Senate panel hears mixed suggestions about energy commodities reform

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.

But others told the Homeland Security and Government Affairs Committee that Congress should act now to preserve the integrity of futures markets which 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, chairman Joseph I. Lieberman (I-Conn.) noted in his opening statement. "Since we initiated this inquiry nearly two months ago, a lot has happened. The Commodity Futures Trading Commission has announced at least four new initiatives to address speculative activity. Last wee, 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 federal regulation," he continued.

More bills introduced

That same morning, Sen. Byron L. Dorgan (D-N.D.) introduced another which would compel the CFTC to differentiate between hedge and other commodity trades, increase margin requirements to 25% for non-hedge 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 which was the Senate counterpart of one which 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 Sen. Susan F. Collins (R-Me.), the committee's ranking minority member, developed three draft discussion documents for a bill which 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 which 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.

"Let me be clear that when we talk about financial speculators, we are talking about those looking to commodity price appreciation or depreciation to generate profits. 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'

In her opening statement, 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. 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 said that she was pleased to be working again with Lieberman to write legislation dealing with a major national issue, but added that 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 United States has traditionally 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 of the 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," he 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.

Commodity 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 which 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 that Lieberman's draft discussion documents follow three of his own recommendations by establishing limits which 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. "It has come to my attention that 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.

James J. Angel, associate professor of finance at Georgetown University's McDonough School of Business, said that Lieberman's proposal to limit commodity market positions by close the swaps loophole would be useful but should be carefully refined. He expressed reservations about the other two proposals because foreign entities such as sovereign wealth funds could simply take their business abroad, while banning institutions from holding commodities would deprive pension funds of a useful diversification tool.

Instead, he suggested, Congress should give the CFTC the powers and resources to regulate close substitutes to exchange-traded products and pass a credible "petroleum and carbon phase-out plan" that creates the right incentives for alternative fuels. "If we can send a credible message to the rest of the world that we're serious about alternatives, oil producers will have a massive going-out-of-business sale and prices will drop like a rock," Angel said.

Limits may be beneficial

Michael Greenberger, a professor at the University of Maryland's School of Law in Baltimore who formerly 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 which trade US commodities to comply with the same regulations which 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 President James E. Newsome, who helped implement the 2000 Commodity Futures Modernization Act as acting chairman and then chairman of the CFTC from 2001 to 2004, said that 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, he 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," Newsome said.

Lukken comes 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.

The CFTC does not want to penalize an investor who legitimately enters futures markets through a swap dealer, he continued. "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