[House Hearing, 110 Congress]
[From the U.S. Government Publishing Office]
HEARING TO REVIEW LEGISLATION AMENDING THE COMMODITY EXCHANGE ACT
=======================================================================
HEARINGS
BEFORE THE
COMMITTEE ON AGRICULTURE
HOUSE OF REPRESENTATIVES
ONE HUNDRED TENTH CONGRESS
SECOND SESSION
__________
JULY 9, 10, 11, 2008
__________
Serial No. 110-40
Printed for the use of the Committee on Agriculture
agriculture.house.gov
HEARING TO REVIEW LEGISLATION AMENDING THE COMMODITY EXCHANGE ACT
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COMMITTEE ON AGRICULTURE
COLLIN C. PETERSON, Minnesota, Chairman
TIM HOLDEN, Pennsylvania, BOB GOODLATTE, Virginia, Ranking
Vice Chairman Minority Member
MIKE McINTYRE, North Carolina TERRY EVERETT, Alabama
BOB ETHERIDGE, North Carolina FRANK D. LUCAS, Oklahoma
LEONARD L. BOSWELL, Iowa JERRY MORAN, Kansas
JOE BACA, California ROBIN HAYES, North Carolina
DENNIS A. CARDOZA, California TIMOTHY V. JOHNSON, Illinois
DAVID SCOTT, Georgia SAM GRAVES, Missouri
JIM MARSHALL, Georgia MIKE ROGERS, Alabama
STEPHANIE HERSETH SANDLIN, South STEVE KING, Iowa
Dakota MARILYN N. MUSGRAVE, Colorado
HENRY CUELLAR, Texas RANDY NEUGEBAUER, Texas
JIM COSTA, California CHARLES W. BOUSTANY, Jr.,
JOHN T. SALAZAR, Colorado Louisiana
BRAD ELLSWORTH, Indiana JOHN R. ``RANDY'' KUHL, Jr., New
NANCY E. BOYDA, Kansas York
ZACHARY T. SPACE, Ohio VIRGINIA FOXX, North Carolina
TIMOTHY J. WALZ, Minnesota K. MICHAEL CONAWAY, Texas
KIRSTEN E. GILLIBRAND, New York JEFF FORTENBERRY, Nebraska
STEVE KAGEN, Wisconsin JEAN SCHMIDT, Ohio
EARL POMEROY, North Dakota ADRIAN SMITH, Nebraska
LINCOLN DAVIS, Tennessee TIM WALBERG, Michigan
JOHN BARROW, Georgia BOB LATTA, Ohio
NICK LAMPSON, Texas
JOE DONNELLY, Indiana
TIM MAHONEY, Florida
TRAVIS W. CHILDERS, Mississippi
______
Professional Staff
Robert L. Larew, Chief of Staff
Andrew W. Baker, Chief Counsel
April Slayton, Communications Director
William E. O'Conner, Jr., Minority Staff Director
(ii)
C O N T E N T S
----------
Page
Wednesday, July 9, 2008
Baca, Hon. Joe, a Representative in Congress From California,
prepared statement............................................. 5
Childers, Hon. Travis W., a Representative in Congress From
Mississippi, prepared statement................................ 6
Goodlatte, Hon. Bob, a Representative in Congress From Virginia,
opening statement.............................................. 4
Peterson, Hon. Collin C., a Representative in Congress From
Minnesota, opening statement................................... 1
Prepared statement........................................... 3
Smith, Hon. Adrian, a Representative in Congress From Nebraska,
prepared statement............................................. 6
Witnesses
Matheson, Hon. Jim, a Representative in Congress From Utah....... 7
Prepared statement........................................... 9
Van Hollen, Hon. Chris, a Representative in Congress From
Maryland....................................................... 11
Prepared statement........................................... 13
DeLauro, Hon. Rosa L., a Representative in Congress From
Connecticut.................................................... 15
Prepared statement........................................... 17
Stupak, Hon. Bart, a Representative in Congress From Michigan.... 18
Prepared statement........................................... 22
Larson, Hon. John B., a Representative in Congress From
Connecticut.................................................... 27
Prepared statement........................................... 29
Welch, Hon. Peter, a Representative in Congress From Vermont..... 33
Prepared statement........................................... 34
Submitted Material
American Soybean Association, submitted statement................ 59
CoBank, submitted statement...................................... 61
Hill, Hon. Baron P., a Representative in Congress From Indiana,
submitted statement............................................ 57
Stupak, Hon. Bart, a Representative in Congress From Michigan,
submitted statement............................................ 58
USA Rice Federation and U.S. Rice Producers Association,
submitted statement............................................ 68
Woods, Eastland, President and CEO, Staplcotn; Member, Board of
Directors, Amcot, submitted statement.......................... 64
Thursday, July 10, 2008
Goodlatte, Hon. Bob, a Representative in Congress From Virginia,
opening statement.............................................. 72
Graves, Hon. Sam, a Representative in Congress From Missouri,
prepared statement............................................. 73
Peterson, Hon. Collin C., a Representative in Congress From
Minnesota, opening statement................................... 71
Prepared statement........................................... 72
Witnesses
Zerzan, Greg, Counsel and Head of Global Public Policy,
International Swaps and Derivatives Association, Washington,
D.C............................................................ 74
Prepared statement........................................... 75
Vice, Charles A., President and COO, IntercontinentalExchange,
Inc., Atlanta, GA.............................................. 81
Prepared statement........................................... 83
Comstock, Michael, Acting Director, City of Mesa, Arizona Gas
System; Vice Chairman, Board of Directors, American Public Gas
Association, Mesa, AZ.......................................... 87
Prepared statement........................................... 89
Greenberger, J.D., Michael, Professor, University of Maryland
School of Law, Baltimore, MD................................... 98
Prepared statement........................................... 100
Pirrong, Ph.D., Craig, Professor of Finance and Director, Global
Energy Management Institute, Bauer College of Business,
University of Houston, Houston, TX............................. 118
Prepared statement........................................... 120
Diamonte, Robin L., Chairman, Subcommittee on Defined Benefits,
Committee on the Investment of Employee Benefit Assets; Chief
Investment Officer, United Technologies Corporation, Hartford,
CT............................................................. 158
Prepared statement........................................... 159
Irwin, Ph.D., Scott H., Professor and Laurence J. Norton Chair of
Agricultural Marketing, Department of Agricultural and Consumer
Economics, University of Illinois at Urbana--Champaign, Urbana,
IL............................................................. 161
Prepared statement........................................... 163
Cicio, Paul N., President, Industrial Energy Consumers of
America, Washington, D.C....................................... 169
Prepared statement........................................... 170
Bond, Richard L., President and CEO, Tyson Foods, Inc.,
Springdale, AR, submitted statement........................ 175
Korzenik, Jeffrey D., Chief Investment Officer, VC&C Capital
Advisers, LLC, Vitale, Caturano & Company, Ltd., Boston, MA.... 179
Prepared statement........................................... 181
Newsome, Ph.D., James E., President and CEO, New York Mercantile
Exchange, Inc., New York, NY; accompanied by Thomas LaSala,
Chief Regulatory Officer, NYMEX................................ 199
Prepared statement........................................... 20
Cochran, Christine M., Vice President, Government Relations,
Commodity Markets Council, Washington, D.C..................... 208
Prepared statement........................................... 210
Nicosia, Joseph T., President, American Cotton Shippers
Association; CEO, Allenberg Cotton Co., Cordova, TN............ 214
Prepared statement........................................... 216
White, C.F.A., Adam K., Director of Research, White Knight
Research & Trading, Alpharetta, GA............................. 218
Prepared statement........................................... 220
Submitted Material
Cicio, Paul N., President, Industrial Energy Consumers of
America, Washington, D.C., supplemental material............... 262
Prestage, William H., President and CEO, Prestage Farms, Clinton,
NC, submitted letter........................................... 261
Mortenson, Roger F., President and CEO, House-Autry Mills, Inc.,
Four Oaks, NC, submitted letter................................ 262
National Cotton Council, submitted statement..................... 267
United Egg Producers, submitted statement........................ 268
Vice, Charles A., Vice President and COO,
IntercontinentalExchange, Inc., Atlanta, GA, supplemental
material....................................................... 251
Friday, July 11, 2008
Peterson, Hon. Collin C., a Representative in Congress From
Minnesota, opening statement................................... 271
Prepared statement........................................... 272
Witnesses
Young, J.D., Mark D., Partner, Kirkland & Ellis LLP, Washington,
D.C.; on behalf of Futures Industry Association................ 272
Prepared statement........................................... 274
Peniket, David J., President and COO, ICE Futures Europe, London,
United Kingdom................................................. 282
Prepared statement........................................... 283
Ramm, Gerry, Senior Executive, Inland Oil Company, Ephrata, WA;
on behalf of Petroleum Marketers Association of America; New
England Fuel Institute......................................... 289
Prepared statement........................................... 290
Greenberger, J.D., Michael, Professor, University of Maryland
School of Law, Baltimore, MD................................... 294
Prepared statement........................................... 100
Duffy, Terrence A., Executive Chairman, CME Group Inc., Chicago,
IL............................................................. 310
Prepared statement........................................... 312
Keith, Kendell, President, National Grain and Feed Association,
Washington, D.C................................................ 331
Prepared statement........................................... 332
Johnston, John L., Independent Trader, IB and Precious Metals and
Energy Consultant, Morristown, NJ.............................. 336
Prepared statement........................................... 337
Lynch, Timothy P., Senior Vice President, American Trucking
Association, Arlington, VA..................................... 356
Prepared statement........................................... 358
Roth, Daniel J., President and CEO, National Futures Association,
Chicago, IL.................................................... 368
Prepared statement........................................... 369
Slocum, Tyson, Director, Energy Program, Public Citizen,
Washington, D.C................................................ 372
Prepared statement........................................... 373
Prater, Capt. John, President, Air Line Pilots Association,
International, Washington, D.C................................. 380
Prepared statement........................................... 382
HEARING TO REVIEW LEGISLATION AMENDING THE COMMODITY EXCHANGE ACT
----------
WEDNESDAY, JULY 9, 2008
House of Representatives,
Committee on Agriculture,
Washington, D.C.
The Committee met, pursuant to call, at 2:39 p.m., in Room
1300 of the Longworth House Office Building, Hon. Collin C.
Peterson [Chairman of the Committee] presiding.
Members present: Representatives Peterson, Holden,
McIntyre, Etheridge, Baca, Cardoza, Marshall, Herseth Sandlin,
Cuellar, Costa, Salazar, Ellsworth, Boyda, Space, Kagen,
Pomeroy, Barrow, Donnelly, Childers, Goodlatte, Lucas, Moran,
Hayes, King, Neugebauer, Boustany, Conaway, Fortenberry,
Schmidt, Smith, and Latta.
Staff present: Adam Durand, Alejandra Gonzalez-Arias, Scott
Kuschmider, Clark Ogilvie, John Riley, Kristin Sosanie, Bryan
Dierlam, Alise Kowalski, Kevin Kramp, and Jamie Weyer.
OPENING STATEMENT OF HON. COLLIN C. PETERSON, A REPRESENTATIVE
IN CONGRESS FROM MINNESOTA
The Chairman. The Committee will come to order. First of
all I want to welcome everybody to today's hearing. It is the
first of three scheduled hearings that this Committee is going
to hold this week on legislation that would amend the Commodity
Exchange Act, and I want to make a couple of announcements.
First of all, we are going to meet on Friday even though
whether we are in session or not, and I don't know if that
decision has been made, but even if we are not in session, we
will meet. We need to get this work done, and initially we had
talked about 10 o'clock, but my intention is to move that
meeting to 9 o'clock on Friday morning. So we will see how long
it takes, so maybe we might be out of here by noon or
something. So that is kind of the schedule. Tomorrow we will
meet at 10 o'clock.
I want to begin by welcoming our six Members that are with
us here today. We appreciate them being with us to discuss
their legislative proposals that they have introduced that
would affect the regulation of futures and the options markets.
And they have agreed to be with us and not only present their
bills but also to remain--to enter into a dialogue and question
and answer session regarding their bills, as part of the
process, to try to educate everybody about where everybody is
coming from. So we appreciate that.
There is some discussion that there might be votes about 3
o'clock. I don't know if that is true or not, but we will have
to work around that as best we can.
So as I said, tomorrow we are going to, well, one other
thing I should say. We are going to do things a little bit
different today. We are going to give the Members that are here
5 minutes to explain their proposals, but when we get to
question and answers, we are not going to operate under a 5
minute rule like we have other times. What we are going to try
to do is go around and recognize Members that will open lines
of questioning in specific areas, and then we are going to kind
of stay on that area to answer the questions, to try to keep
this more focused on the different specific areas. Because
people get confused about all the different areas. I still get
confused about it, so we are going to kind of try to keep that
focus. Bob and I have talked about this. We are not sure if it
will work, but we are going to try it. If it gets out of
control, we will probably have to go back to the 5 minute rule,
try to get it back under control again. So we will see how that
works.
Tomorrow we are going to have a wide variety of stakeholder
groups, including exchanges, traders, hedgers, commodity
producers, buyers, academic researchers, and more, and we are
going to examine these bills that have been placed before us
from all sides, and we are going to get all points of view.
While many factors are putting pressure on the price of
oil, a growing number of people are coming to the conclusion
that a flood of speculative money into energy futures is behind
the crude oil record high prices. Two weeks ago over 400
Members of the House voted for legislation requiring that the
CFTC utilize all of its authority to curb oil market
speculation if it exists.
As oil continues to climb, several bills have been
introduced that would affect the regulation of the futures
market that trade crude oil and other energy contracts.
Speculation has been the boogey man for commodity markets since
their inception. Whenever someone did not like the way the
commodity prices were going, whether it was up or down, they
would raise the specter of the dreaded speculator.
Personally, I have yet to see very much hard data proving
that increased speculation is responsible for the record
increase in commodity prices that we have seen and have been
experiencing. However, I am willing to examine this and be
convinced.
Given that charges against speculators have historically
been more wrong than right, it is important that we have the
facts, the data, the analysis that demonstrate the validity of
this contention before we take action.
Any legislative remedy that seeks to remove speculative
interests from futures markets could result in more volatile
markets, as the role of speculators has always been a vital
price discovery and liquidity option. But as CFTC Commissioner
Bart Chilton recently said, ``There are dollars that did not
exist in these markets a few years ago,'' entering the markets.
And the CFTC has testified on multiple occasions that their
information on those trading in crude oil futures is
incomplete. That is why it is important for this Committee to
be thorough in examining these proposals in order to make the
best-informed decisions possible.
Some changes being proposed for energy future contracts may
be good for those contracts but may have a negative effect on
other sectors, including agriculture, and that is one of the
big concerns of this Committee.
Increasing margin requirements, for example, would be very
problematic, as volatility in the futures prices of the grains
that form the backbone of our food supply system has already
made it tough for elevators in farm country to meet the margin
calls. And we have had numerous calls from people around the
country regarding that.
We have seen and heard examples on this Committee of
elevators having to double or triple their credit lines just to
be able to afford the forward-pricing contracts to farmers. And
such instability can have serious effects on the prices that we
pay in the supermarket.
I just left a meeting with some of my farmers where they
were imparting me, and this isn't the first group, that they
were unable to secure forward pricing for their crops because
of the existing margin situation. And so if we make it worse,
it is going to be an even bigger problem.
The House Agriculture Committee has a proud tradition of
bipartisan support. These hearings have not been scheduled so
that we can gain answers and seek solutions and not engage in
the same old partisan gas-price politics that we have seen
sometimes in the past.
As the Committee with jurisdiction over futures and option
markets, we will be thoughtful and deliberate in examining all
of these legislative proposals in order to develop a
bipartisan, consensus bill that we can move to the House floor
before the August recess. Since we are already in the second
week of July, this means that time is short, and the Committee
has a lot of work to do.
With that said, I again welcome our colleagues on today's
panel, and I would now yield to my friend and Ranking Member of
the Committee, Mr. Goodlatte, for an opening statement.
[The prepared statement of Mr. Peterson follows:]
Prepared Statement of Hon. Collin C. Peterson, a Representative in
Congress From Minnesota
I want to welcome everyone to today's hearing.
Today is the first of three scheduled hearings this Committee will
hold this week on legislation that would amend the Commodity Exchange
Act.
I want to begin by welcoming six of our House colleagues to today's
panel who are here to discuss legislative proposals they have
introduced that would affect the regulation of futures and options
markets.
Tomorrow, we will discuss these and other legislative proposals
with a wide variety of stakeholder groups, including exchanges,
traders, hedgers, commodity producers and buyers, academic researchers,
and more. We will examine these bills from all sides, and will get all
points of view.
While many factors are putting pressure on the price of oil, a
growing number of people are coming to the conclusion that a flood of
speculative money into energy futures is behind crude oil's record high
prices. Two weeks ago, over 400 Members of the House voted for
legislation requiring the Commodity Futures Trading Commission to
utilize all its authority to curb oil market speculation.
As oil continues to climb, several bills have been introduced that
would affect the regulation of the futures markets that trade crude oil
and other energy contracts.
Speculation has been the boogey man for commodity markets since
their inception. Whenever someone did not like the way commodity prices
were going, whether it was up or down, they would raise the specter of
the dreaded speculator. Personally, I have yet to see any hard data
proving that increased speculation is responsible for the record
increases in commodity prices we have been experiencing. Given that
charges against speculators have historically been more wrong than
right, it is important that we have the facts, data, and analysis that
demonstrate the validity of this contention before we take action.
Any legislative remedy that seeks to remove speculative interests
from futures markets could result in more volatile markets, as the role
of speculators has always been vital for price discovery and liquidity.
But as CFTC Commissioner Bart Chilton recently said, ``there are
dollars that did not exist in these markets a few years ago.'' And CFTC
has testified on multiple occasions that their information on those
trading in crude oil futures is incomplete. That is why it is important
for this Committee to be thorough in examining these proposals in order
to make the best-informed decisions possible.
Some changes being proposed for energy futures contracts may be
good for those contracts but may have a negative effect for other
sectors, including agriculture.
Increasing margin requirements, for example, would be very
problematic, as volatility in the futures prices of the grains that
form the backbone of our food supply has already made it tough for
elevators in farm country to meet margin calls. We have seen and heard
examples on this Committee of elevators having to double and triple
their credit lines just to be able to offer forward-pricing contracts
to farmers. Such instability can have serious effects on the prices we
pay at the supermarket.
The House Agriculture Committee has a proud tradition of bipartisan
cooperation. These hearings have not been scheduled so that we can gain
answers and seek solutions and not engage in the same old partisan gas-
price politics.
As the Committee with jurisdiction over futures and options
markets, we will be thoughtful and deliberate in examining all of these
legislative proposals in order to develop a bipartisan, consensus bill
that can move to the House floor before the August recess. Since we are
already into the second week of July, that means time is short and this
Committee has a lot of work to do.
With that said, I welcome our colleagues on today's panel and I now
yield to my friend and Ranking Member of the Committee, Mr. Goodlatte
for an opening statement.
