud and manipulation. In the same month, the CFTC issued a report recommending legislative action to increase the transparency of energy markets.

In May 2008, with the Farm Bill ( H.R. 2419 , P.L. 110-234 ), Congress passed legislation that generally follows the CFTC's recommendations and potentially brings part of the OTC market under CFTC regulation. The new law affects electronic trading facilities handling contracts in exempt commodities (primarily energy or metals). If the CFTC determines that a contract traded on such a facility plays a significant price discovery role, that is, if the prices it generates are used as reference points for other transactions and markets, the facility will come under CFTC regulation. The market will have to register with the CFTC and demonstrate its capacity to comply with several core principles. The principles and requirements include maintaining and enforcing rules against manipulation, establishing position limits or accountability levels to prevent excessive speculation, and providing the CFTC with daily reports on large traders' positions.

The provisions of the Farm Bill, however, do not affect the unregulated status of energy contracts that are not entered into on a trading facility, in other words, the swap market in exempt commodities. Thus, the argument is made that the Enron loophole has been only partially closed. A number of bills propose to end the statutory exemption for OTC energy trades altogether, by putting energy commodities on the same regulatory basis as agricultural commodities. Under current law, derivatives contracts based on farm commodities may only be traded on a regulated exchange, unless the CFTC issues an exemption. The CFTC is authorized to grant such exemptions on a case-by-case basis, after determining that the contract would not be against the public interest.

Other bills, including H.R. 6244 and S. 3268 , would authorize the CFTC to impose reporting requirements and position limits on energy swap markets.

The London Loophole

Unlike the Enron loophole, which addresses the distinction between the regulated exchange markets and the unregulated OTC market, the "London loophole" refers to differences in the oversight of regulated markets in different countries. The U.K. counterpart to Nymex, the leading U.S. energy futures market, is ICE Futures Europe, which is regulated in the U.K. by the Financial Services Authority (FSA).

For several years, the U.K. exchange has been offering energy futures contracts in the United States, via electronic terminals. Ordinarily, an exchange offering futures contracts to U.S. investors is required to register with the CFTC as a "designated contract market," and to comply with all applicable laws and regulations. However, in the case of ICE Futures Europe, the CFTC has waived that requirement, by means of a series of no-action letters, on the grounds that the U.K. market is already regulated at home, and that requiring it to register with the CFTC would be duplicative and add little in terms of market or customer protections.

Initially, the U.K. market offered electronic access to U.S. traders to its most popular contract, a futures contract based on the price of Brent Crude oil, produced in the North Sea. After the market was acquired by ICE, however, it introduced a "look-alike" contract that was identical to Nymex's West Texas Intermediate crude oil future. This contract, which could be settled by making or taking delivery of physical crude oil in the United States, now trades in significant volumes—transactions that would presumably take place on the Nymex otherwise.

With concern over high and volatile energy prices, there has been more scrutiny of ICE Futures Europe's activities in the United States. Can traders avoid speculative position limits by trading on ICE, in addition to (or instead of) Nymex? Does the CFTC receive the same information from ICE Futures Europe about large trading positions that could be a source of manipulation or instability (if they were liquidated suddenly)?

A number of bills propose to close the London loophole, either by requiring foreign boards of trades (exchanges) to comply with all U.S. registration and regulatory requirements if they offer contracts that can be settled by physical delivery within the United States, or by making CFTC relief from such requirements and regulation contingent upon a finding that (1) it will receive from the foreign market information that is comparable or identical to what it receives from domestic exchanges and (2) the foreign market is subject to a regulatory regime that is comparable to the CFTC's.

In the case of ICE Futures Europe, the CFTC announced that it had amended the "no-action relief letter" under which ICE Futures Europe is permitted direct access to U.S. customers. The amended letter conditions direct access on ICE Futures Europe's adoption of equivalent U.S. position limits and accountability levels on its West Texas Intermediate crude oil contract, which is linked to the New York Mercantile Exchange crude oil contract. This agreement complements a 2006 memorandum of understanding with the FSA providing for sharing of trading information.

The CFTC's agreement with ICE appears to fulfill the purposes of several of the bills, but only with respect to the London market. The CFTC has issued other no-action letters granting regulatory waivers to foreign markets, including the Dubai Mercantile Exchange (a joint venture with Nymex), permitting it to offer contracts in the United States (to be cleared by Nymex). On July 7, 2008, the CFTC announced that it would modify the no-action letter to the Dubai exchange on terms similar to the agreement with ICE Futures Europe.

The Swaps Loophole

The view that excessive speculation is driving up energy prices is widely held, but controversial. The question of whether current prices are justified by fundamental factors of supply and demand, or whether irrational exuberance has created a bubble in energy prices (similar to what was observed in dot-com stocks in the late 1990s), is beyond the scope of this report. However, testimony presented to Congress has identified a recent trend in financial markets that some argue may be putting upward pressure on prices: decisions by institutional investors, such as pension funds, foundations, or endowments, to allocate a part of their portfolio to commodities.

From the point of view of a fund manager, investment in commodities may be very attractive under current market conditions. Average returns on stocks and bonds have been relatively low for the past few years, and there is little optimism that they will improve in the near term. Commodities, on the other hand have been the "hot sector." While commodity investment is recognized as being highly risky, a risky asset in a large, diversified portfolio does not necessarily increase overall portfolio risk. The risk of a downturn in commodity prices is not generally correlated with risks in stocks or bonds; in some cases, there may be an inverse relationship. For example, if the price of oil drops suddenly, an institution may lose money on its commodity investment, but the price change will be good for its transportation stocks.

