Senate panel hears mixed energy commodities reform suggestions

Federal lawmakers should consider possible unintended consequences as they contemplate regulations aimed at curbing excessive commodity speculation, which they believe has inflated energy prices, several witnesses told a US Senate committee on June 24.

Jun 25th, 2008

Nick Snow
Washington Editor

WASHINGTON, DC, June 25 -- Federal lawmakers should consider possible unintended consequences as they contemplate regulations aimed at curbing excessive commodity speculation, which they believe has inflated energy prices, several witnesses told a US Senate committee on June 24.

But others told the Homeland Security and Government Affairs Committee that Congress should act now to preserve the integrity of futures markets. They said the markets no longer serve producers and consumers who want to use hedges to lock in prices because the markets have been overrun by speculators who use financial instruments to turn a quick profit.

The hearing was the committee's third this year on the subject, noted chairman Joseph I. Lieberman (I-Conn.) in his opening statement. "Since we initiated this inquiry nearly 2 months ago, a lot has happened. The Commodity Futures Trading Commission (CFTC) has announced at least four new initiatives to address speculative activity. Last week, the chief executive of the New York Stock Exchange indicated that investments by large institutions, particularly pension funds, were completely altering the supply and demand for commodities," he said.

"Our colleagues here in Congress have introduced at least eight bills on this subject, most of them focusing on market transparency but some going further by seeking to bring foreign or over-the-counter markets under [US] federal regulation," he continued.

More bills introduced
That same morning, Sen. Byron L. Dorgan (D-ND) introduced another that would compel CFTC to differentiate between hedge and other commodity trades, increase margin requirements to 25% for nonhedge trades, revoke or modify "all prior actions that prevent the CFTC from protecting legitimate hedge trades and discouraging speculative trades," and convene an international group of regulators to protect petroleum futures markets from "excessive speculation and worldwide forum shopping."

The previous day, Sen. Maria Cantwell (D-Wash.) introduced a bill that was the Senate counterpart of one Rep. Bart Stupak (D-Mich.) announced on June 20. "Americans are desperate for Congress to work together to get to the bottom of these crippling oil prices that cannot be explained by supply and demand fundamentals. For months, I have been calling on various federal agencies to act now and step up to the plate. I have reached across the aisle to the Republicans to join me, and today I am reaching across to the House," Cantwell said.

Lieberman noted that following the Homeland Security and Government Affairs Committee's last hearing on energy commodity markets, he and the committee's ranking minority member Sen. Susan F. Collins (R-Me.) developed three draft discussion documents for a bill that could be introduced after Congress returns from its week-long Independence Day recess. The proposals would extend transparency to unregulated commodity markets by closing a swaps loophole, create speculation limits that would apply to all commodities trading on and off currently regulated exchanges, and restrict large commodity purchases by large institutions through index funds, he said.

Lieberman differentiated between those looking to influence commodity price appreciation or depreciation to generate profits, and the legitimate hedgers. "Increasingly left on the sidelines are the bona fide hedgers—the farmers, fuel oil dealers and others for whom the commodity markets were originally created as a way to reduce their risk by locking in prices on next year's crops or oil production. Let me also be clear that I understand that some speculation in commodity markets helps them function. But the speculation going on now has gone way beyond that," Lieberman said.

'Massive new holdings'
Collins conceded that higher energy costs reflect fundamentals such as increased demand from China and India and the depreciation of the US dollar. "But massive new holdings of oil futures contracts by pension funds, university endowments, and other institutional investors who neither produce nor take delivery of oil also appear to be driving up prices," she said. "Their intentions may be simply to provide good returns and investment diversification, but many experts believe their activities are distorting commodity markets and pushing prices upward."

She said she has reservations about the proposal to ban institutional investors' use of index funds to trade in futures markets even though this may have had an impact on prices. "After all, pension fund managers are investing in commodities as a way to diversify their holdings, hedge against inflation, and improve returns—all in keeping with their fiduciary obligations," Collins said.

The US traditionally has resisted directly regulating pension plan investments, preferring instead to impose rigorous fiduciary responsibilities through the Employee Retirement Income Security Act, said William F. Quinn, chairman of the Committee on the Investment of Employee Benefit Assets (CIEBA), which is comprised of the chief investment officers of most major US private sector retirement funds. "Our concern is both with specific restrictions on pension plan investments in commodities and with the precedent that action will set for allowing the government to intrude on pension investment activities," Quinn told the committee.