OPENING STATEMENT OF HON. BOB GOODLATTE, A REPRESENTATIVE IN
CONGRESS FROM VIRGINIA
Mr. Goodlatte. Well, thank you, Mr. Chairman, and thank you
for calling today's hearing, a continuation of a series of
hearings to review the role of the CFTC in the futures market.
I welcome all of my colleagues who will be testifying here
today.
I think that everyone here today would agree that America
is in the midst of an energy crisis, and Americans everywhere
are feeling the effects of high energy prices. It is important
to look at all of the factors that would contribute to high
energy prices, including supply and demand, global market
conditions, weather, and production conditions as we try to
develop a feasible solution to this problem.
However, one thing is clear. We need to increase domestic
energy production in this country. We need to be more self-
reliant, and we can't do that if we continue to rely on foreign
energy sources. We must diversify our energy supplies by
accessing our domestic sources of oil in Alaska, the Rockies,
and offshore, continuing the development of alternative fuels,
clean coal technologies, and encouraging the production of more
nuclear sites which provide CO2 emission-free
energy.
While this Committee will look at all of the possible
contributing factors under its jurisdiction that might be
influencing higher energy prices, we have no reason to believe
that there has been any nefarious activity in the futures
market or on the part of speculators.
Furthermore, as we heard from the CFTC's acting Director,
Walt Lukken, 2 weeks ago. The Congress has provided the CFTC
with all of the tools and regulatory authority it needs to
operate. Of particular interest and as noted by the Speaker of
the House, the recently-enacted farm bill reauthorization
closed the so-called Enron Loophole. In fact, the CFTC
announced recently--recently unveiled several initiatives
utilizing their existing authority that will allow them to
gather data from areas of the market that we previously had
very little information about. These new efforts will bring
greater transparency to the markets which benefit everyone.
Americans are tired of paying big bucks for the energy they
need to make it through the day, and frankly, I don't blame
them. It can be easy to point fingers, but this is a complex
and dynamic problem, and I urge caution in blaming only
speculators. Speculators add liquidity to the markets and play
a critical role in the market system that benefits traditional
users of the market. Imposing artificial limits on speculation
could cause speculators to dump their positions and create
unintended consequences that would be devastating to everyone.
We will hear from a diverse array of witnesses this week,
and I appreciate them lending us their expertise. I am
concerned, however, that these hearings won't do anything to
address high energy prices, and that American consumers will
continue to feel the impact of high prices at the pumps, in
heating and cooling their homes, and higher costs to feed their
families. We are living the consequences of Congressional
inaction in creating productive and sustainable domestic energy
policy, and it is imperative that the Congress acts now instead
of punting this problem further down the road.
Thank you, Mr. Chairman. I look forward to the testimony of
our witnesses.
The Chairman. Thank you, Bob, and I want to recognize Bob
Etheridge as well. Bob is Chairman of the Subcommittee that has
jurisdiction in this area, and he and the Ranking Member, Mr.
Moran, have done yeoman's work in this regard and provided
tremendous leadership along with all the Members of that
Subcommittee. So I want to recognize them for the great work
that they have done with the number of hearings that they have
held over the last little while, and Mr. Etheridge has a bill
as well.
I would ask that all other Members submit their statements
for the record.
[The prepared statements of Messers. Baca, Smith and
Childers follow:]
Prepared Statement of Hon. Joe Baca, a Representative in Congress From
California
Chairman Peterson and Ranking Member Goodlatte:
I am pleased to be here today to hear from different Members of
Congress, their various proposals for limiting speculation and
manipulation in the commodity futures market.
I thank the Chairman and Ranking Member for convening this hearing.
I also want to thank our witnesses for taking time from their busy
schedule to be here today--and for their proactive involvement in
working to find solutions to high gas prices.
In my home State of California--the average for a gallon of
gasoline is now over $4.57. I repeat--the average price for a gallon of
gasoline is $4.57!
With gas prices at this level, too many of our families have been
forced to sacrifice. Simple actions like driving the kids to school, or
making the extra trip to the market--all have become financial burdens
for too many Americans.
It is important that we take a close examination of the commodity
futures market--and especially the buying and trading of crude oil.
Mr. Chairman, I think everyone in this room realizes the urgent
need for real relief at the pump. American consumers are tired of
paying high gas prices!
While we will examine the merits of each initiative on their own,
it is critical we continue to work together.
We must create a long-term energy plan that is both
environmentally-friendly and domestically based; and also look at bold,
short range solutions in order to help the American people who are
suffering at the pump--like selling off a portion of our nation's
Strategic Petroleum Reserve.
I look forward to hearing from our witnesses today and thank the
Chairman and Ranking Member again for their leadership.
Thank you.
______
Prepared Statement of Hon. Adrian Smith, a Representative in Congress
From Nebraska
Good afternoon and thank you, Mr. Chairman.
The Third District of Nebraska, which I have the privilege to
represent, is a primarily rural district. High gas prices
disproportionately affect those in rural areas. My constituents drive
long distances to town or between towns as part of their day-to-day
routine. Agriculture is one of the primary industries in my district.
Increasing input costs for crop production and escalating feed costs
for livestock have many producers worried. In short, the increasing
costs of food, feed, and energy have greatly impacted my constituents.
Historically, futures markets have played a key role in risk
management for producers and consumers of a product, and for price
discovery by the market. Speculators play an important role in the
market by accepting the risk that producers and consumers hedge. The
Commodity Futures Trading Commission has been granted the authority and
given the charge by this body to oversee and regulate these markets to
ensure transparency and prevent manipulation.
As we examine the recent, and sometimes rapid, increases in
commodity prices, we must be careful not to hastily assign blame to a
convenient scapegoat. Certainly, we do not want the marketplace to be
manipulated by speculators, but we must take care it is not manipulated
by government regulation either. I hope these hearings over the next
few days will allow us to objectively examine the evidence and that we
will thoughtfully consider legislation which will ensure the markets
remain transparent and open while letting the markets work as they were
intended. Ultimately, the government should allow market signals to
work to increase supplies without over-regulation.
I appreciate the Committee holding these timely hearings. Mr.
Chairman, I look forward to continuing to work with you, and I thank
you for your time.
______
Prepared Statement of Hon. Travis W. Childers, a Representative in
Congress From Mississippi
I am here today to better understand the cause of the exorbitant
energy costs that Americans are now facing. I want to thank Chairman
Peterson and the other Members of this Committee for holding this
essential hearing.
When I was elected, the price of gasoline was $3.61 per gallon.
Barely, a month later the price of gasoline per gallon has jumped to
over $4.00. Recently, I met with sweet potato farmers from my district
who are facing increased production costs as the prices of diesel fuel,
fertilizer, and gasoline all rise.
These price spikes have placed a tremendous economic pressure on an
industry that is vital to my district and is threatening the livelihood
of many of the Mississippi working families I represent.
We need a multi-pronged strategy to find our way out of this energy
crisis. We need to reduce our dependence on foreign oil and we must
invest in homegrown, alternative energy sources. Finally, we must
investigate our energy commodities markets and ensure there is a level
playing field when it comes to oil trading.
I look forward to hearing the testimony of my distinguished
colleagues and I believe the testimony over the next 2 days will help
us to separate the facts from the rhetoric in regards to energy prices
within the Commodities markets.
It is my hope that this hearing will provide us with the
information we need to provide bipartisan solutions to help stabilize
the price of oil as quickly as possible.
The Chairman. We now will welcome the Members that have
legislation introduced. I just asked my staff how this order
was determined, and this is apparently kind of like the futures
market. We are not exactly sure, but we hope that you are all
okay with it.
And so first on the list here is the Honorable Jim Matheson
from the Second Congressional District of Utah. We have many
outstanding Members here from our leadership, Mr. Van Hollen,
Mr. Larson, Ms. DeLauro, who worked with us so hard on the farm
bill and has been a good ally of this Committee, her job as
Appropriations Subcommittee Chairman, Mr. Stupak, who does
great work for us in the Energy and Commerce Committee, and Mr.
Welch, who has gotten to be a good friend of mine from Vermont,
who has been a liaison with the freshman class for us, and we
welcome you all here today.
So, Mr. Matheson, we are going to give you 5 minutes each
to summarize your statements. The full statements will be made
part of the record. Welcome to the Committee, and we look
forward to the process.
STATEMENT OF HON. JIM MATHESON, A REPRESENTATIVE IN CONGRESS
FROM UTAH
Mr. Matheson. Well, Chairman Peterson and Ranking Member
Goodlatte, I really appreciate the opportunity to testify
today, and I am glad you are holding this series of hearing.
It was just 2 weeks ago the House passed the Energy Markets
Emergency Act of 2008, almost unanimously, and that called for
the CFTC to exercise emergency powers to ``curb the role of
excessive speculation in any contract market.'' I supported
this bill, and I was pleased to work with you, Mr. Chairman, on
that bill.
Now, while that bill prompted the Administration's
performance oversight duties, many in Congress still believe
there is room to address the role of speculation in oil prices.
While some had advocated for doing nothing and others
believe that we should simply bar index investors and others
from the energy commodity markets altogether, I believe what we
really need is a level playing field that is transparent and
accountable.
Our goal as a Congress should be to make sure that the
regulator, the CFTC, has the ability to ensure undue
manipulation isn't taking place in the markets.
This Committee has a very difficult problem to consider
with no easy solutions. The energy commodity markets are
complex. Simply laying blame on traders ignores the aggregate
problems we are seeing in terms of speculation in these
markets.
I used to work in the energy business before I came to
Congress. I managed a co-op of natural gas users. I was
involved in arranging supply and transportation, and I also
implemented hedging strategies using futures contracts for the
members of that co-op. From my experience, I know that there is
value in the presence of a viable, transparent futures market.
These markets allow for greater efficiency in our economy and
provide critical outlets for hedging against price risks.
Futures markets work because they allow stakeholders to
assess risks, to hedge and protect against losses, and to
secure gains through speculation. There is a legitimate role
for speculation, particularly in the futures market, this just
isn't well understood. That is because the futures markets work
best when liquidity exists to stabilize prices.
By which I mean that if I am an airline CEO or a petroleum
refiner, and I am looking to protect my business against future
price increases or decreases, I want to have the option to
hedge that risk. I want to be able to lock in a price today so
that I have some kind of insurance and certainly against the
future when higher or lower prices might affect my business.
However, in order for a business owner to hedge his
exposure to movement in oil prices, there must be someone in
the marketplace who is willing to assume that risk. The entity
that takes the risk is betting that the price will either rise
or fall and that they will make money. They are speculating.
For every contract, this may sound basic, but we all ought to
remember this. For every contract, there is both a buyer and a
seller. You can't have one without the other.
The problem before us today is not black and white. It
exists in many shades of gray, and that is why we need to be
looking for solutions that force all the players to play by the
same rules. That doesn't happen today.
That is because current law allows people to trade on
foreign exchanges under something called the foreign boards of
trade provision under the Commodity Exchange Act.
Current law allows the CFTC to determine if a foreign board
of trade, such as ICE Futures based in London, is already
regulated in its country of residence. If it is, current law
says that the CFTC doesn't need to regulate it here in the U.S.
That might work in theory, if every country had the same
financial rules. The United Kingdom does have a regulatory
system, and it does oversee ICE Futures, which is a good start.
The problem is that the CFTC hasn't been getting all the
data about trades occurring on the ICE exchange. The other
problem is that ICE Futures does not have the same position
limits on trades as domestic exchanges do, potentially leading
to massive price-affecting holdings that would go undetected by
U.S. regulators.
So if I were a trader and I wanted to buy more energy
commodities than NYMEX would allow, because it has limits, I
could go over to ICE Futures via its electronic exchange in
Atlanta, and buy as many futures as I wanted.
That doesn't make sense. Everyone who wants to trade in the
U.S. energy futures, especially in West Texas crude or natural
gas, should be subject to the same rules.
Now, there is good news to report on this. On June 17 the
CFTC announced a new agreement with ICE Futures Europe to
require ICE Futures to adopt ``equivalent U.S. position limits
and accountability levels,'' on West Texas crude. CFTC has also
reached an agreement with the Financial Services Authority, the
U.K. regulatory counterpart, by which it will receive data on
large positions. This data will be incorporated into the CFTC's
weekly Commitments of Traders reports.
Just this past Monday, the CFTC also amended its No Action
letter to the Dubai Mercantile Exchange in almost exactly the
same way. This is very encouraging, and I think we are on the
right track.
Now, Congress needs to ensure that these positive
developments are enshrined in statute to ensure that the CFTC's
new policy is consistently applied going forward.
While the idea of creating appropriate regulation to stop
excessive market manipulation is appealing, I do want to say we
should approach this issue with caution. If legislation goes
too far, it could drive a significant amount of business that
is taking place today in the U.S., offshore.
That is why I would caution against overreaching and why I
think that we need to look at reasonable solutions. Congressman
Charlie Melancon and I have introduced a bill which we think
helps address this problem, H.R. 6284, the Close the London
Loophole Act of 2008.
This bill requires foreign boards of trade to comply with
all U.S. registration and regulatory requirements if they offer
contracts that can be settled by physical delivery within the
United States. It provides the CFTC with full enforcement
authority over traders within the U.S. who trade on an exchange
outside the U.S.
It also requires the CFTC to set up agreements with foreign
exchanges with respect to comparable speculative limits and
reporting requirements for any exchange that is trading U.S.
energy commodities before the exchange is allowed to establish
direct trading terminals in the U.S.
Our bill would effectively codify the CFTC's recent actions
to require such reporting and limits with ICE Futures, and it
would apply this effort to future agreements. This is important
because the CFTC agreement with ICE Futures does not apply to
other markets. The CFTC has issued No Action letters granting
regulatory waivers to other foreign markets, so it is important
we address this issue to make it more comprehensive in nature.
Unfortunately, Congressman Melancon could not be here today
to testify as well, and I offer this testimony on the part of
both of us. I would like to say that our bill has companion
legislation in the U.S. Senate, authored by Senator Levin of
Michigan.
Mr. Chairman, I appreciate the opportunity to testify and
look forward to answering your questions.
[The prepared statement of Mr. Matheson follows:]
Prepared Statement of Hon. Jim Matheson, a Representative in Congress
From Utah
Thank you, Chairman Peterson and Ranking Member Goodlatte for
inviting me to testify before the Agriculture Committee today. I also
thank you for holding a series of hearings on the issue of energy
market manipulation.
Just a couple weeks ago, the House passed the Energy Markets
Emergency Act of 2008, almost unanimously. It called on the CFTC to
exercise emergency powers to ``curb the role of excessive speculation
in any contract market.'' I supported this bill and I was pleased to
work with you, Mr. Chairman on this bill.
While the Energy Markets Emergency Act of 2008 effectively prompts
the administration to perform its oversight duties, many in Congress
still believe there is room to address the role of speculation in oil
prices.
While some have advocated for doing nothing and others believe that
we should simply bar index investors and others from the energy
commodity markets altogether, I believe what we really need is a level
playing field that is transparent and accountable.
Our goal should be to make sure that the regulator--the CFTC--has
the ability to ensure undue manipulation isn't taking place in the
markets.
This Committee has a very difficult problem to consider, with no
easy solutions. The energy commodity markets are complex. Simply laying
blame on traders ignores the aggregate problems we're seeing, in terms
of speculation in these markets.
I used to work in the energy business. I managed a co-op of natural
gas users. I was involved in arranging supply, transportation, and
implementing hedging strategies for members of the co-op. From my
experience, I know that there is value in the presence of a viable,
transparent futures market. These markets allow for greater efficiency
in our economy, and provide critical outlets for hedging against price
risks.
Futures markets work because they allow investors to assess risk,
to hedge and protect against losses, and to secure gains through
speculation. There is a legitimate role for speculation, particularly
in the futures market, that just isn't well understood. That's because
the futures markets works best when liquidity exists to stabilize
prices.
By which I mean that if I am an airline CEO or a petroleum refiner,
and I'm looking to protect my business against future price increases
or decreases, I want to have the option to hedge. I want to be able to
lock in today's price so that I have some kind of insurance against the
future when a higher or lower price might damage my business.
However, in order for a business owner to hedge his/her exposure to
high oil prices, there must be someone in the marketplace who is
willing to assume my risk. The entity that takes that risk is betting
that the price will either rise or fall and that they will make money.
They are speculating. For every contract, there is both a buyer and a
seller. You cannot have one without the other.
The problem before us today is not black and white. It exists in
shades of grey. That's why we need to be looking for solutions that
force all the players to play by the same rules. That does not happen
today.
That's because the current law allows people to trade on foreign
exchanges, under something called the foreign boards of trade provision
under the Commodity Exchange Act.
Current law allows the CFTC to determine if a Foreign Board of
Trade--such as ICE Futures, based in London--is already regulated in
its country of residence. If it is, current law says that the CFTC
doesn't need to regulate it here in the U.S.
That might work in theory, if every nation had the same financial
rules. The U.K. does have a regulatory system and it does oversee ICE
Futures, which is a good start.
However, the problem is that the CFTC hasn't been getting all the
data about trades occurring on the ICE exchange. The other problem is
that ICE Futures does not have the same position limits on trades as
domestic exchanges do, potentially leading to massive, price-affecting
holdings that would go undetected by U.S. regulators.
So if I were a trader and I wanted to buy more energy commodities
than NYMEX would allow, because it has limits, I could go over to ICE
Futures, via its electronic exchange in Atlanta and buy as many futures
as I wanted.
This doesn't make sense. Everyone who wants to trade in U.S. energy
futures, especially in West Texas crude oil or natural gas, should be
subject to the same rules.
Now, there is good news to report too. On June 17th, the CFTC
announced a new agreement with ICE Futures Europe to require ICE
Futures to adopt ``equivalent U.S. position limits and accountability
levels'' on West Texas crude oil. CFTC has also reached an agreement
with the Financial Services Authority, the UK regulatory counterpart,
by which it will receive data on large positions. This data will be
incorporated into the CFTC's weekly Commitments of Traders reports.
Just this past Monday, the CFTC also amended its No Action letter
to the Dubai Mercantile Exchange in almost exactly the same way. This
is very encouraging and I think we're on the right track. Now, Congress
needs to ensure that these positive developments are enshrined in
statute to ensure that the CFTC's new policy is consistently applied
going forward.
While the idea of creating appropriate regulation to stop excessive
market manipulation is appealing, we should approach this issue with
caution. If legislation goes too far, it could drive a significant
amount of business that is taking place in the U.S. today, offshore.
That is why I would caution against overreaching and why I think
that we need to look at reasonable solutions today. Congressman Charlie
Melancon and I have introduced a bill that we think addresses the
problem--H.R. 6284, the Close the London Loophole Act.
The Matheson-Melancon bill requires foreign boards of trades to
comply with all U.S. registration and regulatory requirements if they
offer contracts that can be settled by physical delivery within the
United States. It provides the CFTC with full enforcement authority
over traders within the U.S. who trade on an exchange outside the U.S.
