Tuesday, July 28, 2009

CFTC Points Finger, Traders Balk

The Chairman of the Commodity Futures Trading Commission (CFTC) is talking tough about instituting trading curbs on energy contracts. Gary Gensler, the new CFTC chairman as of May, is pulling an abrupt about-face from the previous administration's stance, which was very hands-off and pro-trader. Mr. Gensler believes that speculation by index investors contributed to massive volatility in the price of oil last year. The CFTC plans to issue a report next month suggesting that speculators played a significant role in driving wild price swings in the price of oil, which is a reversal of the findings of the CFTC last year, which claimed that it was purely supply and demand driving the prices swings. The UK's regulator, the FSA, has also cleared speculators of any responsibility for excessive oil price volatility. Who's right? The truth is probably somewhere in between. What began as a spike in oil prices based on fundamentals, turned into a pile-on of endowments, pensions and other investors looking to get in on the action as a hedge against inflation, or just a bet on something that was going higher. When $300 billion enters a market via new index products, as it did over the course of a few years, it is bound to drive up the price. Whether these folks should be allowed to play in the market is entirely a matter of interpretation. The previous administration believed that everyone was allowed to the party, while the current administration wants to break the party up. The fact that the price of oil is such a major determinant in economic growth is not something that this administration is taking lightly. While the prior administration's laissez-faire attitude may be reflected on wistfully by energy traders, at least the CFTC's tough stance doesn't involve invading any countries. Like I said, it's all a matter of interpretation.

The CFTC is planning to propose new curbs on trading positions in order to limit speculators' ability to drive commodity prices. Currently the CFTC only sets hard limits on speculative trading in certain agricultural markets, leaving the exchanges to set limits on other products. Exchanges only impose hard limits on energy products in the last three days of trading before a contract's expiration. The rest of the time, they impose accountability levels, which trigger additional oversight if exceeded. Mr. Gensler revealed today that in the past 12 months , a total of 70 different parties exceeded those accountability levels in the four major energy contracts. The CEO of the CME, Craig Donohue has apparently agreed to set hard limits on energy contracts, but he doesn't sound happy about it. Mr. Donohue argued that speculators have been wrongly targeted in the debate over energy prices and he believes that any effort to control prices or market volatility by position limits is a "failed strategy."

For some small foreshadowing of what could happen in the oil markets, we go to the New York Mercantile Exchange to check in with the natural gas market. Traders are grumbling about the new limits exchanges have imposed on natural gas trading. In the face of pending restrictions , natural gas prices have swung wildly and trading volume has declined markedly. In June, the New York Mercantile Exchange sent a notice that it would start imposing hard position limits on seven cash-settled natural-gas contracts, limits on the positions traders can hold in the three days before the contracts expire. This is supposed to limit volatility and seems to be working about as well as the price caps imposed on oil in the 70's. Natural gas prices jumped 11% in early June, followed by a 23% dive until July 13 and then rebounded 10% in recent days. Price volatility of three-month contracts shot up in June to the highest levels since the Gulf War, the First Gulf War, when the natural gas contract first started trading. So, you know, so far the restrictions are working really well in terms of curbing volatility.

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