CIEBA and its members believe that commodities may be part of a prudent, well-diversified investment portfolio by providing a hedge against inflation and minimizing volatility, he continued. "Pension plans are long-term investors, not speculators. The most successful plans do not 'chase' returns. Rather, they have disciplined strategies for minimizing risk and enhancing returns so that plan sponsors can fulfill the promises they make to their employees," Quinn said. The case for limiting pension investments in commodities simply has not been made, and proposals to restrict commodity investments do not define commodity investing with any specificity, he added.

Markets' purpose
But Michael W. Masters, managing member and portfolio manager of Masters Capital Management LLC in the US Virgin Islands, said that purely financial investors should not play a major role in commodity markets that exist primarily for the benefit of bona fide physical hedgers. These markets provide producers and consumers of the actual commodities with two vital functions: a means for price discovery, and a means to offset risk. "If we lose one or both of these functions, physical hedgers will abandon these markets," he said.

Masters said Lieberman's draft discussion documents follow three of his own recommendations by establishing limits that apply to every market participant, placing an overall limit on excessive speculation for each commodity and prohibiting commodity index replication strategies. But he also suggested that Congress should investigate physical hoarding by some investors. "Some Wall Street banks are offering commodity swaps based on actual physical commodities. This is a distressing development because it means that investors are directly competing with American corporations for natural resources and thereby are competing with American consumers," he said.

Beneficial limits
Michael Greenberger, a professor at the University of Maryland's School of Law in Baltimore who directed the CFTC's trading and markets division from September 1997 to September 1999, said that placing limits on speculators' commodity positions would be beneficial. He was less certain about the possible benefit of placing speculation limits on each contract or restricting public or private pension funds with more than $500 million of assets from participation in commodity markets, including regulated exchanges.

But he was emphatic that Congress should require overseas exchanges that trade US commodities to comply with the same regulations the New York Mercantile Exchange and other domestic exchanges follow. "I think we've made a terrible mistake calling the InterContinental Exchange a [British] exchange when its headquarters are in Atlanta, its operations are in Chicago, and it has trading engines across the United States," Greenberger said.

NYMEX Pres. James E. Newsome, who helped implement the 2000 Commodity Futures Modernization Act as acting chairman and then chairman of the CFTC in 2001-04, said the law, which Greenberger and others have criticized, actually "has proven to be the gold standard of commodities regulation" because it allowed US markets to adapt readily to changing market demand. "A number of legislative initiatives have been proposed that are intended to respond to a perceived problem of excessive speculation in the markets. NYMEX reiterates that it is important to collect the data in order to accurately assess the activity and influence of speculation before adopting a legislative solution," he said.

Congress should also consider the potential impact on the markets' hedging and price discovery functions, Newsome told the committee. "Price signals are the most efficient transmitters of economic information, telling us when supplies are short or in surplus, when demand is robust or wanting, or when we should take notice of longer-term trends. Thus, futures markets like NYMEX are the messengers carrying this information from the energy industry to the public. It would be contrary to the public interest to adopt legislation that impairs the important price discovery function of the markets," he said.

Lukken under fire
Walter L. Lukken, the CFTC's acting chairman, drew criticism from Lieberman for initially not responding to the lawmaker's proposals. "I understand you're busy, but most of what you've described sounds more like study than action. This matter is urgent, and we need to act," the committee chairman said.

Lukken, who had testified the previous day before the House Energy and Commerce Committee's Oversight and Investigations Committee and was scheduled to appear that afternoon before the House Agriculture Committee, said that Lieberman's proposal concerning swaps tries to address information needs.

"Everyone can agree that a large amount of index fund money has come into the commodity markets. Unfortunately, most of this comes indirectly through swap dealers who sell their clients board exposure to the commodity markets through an over-the-count commodity index contract. Swap dealers then are exposed to commodity price risk as a result of aggregating these transactions and must utilize the futures markets to manage their own remaining residual risk. This 'netting out' of risk by swap dealers before coming to the futures markets makes it difficult for regulators to determine the total amount of index trading occurring in the energy markets," Lukken said.

He said the CFTC does not want to penalize an investor who legitimately enters futures markets through a swap dealer. "But if someone is trying to evade position limits they should be stopped. I'm not sure how we would police new limits without putting the government's footprint on the markets. Our mission in the past has been to deal with illegal manipulation. The question of excessive speculation is a new issue, and we're trying to get our hands around it," Lukken said.

Late in the hearing, Sen. Claire McCaskill (D-Mo.) urged caution. "This is a dangerous time. Millions of businesses are on the brink of collapse. Millions of American families wake up afraid each morning. For elected officials, there's a temptation to wade in and make changes without considering unintended consequences," she said.

Contact Nick Snow at nicks@pennwell.com

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