It also requires the CFTC to set up agreements with foreign
exchanges with respect to comparable speculative limits (they exist on
NYMEX already) and reporting requirements for any exchange that is
trading U.S. energy commodities before the exchange is allowed to
establish direct trading terminals in the U.S.
Our bill would effectively codify the CFTC's recent action to
require such reporting and limits from ICE Futures and it would apply
this effort to future agreements. This is important because the CFTC
agreement with ICE Futures does not apply to other markets. The CFTC
has also issued No Action letters granting regulatory waivers to
foreign markets, including the Dubai Mercantile Exchange, so it is
important that we address this issue as soon as possible.
Unfortunately, Congressman Melancon could not be here today to
testify as well and I offer my testimony for both of us. I'd also like
to say that our bill has companion legislation in the Senate, authored
by Senator Levin of Michigan.
Thank you, Mr. Chairman.
The Chairman. Thank you very much, and next we will move to
Mr. Van Hollen from the Eighth District of Maryland, a Member
of our leadership, and welcome to the Committee. We look
forward to your testimony.
STATEMENT OF HON. CHRIS VAN HOLLEN, A REPRESENTATIVE IN
CONGRESS FROM MARYLAND
Mr. Van Hollen. Thank you, Mr. Chairman. I would like to
start by commending you, Chairman Peterson, and Ranking Member
Goodlatte, as well as Subcommittee Chairman Etheridge and Mr.
Moran, the Ranking Subcommittee Member, for your leadership and
the substantial amount of work this Committee has already done
looking into this issue and the legislation in connection with
the farm bill.
I would also like to recognize my colleagues here for their
work; Bart Stupak, who has had a longstanding interest in this
area and done a lot of work, Mr. Larson, Mr. Welch, Mr.
Matheson, and my colleague Rosa DeLauro, with whom I have
introduced legislation entitled, the Energy Markets Anti-
Manipulation and Integrity Restoration Act, which we will
discuss today.
And as you said, Mr. Chairman, at the outset, I hope that
under the leadership of this Committee we can find common
ground going forward in this area.
I do think at the outset it is important to remember why
futures markets exist in the first place, and I think the
easiest thing to do is take the definition of the CFTC, which
says, ``The futures markets serve the important function
providing a means for price discovery and offsetting price
risk.'' So long as the price discovered by the futures market
accurately reflects the forces of supply and demand, producers
and consumers of commodities can go to the futures market and
hedge with confidence in order to offset their price risk.
But when excessive speculation unhinged the futures markets
from supply and demand fundamentals, hedgers begin to lose
confidence in the price discovery function of futures markets,
and the distorted futures prices transmitted to the spot market
winds up overcharging consumers for the energy they rely on
every day, our constituents.
Let me say at the outset that I do not believe that
excessive speculation is the sole cause or even the major cause
of the recent surge in energy prices. Without question, other
factors, such as increasing worldwide demand in countries like
India and China, supply disruptions in Nigeria, and devaluation
of the dollar, have all played a role.
However, a growing chorus of Congressional testimony and
market commentary from a wide range of credible and
authoritative sources has concluded that the run-up in today's
price of oil cannot be explained by the forces of supply and
demand alone. They include the Senate Permanent Subcommittee on
Investigations; the IMF; the Japanese Ministry of Economy,
Trade and Industry; respected media outlets from The Washington
Post to Fortune magazine; and stakeholders including large
institutional investors, hedge fund managers, oil company
executives, financial analysts, economists, consumer advocates,
and academic experts. They increasingly point to a meaningful
speculation premium in today's price of oil. A May, 2008,
market report from the respected institutional financial
consulting firm, Greenwich Associates, summed it up this way,
``The entry of new financial or speculative investors into
global commodities markets is feeling the dramatic run-up in
prices.''
There are some, including the Oppenheimer Managing Director
and Senior Oil Analyst Fadel Gheit, who put the speculation
premium as high as 50 percent. I don't think anybody knows for
sure exactly how big this premium is. It is difficult to
quantify. I do think it is above zero, and so long as it is
above zero, so long as it is not based solely on the force of
supply and demand, I think we should act to wring out that
excessive speculation in the market.
The legislation that Ms. DeLauro and I have introduced
offers what we believe are three important steps Congress can
take to address these issues.
First, it would build upon the reform this Committee began
in the most recent farm bill. By adding energy commodities to
the definition of an exempt commodity under the Commodity
Exchange Act, effectively treating energy commodities the same
way this Committee has already decided to treat agriculture
commodities under current law. This Committee has jurisdiction
over those agriculture commodities. We are saying treat them
under the law, treat energy commodities the same way as you
have chosen to treat agricultural commodities.
Taking this step would close the door even more firmly on
the so-called Enron Loophole by requiring that energy futures
contracts trade on Designated Commercial Markets or Designated
Transaction Execution Facilities, unless the CFTC provides a
specific exemption as it currently can do for agricultural
commodities.
Second, to ensure that swaps are not used to circumvent the
regulation and CFTC oversight intended by adding energy
commodities to the CEA's definition of an exempt commodity, we
bring those swaps under the jurisdiction of the CFTC.
Finally, H.R. 6341 would close what has become known, as my
colleague, Mr. Matheson, referred to it as the, it is the
London-Dubai Loophole, by amending the Commodity Exchange Act
to forbid an exchange from being deemed an unregulated foreign
entity if its trading affiliate or trading infrastructure is in
the United States, and it offers a U.S. contract that
significantly affects price discovery.
In that regard, I believe that our constituents would
probably assume that a market like ICE, the
IntercontinentalExchange, operating inside the United States
and facilitating an estimated 30 percent of the trade in our
U.S. West Texas Intermediate futures contract would be fully
subject to CFTC oversight and U.S. law.
Like Members of this Committee, I have a long-term concern
about the escalating worldwide demand for energy and the impact
that it will have on the price of oil and fuels derived from
oil as we move forward. While this concern makes me and many an
ardent advocate for accelerating the development and deployment
of the next generation of energy alternatives, it also causes
me to conclude that we must make every effort to ensure that we
do not exacerbate the current challenge for our constituents by
layering on an additional speculation premium.
Moreover, in light of the dramatically increased
speculative inflows into the energy futures markets and the
unprecedented re-composition of these markets' hedger-
speculated participation ratios over the past 10 years that
coincide with a staggering 1,000 percent jump in the price of a
barrel of oil over the same period of time, I believe the
burden is on those who would argue for maintaining the status
quo to convincingly establish that excessive speculation is not
having an impact on today's energy prices.
Furthermore, those who would maintain current law must
demonstrate that the exceptions we have so far permitted to
persist under the Commodity Exchange Act do, in fact, support
rather than weaken the primary functions of price discovery and
offsetting price risk necessary for a healthy energy futures
marketplace.
I appreciate the opportunity to testify today and look
forward to working with you, Mr. Chairman, Ranking Member
Goodlatte, and other Members of the Committee as we move
forward.
Thank you.
[The prepared statement of Mr. Van Hollen follows:]
Prepared Statement of Hon. Chris Van Hollen, a Representative in
Congress From Maryland
Chairman Peterson, Ranking Member Goodlatte, and Members of the
Committee:
First of all, I'd like to commend Chairman Peterson, Ranking Member
Goodlatte, Subcommittee Chairman Etheridge and the rest of the
Committee for the substantial amount of work that has already been done
on this issue. I'd also like to recognize Rep. Bart Stupak (D-MI) for
his longstanding interest in this area, Rep. John Larson (D-CT) for his
diligent attention to this matter, Rep. Jim Matheson (D-UT) for the
personal perspective he brings to this discussion, and of course, Rep.
Rosa DeLauro (D-CT) with whom I have introduced the Energy Markets
Anti-Manipulation and Integrity Restoration Act (H.R. 6341) I will be
discussing today.
At the outset, I think it's useful to remember why futures markets
exist in the first place. According to the Commodity Futures Trading
Commission (CFTC), ``the futures markets . . . serve the important
function of providing a means for price discovery and offsetting price
risk.'' So long as the price discovered by the futures markets
accurately reflects the forces of supply and demand, producers and
consumers of commodities can go to the futures markets and hedge with
confidence in order to offset their price risk. But when excessive
speculation unhinges the futures markets from supply and demand
fundamentals, hedgers begin to lose confidence in the price discovery
function of futures markets, and the distorted futures price
transmitted to the spot market winds up overcharging consumers for the
energy they rely on every day.
Let me say at the outset that I do not believe excessive
speculation is the sole cause of the recent surge in energy prices.
Without question, other factors--such as increasing worldwide demand in
countries like India and China, supply disruptions in Nigeria, and the
devaluation of the dollar--have all played a role.
However, a growing chorus of congressional testimony and market
commentary from a wide range of credible and authoritative sources has
concluded that the run-up in today's price of oil cannot be explained
by the forces of supply and demand alone. Among those sources are the
Senate Permanent Subcommittee on Investigations, the International
Monetary Fund and the Japanese Ministry of Economy, Trade and Industry
(METI). Respected media outlets from The Washington Post to Fortune
magazine have voiced similar concerns. And stakeholders including large
institutional investors, hedge fund managers, oil company executives,
financial analysts, economists, consumer advocates and academic experts
increasingly point to a meaningful speculation premium in today's price
of oil. A May 2008 market report from the respected institutional
financial consulting firm Greenwich Associates summed it up this way:
``The entry of new financial or speculative investors into global
commodities markets is fueling the dramatic run-up in prices.''
Some experts--like Oppenheimer Managing Director and Senior Oil
Analyst Fadel Gheit--put today's speculation premium in the oil markets
in excess of 50%, arguing that true market fundamentals imply a price
of approximately $65 a barrel. Since it is difficult to quantify the
role of market speculation with mathematic precision, it is hard to
know the exact magnitude of today's speculation premium. But I do not
believe that it is zero. And that is why I believe we must act.
The Energy Markets Anti-Manipulation and Integrity Restoration Act
(H.R. 6341) that I have offered with my colleague Rosa DeLauro and
others proposes what we believe represents the three most important
steps Congress can take to eliminate the possibility of any outright
manipulation occurring in unregulated markets and to wring excessive
speculation out of today's energy marketplace.
First, H.R. 6341 would build upon the reform this Committee began
in the most recent farm bill by adding energy commodities to the
definition of an exempt commodity under the Commodity Exchange Act
(CEA), effectively treating energy commodities the same way we treat
agricultural commodities under current law. Taking this step would
close the door even more firmly on the so-called ``Enron Loophole'' by
requiring that energy futures contracts trade on Designated Commercial
Markets (DCMs) or Designated Transaction Execution Facilities (DTEFs),
unless the CFTC provides a specific exemption.
Second, to ensure that swaps are not used to circumvent the
regulation and CFTC oversight intended by adding energy commodities to
the CEA's definition of an exempt commodity, H.R. 6341 would also add
energy commodities to the definition of excluded swap transactions
under the Commodity Exchange Act.
Finally, H.R. 6341 would close what has come to be known as the
London-Dubai loophole by amending the Commodity Exchange Act to forbid
an exchange from being deemed an unregulated foreign entity if its
trading affiliate or trading infrastructure is in the United States,
and it offers a U.S. contract that significantly affects price
discovery.
In that regard, I think most of our constituents would probably
assume that a market like the Intercontinental Exchange (ICE Futures
Europe) operating inside the United States and facilitating an
estimated 30% of the trade in our U.S. West Texas Intermediate (WTI)
futures contracts would be fully subject to CFTC oversight and U.S.
law. But as all of us in this room understand, that is currently not
the case. When it comes to the integrity and transparency of energy
markets operating inside the United States, we simply cannot outsource
the responsibility for policing those markets to foreign governments or
regulatory authorities.
Like Members of this Committee, I have a long term concern about
the escalating worldwide demand for energy and the impact that it will
have on the price of oil and fuels derived from oil going forward.
While this concern makes me an ardent advocate for accelerating the
development and deployment of next generation energy alternatives, it
also causes me to conclude that we must make every effort to ensure
that we do not exacerbate the current challenge for our constituents by
layering an additional speculation premium on top of it. Moreover, in
light of the dramatically increased speculative inflows into the energy
futures markets, and the unprecedented re-composition of these markets'
hedger-speculator participation ratios over the past 10 years
coinciding with a staggering 1,000% jump in the price of a barrel of
oil, I believe the burden is on those who would argue for maintaining
the status quo to convincingly establish against the available evidence
that excessive speculation is not having an impact on today's energy
prices. Furthermore, proponents of maintaining current law must
definitively demonstrate that the exceptions we have thus far permitted
to persist in the Commodity Exchange Act do in fact support the primary
functions of price discovery and offsetting price risk necessary for a
healthy energy futures marketplace.
I appreciate the opportunity to testify today, and I stand ready to
work with Members of the Committee to fashion language that achieves
our common goals on this important public policy issue.
The Chairman. Thank you very much, Mr. Van Hollen. I
appreciate your testimony.
Now Chairwoman Rosa DeLauro, a good friend of this
Committee. We worked with her a lot on the different issues
that affect both of our Committees. We appreciate you being
with us from the Third District of Connecticut. Rosa.
STATEMENT OF HON. ROSA L. DeLAURO, A REPRESENTATIVE IN CONGRESS
FROM CONNECTICUT
Ms. DeLauro. Thank you very much, Mr. Chairman, and if it
is all right with you, maybe I can be ex officio on this
Committee. We have spent a lot of time together and a lot of
very productive time, and I am happy to join with you and
Ranking Member Goodlatte and Mr. Etheridge, Mr. Moran, and the
entire Committee. And I thank you for allowing me to submit
testimony today.
I also, as my colleagues have, want to recognize them, Mr.
Matheson, Mr. Van Hollen, who I have introduced legislation
with, Mr. Stupak, Mr. Larson, Mr. Welch, all who have a
consuming interest in this area and the issue of excessive
speculation and the energy futures market is critical and does
have an impact on our entire economy.
I want to say, Mr. Chairman, to be sure, and I understand
this, that I am not an economist, nor do I profess to study
this issue with an academic's eye. But I care about this
subject deeply because it affects my constituents and our
economy as a whole. We know that soaring gas prices are
shattering everyone's budget, killing middle-class families
trying to make ends meet, farmers harvesting their crops,
truckers traveling our highways. High gas prices threaten to
wipe out the holidays that families have been looking forward
to all year. Families in Connecticut and across the country
want to know what government is going to do and what the oil
companies are going to do. With gas at a national average of
$4.11 a gallon, $1.18 more than this time last year, and diesel
hovering at around $5, energy prices are a suffocating tax on
our entire economy.
We are in a crisis, and as such, we need to look at every
aspect that could potentially affect energy prices. Of course,
we must take into account factors such as a weak dollar, strong
demand from emerging economies, geopolitical tensions in oil-
producing regions, and supply disruptions. But we must also do
everything in our power to protect consumers from unregulated
market manipulation and excessive energy speculation.
From the Senate Permanent Subcommittee on Investigations to
the International Monetary Fund, experts refer to the mass
migration of energy futures trading, off regulated exchanges
onto exempt commercial markets as a possible factor distorting
energy prices in a way that enriches speculators at the expense
of the American consumer.
That is why I have come to believe that such activity is
responsible for a big part of the commodity price increases
that we are experiencing. Doing nothing in this area in my view
is not an option. We must continue to empower the Commodity
Futures Trading Commission to do its regulatory job. As its
mission reveals, the CFTC's primary function is, ``To protect
market users and the public from fraud, manipulation, and
abusive practices related to the sale of commodity and
financial futures and options and to foster open, competitive,
and financially-sound futures and option markets.''
And as the Chair of the House Appropriations Subcommittee
on Agriculture, I have worked to ensure that the CFTC has the
resources that it needs to act and fulfill its mission. Yet, as
the GAO's report, Trends in Energy Derivatives Market Raises
Questions About CFTC's Oversight, they found last fall, and
again, ``Trading in these markets, specifically electronic
commercial markets and over-the-counter markets, is much less
transparent than trading on futures exchanges and comprehensive
data are not available because these energy markets are not
regulated.'' Clearly we need a full market transparency, and we
need to hold the CFTC's feet to the fire to do its job.
With your leadership, Chairman Peterson, and a group of our
colleagues, we made progress in this area when we passed
legislation directing the CFTC to examine unregulated
speculation in our futures markets and to use its emergency
powers to stop market manipulations. And with the farm bill
your Committee tackled the need to bring transparency to energy
trading environments by creating a new regulatory regime for
certain over-the-counter energy derivatives markets, subjecting
them to a number of exchange-like regulations.
But as I understand it, we have more to do to ensure
excessive speculation is not distorting energy prices and the
CFTC has access to over-the-counter markets and foreign boards
of trade which still remain obscure. I believe we can bring
further transparency to the futures markets if we fully close
the so-called, Enron Loophole, and the Foreign Board of Trade
Loophole.
That is why Congressman Van Hollen and I have introduced
H.R. 6314, the Energy Markets Anti-Manipulation and Integrity
Restoration Act, which would do two simple things. First, close
the so-called, Enron Loophole, by adding energy commodities and
related swaps to the list of items that cannot be traded on
unregulated exempt commercial markets. And second, close the
London-Dubai Foreign Board of Trade Loophole by forbidding an
exchange from being deemed an unregulated foreign entity if its
trading affiliate or trading infrastructure is in the United
States, and it trades a U.S. delivered contract that
significantly affects price discovery.
Our legislation would go a long way toward preventing
improper speculation, ensuring real transparency, and bringing
oversight and enforcement to our energy and agricultural
futures markets. It would also restore the balance that has
been missing since 2000, when the Commodity Futures
Modernization Act placed large segments of the commodities
futures market outside of CFTC jurisdiction and allowed for
virtually unregulated, over-the-counter, and electronic trading
of many commodities futures.
Mr. Chairman, the fact is some will always argue against
regulating market forces. But we have seen the consequences of
that kind of approach over the last 8 years and even further
back. From the savings and loans to the subprime mortgage
crisis to the Federal Reserve backed bailout of Bear Sterns,
speculative bubbles emerge. If regulators do nothing, consumers
pay. It is a familiar cycle, and the same thing I am afraid may
be happening with food prices.
Mr. Chairman, it is time for us to act, change the way we
oversee our futures markets, and restore balance to the energy
marketplace. It is time to protect consumers.
And I thank the Committee and look forward to working with
you.
[The prepared statement of Ms. DeLauro follows:]
Prepared Statement of Hon. Rosa L. DeLauro, a Representative in
Congress From Connecticut
I want to thank Chairman Peterson, Ranking Member Goodlatte and
Members of the Committee for having this important hearing and for
allowing me to submit testimony today. The issue of excessive
speculation in the energy futures markets is critical and has an impact
on our entire economy.
I also want to recognize my friend and colleague, Rep. Chris Van
Hollen and thank him for allowing me to work with him on this important
issue. Chris was one of the first to highlight the potential role of
improper speculation in our energy markets and has been a real advocate
pushing us all in the Congress to take decisive action.
