USCF wants exemption if CFTC limits energy positions

The chief investment officer of a group of exchange-traded funds (ETF) tracking oil and gas commodity prices urged the US Commodity Futures Trading Commission to look beyond aggregate positions if it decides to set limits on energy commodity holdings.

Nick Snow
OGJ Washington Editor

WASHINGTON, DC, Aug. 5 – The chief investment officer of a group of exchange-traded funds (ETF) tracking oil and gas commodity prices urged the US Commodity Futures Trading Commission to look beyond aggregate positions if it decides to set limits on energy commodity holdings.

United States Commodity Funds LLC’s funds significantly differ from other ETF funds, John Hyland told the CFTC on Aug. 5 at its third hearing examining whether to establish energy commodity position limits and exemptions in certain cases.

“Although the futures positions held by the funds may appear to be large in relation to each fund as the legal holder of such positions, these investments represent the aggregation of demand from tens of thousands of individual investors seeking to reduce their financial risk through hedging in the commodity futures market,” he said. “If it is determined that position limits are appropriate, we believe that the CFTC should extend hedge protections to highly aggregated single funds that track commodities.”

But a second witness, Paul N. Cicio, president of the Industrial Energy Consumers of America, said that at least one of USCF’s funds, the United States Natural Gas Fund LP, influences the commodity’s price. “Its transactions have nothing to do with supply and demand. Unlike other players, it predictably rolls its positions forward each month, and it lets everyone know it,” he testified.

“Price formation is not ‘passive’; it is dynamic. It is a combination of reaction and pro-action and without a pattern. Price formation is unpredictable, not predictable and reflects changes in supply and demand to the underlying commodity,” Cicio continued. “The USNGF is a ‘long-only’ fund and it does not contribute to the price formation dynamics; it undermines price formation.”

Limits have support
The CFTC apparently was moving toward adopting position limits for energy commodities as its third hearing got under way. “Several major market participants and exchanges have expressed their support for position limits. Traders have testified that position limits in the energy realm would be beneficial to the market. The signal they sent of their interest to protect the market was very helpful,” CFTC Chairman Gary G. Gensler said in his opening statement.

Position limits exist for agricultural commodities, he continued, but there also are significant differences between the energy and agricultural markets. “Agriculture markets are smaller, to be sure, and primarily export markets. But I believe we can’t simply step back because the energy markets are larger. There also have been a lot of changes since the early 1990s when a lot of exemptions were granted,” he said.

Finally, said Gensler, the core question is how much market concentration is too much. “I think we can all agree that if one party controls more than half the market, it decreases liquidity and market integrity,” he said.

Cicio suggested that the US Natural Gas Fund might fit that definition. “We understand that the USNGF currently has 300 million shares and that this represents nearly 30% of the prompt month volume, a significant position for one entity. A Wall Street Journal article of July 8, 2009, reports that the USNGF has asked the Security Exchange Commission for a ten-fold increase in issued shares to 1 billion. This is a significant increase and raises market power concerns,” he said.

He said that IECA’s analysis of the fund shows more existing influence than is readily apparent. “Total open interest in the August natural gas futures contract as of 2 weeks ago was about 140,000 contracts. The fund maintains that 23% of UNG funds are invested directly into prompt month gas futures and about 34% in Henry Hub swaps. However, when looking closer at its holding, we estimate that USNGF held 27,203 contracts in August natural gas futures alone,” he said. USNGF also held 51,747 in New York Mercantile Exchange Henry Hub swaps (quarter-size contracts), which convert to 12,937 full-size futures contracts, Cicio said.

On the InterContinental Exchange, he continued, USNGF held 339,234 in Henry Hub Swap look-alike contracts two weeks, which he said converts to 84,809 full-size NYMEX contracts. “So when everything is converted to full-size NYMEX contracts, it's as if the USNGF maintains around 86% of the entire NYMEX August open interest or roughly 125,000 contracts,” he said.

Major differences
Hyland said that USCF’s funds differ from other ETFs because they are highly regulated, are widely held by individual investors, are not leveraged (since all their futures positions are fully collateralized), have highly transparent pricing and investments, and are priced by the value of each fund’s assets and the market.

“The two largest funds, USO and UNG, each have hundreds of thousands of shareholders. For calendar year 2008, the funds had a combined 325,000 investors. For 2009, management estimates that there are over 600,000 shareholders in all of the funds,” he told the commission. “Management’s analysis of prior year shareholder data, derived from tax reporting information, suggests that 75-90% of all shareholders, depending on the fund, could be deemed individual, ‘retail’ investors, i.e., not institutions or investment funds.”