Institutional investors may take positions in commodities in a number of ways, but they do not generally trade on the futures exchanges directly. Instead, they use an intermediary, such as a commodity index fund or an OTC swap contract that is structured to match the return of a published index of commodity prices. As a result of this investment strategy, institutional investors in commodities are often called "index traders."

While the decision of an individual pension fund to put 3%-4% of its portfolio in commodities may appear entirely rational, some observers argue that the aggregate impact of institutional index trading has been to overwhelm the commodity markets, because of the disproportion between the amount of money held by pension funds, foundations, and other institutions and the amounts that have traditionally been traded in the energy futures market. In other words, index investing is seen as excessive speculation. One particular feature of index trading is the focus of several legislative proposals: the "swaps loophole."

The CFTC and the exchanges maintain position limits or accountability levels that apply to speculative traders. Speculators either face a ceiling on the number of contracts they may own, or, if they breach a position accountability level, they must explain to the exchange why they are accumulating such a large position. The purpose of the speculative limits is to prevent manipulation by speculators with very large positions, and to limit the market impact in cases where losses force speculators to liquidate their positions suddenly.

Hedgers, those who use the futures markets to offset price risk arising from their dealings in the underlying commodity, are generally exempt from position limits. Hedgers are allowed to take futures positions of any size, provided those positions are commensurate with their commercial interests. The rationale for exempting them from position limits is that when they have a hedged position, they have no incentive to manipulate the market: any gains in their futures position will be offset by losses in their physical transactions, and vice versa. (They use the futures markets to lock in today's price, meaning that subsequent price changes do not affect them.)

Traditionally, hedgers have been thought of as those who are active in the physical commodity market; in the energy market, these would be oil producers, refiners, transporters, and industrial users such as airlines and utilities. With the rise of index trading, however, the definition of hedger has broadened. Both the CFTC and Nymex now extend exemptions from speculative position limits to swaps dealers who are using the futures exchanges to hedge price risk arising from a financial contract with an institutional investor.

In other words, a pension fund wishing to invest in commodities may go to a swaps dealer and enter into a contract that will pay returns equal to the percentage increase in an index of commodity prices. In economic terms, this is equivalent to a long position in futures, which will gain value if the underlying commodity price rises. The swap dealer has, in effect, taken the short side of the trade: it will lose money if prices rise.

The swap dealer is exposed to price risk, and may wish to offset that risk by purchasing exchange-traded futures contracts. Because the dealer is using the futures market to hedge the risk of the swap, the exchanges and the CFTC exempt it from position limits, even though it does not deal in the physical commodity. The rationale is the same as for traditional hedgers: since the swap dealer will gain on its futures position whatever it loses on the swap, and vice versa, it has no incentive to manipulate futures prices.

The effect of this "swaps loophole," however, is to permit the ultimate customers—the institutional investors who are clearly speculating on commodity prices—to take larger positions than they would be able to do if they traded directly on the futures exchanges, where they might be constrained by speculative position limits. Hence the description of institutional investors' index trading as excessive speculation.

A number of bills propose to constrain the ability of institutional investors to use the swaps loophole. They would limit the definitions of "bona fide hedger" or "legitimate hedge trader" to those who deal in the physical commodity, or they would prohibit trading in OTC energy contracts by those who do not deal in the physical commodity.

Other Legislative Approaches

Raising Margins

Three bills ( H.R. 2991 , S. 3044 , and S. 3183 ) call for the CFTC to raise margins on oil futures. The margin requirement is the minimum amount of money per futures contract that traders must deposit with their brokers. Margin requirements are set by the exchanges, and are intended to cover losses. At the end of each day, the exchange credits or debits every trader's margin account with the amount of gains or losses. Traders whose margin accounts fall below the minimum requirement will be required to post additional margin before the market opens next day, or their positions may be closed out at a loss.

The exchanges tend to raise margins during periods of price volatility, when the probability of large price swings increases the risk of loss. Nymex has raised the initial margin requirement for crude oil futures contracts (each of which represents 1,000 barrels of oil) several times in 2008.

Since everyone in futures markets trades on margin, raising margins means higher trading costs, which should cause some traders to reduce the size of their positions and reduce trading volume overall. However, as noted above, there is no empirical evidence that higher margins dampen price volatility, making the effect on price uncertain.

Increasing CFTC Resources

Several bills call for supplemental appropriations to permit the CFTC to hire 100 new employees to monitor the energy or agricultural derivatives markets.

Emergency Actions

H.R. 6377 , passed by the House on June 26, 2008, and other bills direct the CFTC to use its existing powers, including its emergency authority, to curb immediately the role of excessive speculation in energy and to eliminate price distortion, unreasonable or unwarranted price fluctuations, or any unlawful activities that prevent the market from accurately reflecting the forces of supply and demand for energy. (CFTC's emergency authority includes the power to change margin levels or order the liquidation of trading positions.)

Studies of the Market

A number of bills call for studies of various aspects of the market, including the effects of raising margin, the adequacy of international regulation, the effects of speculation, and the impact of index trading on prices.

Table 1 below provides summaries of all legislation that bears on the regulation of energy speculation. Table 2 provides a more detailed comparison of H.R. 6604 and S. 3268 , two bills that were brought to the floor in their respective chambers in July 2008 but failed on procedural votes.

Appendix. Mechanics of Futures Contracts