Mr. Chairman, to be sure, I am not an economist; nor do I profess
to study this issue with an academic's eye. But care about this subject
deeply because it affects my constituents and our economy as a whole.
We know that soaring gas prices are shattering everyone's budget,
killing middle class families trying to make ends meet, farmers
harvesting their crops, truckers traveling our highways. High gas
prices threaten to wipe out the holidays that families have been
looking forward to all year. Families in Connecticut, and across the
country, want to know what government is going to do and what the oil
companies are going to do.
With gas at a national average of $4.11 a gallon--$1.18 more than
this time last year, and diesel hovering at $5 dollars--energy prices
are a suffocating tax on our entire economy.
We are in a crisis, and as such, we need to look at every aspect
that could potentially affect energy prices. Of course, we must take
into account factors such as a weak dollar, strong demand from emerging
economies, geopolitical tensions in oil-producing regions and supply
disruptions. But we must also do everything in our power to protect
consumers from unregulated market manipulation and excessive energy
speculation. Experts refer to trading energy futures off regulated
exchanges onto less transparent exchanges as a possible factor
distorting energy prices in a way that enriches speculators at the
expense of the American consumer. I have come to believe that such
activity is responsible for a big part of the commodity price increases
we are experiencing. Doing nothing in this area is not an option.
That is why we must continue to empower the Commodity Futures
Trading Commission to do its regulatory job. As its mission reveals,
the CFTC's primary function is ``to protect market users and the public
from fraud, manipulation, and abusive practices related to the sale of
commodity and financial futures and options, and to foster open,
competitive, and financially sound futures and option markets.'' Yet,
as the GAO's report ``Trends in Energy Derivatives Markets Raises
Questions About CFTC'S Oversight'' [GAO-08-25, October 19, 2007] found
last fall, ``trading in these markets-specifically electronic
commercial markets and over-the-counter (OTC) markets--is much less
transparent than trading on futures exchanges, and comprehensive data
are not available because these energy markets are not regulated.''
Clearly we need full market transparency and we need to hold the CFTC's
feet to the fire to do its job.
With your leadership, Chairman Peterson, and a group of our
colleagues, we made progress in this area when we passed legislation
directing the CFTC to examine unregulated speculation in our futures
markets and to use its emergency powers to stop market manipulation.
And with the farm bill your Committee tackled the need to bring
transparency to energy trading environments by creating a new
regulatory regime for certain over-the-counter (OTC) energy derivatives
markets, subjecting them to a number of exchange-like regulations.
But as I understand it, we have more to do to ensure excessive
speculation is not distorting energy prices and the CFTC has access to
the over-the-counter markets and foreign boards of trade which still
remain obscure. I believe, we can bring further transparency to the
futures markets if we fully close the so-called ``Enron-loophole'' and
the ``Foreign Board of Trade (FBOT) Loophole.''
That is why, Congressman Van Hollen and I have introduced The
Energy Markets Anti-Manipulation and Integrity Restoration Act--which
would do two simple things: first, close the so-called ``Enron
Loophole'' by adding energy commodities and related swaps to the list
of items that cannot be traded on unregulated exempt commercial markets
and second, close the London-Dubai ``Foreign Board of Trade (FBOT)
Loophole'' by forbidding an exchange from being deemed an unregulated
foreign entity if its trading affiliate or trading infrastructure is in
the U.S., and it trades a U.S. contract that significantly affects
price discovery.
Our legislation would go a long way toward preventing improper
speculation, ensuring real transparency, and bringing oversight and
enforcement to our energy and agricultural futures markets. It would
also restore the balance that has been missing since 2000 when The
Commodity Futures Modernization Act (``CFMA'') placed large segments of
the commodities futures market outside CFTC jurisdiction and allowed
for virtually unregulated over-the-counter and electronic trading of
many commodities futures.
Mr. Chairman, the fact is some will always argue against regulating
market forces. But we have seen the consequences of that kind of
approach over the last 8 years. It is time to change the way we oversee
our futures markets and restore balance to the energy marketplace.
The Chairman. Thank you very much. We appreciate your
testimony.
Next we have Mr. Stupak from the First District of
Michigan, esteemed Member of the Energy and Commerce Committee
and very active on this issue. Welcome to the Committee.
STATEMENT OF HON. BART STUPAK, A REPRESENTATIVE IN CONGRESS
FROM MICHIGAN
Mr. Stupak. Well, thank you, Mr. Chairman, and thank you
Members of this Committee. I want to thank Mr. Etheridge and
all the Members up here at this front table. In fact, all
Members who put forth legislative proposals to address the run-
up in energy costs.
The price of crude oil has doubled over the past year. It
is now $136 a barrel. Gasoline prices have increased more than
$1.14. It is now at $4.11. Diesel prices have increased $1.90
to $4.73 per gallon.
As a result, industries across the country are hurting.
Airlines are eliminating service to more than 100 cities,
laying off thousands of workers and projecting up to $13
billion in losses this year due to jet fuel price increases
that cannot be passed onto customers.
Truck drivers are going out of business and many more are
just parking their trucks because they actually end up losing
money after paying so much for diesel. Farmers face increased
costs in all stages of their operations, from planting and
harvesting to transporting their product to market. As a
result, high energy prices have caused significant increases in
the cost of food.
There is no way to justify the doubling of oil prices based
on supply and demand.
In October of 2007, the Government Accountability Office
released its report on the ability of the Commodities Futures
Trading Commission to properly monitor energy markets to
prevent manipulation. The GAO found that the volume of trading
in energy commodities has skyrocketed as our first chart shows
right here. Specifically, after the Enron Loophole was enacted
in 2000, the GAO also found that while trading has doubled
since 2002, the number of CFTC staff monitoring these markets
has declined.
And the numbers back this up. If we look at Chart 2 between
September 30, 2003, and May 6, 2008, traders holding crude oil
contracts jumped from 714,000 contracts traded to more than
three million contracts traded. From 714 contracts to more than
three million contracts traded. This is a 425 percent increase
in trading of oil futures in less than 5 years.
Since 2003, commodity index speculation has increased 1,900
percent, from an estimated $13 billion to $260 billion. Lehman
Brothers recently estimated that crude oil prices go up about
1.5 cents for every $100 million in commodity index
investments.
By the Lehman Brothers estimate, the 1,900 percent increase
in commodity index speculation has inflated the price of crude
oil by approximately $37 a barrel. Other experts estimate it
could be even more.
On June 23, 2008, the Oversight Investigation Subcommittee
that I Chair held a hearing on the effect speculators have on
our energy prices. This was the sixth hearing that the Energy
and Commerce Committee has held on gas prices over the past 2
years. Fadel Gheit, Managing Director and Senior Oil Analyst at
Oppenheimer and Company, testified that, ``I firmly believe
that the current record oil price in excess of $135 a barrel is
inflated. I believe, based on supply and demand fundamentals,
crude oil prices should not be above $60 per barrel.''
If we take a look at Chart 3, in 2000, physical hedgers,
businesses like airlines that need to hedge to ensure a stable
price for fuel in future months, accounted for 63 percent of
the oil futures market. Speculators accounted for 37 percent.
By April of 2008, physical hedgers only controlled 29 percent
of the market. What we now know is approximately 71 percent of
the market has been taken over by swap dealers and speculators,
a considerable majority of whom have no physical stake in the
market. Over the past 8 years there has been a dramatic shift
as physical hedgers continually represent a smaller and smaller
portion of the market.
The New York Mercantile Exchange has granted 117 hedging
exemptions since 2006, for West Texas Intermediate crude
contracts, many of which are for swap dealers without physical
hedging positions. This excessive speculation is a significant
factor in the price Americans are paying for gasoline, diesel,
and home heating oil. Even the executives of the major U.S. oil
companies recognize this.
On April 1, 2008, testimony before the Select Committee on
Global Warming, Mr. John Lowe, Executive Vice President of
ConocoPhillips said, ``It is likely that the large inflow of
capital into the commodity funds is temporarily exaggerating
upward oil price movements.''
At the same hearing Mr. Peter Robertson, Vice Chairman of
Chevron noted, ``a flight to commodities,'' adding that an
economist was quoted in The Wall Street Journal saying, ``Crude
prices have decoupled from the forces controlling the
underlying physical flows of the commodity.''
And at the May 21, 2008, Senate Judiciary hearing, Shell
President John Hofmeister agreed that the price of crude has
been inflated, saying that the proper range for oil prices
should be, ``somewhere between $35 and $65 a barrel.''
Look at the next chart with the International Monetary
Fund. In May of 2008, the IMF compared crude oil over the past
30 years to the price of gold. Gold prices are not dependent on
supply and demand and have been viewed as a highly speculative
commodity. The IMF analysis shows crude oil prices track
increases in gold prices.
If we take a look at Chart 4, what this means is that oil
has been transformed from an energy source into a financial
asset like gold, where much of the buying and selling is driven
by speculators instead of the producers and consumers. Oil is
morphed from a commodity into a financial asset, traded for its
speculative value instead of its energy value.
Even the Saudi Oil Minister has argued that high oil prices
are due to excessive speculation in the markets.
As former Secretary of Labor Robert Reich noted on National
Public Radio a few weeks ago, the problem is the government's
failure to curb excessive speculation.
The Commodity Exchange Act recognizes the dangers of
excessive speculation. Section 4A of the Act states,
``Excessive speculation in any commodity under contracts for
sale of such commodity for future delivery made on or subject
to the rules of contract markets or derivatives transaction
execution facilities causing sudden or unreasonable
fluctuations or unwarranted changes in the price of such
commodity, is an undue and unnecessary burden on interstate
commerce.''
As a result, Section 4A provides the CFTC with the
authority to set position limits or take other actions
necessary to curb excessive speculation.
However, there are significant loopholes that exempt energy
trading from these protections against excessive speculation:
the Enron Loophole, the foreign boards of trade No Action
letters, the Swaps Loophole, and the Bona Fide Hedging
Exemption. While the recently-passed farm bill addressed the
Enron Loophole for electronic trading for natural gas, a
significant portion of the energy trading continues to be
exempt from CFTC action to curb excessive speculation.
For 3 years I have looked into excessive speculation in the
energy markets. My latest bill, the 2008, Prevent Unfair
Manipulation of Prices, the PUMP Act, H.R. 6330, would end all
of these exemptions, to ensure that excessive speculation is
not driving these markets beyond the supply and demand
fundamentals.
The PUMP Act, the most comprehensive energy speculation
bill in Congress would address bilateral trades and require
that bilateral trades be subject to CFTC oversight of foreign
boards of trade. To clarify, CFTC's jurisdiction over these
foreign boards of trade, the PUMP Act would give the CFTC
authority over these exchanges if they are using computer
terminals in the United States or they are trading energy
commodities that provide for a delivery point in the United
States.
Swaps Loophole: Swaps are currently excluded from
requirements for position limited to prevent excessive
speculation. Today, 85 percent of the futures purchases tied to
commodity index speculation come through swap dealers.
Bona Fide Hedging Exemption: Since 1991, 15 different
investment banks have taken advantage of this exemption, even
though they do not have legitimate anticipated business need.
The PUMP Act would clarify that legitimate anticipated business
needs does not mean energy speculators.
Strong aggregate position limits: By setting strong
aggregate position limits over all markets, CFTC would be able
to curb excessive speculation by making sure traders aren't
amassing huge positions in a commodity in an attempt to play
one exchange off of another.
By closing all of these loopholes and setting strong
aggregate position limits, CFTC would be better able to monitor
trades to prevent market manipulation and help eliminate the
unreasonable inflation of energy prices caused by excessive
speculation, helping to protect American consumers.
I bring this balloon because it helps to explain. No matter
what loophole you close here with the Commodity Futures Trading
Commission, you squeeze the Enron Loophole, we will go to
Swaps. You squeeze Swaps, we go back to Enron. You do hedging
or the Bona Fide Exemption or the Foreign Boards of Trade, it
squeezes. You have to do it all. Whatever you do to one side of
the balloon, it just rushes to the other. You have to get all
of the these in order to stop this excessive speculation we see
in the energy market.
If you don't believe excessive speculation is running up
energy prices, keep this one thought in mind. On June 23 when I
had my hearing, home heating oil was $3.98. Three days later
the PUMP Act, my Act, was introduced in the Senate, and 3 days
later home heating oil was $4.60. Yesterday to lock in or to
hedge your home heating costs for this winter it will cost you
$5.60 a gallon. That is more than a 20 percent increase in less
than the last few days.
This is excessive speculation gone wild. The PUMP Act has
60 bipartisan cosponsors, been endorsed by several
agricultural, airline, labor, and industry groups. The full
list is part of my testimony. I have included a section-by-
section description of the PUMP Act with my testimony.
I understand that there is essentially a war room that has
been created by those on Wall Street who would like to continue
to see energy trading remain in the dark. I am sure they are
hiring a lot of lobbyists and are making every attempt they can
to discredit those who are calling for reform.
However, I urge the Members of this Committee and my
colleagues in the House to look at the evidence for themselves.
We can either continue the status quo and excessive speculation
can continue to inflate energy prices beyond the underlying
supply and demand fundamentals, or we can stand up for our
constituents who are facing high prices at the pump and our
nation's businesses who are struggling to cope with a weak
economy and high production and transportation costs due to
energy.
Excessive speculation is having a devastating effect on
energy prices, causing a significant hardship for our entire
economy. I look forward to working with Chairman Peterson and
the Members of this Agriculture Committee and send legislation
to the President's desk to address excessive speculation in the
energy markets, to offer consumers relief at the pump.
Thank you, Mr. Chairman. I look forward to your questions
and those of the Members of this Committee.
[The prepared statement of Mr. Stupak follows:]
Prepared Statement of Hon. Bart Stupak, a Representative in Congress
From Michigan
The price of crude oil has doubled over the past year, oil is now
$73.90 more than it was at this time last year. This spike has caused
gasoline prices to increase $1.14 a gallon more than last year's highs,
a national average of $4.10 per gallon. Diesel prices are up $1.82 per
gallon compared to last year, up to $4.65 per gallon.
As a result, industries across the country are hurting. Airlines
are eliminating service to 100 cities, laying off thousands of workers,
and projecting up to $13 billion in losses this year due to jet fuel
price increases that cannot be passed on to consumers.
Truck drivers are going out of business, and many more are just
parking their trucks because they actually end up losing money after
paying so much for diesel. Farmers face increased costs in all stages
of their operations, from planting and harvesting to transporting their
product to market. As a result, high energy prices have caused
significant increases in the cost of food.
There is no way to justify the doubling of oil prices based on
supply and demand.
In October 2007, the Government Accountability Office (GAO)
released its report on the ability of the Commodities Futures Trading
Commission (CFTC) to properly monitor energy markets to prevent
manipulation. The GAO found that the volume of trading in energy
commodities has skyrocketed, specifically after the Enron Loophole was
enacted in 2000. The GAO also found that while trading has doubled
since 2002, the number of CFTC staff monitoring these markets has
declined.
And the numbers back this up. Between September 30, 2003 and May 6,
2008, traders holding crude oil contracts jumped from 714,000 contracts
traded to more than three million contracts. This is a 425 percent
increase in trading of oil futures in less than 5 years.
Since 2003, commodity index speculation has increased 1,900
percent, from an estimated $13 billion to $260 billion. Lehman Brothers
recently estimated that the crude oil price goes up about 1.5 percent
for every $100 million in commodity index investments.
By the Lehman Brothers estimate, the 1,900 percent increase in
commodity index speculation has inflated the price of crude oil by
approximately $37 a barrel. Other experts estimate it could be even
more.
On June 23, 2008, the Oversight and Investigations Subcommittee
that I Chair held a hearing on the effect speculators have on energy
prices. Fadel Gheit, Managing Director and Senior Oil Analyst at
Oppenheimer & Co. Inc. testified that: ``I firmly believe that the
current record oil price in excess of $135 per barrel is inflated. I
believe, based on supply and demand fundamentals, crude oil prices
should not be above $60 per barrel.''
In 2000, physical hedgers--businesses like airlines that need to
hedge to ensure a stable price for fuel in future months--accounted for
63% of the oil futures market. Speculators accounted for 37%. By April
2008, physical hedgers only controlled 29% of the market. What we now
know is that approximately 71% of the market has been taken over by
swap dealers and speculators, a considerable majority of whom have no
physical stake in the market. Over the past 8 years, there has been a
dramatic shift as physical hedgers continually represent a smaller and
smaller portion of the market.
The New York Mercantile Exchange (NYMEX) has granted 117 hedging
exemptions since 2006 for West Texas Intermediate crude contracts, many
of which are for swap dealers without physical hedging positions.
This excessive speculation is a significant factor in the price
Americans are paying for gasoline, diesel and all energy products. Even
the executives of the major U.S. oil companies recognize this.
On April 1, 2008, in testimony for the Select Committee on Global
Warming, Mr. John Lowe, Executive Vice President of ConocoPhillips
said, ``It is likely that the large inflow of capital into the
commodity funds is temporarily exaggerating upward oil price
movements.''
At the same hearing, Mr. Peter Robertson, Vice Chairman of Chevron
noted a ``flight to commodities'' adding that an economist was quoted
in The Wall Street Journal saying: ``Crude futures prices have
decoupled from the forces controlling the underlying physical flows of
the commodity.''
In the testimony of Mr. Robert A. Malone, Chairman and President of
BP America, he pointed to a ``growing interest among financial
investors in oil and other commodities.''
And at a May 21, 2008, Senate Judiciary Committee hearing, Shell
President John Hofmeister agreed that the price of crude oil has been
inflated, saying that the proper range for oil prices should be
``somewhere between $35 and $65 a barrel.''
In May 2008, the International Monetary Fund (IMF), compared crude
oil, over the past 30 years, to the price of gold. Gold prices are not
dependent on supply and demand, and have been viewed as a highly
speculative commodity. The IMF analysis shows that crude oil prices
track increases in gold prices.
What this means is that oil has been transformed from an energy
source into a financial asset, like gold, where much of the buying and
selling is driven by speculators instead of producers and consumers.
Oil has morphed from a commodity into a financial asset, traded for its
speculative value instead of its energy value.
Even the Saudi Oil Minister has argued that high oil prices are due
to excessive speculation in the markets.
As former Secretary of Labor Robert Reich noted on National Public
Radio a few weeks ago, the problem is the government's failure to curb
excessive speculation.
The Commodity Exchange Act recognizes the dangers of excessive
speculation. Section 4a of the Act states, ``Excessive speculation in
any commodity under contracts of sale of such commodity for future
delivery made on or subject to the rules of contract markets or
derivatives transaction execution facilities causing sudden or
unreasonable fluctuations or unwarranted changes in the price of such
commodity, is an undue and unnecessary burden on interstate commerce.''
(emphasis added) As a result, Section 4a provides the CFTC with the
authority to set position limits or take other actions necessary to
curb excessive speculation.
