Energy Speculation, the CFTC, and Position Limits

Q1: If the economy is so bad, why is the price of oil up? How much of this is just speculation?

A1: This week oil futures prices again topped $70 per barrel, up from $63 only a few weeks ago but still less than half of the peak prices seen last summer. Analysts remain perplexed as to why prices remain so robust in a weak global economy, especially given the bearish case supporting the traditional supply/demand “fundamentals.” Current oil supply is more than adequate to meet current demand. Crude inventory levels are well above their historic range, global demand remains anemic (although certain markets are beginning to show increases), and as a consequence of declining demand and OPEC production cuts, there is a healthy glut of spare production capacity available—a condition that generally exerts downward pressure on prices.

These indicators all suggest that prices should be lower. But as we learned in 2007–2008, other factors, including bullish forecasts for a speedy economic recovery, ongoing geopolitical upheaval, (misplaced) confidence in OPEC’s ability to enforce target quota compliance in a rising price environment, the declining dollar, investor moves back into commodities, and the so-called real replacement price for oil, also affect oil price fluctuations.

In the absence of persistent strong indicators of demand growth or decline, traders have seized on weak indicators and the hopes of an economic recovery. This optimism has pushed funds back into the commodities sector, a sector that endured an abrupt flight of capital in the latter half of 2008. The credit collapse of 2008 served as a giant margin call and forced many leveraged investors to either pay down their loans or liquidate. Those investors are now returning to the market.

For world leaders hoping for a recovery unfettered by high energy prices, the role and return of financial “speculators” is too great to ignore. They fault speculators, loosely defined as any entity without a vested commercial interest in the underlying commodity upon which they are betting, with the rise in crude prices in early 2008 and early 2009. Regulators and members of Congress routinely cite excessive volatility and the rise of investment vehicles designed to take advantage of that volatility as evidence of the pernicious effect financial bettors have had on markets. As a result, the regulatory body tasked with overseeing commodities trading, the Commodity Futures Trading Commission (CFTC), is once again examining the role of speculation and speculators in energy markets.

Q2: What sparked the current controversy at the CFTC?

A2: Bart Chilton, one of four appointed CFTC commissioners, told the Wall Street Journal that the CFTC would be releasing a report in August that would contradict its 2008 report on speculators and oil prices, which determined that market fundamentals—supply and demand—were the dominant factors in the run-up of crude prices from 2002 to 2008. Chilton noted that the 2008 report was based on “deeply flawed data.” However, Gary Chensler, current CFTC chairman, has more recently countered that “… it is inappropriate to speculate on data that the Commission will be releasing in the future—data that none of the Commissioners has seen. News reports that the CFTC will release a study reversing the agency’s position on energy speculation are both premature and inaccurate.”

Q3: What’s the context here?

A3: In 2000, Congress passed the Commodity Futures Modernization Act, which deregulated much of the derivatives (futures, options, etc.) sector, including the credit default swaps (CDSs) that have been widely credited with the assist in bringing the global economy to its knees. Until 2000, outside of the standard commodity desks at investment banks, the people investing in crude futures were mostly industry players and large consumers—for example, airlines, refiners, and producers who used the futures market to hedge their risk. Since 2000, the derivatives and commodity markets have witnessed a large shift in their counterparty lists. For crude oil, the most relevant parties were index fund investors and “exchanged traded funds” (ETF) investors. Index fund investors put money into a managed fund that contains a basket of commodities (somewhat like a mutual fund) that is generally invested for the long haul. ETFs are also composed of commodities or commodity-linked financial instruments, but they trade like a stock on an exchange and are usually tied to a specified index, say the Goldman Sachs Commodity Index (GSCI), which contains a wide variety of commodities but is not actively managed like an index fund’s basket.

Over the last eight years or so these new investors provided an inflow of capital to commodities in general. Some market observers have suggested that the nature of index investors, who generally have a longer investment timeline, did not provide the traditional balance of buyers and sellers (they buy and hold) and that continued interest in index funds may have added undue upward pressure to the market, though this theory is difficult to substantiate. The scale of investment, however, is not. According to the Wall Street Journal, over $300 billion was invested in index funds in July 2008, up over four-fold from 2006. Whatever the vehicle, it is clear that a significant amount of new money flowed into commodities of all types, not just oil, from 2000 onward.

Q4: What is a position limit?

A4: A position limit is a cap on the net long (bought) or short (sold) position that an entity, or aligned entities, is legally allowed to hold in a given exchanged-listed contract. Some position limits are set daily, others are set monthly. An example of a position limit would be a bank being allowed to hold only a net long position of 10,000 contracts for delivery of oil in December 2009. The exchange or relevant regulatory body sets the position limit for each contract. Position limits are designed to limit market manipulation and, in theory, promote fair market practices. Generally, limits are narrower in the “spot month” or current month of delivery, to prevent excess volatility.