Citing statements that investments made in crude oil and natural gas commodity markets in 2008 by large, unleveraged and passive index funds drove oil and gas prices higher in the first half and made them plunge in the second half, Hyland said that data show that this does not apply to either its crude oil or natural gas fund.

Displaying a chart comparing the price of NYMEX’s front month light sweet crude contract to the actual size of USCF’s United States Oil Fund’s holdings from its April 10, 2006, inception date to June 30, 2009, he said that its data show that USOF’s crude futures contract holdings declined during the crude oil price surge from January 2007 to July 2008. “Furthermore, the large increase in crude oil contracts held by USO occurred in late 2008 and continued to February 2009, coinciding with a period of time when crude oil prices trended lower, not higher,” he said.

“Finally, the most recent increase in crude oil prices, which began in February of 2009 and continues to the present, coincides with a period in which USO was once again a large scale seller of futures contracts, not a buyer,” said Hyland. “During the most recent run-up in prices, USOF has steadily sold off 65% of its peak level holdings. The data presented in the chart does not support the theory that USOF’s activities drove prices significantly higher in recent months.”

Similar gas results
Hyland said that an examination of USCF’s gas fund’s holdings and gas futures prices from the fund’s April 17, 2007, inception to June 30, 2009, produced similar results. “The data show that during the run-up in gas prices from September 2007 and $5.50/MMbtu, to July 2008 and roughly $13.50/MMbtu, UNGF’s holdings in gas futures contracts were essentially flat (8,093 contracts on Sept. 7, 2007, and 8,587 contracts on July 3, 2008),” he said.

More recently, he continued, the fund has increased the number of gas contracts it owns as gas prices have trended lower, not higher. This does not support the theory that the fund’s purchase of contracts drives gas futures prices upward, he declared.

“The question is whether there’s a difference between an aggregator like us with thousands of investors managing their positions, and a single trader with a large position. Should the trading funds at Morgan Stanley and Goldman Sachs have limits? I think so because they are a single investor,” Hyland said.

Imposing position limits on his group’s funds would drive up their costs, he said in response to a question by CFTC Commissioner Jill E. Sommers. “Arguably, I could split a fund up four ways. That would be more expensive for shareholders, and liquidity would go down. The market works better with bigger than smaller pools of liquidity,” he said.

Other witnesses’ recommendations at the Aug. 5 hearing varied. Elliott Chambers, Chesapeake Energy Corp.’s corporate finance manager, said in his written statement that while the independent oil and gas producer is not opposed to energy commodity position limits, it is concerned that setting them too low would remove vital liquidity from the marketplace.

Swap dealers’ role
“Additionally, Chesapeake has concerns regarding removing hedge exemptions for swap dealers. It should be recognized that without swap dealers Chesapeake’s risk-management program would not be possible,” he continued. “Typically, when we place a hedge with a swap dealer, they quickly off-load it, thus running a balanced derivative book. If there is any excess position left, swap dealers quickly utilize the futures market to remove that residual risk. These are valid risk-management activities. In short, we believe that both sides of this equation should be exempt from position limits since our activities are inherently risk-reducing.”

Testifying on behalf of the Futures Industry Association, Mark D. Young, a partner in the Washington office of Kirkland & Ellis LLP, said that the FIA’s primary concern is that if new position limits are too restrictive domestically, traders would simply conduct business overseas.

“Human nature tells us that those who are well-capitalized and looking for commodity market price exposure (as a hedge against expected inflation, for example) would, all other things being equal, choose a market without rigid limits, rather than a market with such limits. No one is saying this is certain to happen, but enough people are saying it could that migration risk should not be relegated to the ‘boy who cried wolf” category,” he said.

Steven Graham, a vice president of Schneider National Inc., a Green Bay, Wis.-based trucking company, said that position limits should be applied to all energy commodity market participants equally if the CFTC decides to adopt them. “The failure to include all markets in the position limit calculations will create loopholes in the regulatory scheme that could be exploited by entities seeking to circumvent the position limits. These loopholes will undermine the very purpose of establishing position limit,” he said, testifying on behalf of the American Trucking Associations Inc.

The position limits should be applied at different levels for different market participants, he continued. “A distinction between commercial and non-commercial participants is important to ensure that trucking companies who are dependent upon petroleum products are able to hedge their exposure to changes in petroleum prices; and that they may continue to offer their customers/shippers fixed price transportation contracts and lay off or hedge the exposure that comes with providing a fixed price,” he said.

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