However, there are significant loopholes that exempt energy trading
from these protections against excessive speculation: the Enron
Loophole, the Foreign Boards of Trade Loophole, the Swaps Loophole, and
the Bona Fide Hedging Exemption. While the recently passed Farm bill
addressed the Enron Loophole for electronic trading facilities here in
the United States, a significant portion of the energy trading
continues to be exempt from any CFTC action to curb excessive
speculation.
My bill, the 2008 Prevent the Unfair Manipulation of Prices Act
(H.R. 6330), would end these exemptions, to ensure that excessive
speculation is not driving these markets beyond supply and demand
fundamentals.
The 2008 PUMP Act, the most comprehensive energy speculation bill
in Congress, would address:
Bilateral Trades: These trades are made between two
individuals and are not negotiated on a trading market. Because
the farm bill only closed the Enron Loophole for trades on
electronic exchanges, these bilateral trades remain in the
dark.
The PUMP Act would require that these bilateral trades are also
subject to CFTC oversight.
Foreign Boards of Trade: Petroleum contracts offered through
the IntercontinentalExchange (ICE) on ICE Futures are cleared
on a foreign board of trade in London. On average, more than 60
percent of traders on ICE Futures are located in the United
States. They're trading West Texas Crude, with a delivery point
in the United States. That's a foreign board of trade in name
only.
Recently, ICE Futures agreed to provide the CFTC with trader
information and to set position limits for their traders.
However, this step is not enough. ICE still has a revised ``No
Action'' letter, meaning that beyond information sharing and
position limits, CFTC still won't have any authority to enforce
U.S. laws.
In addition, NYMEX is in the process of offering U.S. traders
access to the exchange in Dubai, raising similar questions for
that market.
To clarify CFTC's jurisdiction over these ``foreign'' boards of
trade, the 2008 PUMP Act would give the CFTC authority over
these exchanges if they are using computer terminals in the
United States, or they are trading energy commodities that
provide for a delivery point in the United States.
Swaps Loophole: Swaps are currently excluded from
requirements for position limits to prevent excessive
speculation. Today, 85 percent of the futures purchases tied to
commodity index speculation come through swap dealers.
Because there are no requirements for position limits, these
swaps have grown exponentially, driving crude oil prices
higher. By eliminating this exemption, swaps would be subject
to position limits to prevent excessive speculation.
Bona Fide Hedging Exemption: The Commodity Exchange Act
allows exemptions from position limits for businesses ``to
hedge their legitimate anticipated business needs.''
However, in 1991, CFTC authorized the first ``bona fide
hedging'' exemption to a swap dealer (J. Aron and Company,
which is owned by Goldman Sachs) with no physical commodity
exposure, and therefore, no legitimate anticipated business
need.
Since 1991, 15 different investment banks have taken advantage
of this exemption, even though they do not have a legitimate
anticipated business need.
The 2008 PUMP Act would clarify that ``legitimate anticipated
business needs'' does not mean energy speculators.
Strong aggregate position limits: Once all of these
loopholes are closed, we can then take effective steps to curb
excessive speculation.
My bill would require the CFTC to set aggregate position limits
on energy contracts for a trader over all markets. Especially
with the growing number of markets, speculators can currently
comply with exchange specific position limits on several
exchanges, while still holding an excessive number of total
contracts in the aggregate.
By setting strong aggregate position limits over all markets,
CFTC would be able to curb excessive speculation by making sure
traders aren't amassing huge positions in a commodity in an
attempt to play one exchange off of another.
By closing all of these loopholes and setting strong aggregate
position limits, CFTC would be better able to monitor trades to prevent
market manipulation and help eliminate the unreasonable inflation of
energy prices caused by excessive speculation, helping to protect
American consumers.
The 2008 PUMP Act has 60 bipartisan cosponsors, and has been
endorsed by several agriculture, airline, labor, and industry groups,
including the National Farmers Union, the Air Transport Association,
the International Brotherhood of Teamsters, and the Industrial Energy
Consumers of America, which is a coalition of more than 35 different
companies such as Dow Corning, Goodyear, BASF, U.S. Steel, Tyson Foods,
and International Paper, amongst others. The full list of groups
endorsing the 2008 PUMP Act is listed on the endorsement letter that I
have included with my testimony. I have also included a section by
section description of the 2008 PUMP Act.
I understand that there is literally a ``War Room'' that has been
created by those on Wall Street who would like to continue to see
energy trading remain in the dark. I'm sure they're hiring a lot of
lobbyists and making every attempt they can to discredit those who are
calling for reform.
However, I urge the Members of this Committee and my colleagues in
the House to look at the evidence for themselves. We can either
continue with the status quo, and excessive energy speculation can
continue to inflate energy prices beyond underlying supply and demand
fundamentals. Or, we can stand up for our constituents, who facing high
prices at the pump, and our nation's businesses, who are struggling to
cope with a weak economy and high production and transportation costs
due to energy prices.
Excessive speculation is having a devastating effect on energy
prices, causing significant hardship for our entire economy. I look
forward to working with Chairman Peterson and the Members of the
Agriculture Committee to send legislation to the President's desk to
address excessive speculation in energy markets, to offer consumers
some relief at the pump.
Attachment I
Section 1
Short Title: ``Prevent Unfair Manipulation of Prices Act of 2008''
Section 2
Energy Commodities No Longer Exempt from CFTC Oversight
Eliminates the current exemption from CFTC regulation for
over-the-counter energy commodities by amending the definition
of an exempt commodity to no longer include energy.
Defines an ``Energy Commodity'' to include: coal, crude oil,
gasoline, diesel fuel, jet fuel, heating oil, propane,
electricity, and natural gas.
Stipulates that if an energy transaction provides for a
delivery point in the United States or is traded on a computer
terminal located in the United States, it is subject to the
rules that regulated markets (NYMEX) are already subject to,
including large trader reporting, record-keeping, and
prohibitions against fraud and market manipulation.
This applies to: designated contract markets, energy trading
facilities here in the U.S., bilateral trades, and trades
transacted on a foreign board of trade.
Extension of Regulatory Authority to Swaps Involving Energy
Transactions; Section 2(g) of the Commodity Exchange Act (CEA):
Closes the swaps loophole, no longer allowing energy
transactions to be excluded from the requirements of the
Commodity Exchange Act. This would require the CFTC to provide
greater oversight over these swap transactions.
Extension of Regulatory Authority to Energy Transactions on Foreign
Boards of Trade; Section 4 of CEA:
Requires that traders of energy commodities on a foreign
board of trade be subject to the rules that regulated markets
are already subject to if they are using computer terminals in
the United States or they are trading energy commodities that
provide for a delivery point in the United States.
Requires the CFTC to notify Congress and allow public
comment on any energy transaction that it intends to exempt
from regulation in the future.
Nullifies all previously issued ``No Action'' letters for
foreign boards of trade for energy transactions and provides
180 days for exchanges to comply.
Requirement to Establish Uniform Position Limits on Energy Commodities;
Section 4a(a):
Requires the CFTC to set aggregate position limits on energy
contracts for a trader over all markets. Especially with the
growing number of markets, speculators can currently comply
with exchange specific position limits on several exchanges
while still holding an excessive number of total contracts in
the aggregate. By setting aggregate position limits over all
markets, CFTC would be better able to make sure traders aren't
amassing huge positions in a commodity in an attempt to play
one exchange off of another.
Swaps No Longer Eligible for Exemption as Bona Fide Hedging for Energy
Transactions; Section 4a(c) of CEA:
Closes the bona fide hedging exemption for energy swaps not
backed by a physical commodity. A growing number of speculators
have taken advantage of the bona fide hedging exemption to
avoid position limits and other CFTC action to limit excessive
speculation. While 4a(c) provides an exemption from position
limits for bona fide hedging to allow businesses ``to hedge
their legitimate anticipated business needs'', speculators have
exploited this provision, even though their trading is
speculative and, not for the legitimate business needs of a
user or producer.
Special Rules Applicable to Bilateral Included Energy Transactions;
Section 4(a) of the CEA:
Requires reporting and record-keeping by bilateral traders.
This will allow CFTC to monitor for fraud and manipulation.
Public Disclosure of Index Funds; Section 8 of the CEA:
Requires CFTC to make public information on the size of
positions invested in commodity index replication strategies
and disclose the total value of energy contracts traded by
commodity index speculators.
No Effect on FERC Authority; Section 2 of CEA:
Protects the Federal Energy Regulatory Commission's (FERC)
authority provided in the 2005 Energy Policy Act to prosecute
market manipulation in natural gas and electricity markets.
Section 3
FERC Cease and Desist Authority; Section 20 of the Natural Gas Act,
Section 314 of the Federal Power Act:
Provides FERC with Cease and Desist Authority to freeze the
assets of companies prosecuted under the anti-manipulation
authority given to FERC in the 2005 Energy Policy Act. FERC is
currently unable to freeze the assets of violators. As a
result, by the time FERC is ready to assess penalties, the
company could have liquidated and distributed their assets,
allowing them to avoid any monetary penalties. This legislation
will allow FERC to freeze these assets to ensure that once a
company is found guilty of manipulating natural gas or
electricity markets, the agency can secure a full recovery on
behalf of consumers and taxpayers.
Attachment II
June 20, 2008
Hon. Bart Stupak,
Chairman,
Subcommittee on Oversight and Investigation,
Committee on Energy and Commerce,
U.S. House of Representatives,
Washington, D.C.
Dear Mr. Chairman:
Ten days ago, a broad coalition of consumer, labor, and business
organizations joined to advocate immediate reforms in the widely-
speculative energy commodity futures markets. While a long-term,
rational energy policy including increased supply is our ultimate goal,
bipartisan, near-term solutions to the market frenzy are absolutely
critical. Experts agree that today's surging oil prices are beyond
those warranted by supply-demand fundamentals and are due, in large
part, to rampant speculation.
In early June, speculators traded more than 1.9 billion barrels of
crude oil--22 times the size of the physical oil market, including $150
billion traded on the New York Mercantile Exchange alone. Sophisticated
``paper'' speculators who never intend to use oil are driving up costs
for consumers and making huge profits with little to no risk.
With your leadership, we see an end to the current unwarranted
escalation in oil prices. All coalition members are pleased to endorse
and to pledge our full support for the prompt enactment of your
proposed ``Prevent Unfair Manipulation of Prices Act of 2008.'' The
PUMP Act will apply a much needed brake on rampant energy commodity
speculation to drive down unprecedented, surging oil prices crippling
the economy.
The heart of PUMP is Section 2 that extends CFTC jurisdiction over
energy commodities that now enjoy a host of trading loopholes.
Specifically, we applaud your bill's focus onopening up the market to
greater transparency and fairness to level the playing field for all
traders. We fully support the bill, including strong provisions that:
bring over-the-counter energy commodities within CFTC's
oversight responsibilities;
close the ``swaps loophole'' by extending CFTC regulatory
authority to swaps involving energy transactions, another
important step towards needed transparency;
extend CFTC regulatory authority to energy transactions on
foreign boards of trade that provide for delivery points in the
United States, a common sense measure as other products
delivered in the United States are subject to the full panoply
of United States regulation, save energy commodities; and
require CFTC to set aggregate position limits on energy
contracts for a trader over all markets, ensuring that traders
do not corner markets by amassing huge positions and playing
one exchange off another.
The undersigned strongly endorse the PUMP Act, urge Congress to act
promptly, and pledge our full support for your efforts.
Air Carriers Association of America;
Air Line Pilots Association;
Airports Council International;
Air Transport Association;
Air Travelers Association;
American Association of Airport Executives;
American Society of Travel Agents;
Association of Professional Flight Attendants;
Industrial Energy Consumers of America;
International Association of Machinists;
International Brotherhood of Teamsters;
National Air Traffic Controllers Association;
National Business Travel Association;
National Farmers Union;
Regional Airline Association.
The Chairman. I thank the gentleman for his testimony.
Next we have Mr. Larson from the First District of
Connecticut, Member of our leadership and somebody who has been
very active as well on this issue.
Mr. Larson, welcome.
STATEMENT OF HON. JOHN B. LARSON, A REPRESENTATIVE IN CONGRESS
FROM CONNECTICUT
Mr. Larson. Thank you, Chairman Peterson, and Ranking
Member Goodlatte, Mr. Etheridge, and Mr. Moran for your
outstanding work and service, distinguished Members of the
Committee for your hard work, and I think the Chairman set the
appropriate antenna at the start of the hearing when talking
about the complexity of this issue and yet the need for us to
get it right.
And the historic position that has been played by the
Agriculture Committee, especially in looking at the whole
issues of commodities dating back to 1935, and the Act's
inception, and the grave concerns that were laid out back then
by President Roosevelt and the need for us to make sure that we
looked very clearly and specifically into this issue of
speculation.
You are the heirs of a great tradition and one that I think
the Chairmen jointly points out that you have to make sure you
are weighing all sides of the issues and arguments but in the
final analysis that you get it right.
I am proud that, in the tradition of this Committee, I have
introduced legislation ``bipartisanly'' with Mr. LoBiondo that
is called the Consumer Oil Price Protection Act. There are more
than 120 sponsors of this Act, and the genesis of it, I would
like to take credit for it, but it comes from Main Street
America. It comes from the Independent Connecticut Petroleum
Association, it comes from your local gas station attendant, it
comes from the diesel fuel owners, the home heating oil people,
who have recognized that the whole issue of supply and demand
has gone awry, something that in testimony by everyone from the
former head of the CFTC to the President's EIA Commissioner,
and also everyone down to the Secretary General of OPEC,
indicating that speculation has played a role in this process.
Very simply, my legislation says that if you intend to
participate in the currently unregulated dark market
established by Section 2(g) or 2(h) of the Commodity Exchange
Act, then you must be capable of either producing or taking
final delivery of the product. In other words, we are taking
speculators out of the dark markets and shedding light on their
activities.
Speculators play an important role. They play an important
role in a regulated market. Roosevelt recognized it. Your
forbearer recognized it as well. What they also recognized was
the need to limit those positions in terms of making sure that
those that are actually the physical hedgers, those that are in
the forefront of supply and demand and making sure that a
market-based system prevails with the oversight of government,
be allowed to go forth. That is the premise of this
legislation.
Mr. Stupak has gone into some of the statistics that--I
think everybody should take notice when you see this 71 percent
of the market is dominated now by speculators as opposed to
physical hedgers, only account for 29 percent of that market,
then something is awry.
So what is it then that I and Mr. LoBiondo and other
Members are asking of this Committee and what I believe the
Chairman has laid out? You are the policymakers in the final
analysis. Who do commodity markets serve? The producers and the
consumers of the underlying commodity or the speculators? My
grandfather Nolan had a great way of saying it, ``Trust
everyone but cut the cards.'' And your responsibility is, which
I don't have to inform you of, is to make sure that, not only
that you cut the cards but you shuffle them. Make sure people
are getting a fair deal with respect to this.
So should oil be treated as a physical commodity with a
finite supply as it was before 2000, or as a financial asset as
it is being treated today? That is very important for this
Committee. Treat it as a commodity or a financial asset or some
kind of alchemy that has happened in-between in the dark
market.
What citizens in this country demand, given the
complication of this issue, is straightforward answers and a
Congress that will level with them about the plight that we are
currently in.
This Committee, as was pointed out by several of my
colleagues here, established on March the 18th of 1935, two
basic principles. They said, ``The fundamental purpose of the
measure,'' that being the Commodity Exchange Act, ``is to
ensure fair practice and honest dealing of the commodity
exchanges and to provide a measure of control over those forms
of speculative activity, which too often demoralized the
markets to the injury of producers and consumers and the
exchanges themselves.''
The bill has another objective. The restoration of the
primary function of the exchanges, which is to furnish a market
for the commodities themselves. I believe that President
Roosevelt had it right. I believe that the Committee back then
had it right. I understand the awesome responsibility and
challenge that you have, and this Committee has already taken
bold steps as previous speakers have already indicated.
But this is also an important step. It is not a panacea.
There is no silver bullet in this, but this is in terms of the
integrity of the laws of supply and demand, and I dare say the
Congress in this Committee as it relates to restoring market
principles, to be able as Leonard Boswell says very simply, to
take delivery, makes common sense at a time when Americans are
trying to conserve their cents and dollars.
Last, I would like to say that I hope the Committee takes a
look within the CFTC, and I realize it is not the domain of the
Committee. I have a bill currently before Henry Waxman's
Committee, to establish an independent Inspector General, one
that is appointed by the President, ratified by the Senate, but
has independent status on the CFTC. Not someone that is
appointed by the CFTC and therefore, is under the stipulations
of that person who has hired them, but someone who is truly
independent. I hope the Committee takes that into
consideration.
In closing, I think that the bell has rung and that the
historic evidence is here for the Committee to take action.
Historically it has got away. How are we going to treat this
issue? Are we treating the finite supply of oil as a commodity,
or are we going to allow it to be treated as a financial asset
or some kind of alchemy in-between? That is a difficult choice.
Your forbearer made it by limiting the positions and
understanding as Mr. Stupak has alluded to in his legislation
and as others, Ms. DeLauro, Mr. Van Hollen, to limit that
position so that we can provide a more democratic process and
allow the Main Street participants to more fully participate in
the benefits of a free market system.
I thank you for the opportunity to speak before you today.
[The prepared statement of Mr. Larson follows:]
Prepared Statement of Hon. John B. Larson, a Representative in Congress
From Connecticut
I want to thank Chairman Peterson and Ranking Member Goodlatte for
myself, and for the 119 cosponsors of my legislation, H.R. 6264, which
I call the Consumer Oil Price Protection Act, for holding this
important hearing and providing the opportunity for me to speak here
today. I'd also like to recognize and thank Congressman LoBiondo, the
lead Republican cosponsor on this bipartisan legislation for his
commitment to this issue.
First let me recognize the hard work of the Chairman and this
Committee on the 2008 Farm Bill over the last year, which took a first
step towards regulating the ``dark'' energy markets. It has become
clear to me, however, that these provisions, first put forward over a
year ago, have already been overcome by the frenzied activity in our
commodity markets. More direct and expedient action is now required.
According to the American Petroleum Institute's July 1st U.S. Pump
Price Update, the price of gasoline is up almost 30% from a year ago.
Current prices for gasoline are at their highest levels over the last
90 years when adjusted for inflation, and June set the record for the
highest modern monthly average price for gasoline. The record high for
the average price of gasoline changed fifteen times in the last
seventeen weeks.
My constituents, consumers and businesses alike, are desperate not
just for relief--but for a fair deal. There is increasing evidence that
the skyrocketing cost of a barrel of oil today, or a gallon of heating
oil or gasoline at the pump no longer reflects actual consumer supply
and demand for oil and gas.
A myriad patchwork of loopholes in our commodities markets that
have become apparent since the enactment of the Commodity Futures
Modernization Act of 2000. These loopholes plague the perception that
the market is functioning normally and impede the ability for the CFTC
to conduct necessary oversight and data collection across the entire
market.
Today you will hear about legislation introduced by my colleagues
to close and regulate the various loopholes that are commonly referred
to as the `Enron Loophole', the `London' or `Foreign Board of Trade'
Loophole, the `swaps loophole'. I strongly support these approaches.