Q5: Who is currently exempt from position limits?

A5: The CFTC currently grants exemptions to “bona fide hedgers.” Unfortunately, that term is often difficult to define. A classic example of a bona fide hedger would be a refiner that is expecting to take delivery of oil in the future and would prefer to lock in a price against his current inventory. The refiner would use a futures contract to reduce his market risk. In practice, refiners rarely do this trade themselves. “Swap dealers,” or financial institutions, often serve as the intermediary and aggregating facility for refiners, airlines, etc., that have a genuine economic stake in the market (unlike pure speculators, who live and die on changes in the price of the asset). This scenario makes regulation difficult because it obfuscates some market players and, as a result, affords exemptions to some that may not be within the letter of exemption status. Banks and investment trading houses are routinely granted exemptions from position limits set by the exchanges because they execute market hedging for commercial interests, but these banks often have a speculative position as well. They argue that their position as intermediary for utilities, airlines and refiners serves to provide liquidity to a market that would otherwise become fractured.

Q6: What is the CFTC considering doing?

A6: The CFTC is considering position limits for certain market participants that have, until now, relied on exemptions to conduct their business. The CFTC is authorized by the Commodity Exchange Act “to impose limits on the size of speculative positions in futures markets.” At present, the CFTC imposes position limits in a number of agricultural commodities including corn, oats, wheat, soybeans, and cotton. Position limits for energy commodities are the purview of the exchange in which they are traded. (The New York Mercantile Exchange [NYMEX], Chicago Mercantile Exchange [CME], and Intercontinental Exchange [ICE] are the largest energy commodity markets operating in the United States.) The CFTC can levy “disciplinary action” if it believes the position limits set by the respective exchanges are being ignored or are not stringent enough. However, in practice, the CFTC has historically been lax in this regard and has not levied fines to alter market behavior.

Q7: What would stricter position limits actually do?

A7: It would depend on how they were implemented and whether the exemption process was altered as well. One possible outcome, and probably the most palatable to all parties, is that the job of setting position limits is moved from the exchanges to the CFTC. (The CFTC has been collecting data from banks through a mechanism known as the “Special Call” since the run-up in prices in 2008 and would likely expand this effort to better regulate position limits if this move occurred.) Because position limits are easily avoided through a distribution of investments, the CFTC might also look to view position limits on an aggregate basis, meaning contracts done on the exchanges as well as those done over the counter (OTC) between parties1. Aggregate position limits would make it harder to hide an entity’s true exposure.

The exemption process is politically thorny. Because banks often serve as legitimate intermediaries, and many pension funds invest in commodities through them, establishing a new regime for exemption grants will be difficult if not impossible.

Q8: What could go wrong?

A8: If the CFTC sets position limits too low, or is stingier with exemptions, the market could function less smoothly. The other strong possibility is a flight of investment to alternative markets, namely London. The Financial Services Authority (FSA), the CFTC’s rough corollary in the United Kingdom, is convening a meeting of energy market participants this week, but has given strong indications that it is unlikely to adopt new regulations. Like the CFTC, the FSA has conducted extensive market surveys and found no hard evidence of speculators playing a dominant role in 2008’s crude price run-up. Historically, the market moves to its least regulated area. As noted by commodity trading adviser John Lothian in his testimony before the CFTC, in an effort to squeeze the USSR, President Jimmy Carter shut down U.S. grain futures trading in 1979 only to watch traders move their bets to the Winnipeg Commodity Exchange. Similarly in 1864, President Abraham Lincoln was fed up with gold price speculation and outlawed delayed delivery of the commodity. The market responded by trading verbally in the streets of New York—analogous to today’s OTC trading. The market did not stop functioning, it simply moved to an unregulated area.

Q9: Keys to watch for?

A9: The headline to keep an eye out for is whether the position limit and exemption process is moved from the relevant exchanges to the CFTC. Also watch how the position limits are implemented, whether aggregate or not, net or gross, and watch for any changes to the exemption review process. Additionally, look for any changes in how the CFTC’s data is collected.

1OTC trades are less regulated, and many fear that stricter position limits would push more of the market into unseen OTC deals, thereby making the problem even worse with limited transparency.

Brendan Harney is a researcher with, and Frank Verrastro the director of, the Energy and National Security Program at the Center for Strategic and International Studies in Washington, D.C.

Critical Questions is produced by the Center for Strategic and International Studies (CSIS), a private, tax-exempt institution focusing on international public policy issues. Its research is nonpartisan and nonproprietary. CSIS does not take specific policy positions. Accordingly, all views, positions, and conclusions expressed in this publication should be understood to be solely those of the author(s).

© 2009 by the Center for Strategic and International Studies. All rights reserved.

Frank A. Verrastro
Senior Adviser (Non-resident), Energy Security and Climate Change Program

Brendan Harney