Nick Snow
OGJ Washington Editor
WASHINGTON, DC, Apr. 8 -- While purely financial players have become increasingly prominent in energy commodity markets and new regulations appear likely, stronger evidence is needed that they created crude oil price spikes in 2008, several panelists said Apr. 6 at an energy conference in Washington, DC.
“We have yet to articulate how a specific mechanism such as swaps affect oil prices. We should not make policies based on an assumption which may not be true,” David M. Arsenau, a senior economist in the Federal Reserve’s International Finance Division, said during the 2010 Annual Energy Outlook Conference cosponsored by the US Energy Information Administration and John Hopkins University’s School for Advanced International Studies.
Edward L. Morse, a managing director and head of global commodities research at Credit Suisse in New York, said oil prices became more volatile after 2003 because of supply shortages resulting from underinvestment. Commercial participants began to enter commodity markets about the same time and increased their positions as other investment areas turned sour, he said during the breakout session on short-term energy price influences where Arsenau also was a panelist.
These investors apparently have returned to energy commodity markets after pulling out during 2008’s second half as crude prices plunged from a record $147/bbl in late June, according to some members of a second panel on energy commodity regulation. “You don’t hear much about commodities right now, which worries me,” said Sean O. Cota, an oil products marketer from Bellows Falls, Vt. “Huge amounts of passive investments have gone back into the markets in recent months.”
A second panelist, Natural Gas Supply Association Pres. R. Skip Horvath, said he agrees with the US Commodity Futures Trading Commission that systemic risk in the markets should be addressed by requiring that more trades occur on regulated exchanges and position limits established for some participants. “The question is how far the net needs to be cast,” Horvath said, adding, “Anybody with assets in the ground should be exempt.”
Transparency matters
Making markets more transparent is the key, panelists in both sessions agreed. Crude prices have strengthened in recent months despite excess spare production capacity, lower demand, and increased production by members of the Organization of Petroleum Exporting Countries, noted Guy F. Caruso, a senior advisor in the Center for Strategic and International Studies Energy and Nation Security Program who led EIA from 2000 through 2008.
Caruso said during the discussion on prices that other possible factors include a lack of reliable data outside Organization for Economic Cooperation and Development countries, misplaced confidence in OPEC quota compliance, possibly premature economic recovery forecasts, and fear of longer-term constraints on supplies from Nigeria, Iran, Mexico, and Venezuela. Caruso also said money managers’ reinvestments in energy commodities have grown 70% since Dec. 1. “We need to improve the data information systems that link financial and commodity markets,” he said, adding, “EIA initiatives and CFTC requirements will help, but it will take time.”
Christopher Ellsworth, who works in the US Federal Energy Regulatory Commission’s Energy Markets Oversight Division, said at the same session that factors beyond supply and demand also drove natural gas prices higher in 2008. “Some of the strength had to do with the global financial market’s perception of expectations,” he said. “Interestingly, commodity prices collapsed 2 months before equity markets.”
Gas prices settled into a range more closely related to physical supplies following the 2007-08 rollercoaster, although many financial investors are returning with instruments which mimic regulated exchanges, Ellsworth said, adding, “Their investment in commodities is not manipulation. Passive investors play an important liquidity role in commodity markets.”
Credit Suisse’s Morse said, “The new generation of commodity index funds differs from the ones offered in 2007 and 2008 because they’re not long-only and offer more approaches. Government intervention, particularly in emerging economies, is a major factor in food and energy price volatility. But markets today are significantly less volatile than in 2007-08.”
Emerging regulations
Congress is developing legislation and the CFTC is formulating regulations designed to make markets more transparent, panelists at the commodities session said. Dan M. Berkovitz, CFTC’s general counsel, said the commission has proposed position limits on more trading months and pursued cases where trading in exempt markets performed a significant price discovery function.
Bills emerging from US House and Senate committees general recognize oil and gas producers and other physical end-users’ need to trade without major financial collateral, Berkovitz said, but separating physical from financial participants is a problem since many traders use both kinds of instruments. “Bilateral customized trades will still be permitted, but they’ll have to be reported,” he said.
“Cleared futures contracts were absolutely sound through the financial crisis,” Berkovitz said. “A particular end user deciding not to clear his trade won’t break the market. The problem could come as a large financial institution aggregates these unregulated trades to higher levels. Also, if you actually look at who’s behind these large financial investments, it’s often pension funds, universities and other major institutions trying to keep pace with inflation. We’re working to keep any exemption tight if we’re going to have one.”
NGSA’s Horvath said, “Asset-owning industries use over-the-counter trades to reduce risk. Their in-ground assets aren’t always recognized as collateral. Smaller players could be removed, reducing liquidity.” Horvath noted that NGSA has estimated that if oil and gas producers aren’t able to hedge, they’d have to reduce their investments by $900 billion.
The one certainty is that companies trading commodities will need to build strong compliance programs to comply with new regulations, according to Deanna L. Newcomb, a regulatory and compliance analyst at McDermott Will & Emery LLP’s Houston office. “A good compliance program will require management support, written policies and procedures, training, monitoring, surveillance, risk assessment, and reviews,” she said.
Regulations will cast a wide net because the federal government wants to make certain that markets run properly and learn why if they don’t, Newcomb said. Regulators also won’t give companies the benefit of the doubt so completed documentation will be needed, she said, adding, “Welcome to the energy industry. You’re going to be regulated.”
Contact Nick Snow at [email protected].