However, while closing those loopholes will finally bring
transparency and oversight to the markets, it will not entirely address
a more fundamental issue: the level of speculative participation in the
markets. Which is why my legislation takes a different approach to this
problem, one that can be considered as part of a comprehensive approach
to reforming these markets.
Very simply, my legislation says that if you intend to participate
in the currently unregulated, or ``dark'' markets established by
Section 2(g) or 2(h) of the Commodity Exchange Act, that you must be
capable of either producing or taking final delivery of the product. In
other words, we are taking the speculators out of the ``dark'' markets
and shedding light on their activities.
This approach is based on the premise that the commodity markets,
as established by the Commodity Exchange Act of 1936, exists to serve
the benefit of those dealing in the production and consumption of a
physical, tangible, product with a finite supply.
My legislation grew out of the concerns of the Independent
Connecticut Petroleum Association, which represents fuel oil dealers
and gasoline distributors across my state, many of which are small
family owned businesses. These businesses are on the front lines of
this issue, facing end use consumers on one end, some of whom have to
turn over their entire Social Security check to pay for heating oil,
and the oil markets on the other end. They are closest on the ground to
the true pulse of supply and demand in these markets, and as the price
continues to skyrocket, more and more companies are having trouble
increasing their credit necessary to continue deliveries to their
consumers.
In 2005, I requested a GAO investigation into the CFTC and oil
futures trading on NYMEX, specifically to determine the impact of the
new trend of large noncommercial or institutional investors such as
hedge funds speculating in the market.
This report was completed in October 2007 and concluded ``in light
of recent developments in derivatives markets and as part of CFTC's
reauthorization process, Congress should consider further exploring
whether the current regulatory structure for energy derivatives, in
particular for those traded in exempt commercial markets, provides
adequately for fair trading and accurate pricing of energy
commodities.'' \1\
---------------------------------------------------------------------------
\1\ GAO-08-25 Commodity Futures Trading Commission, Trends in
Energy Derivatives Markets Raise Questions about CFTC's Oversight,
October 2007, p. 58.
---------------------------------------------------------------------------
The Role of Physical Hedgers Versus Speculators
In properly functioning markets, speculators play an important role
in managing financial risk. The danger of combining unregulated
speculation with commodities that have a finite supply like oil is that
it can become excessive, causing artificial price distortions and
volatility in the market. New CFTC data, discussed in a hearing in the
Energy and Commerce Subcommittee on Oversight and Investigations last
month show that in 2000, when the CMFA was enacted, 63 percent of the
oil on the WTI futures market was held by physical hedgers, compared to
37 percent held by speculators.
By April of this year, that ratio had reversed itself, with
speculators now dominating 71 percent of the market compared to
physical hedgers at 29 percent. This dramatic shift begs this Committee
to address the philosophical questions:
(1) Who do the commodity markets exist to serve--The producers and
consumers of the underlying commodity, or the speculators?
(2) Should oil be treated as a physical commodity with a finite
supply, as it was before 2000, or as a financial asset, as it
is being treated today?
The historical record is quite clear that the commodity markets
exist for what are referred to as physical hedgers. Physical hedgers
are essentially the producers and consumers of the underlying product.
Report Number 421 from the Committee on Agriculture in the 74th
Congress, on the Commodity Exchange Act submitted on March 18, 1935
stated the two basic tenants behind the Commodity Exchange Act:
(1) ``the fundamental purpose of the measure is to insure fair
practice and honest dealing on the commodity exchanges and to
provide a measure of control over those forms of speculative
activity which too often demoralize the markets to the injury
of producers and consumers and the exchanges themselves.''
(2) ``The bill has another objective the restoration of the primary
function of the exchanges which is to furnish a market for the
commodities themselves.''
President Roosevelt said in his message to Congress on February 9,
1934, ``It should be our national policy to restrict, as far as
possible, the use of these exchanges for purely speculative
operations.'' Given that since 2000 speculators have taken control of
over 70 percent of the WTI futures market, on the one exchange that is
currently regulated, we need to ask ourselves if the market has become
exactly what President Roosevelt warned against.
Market Fundamentals No Longer Apply
There are many parallels to what is happening today in our economy
between investment in the commodity markets and Congress' grappling
with the activities of speculators during consideration of the
Commodity Exchange Act in 1935 and 1936. This Committee recognized in
its report on the Commodity Exchange Act in 1935, that ``Since the
passage of the Securities Exchange Act of 1934, there has been observed
an increasing tendency on the part of professional speculators to
transfer their activities from the security markets to the commodity
markets, a tendency which makes the enactment of this bill without
further delay of vital importance.''
A similar shift in activity and capital has become evident since
large portions of the commodity markets for oil were deregulated by the
CFMA of 2000. Just as the equity markets face increasing scrutiny and
potential regulation from the subprime mortgage fallout, we start to
see more dramatic increases in capital suddenly flowing to the oil
commodity markets. Additionally actions by new institutional investors
not envisioned in the 2000 CFMA reforms have emerged, including those
seeking to use the commodity markets as a hedge against the falling
dollar and those applying long term equity portfolio growth strategies
to commodities.
The essential function of price discovery that futures markets play
has become distorted in the current excessive speculative activity. As
far back as 2005, Lee R. Raymond, the Chairman and CEO of Exxon Mobil
said, ``We are in the mode where the fundamentals of supply and demand
really don't drive the price.'' \2\ Earlier this year, Chip Hodge, a
Managing director of MFC Global Investment Management's $4.5 billion
energy portfolio said, ``Clearly, the fundamentals don't matter at this
point.'' \3\ Guy Caruso, head of the Energy Information Agency
testified to the Senate earlier this year that a speculative premium
existed in the price of a barrel of oil.\4\ Even Abdalla al-Badri, OPEC
Secretary General was widely quoted in the press in December 2007
saying that ``The market is not controlled by supply and
demand . . . It is totally controlled by speculators who consider oil
as a financial asset.''
---------------------------------------------------------------------------
\2\ ``Some Wonder if the Surging Oil Market Is Ignoring Supply and
Demand'' by Simon Romero, New York Times, March 15, 2005.
\3\ ``Crude Oil Trades Near Record $108 as Returns Outpace
Equities'' by Mark Shenk, Bloomberg.com, March 11, 2008.
\4\ Senate Energy and Natural Resources Committee Oversight
Hearing: EIA's Revised Energy Outlook, March 4, 2008.
---------------------------------------------------------------------------
There seems to be general agreement between oil executives,
investment managers, the Department of Energy, and consumers that the
current price of oil is not entirely contributable to supply and
demand.
Supply-Side Arguments Reinforce the Need for Re-Regulating Oil Markets
Critics of legislation targeting speculators often cite increased
demand from China and India, bottlenecks in the refining process, or
other supply disruptions like natural disasters for rising prices.
However, if it is limited access to supplies of oil that is
increasing the price, not excessive speculation in the market, then
clearly, oil is a tangible commodity with a finite supply, not an
intangible financial instrument as defined by the CFMA of 2000. It
should therefore minimally be subject to the same regulatory
protections provided for agriculture products.
These arguments only reinforce the need for the approach taken in
H.R. 6264, that the markets should operate on the needs of the
underlying physical producers and consumers.
Restoring Basic Fundamentals to the Market
The approach H.R. 6264 takes to restore the fundamentals of supply
and demand to the market and reestablish a reliable price discovery
process is to focus on the activities of the physical hedgers, the
producers and consumers, the market participants the commodity markets
were established to serve.
Michael Masters, in his testimony before the Energy and Commerce
Subcommittee on Oversight and Investigations on June 23, 2008, summed
up why this is effective very succinctly:
``Bona fide physical hedgers are motivated by one thing--risk
reduction. Physical commodity producers trade in order to hedge
their actual physical production. Physical commodity consumers
only trade in order to hedge their actual consumption. For this
reason, their trades are always based on the actual supply and
demand fundamentals that directly affect them in the underlying
physical markets. Their trading decisions strengthen the price
discovery function of the commodities futures markets.''
To accomplish this, H.R. 6264 says that if you intend to
participate in the currently unregulated, or ``dark'' markets
established by Section 2(g) or 2(h) of the Commodity Exchange Act, that
you must be capable of either producing or taking final delivery of the
product. In its current form, it is written against current law, and
assumes that sections 2(g) and 2(h) of the CEA are not modified as
proposed by Mr. Stupak in H.R. 6330 or Mr. Van Hollen in H.R. 6341.
Recognizing that responsible speculation provides the liquidity
necessary for the commodity markets to function efficiently, H.R. 6264
allows speculators to continue to participate in the existing regulated
markets, where their activities can be conducted in the light of day
and are fully disclosed, and subject to position limits and other
oversight measures followed by regulated exchanges. By limiting the
participation of speculators and focusing on the activities of the
physical hedgers this legislation will ensure that prices will most
accurately reflect the true supply and demand of the underlying
physical commodity.
Even if provisions of H.R. 6330 or H.R. 6341 are adopted that would
change the current structure of Sections 2(g) or 2(h) of the CEA, this
Committee will still need to look at solutions to address or determine
the limits defining excessive speculation in the market. H.R. 6264 is
adaptable to those changes. For example, one approach suggested by
Michael Masters in his recent testimony would be to allow the physical
commodity producers and consumers to determine what level of
speculation, and thereby liquidity, is necessary for the proper
functioning of their market.\5\
---------------------------------------------------------------------------
\5\ Michael Masters, Managing Member/Portfolio Manager, Masters
Capital Management, LLC, Testimony before the House Committee on Energy
and Commerce Subcommittee on Oversight and Investigations, June 23,
2008.
---------------------------------------------------------------------------
Establish an Independent Inspector General at the CFTC
As Congress seeks to implement reforms of the oil commodity
markets, it is imperative that the CFTC have an independent Inspector
General office to ensure that the directives issued by Congress are
implemented and adhered to by the CFTC. The current Inspector General
sits under the office of the Chairman of the CFTC, who also hires the
agency's IG. This relationship makes the IG dependent on the Chairman.
However, an Inspector General appointed under Section 3 of the
Inspector General Act of 1978 would be chosen by the President and
confirmed by the Senate. They maintain an independent office. I have
recently introduced legislation, H.R. 6406 that would establish an
independent Inspector General's office at CFTC. While this legislation
has been referred to the Government Reform Committee, it is
nevertheless relevant to this discussion and important to this
Committee's deliberations.
Closing
This Committee must determine whether the underlying purpose of the
Commodity Exchange Act is to provide a market for the commodities
themselves and some control over speculative activities, or whether the
markets exist purely for the use of speculators.
The historical record to me is clear: commodity markets exist to
match buyers and sellers of physical commodities, with finite supplies,
with consumers or end-users. The data that continues to come forward in
Congressional hearings and now even from the CFTC is clear. The ratios
of speculative activities to physical activities in these markets are
skewed. A mechanism must be set to determine or limit speculative
positions across all markets and reduce the role noncommercial
investors, who cannot and do not accept delivery of the physical
product.
H.R. 6264 provides a pathway to accomplish that. Together this bill
and the proposals put forward by my colleagues today provide a
framework for a comprehensive solution. I stand ready to work with you
to craft the best possible policy to address the changes in the
commodity markets that have evolved over the last several years.
I thank the Chairman and Ranking Member for their consideration of
these views, and would be happy to answer any questions.
The Chairman. I thank the gentleman very much for his
testimony, and we have enough time to get Mr. Welch in before
we have to vote. I want to remind all the Members of the panel
if you want to make sure your legislation has a good chance of
getting passed or incorporated, that you come back and engage
in a dialogue with us as we try to move through this, but I
understand people are pulled different ways, but we would
appreciate coming back.
So we will hear Mr. Welch and then we will come back as
soon as the votes are over.
STATEMENT OF HON. PETER WELCH, A REPRESENTATIVE IN CONGRESS
FROM VERMONT
Mr. Welch. Thank you, Mr. Chairman, Mr. Goodlatte. Thank
you, Committee Members. I really appreciate the opportunity to
be here, and I will be brief with votes coming up.
I introduced a bill on November 1, 2007, to close the Enron
Loophole, and basically the question that this Committee has to
provide guidance to the full Congress on is number one, should
we regulate? Should we regulate the energy future markets?
The 109th Congress came to a conclusion that we should not,
and they passed into law the Enron Loophole that took away any
regulatory oversight of those exchanges. This Congress with the
leadership of this Committee, came to a different conclusion
and said, we should regulate. And you passed regulatory
provisions that started closing the Enron Loophole in the farm
bill, and I thank you for that.
The second question is, does speculation have adverse
consequences? It has been stated by many, and it is well known
by the Members of this Committee more than any others in
Congress that it serves a very constructive function. But what
we do know is that there are historic examples, recent historic
examples where unregulated speculation has had very damaging
effects on markets and on consumers. The most vivid and current
example is what happened with the Enron Loophole, and Enron
used that, of course, with its Enron On-Line to drive up the
price of electricity in California by 300 percent.
And all of us opposed that. So the question now is if we
have made a different decision as a Congress, that there is a
rule for proper, and I emphasize the word proper, and the
burden is on this Committee to give us guidance on what that
means, regulation or what should we do? My legislation did
basically three things.
First, it said we have to have transparency in the
transactions. Plain and simple. Then all market players are
aware of what is going on. Second, it required that there be
real time information given to the CFTC so they would be able
to do their job on a timely basis.
And third, it said all traders, whether they are foreign or
domestic, are subject to the same rules, and that is why many
of my colleagues have introduced legislation to close the
London Loophole or the Dubai Loophole. But basically it is
common sense that if you have a regulatory scheme, it should
apply to all who trade, whether they do it from a terminal in
London, Dubai, or Washington D.C.
Now, this Committee did pass and Congress adopted your
provisions on closing the Enron Loophole, but my suggestion,
Mr. Chairman, is that we need to go a bit farther, and the
major reservation I have about what we did pass was that in
order for the CFTC to enact regulation on some of these foreign
exchanges, it required the CFTC to make a specific finding on a
contract-by-contract basis of a significant price discovery
event.
And frankly, what that does is create an enormous
regulatory and bureaucratic burden. What I believe is a better
approach on regulation is to have a bottom line approach of
what it is you want for information, transparency, timely
disclosure, and then rules that everyone understands and can
play by. And then the enforcement is ferreting out when there
have been violations and take an appropriate enforcement
action.
So it is going to be the job, it is the job of this
Committee. I really applaud you, Mr. Chairman, for asserting
jurisdiction, because there is a lot of pressure out there on
all of us to, ``do something,'' and we all want to do
something, but it is imperative that the something that we do
helps, and doesn't hurt.
So thank you very much for allowing me to be part of this
important hearing.
[The prepared statement of Mr. Welch follows:]
Prepared Statement of Hon. Peter Welch, a Representative in Congress
From Vermont
First, let me thank Chairman Peterson for convening this critically
important hearing. I also need to thank Sean Cota, President of a great
community-based fuel dealer in my State of Vermont for first bringing
the issue of speculation in the fuel markets to me last fall.
Vermonters and residents of other cold-weather states are facing
the equivalent of a Category 5 storm. Our constituents are on the edge,
and as they look forward to the cold, winter months, many of them are
afraid of what they might find--home heating bills doubled, sometimes
tripled from what they were last year.
Each weekend I hear the same thing from Vermonters: increasing
expenses for fuel, child care, health care, and education are making it
harder and harder for working families to make ends meet. Energy costs
are an enormous driver of this crisis and they are only escalating. The
average U.S. heating oil bill is expected to be a record $3,500 for the
upcoming winter, up 76% from two winters ago. This is not sustainable.
Based on the current state of the market, speculation is a large
contributing factor to the astronomical spikes we have had in just the
past 12 to 18 months.
I frequently hold ``Congress in Your Community'' events around my
state in order to hear directly from Vermonters about the issues
important to them, and to see if I can offer assistance. It was a
Congress in Your Community last fall in Bellows Falls where Sean Cota
approached me with a story that was truly hard to believe: in 2000, the
109th Congress passed a loophole for Enron that is now inflating fuel
prices for all of our constituents by an average of $800 to $1,000 a
year. I then discovered that the non-partisan Government Accountability
Office (GAO) had documented this consumer rip-off. A few days later, I
introduced H.R. 4066, to close this egregious ``Enron Loophole.''
In 2000, Enron and several large energy companies successfully
lobbied the Republican-led Congress to exempt energy markets from
government regulation. This lack of oversight has resulted in multi-
billion dollar price manipulation and excessive speculation by traders.
This special interest loophole is allowing energy traders to rip off
Vermonters and Americans who are already struggling every winter to
heat their homes. The previous Congress sold us out to Enron, creating
a Wild West in the energy markets at the public's expense. It's time to
end this rip off.
The ``Close the Enron Loophole'' bill calls into question the
excessive speculation occurring in the marketplace. Are we going to
allow the oil futures market to continue to profit from ripping-off our
hardworking constituents, or are we to pass and enforce responsible
regulations on energy futures trades. Families, who already struggle to
pay fuel bills, should not be forced to choose between putting food on
the table and keeping their house warm as energy traders continue to
line their pockets.
Several provisions of my bill were included in the farm bill
recently signed into law. Unfortunately, it was not enough, and I
believe the language was far too diluted. My bill if enacted will
establish government oversight of the trading of unregulated energy
commodities to prevent price manipulation and excessive speculation.
The bill would give the Federal Commodity Futures Trading Commission
much-needed monitoring and enforcement authority.
This legislation simply introduces oversight to the energy market.
It is an overdue fix to a grossly irresponsible loophole that never
should have been created.
Again, thank you Chairman Peterson for your attention and
commitment to finding a solution to this problem. Speculators should
not have free reign in the oil markets, reaping vast profits at the
expense of American families. I am happy to answer any questions about
my legislation.
The Chairman. I thank the gentleman very much. I thank all
of the panel Members. I would encourage all Members to come
back because immediately after the votes we will proceed to
questions and come to a conclusion.
The Committee is in recess.
[Recess.]
The Chairman. The Committee will come back to order. As I
expect, there are all kinds of other stuff going on, so I am
not sure exactly who is going to be here how long, but we will
move ahead here with whatever time we have available.
So I am going to first recognize the gentleman from North
Carolina, our Subcommittee Chairman in this area, Mr. Etheridge
for a short statement and question.
Mr. Etheridge. Mr. Chairman, thank you, and let me thank
you and the Ranking Member for holding this meeting and my
partner, Jerry Moran, for being here.
I think since 2000, we all know the volume on the
commodities market have increased six fold. However, during
that same period of time, the staffing level for the CFTC has
fallen to the lowest level in the agency's 33 year history. And
there has been a growing concerning about energy trading and
overseas futures market. Some worry that trading on these
markets, particularly crude oil trading on the European
markets, is affecting our own domestic energy markets by
increasing volatility and raising prices.
As you know, today, tomorrow, and Friday, hearings will
examine these issues and determine if additional Congressional
action is necessary. Like many of my colleagues here, I've
introduced a piece of legislation, H.R. 6334 that addresses
many of these issues and will do three very specific things,
others, but I will just mention them here before I get to
questions. It will ensure that foreign markets are not
adversely affecting our markets. My bill directs the CFTC to
ensure that these markets are comparable, required to publicize
the trading information, position limits, accountability levels
for speculators, as do domestic markets that trade U.S. energy
products. My bill will also require the CFTC to change their
reporting of traders in energy markets to more clearly show
what positions and how much influence these funds have in
energy markets.
And finally, it would require an additional 100 full-time
equivalents at the CFTC that are needed to effectively regulate
the futures market, including our energy markets. And let me
remind everyone that this was asked for by the Chairman of the
CFTC that I think is important.
Now, let me say that no one factor is responsible for the
current energy prices. So it behooves us to examine the
question of excessive speculation, deliberately and
thoughtfully, and these hearings will allow us to do that. That
being said, let me thank my colleagues for being here today for
the work they put in this for studying, and let me ask the
first question to my colleague, Mr. Stupak. In reading your
testimony, you mention that 117 hedge exemptions were granted
since 2006 for the West Texas crude oil contracts on NYMEX,
many of them for swap dealers. Your bill addresses hedge
exemptions by limiting the exemptions to bona fide hedges and
denying exemptions to those seeking to hedge a swap
transaction. Is that correct?
Mr. Stupak. That is correct.
Mr. Etheridge. With that, let me run a few numbers by you
and get your response. On January 2, 2006, according to
testimony, crude oil was trading at about $65. In January of
2007, it was still in the low $60's. The number of hedge
exemptions granted for traders hedging against a swap in 2006
was 46. That is approximately 109,783 long contracts, and
113,283 short contracts were held in excess of position limits
over the course of the year.
In January of 2008, oil has climbed to almost $100
representing a 54 percent increase over the course of 2007. The
number of hedge exemptions granted to traders for a swap
declined in 2007 to 36, and the number of contracts held in
excess of position limits for the whole year also declined to
approximately 94,519 long contracts, and 90,253 short
contracts. Today, crude oil is about $135 to $137 which is a 35
to 37 percent increase over this year.
The number of hedge exemptions granted to traders for swaps
so far in 2008 has fallen to 11, and this represents 23,804
long contracts, 23,709 short contracts so far this year. So as
the price of oil has risen, use of the hedge exemption and the
number of contracts given to hedge exemption has steadily
declined. I raise that because since you worked in this area, I
will get your answer. What does this say about your argument
that swap dealers are using the hedge exemption to ramp up
prices?
Mr. Stupak. There, Mr. Chairman, because where are they
settling at? The long and the short, where are they settling
at? What is the price they are settling at? It is not the
number of contracts that is out there, it is where are they
settling.
Mr. Etheridge. Yes, but if the numbers are reducing, the
overall contracts and numbers, how does that indicate--cashing
the exemption?
Mr. Stupak. Look at your open interest on that one chart
that I had. What was your open interest? What are they settling
at when they settle? That is what it would be. I bet if you go
back to 1979, when the Hunt brothers tried to take over the
silver market, I bet you would find the same thing that
exemptions and that given would probably settle out. What
happened with the Hunt brothers? Until we cut off the
exceptions that they were given, they netted out every day. The
longs and short netted out each day. And therefore, the
argument--the same thing was made. You have a long, you have a
short. You have a short for every long. But what happened? It
was $7. It went to $50. And then as soon as they told the Hunt
brothers, enough is enough and we closed off that market to
them, it went right back to $7. It wasn't the number of
contracts, it is where does the contract settle?
Mr. Etheridge. But in that case, they were actually taking
possession of the silver.
Mr. Stupak. No, they weren't. They were required to take
possession of the silver. And therefore, that's when we brought
it back down, the price of silver, when they tried to hoard the
silver market in 1979.
The Chairman. The gentleman from Kansas.
Mr. Moran. Mr. Chairman, thank you very much. I appreciate
the opportunity we are going to have this week to consider this
issue of speculation. I appreciate my colleagues from across
the country and their interest in being here today and trying
to highlight some legislative options that we have in regard to
speculation. I also would like to associate myself with the
remarks of Mr. Peterson, the Chairman, and Mr. Goodlatte, the
Ranking Member, in their opening statements. Very much what
they said is compatible with my thought process on this.
I am fearful that we have become confused in the difference
between speculation and manipulation, and clearly we want to
make certain that market manipulation is not occurring but
excessive speculation, I need to understand why excessive
speculation is actually something that manipulates the market.
It is interesting to me that we are having these
discussions for much of the time I have been in Congress. My
farmers have complained to me about speculation, those who
don't have to deliver a commodity. Their complaints have been
based upon the reality that commodity prices are too low. And
so today we hear that speculation causes high prices. In years
past and on the agricultural side, we heard numerous times
about how speculators caused low prices.
This Subcommittee that Mr. Etheridge chairs that I serve as
the Ranking Member has been very active in these topics, and I
am pleased that we are re-engaged in this issue and continue to
be engaged in this issue that now confronts us.
I guess my question would be perhaps to you, Mr. Stupak. I
watched part of your Subcommittee's hearing, and the slides
that you showed, and maybe this is what you were suggesting to
Mr. Etheridge, the slides showed that 71 percent of the long
open interest crude was held by speculators, and then the
Subcommittee had another slide showing that 68 percent of the
short, open interest in crude was held by speculators. So
roughly 7 in 10 speculators hold long positions. Those market
participants would profit if the price went up, and almost the
same number, almost 7 in 10, would profit if the markets went
down. Is that fact significant as we look at the relationship
between increased speculation, greater speculators, greater
volume of speculation in the market as compared to rising crude
prices?
Mr. Stupak. Well, as you indicated, and that is the chart
right there that we had at the Subcommittee, we refined it a
little bit more based upon information from the CFTC. And in
January, the commercial or the hedgers controlled 63 percent of
the market. Look at the movement over the last 8 years. You are
down to what, 30 percent of the market. The people who are
legitimately hedging, the airline industry, the trucking
industry, those would have to buy their fuel to hedge against
future increases are getting squeezed out of the market. And as
more money flows into this market, the more they are going to
get squeezed. With the swap dealers, they have almost doubled
their position, and the noncommercial entities, those are those
who have no interest, but they are playing in this market. Too
much liquidity, too much cash, drives the market up. And that
is what you are seeing right here, this trend. The trend is
rather disturbing. You go from what, what did I say in my
opening statement? How many contracts where you are talking
about there at one time, and now you are up to over three
million? It was 114,000 to 3 million in a short period of time.
The Chairman. Will the gentleman yield?
Mr. Moran. I yield, Mr. Chairman.
The Chairman. I don't pretend to be an expert in this but
what I have been asking people is if you go into this swap
market and you get a position, then they turn around and lay
that risk off in the over-the-counter market. It is how it
works and they net these things out, and there might be a
situation where you have some small amount of long or short
that you have to cover in the NYMEX and that happens at some
level, whatever it is, four percent, ten percent, whatever it
is. But it is a small amount, but that ends up over in the
NYMEX. But the rest of this never gets into the system, I don't
see how it affects anything because it is these two guys over
here making this deal and whatever they settle at is not doing
anything with price discovery, it is not affecting the futures
market. The only part of it that is going into the marketplace
that could have an effect is that difference that they have to
go in and lay off in the NYMEX or wherever they are doing it,
or the ICE.
Mr. Stupak. And CFTC has been using this argument, long and
shorts, they come in very close, there is very little
difference as you indicated, basically a net zero. But what
they are not telling you is when the buyer and seller, when
they settle, when they cross, what is the price?
The Chairman. What difference does it make because it is
not being used for price discovery?
Mr. Stupak. Because that contract is then sold and it is at
a higher floor than what it was before. You don't know where it
settled.
The Chairman. So this is affecting the spot market?
Mr. Stupak. Second, Mr. Chairman, you indicated yourself
you don't know where the over-the-counter trades are going on.
You are only seeing part of the picture. That is why
transparency is so important.
The Chairman. If the gentleman would yield, I would agree
that we need to know what is going on here. I don't think many
of us disagree with that, but I am still trying to understand,
if you go out there and make this thing--some of these people
are never buying oil.
Mr. Stupak. True.
The Chairman. So you have these index funds--so that that
money goes some place. I guess it is in some Wall Street
account or something. Then they go and hedge this with some
other bank. But this never buys and oil, it never goes onto the
NYMEX to have any affect. So what I am trying to get at is
nobody can tell me and draw a line to show how this is working.
It sounds like something devious, but I am a CPA and I need to
follow the money and understand how this works and I still
can't track this. It doesn't seem like this is having an affect
on price discovery.
Now, you may not like the fact that these people are doing
this, and that is kind of a different issue. I am not sure
pension funds should be in the commodity market at all given
the volatility of it. So I just would like somebody to explain
to me if these things never get over on the market, how they
are affecting the price.
Mr. Stupak. But when you take the hedge fund exceptions,
they only cover the last 3 days of that trading. When you do a
contract, you hold it and it is the last 3 days that are most
critical. What happened the first 27 days, you have no idea. So
there is a lot of movement in this market. If I don't hold mine
for the 27th day, I sell mine on the 25th day, you have no idea
what I did----
The Chairman. I understand that.
Mr. Stupak. You don't know what the cash settlement----
The Chairman. The money is not going into the market, it is
going into Goldman Sachs or whoever has this deal.
Mr. Stupak. Correct.
The Chairman. So what is it doing, affecting the price of
their stock? I don't see how it affects the futures market if
it doesn't go into the futures market. I mean, if somebody
could explain that to me, it would make this job easier. I
don't see how----
Mr. Stupak. We don't know a lot of it because as you have
indicated yourself, Mr. Chairman, half of it is on the over-
the-counter trading, the ICE market, the Dubai market. We don't
know what is going on in those markets. We don't have any idea
what is going on, but we know that they are selling West Texas
crude. We know the Enron loophole for the London market, 64
percent of the WTI, West Texas Intermediate, had been traded on
that market which is running up that price of that crude. And
the cash settlement, when you come to settle out, there is no
substitute for oil. So you are stuck at that price. Even the
spot market looks to the market, the NYMEX, for their price.
The Chairman. The gentleman from Virginia. I think you had
some questions in this area.
Mr. Goodlatte. Yes, I do. I wanted to follow up on the
questions that the gentleman from North Carolina was asking
about, the hedging that the gentleman from Michigan mentioned
in his testimony.
Mr. Stupak, in your testimony you said that physical
hedgers represent a smaller and smaller portion of the market
and offer this as proof that increased speculation yields
higher prices. However, we will hear testimony tomorrow from
Dr. Jim Newsome who is the CEO of the New York Mercantile
Exchange that data analysis indicates that the percentage of
open interest held by speculators relative to commercial
participants actually decreased over the last year, even at the
same time that prices were increasing.
He further states in his testimony that noncommercial long
and shorts, in other words speculators, consistently have been
in the range of 30 to 35 percent of the open interest. This
would mean that hedgers make up the balance or 65 to 70 percent
of the market. That is much different than the 29 percent that
you cite in your testimony. And so I guess my question is how
are we, the Committee of jurisdiction on this issue, supposed
to interpret the disparities between the claims made by you and
others and the data provided to us by the exchange that knows
exactly what positions are on their exchange?
Mr. Stupak. I would suggest you ask the gentleman if the
noncommercial leaves out the swaps. The answer is noncommercial
trades leave out the swaps. That is where you can see here on
our chart, April 2008. We broke it out so you could see your
noncommercial and you could also see the swaps. So I would ask
them that question, does noncommercial include swaps or not?
Mr. Goodlatte. Okay. I will ask him that. Let me ask you
this. In addition to this data, Dr. Newsome will testify that
noncommercials, speculators, are relatively balanced between
being long and being short, and that has already been mentioned
already by some of the others here. How do we reconcile that
data with your testimony and some of the things we are seeing
in the media?
Mr. Stupak. The issue isn't how many are long, how many are
short to get to a net position. Again, as I have tried to
indicate, since there is a long for every short and a short for
every long, the net positions don't tell you what price the
buyer and seller actually crossed at. What is that floor that
is being established? You don't know that. You know the number
of contracts. Only on NYMEX, only on NYMEX. You don't know the
number of contracts, long and short, on ICE. You don't know the
number of contract on Dubai. And when you take a look at it,
the experts we consulted with pointed out that the chart that
the CFTC will show you tomorrow takes in all the contracts that
could be for every month which takes in all months and lump
them all together. And in the information that we have been
providing you have been 30 day look-sees. When you put all 9
years' worth and then you close it out, you can't pinpoint
anything by lumping all these months together. The good news is
the CFTC is going to ask these swap dealers for their
information, and I look forward to seeing that data when it
comes in.
But remember, go back to silver, the Hunt brothers. Every
day they had long and short. There was a zero there.
Mr. Goodlatte. But remember, the Hunt brothers controlled a
significant amount of the supply of silver, and we don't have
that situation here with the type of speculators that you are
talking about.
Mr. Stupak. Well, if you see with the noncommercials and
the swaps are controlling 70 percent of the market, I think
that is a significant part of the market. The hedgers are only
down to 30 percent. That is just like the Hunt brothers all
over. Instead of calling them swaps and noncommercials, let us
call them the Hunt brothers. They have moved from 30 percent of
the market----
Mr. Goodlatte. But I don't think----
Mr. Stupak.--and now it is 70----
Mr. Goodlatte. I don't think they own anything. I don't
think they control the supply. And on that point----
Mr. Stupak. They have these contracts, don't they?
Mr. Goodlatte. Let me----
Mr. Stupak. And there are only so many contracts given,
right?
Mr. Goodlatte. They don't control the supply of oil the way
the Hunt brothers controlled the supply of silver. But let me
ask you this on that very point.
Mr. Stupak. Go ahead.
Mr. Goodlatte. You and some others have cited hedge
exemptions as a way for parties to increase their speculative
positions. The CFTC has now made data available to us that
allows us to analyze this. In 2006, for swap agreements, 19
firms requested hedge exemptions. Thus far in 2008, only four
firms have requested hedge exemptions. For combination hedge
and swap agreements, 23 firms requested hedge exemptions in
2006. In 2008, thus far only eight firms have requested hedge
exemptions.
During the time that crude oil had a large run-up in price,
the request for hedge exemptions have fallen significantly. How
do we reconcile that data with what we have been hearing here
today?
Mr. Stupak. If I have one of these exemptions, if I have my
hedge exemption, and I said there are 117 of them, right, there
is no need for me to go back next year to get another exemption
from the CFTC because I already have it.
Mr. Goodlatte. Why didn't it happen a lot sooner then?
Mr. Stupak. Why didn't it?
Mr. Goodlatte. Yes.
Mr. Stupak. The first one started in 1991. It was J. Enron
which is----
Mr. Goodlatte. Well, I know----
Mr. Stupak.--Goldman Sachs.
Mr. Goodlatte. The price increases in oil which are a
concern to all of us right now----
Mr. Stupak. Sure.
Mr. Goodlatte.--and we want to get to the bottom of it and
if you or others are right, we certainly want to make sure that
there is all the transparency in this market so that there
isn't an artificial inflation here. But assuming that your
observation is correct, and we will again ask our witnesses
tomorrow about that, but assuming it is correct, why didn't it
happen sooner than now, this year, the last few months? Why
does it all of a sudden spike up now when these exemptions have
been granted over a long period of time and very few of them
are being additionally granted now? Presumably if this were the
avenue toward creating the bubble you talk about, you would
think there would be more people in there saying, ``Hey, I
missed the boat, I want that exemption now.''
Mr. Stupak. Well, I guess you would almost have to ask
them, but as my testimony indicated, NYMEX granted 117 hedging
exemptions since 2006 just for West Texas crude, 117 in less
than 2 years for West Texas crude. Remember, these exemptions
are usually permanent over the last 3 days of the contract.
Mr. Goodlatte. Thank you. We will ask those questions of
our witnesses tomorrow. Thank you, Mr. Chairman.
The Chairman. Are there any other Members that have
questions along this line? Mr. Conaway?
Mr. Conaway. Thank you, Mr. Chairman, and I was excited to
hear almost every one of the witnesses say they wanted to do
everything possible to address these high prices. I am excited
about the opportunity to address supply issues in maybe a
different forum.
If there is a huge premium in the market, why is this Fadel
Gheit--has his firm shorted this market? In other words, if
there is this giant bubble in there that we think is about to
burst, have they shorted it and it was sold out? These guys are
the professionals, the pros, that don't take delivery of crude
oil. They are making money going both directions, so why are we
not seeing a lot of pressure on the short side?
Mr. Stupak. I guess you would have to ask him.
Mr. Conaway. Yes, we will.
Mr. Stupak. Oppenheimer, you know.
Mr. Conaway. Yes.
Mr. Stupak. That is who he is with.
Mr. Conaway. But I mean, you testified, you used his
testimony to support your position.
Mr. Stupak. Yes.
Mr. Conaway. And I am just saying, did you ask him that? If
he is so firm on his position his conviction, has he actually
shorted the market?
Mr. Stupak. I did not ask him that question.
Mr. Conaway. Okay. Mr. Van Hollen, you mentioned a zero
speculative premium. How would we know that?
Mr. Van Hollen. I am sorry?
Mr. Conaway. You mentioned that you wanted to wring out all
the speculative premium and get it to zero. How would we ever
know that?
Mr. Van Hollen. What I said was I thought that the changes
that we are suggesting through this legislation in terms of
greater transparency in the markets, both with the London
loophole as well as other actions we could take, would help
squeeze out what I believe is a speculative premium. And
again----
Mr. Conaway. But you mentioned getting to zero in your
testimony, and I was just curious----
Mr. Van Hollen. No, what----
Mr. Conaway.--how would we know?
Mr. Van Hollen. What I said was, there have been different
testimonies given before different Committees as to exactly
what the speculative premium is. All I was suggesting was based
on all the testimony I have heard, I think it is above zero. I
don't know what it is. Some people have said it is 50 percent,
some people have said it is $30 per barrel. I think what I was
saying was based on the testimony I have heard, it is above
zero. The CFTC, as you know, has stated that it is in perfect
balance, that their testimony so far I believe before Congress
has been that there is no speculative component, that the price
of oil is being set by the force of supply and demand. I just
think that there is enough testimony out there to suggest that
there is some premium there, and what we are proposing here are
some different ways to get at it by giving the CFTC greater
regulatory authority.
If I might just quickly, because I know Dr. Newsome is
going to be testifying before this Committee, he testified
earlier, as you know, before the Congress, and I know you are
going to get to the FBOT, the London loophole issue, but his
testimony before this Congress was with respect to ICE, ``It
was not anticipated that the no action process would be used in
this manner which has effectively diminished the transparency
to the CFTC of approximately \1/3\ of the West Texas
Intermediate crude oil market and permitted an easy avenue to
circumvent position limits designed to prevent excessive
speculation.'' So the purpose of this legislation is to begin
to get at some of these things which, according to Dr. Newsome
and other experts, have created some speculation premium. I
don't know what it is, but what I was saying is I think it is
greater than zero.
Mr. Goodlatte. Will the gentleman yield?
Mr. Conaway. Yes, but I do have one more question.
Mr. Goodlatte. I just wanted to make a note in the record
on the issue that we have been discussing on hedge funds and
hedge exemptions, we have here a report from the CFTC regarding
the figures that I just cited. There are two types of hedge
exemptions. One is an annual exemption valid for 1 year, and
one is a temporary exemption valid for one trade. There are no
permanent hedge exemptions to our knowledge. The four that I
cited in 2008, three were temporary, in other words for one
trade, and one was an annual exemption. Thank you, Mr.
Chairman.
Mr. Van Hollen. Mr. Chairman, I am sorry. I don't know if
you are keeping track of time or if this is more----
The Chairman. Well, we are in free flow here.
Mr. Van Hollen. Unfortunately----
The Chairman. So I recognize the gentleman from Maryland.
Mr. Van Hollen. Thank you, because unfortunately, I have a
4:30 meeting that I have to be at. I just want to mention one
other thing in connection with the conversation with Mr.
Stupak. Regardless of how much money at the end of the day is a
result of swaps is going into the futures market, it seems to
me there is also a legitimate question about whether or not
when you have index funds making those investments in the
futures market, whether they should get these hedge exemptions.
As you know, you or I can go buy Goldman Sachs index funds, and
Goldman Sachs can then go hedge that risk. They go into the
futures market, and there is no reason that my investment in
Goldman Sachs via their transfer into the futures should be
treated as a hedger. I am a speculator. I am using this as an
investment vehicle. And the fact of the matter is, there has
been testimony, even from the CFTC, that that is an opaque area
that they can't figure out and they have been granting these
exceptions as if every dollar going in is a hedger. And that is
just not the case.
So I just want to make that point. Unfortunately, I have
to----
The Chairman. Yes, I understand that and that information
is now being acquired as I understand it by the CFTC, and this
has been one of the things we have discussed with them. They
are acquiring it. I talked to them yesterday, and the
information is coming in. Initially they were going to have
this ready by the 15th of September. I told them I thought that
was too late. And so they are moving this along as fast as they
can, but we are apparently going to get that information,
hopefully. But these index funds, from what I can understand,
money is being put in there by a pension fund or whoever it is.
They get some kind of an investment back, a piece of paper, I
don't know what it is, that money never buys any oil. And
generally, the money doesn't go into the futures market. What
happens is whatever that position is, they go over-the-counter
and hedge it with some bank or whoever will take the risk on
the other side. No oil is ever bought. The only time this ever
has any impact on price discovery or the futures market is when
there is a difference that they can't lay off over-the-counter
and net out, and then they will go over to the futures market
and then it will be--it is in there and we can see what it is.
So again, my question is that if this money is never going
in there, and if it is not being used for price discovery, and
they are over here doing whatever they are doing, I think
somebody is going to lose a lot of money at some point. But
that is not what this Committee's business is about. We are
trying to make sure the futures markets are not being
manipulated, and nobody is cornering the market on anything and
so forth. So we are kind of getting mixed up. It is like these
securitized mortgages that they trenched and sold to people.
Somebody should have been watching that. There is no way they
should have ever let them do that. But that is a different
issue.
Ms. DeLauro. But Mr. Chairman, if I might for a second. It
may be a different issue except it is a part of what I said in
my comments. This is a fact. We dealt with the lack of
oversight, the lack of regulation, as it had to do with the
subprime market. We have an agency which is coming before my
Committee tomorrow, it is going to come up before this
Committee tomorrow. Where were they, where have they been, what
are they doing? They are charged with addressing this issue of
potential manipulation or excessive speculation. And it was
only recently, within the last few weeks, that they decided
that they would need to have additional reports, additional
transparency. This is not just the last couple of weeks. This
is an agency that in fact has been in my view, and we are going
to ask them the questions about this, they have been asleep at
the switch while this is going on, and who pays the price.
The Chairman. Well----
Ms. DeLauro. It is the ordinary person. It is the ordinary
individual who is getting killed out there with this.
The Chairman. Well, I wouldn't disagree that they have been
behind the curve on this, okay, and that we probably should
have had more information. But in their judgment and what the
testimony has been is that they are saying that they don't
think that this swap situation is affecting the prices and so
forth, and maybe they are wrong. And this is what we are trying
to figure out here, but you have just as many people saying
that this is not running up the prices as you have saying that
it is. And that is what we are trying to get to the bottom of
here.
Ms. DeLauro. I understand, Mr. Chairman, except I would
say, I don't know, I am not going to make a calculation of how
many are saying that there is and how many not. I don't have a
balance here, but there seems to be a predominance of
information that this has some bearing.
I will make this comment, and I hope it is not offensive to
some folks is that these are agencies that are charged with
addressing a serious crisis. The fact of the matter is, and I
believe the right decision was made, that people spent day in
and day out Treasury and others, looking at what was going on
with Bear Stearns. And they said, ``We have to act quickly
because we are going to see the financial markets collapse.''
So they worked day in and day out, overnight, behind closed
doors, and they addressed the issue and came up with a
solution. Whether you agree with it or not, I think they had to
do what they had to do.
We now have a very serious situation, very serious for
consumers. We are now just saying, well, it is the market, this
is the volatility of the market, that is that. And the agencies
charged with addressing this issue again in my view are not
doing their job in terms of sitting down and getting to the
answers that we are talking about. I for one, and I said in my
opening comments, I am not an economist, I am not an academic
in this area. I look to the agencies that we charge with the
responsibility to address these issues, and they have fallen
short and they quite frankly pick and choose the areas in which
they are going to bring relief in the marketplace.
Mr. Conaway. Mr. Chairman----
The Chairman. I thank the gentlelady.
Mr. Stupak. Mr. Conaway, could I----
Mr. Conaway. I just have one more question and that is back
in June 23rd----
Mr. Stupak. Right.
Mr. Conaway.--there was a report in response to maybe your
bill, Bart, I don't know, but the issue of American
imperialism, in other words, the extra-territorial use of
American laws will have a backlash among the folks in London
and Dubai and other places where they think they may do a
pretty good job of regulating. Would you address your attitude
toward their responses on us telling them how to regulate their
markets?
Mr. Stupak. Sure. First, you asked about Mr. Gheit, Fadel
Gheit, if he sold short, I pulled his testimony. He is the
Managing Director and Senior Oil Analyst so he is not in the
commodities so he wouldn't have been selling short or long.
Mr. Conaway. He works for a firm that does that all day
long.
Mr. Stupak. Right. But not him. I thought you meant him
personally.
Mr. Conaway. Oh, heavens no. He doesn't make that much
money.
Mr. Stupak. So you have to check with him. For the London
loophole, the ICE market, we have given our enforcement powers
to London for an exchange that has its headquarters in Atlanta,
has its trading engines in Chicago, Atlanta, which does, some
estimate, 30 percent West Texas crude sold in here. They sell
contracts that says for delivery in Cushing, Oklahoma, and they
use terminals here in the United States. But because we have
this No Action letter given by the CFTC, we rely upon London to
enforce the laws because we say London laws are similar to
ours. I respectfully say they are not.
For instance, London does not require position limits or
accountability levels to prevent excessive speculation or
market manipulation. That is allowed in London and the same as
Dubai. Unlike the CFTC, the FSA, Financial Services Authority,
does not publish a Commitment of Traders Report which provides
a public accounting of long and short futures positions held by
large traders, plus there is far less transparency under the
FSA regime. The FSA does not provide comparable emergency
powers--to suspend trading or increase margins.
So why would we outsource our enforcement in this field
that affects all of us so much? Why don't we put the cop back
on the beat here in the United States?
Ms. DeLauro. Would the gentleman yield?
Mr. Stupak. Sure.
Ms. DeLauro. I just would add to the issue of the No Action
letters, I think it is imperative to find out and it is one of
the things I am going to try to ascertain in our hearing is I
understand the current process to CFTC staff has issued these
No Action letters. I have a series of questions that I am
interested in. Who broadly defined requests in No Action
letters? Who reviewed or effected the content and the timing of
the No Action letters within CFTC and elsewhere? What legal and
policy rationale was used to justify the letters? And why,
given the enormous consequences and the controversial nature
that the full Commission does not formally review and approve
them? Or who is accountable for the issuance of these letters?
And as my colleague, Mr. Stupak said, we are off-shoring, if
you will, authority in these areas which doesn't seem to make
sense.
It is very, very interesting that with regard to some of
these efforts, the primary financial beneficiaries are Goldman
Sachs and Morgan Stanley. I also think that it is also
important to note that their representatives, sit on the CFTC's
Energy Advisory Committee. I think one has to take a look at
that. Is this in fact a conflict of interest? How do we have
two of the principal beneficiaries in this area who sit on one
of the four or five committees that are the underpinnings of
the Commission. You understand that these are serious
questions, you want to get to the bottom of it as we do. And
what we are trying to do is to propose legislation where we
think we can bring back the issue of home-based enforcement
before, as was the case before 2000.
Mr. Larson. Will the gentlelady yield? To that point, Mr.
Chairman, I do think that especially given the legislation that
this Committee has already put forward and to the gentlelady's
questions, and questions that were being developed by Mr.
Stupak, that it does seem entirely logical that we would have
an independent Inspector General within the CFTC. We currently
do not. And in your considerations, I hope you will take that
under advisement as I know the gentlelady will as her Committee
looks at this and the importance of making sure--you know,
there is a tendency to feel like Eddy Murphy in Trading Places
here when you are talking about swaps and hedging and series.
And I think Mr. Chairman, you have said this before that it
takes a while to get your arms around all this stuff and
demystify it for the general public. And yet, that is our
responsibility and in part, this Committee's responsibility in
the long run. It sure would help if you had an independent
source appointed by the President, confirmed by the Senate,
that you knew was assisting in looking out for the American
consumer.
The Chairman. I thank the gentleman. The gentleman from
Georgia, Mr. Marshall.
Mr. Marshall. Thank you, Mr. Chairman. I think we have some
31 different pieces of legislation that have been introduced in
order to try to address this problem. It may be more than that.
The CRS report that covers this issue lists 31. I am one of
them. I have a piece of legislation that is similar to Mr.
Etheridge's that also provides for more independence for the
auditor, Inspector General, within the CFTC.
I think it is important for all of us to put into context
the sort of heat that has been exchanged here. We are all
interested in seeing lower prices for our consumers. There is
nobody here that isn't interested in that. We all appreciate
the extent to which people are suffering. Ordinary folks are
suffering with this. It is certainly the case in a district
like mine which is very rural, and people are very dependent
upon gas prices. Just to get to work is a challenge for people,
diesel and gas the way it is right now.
And so we are all in the same boat. We are all trying to
figure out what the problem is here and what can be done about
it. Virtually everybody who has testified before this
Committee, including virtually every expert I have talked to,
acknowledges that a large part of the problem is the weak
dollar. Estimates range from 25 percent to more. So let us not
lose sight of that. We have a weak dollar policy at the moment.
The weak dollar is part of the problem here.
Everybody also concedes that there are market fundamentals
that are involved in this, that worldwide demand has caught up
with the world's ability to provide supply. Everybody concedes
that. So let us not lose sight of that as we talk about what
has been referred to here as ``excessive speculation.''
And the final thing that we don't want to lose sight of,
and many people don't want to hear this, is expert after expert
after expert will tell us that if we overstep, if we make a
mistake in the process of trying to address this issue, we will
wind up pushing these markets to places where they will be less
opaque and less regulated. They will have the same kind of
impact on us because we are stuck with the world commodity
market; that is every single expert virtually without
exception.
Now, obviously there are things we can do. Many of us have
suggested that. We are trying to figure out what it is, and
what I keep hearing today is excessive speculation, excessive
speculation. I would like to explore that with some questions,
if I could.
The way the futures markets have evolved, and it is not
just oil, it is all commodities, we initially were just looking
to give people who were in business an opportunity to hedge
risks, one way or the other. And it was difficult to pull them
together. It was difficult to find somebody who was interested
in buying that commodity that somebody wanted to make sure they
could sell at some point in the future and vice versa.
The way the markets evolve is actually over a period of
time in a process that invited what you might call speculators
to come in and provide liquidity to take opposite positions. It
was something that was very important to commercial entities.
They had to have that, and all responsible commercial entities
recognized that. So we have traders today in these markets who
never take delivery, they are basically playing the market,
whatever you want to call it. They are making their financial
bets but they are providing liquidity which makes available to
hedges that are important to commercial ventures, and it also
lessens the cost associated with getting your hedge. That is
also very important to these commercial folks.
So I am unsure. We are not talking about that as being
excessive speculation. This is the sort of thing that is just
part of the market. DRW, Inc., in Chicago, for example, its net
delta is always zero, and it probably provides more liquidity
for the oil market than any trader in the world.
Now, we weren't talking about excessive speculation 2 or 3
years ago. We are talking about it now. I don't think there was
any legislation in the hopper to deal with excessive
speculation 2 or 3 years ago. So something has happened in the
last 2 or 3 years that sort of jumped up and has gotten our
attention. I have to believe it is the recent interest by
pension funds, sovereign wealth funds, and others in taking
positions in the commodity markets. And so I guess my question
is to my fellow Members here who are struggling just like I am
trying to figure out a way to fix this for our folks; that is
what excessive speculation is. Is anybody here suggesting we
should not let pension funds or ordinary folks who otherwise
wouldn't have access to the commodity markets or buying
commodities, we ought not let them to have access to buying
commodities to take positions where commodities are concerned?
Mr. Stupak. I don't think anyone is saying that. Two years
ago some of us were concerned about the excessive money and
liquidity coming into the market. That is when I first did the
PUMP Act, looking at certain aspects of it was 2005, 2006 when
I introduced the legislation. There has to be some liquidity in
the market. Speculators can and do play a role for significant
price discovery, but when you go from a $13 billion to $260
billion at the blink of an eye, there is too much in there. It
is driving up these prices.
If Congress does nothing, this market was already
determined to become a foreign board of trade. Ask Mr. Newsome
when he comes tomorrow when he is helping to set up the Dubai
exchange, NYMEX. The regulated market can't beat ICE, the
IntercontinentalExchange, so they might as well become them. So
they are setting up this Dubai market and they will be asking
for a No Action letter. So in other words, this market is
moving more and more in the dark, not more transparency but
less transparency.
Mr. Marshall. I hate to interrupt my baseball buddy----
Mr. Stupak. Sure.
Mr. Marshall.--but you are just a witness here. You are a
fellow Member, but you are a witness so I get to interrupt you.
Mr. Stupak. Okay.
Mr. Marshall. Would you get back to what excessive
speculation is so I can understand that? Tell me how I figure
out what speculation is and----
Mr. Stupak. Well, go back to your definition----
Mr. Marshall.--what speculation is not.
Mr. Stupak.--Section 4(a) of the Commodity Exchange Act
that I had in my testimony where they set forth what it means.
And in a nutshell, when the market has a detrimental impact to
your national economy as energy has right now, I hope we, as
responsible legislators and good baseball players, will go take
the bat to this and bring some control to this market because
we are really hurting this whole economy----
Mr. Marshall. Mr. Stupak----
Mr. Stupak.--causing sudden or unreasonable fluctuations of
unwarranted changes in the price of such commodities is an
undue and unnecessary burden on interstate commerce.
Mr. Marshall. Every one of us agrees. We are just trying to
figure out what it is that is causing this to occur and how to
stop the thing that is causing it. So are you saying figure out
how not to let pension funds get involved in this or sovereign
wealth funds or----
Mr. Stupak. Why would a pension fund want a bona fide
hedging exemption? They are not interested in oil, the Chairman
said many times. Why does Harvard invest their endowment funds
in the commodities market? Are they interested in taking
control of any wheat, any corn, any oil?
Mr. Marshall. Would----
Mr. Stupak. But they use this exception----
Mr. Marshall. May I interrupt? Would we prohibit hedge
funds from--what you are talking about is the hedge exemption
is being used in order to permit money flowing into Goldman
Sachs, Morgan Stanley----
Mr. Stupak. Yes, I'm Harvard. I go to Goldman Sachs and I
say, ``Yes, I got this $2 billion----
Mr. Marshall. I got that, but would you prohibit these
folks from investing directly in the futures market?
Mr. Stupak. No. No.
Mr. Marshall. Taking long----
Mr. Stupak. But how about some position limits? I can play
one exchange off the other. When Dubai gets their exchange, if
I ever did my position, I can play one exchange off the other,
NYMEX, Dubai, ICE, and take my aggregate position and I can
influence a market, especially one as small as----
Mr. Marshall. Would it be position limits for each of the
individual pension funds or the individuals who hold interest
in those pension funds? How would that work?
Mr. Stupak. Who is doing the hedging? Is it Goldman Sachs
commodity index fund or is it really Harvard? It is really
Goldman Sachs.
Mr. Marshall. So if----
Mr. Stupak. So Goldman Sachs should only be allowed to hold
so much, right? So much position on NYMEX, so much position on
ICE, so much position on Dubai. But take the aggregate, not the
individual, not the individual. Take the aggregate of what they
are holding. On NYMEX, it is supposed to be 20,000 contracts.
Go look at it. You know how they enforce it? They call you up
and say, ``Hey, Jim, you got too many. Dump a little.''
Ms. DeLauro. You will recall with Enron and what happened
with the pension funds, pension funds ought to be able to
invest but also we have an obligation to make sure that there
is some regulation around so that unlike the people at the top
who took their pension and ran, a whole lot of folks at the
bottom lost their pension and who is there with a safety net
for them? I will just say to you that I think we are looking at
similarities in what is happening, and this is not just one
place, it is in a variety of places, and they should invest but
I believe we have the obligation to make sure that they don't
go belly-up and the people who rely on them don't go belly-up.
Mr. Marshall. And I think the question concerning whether
or not pension funds should be permitted to invest in things
like this is a separate one from the question, what is the
impact on the futures market, on the prices of commodities
caused by all of these investors seemingly interested in
getting into commodities and buying commodities.
Mr. Matheson, you have sat here patiently----
Mr. Matheson. Sure. Mr. Marshall, I appreciate the
question. The Commodity Exchange Act has a definition of
``excessive speculation.'' My concern is not specifically
excessive speculation. My concern is the potential for market
manipulation based on the loophole on foreign exchanges where
the CFTC isn't getting the data, and we are not holding U.S.-
based traders to the same limitations that they are subject to
today trading on NYMEX for example.
So I think we do have over many years developed a process
in this country. We have gotten comfortable about some of the
boundaries we have developed for trading here in the U.S., and
technology has taken us to a new place where now we have these
new challenges. We are trying to figure out how we can adjust
with those technological changes. I don't think you should
limit people from being able to trade in the market. I don't
think you can have too much liquidity in the market. I think
liquidity is good. It creates greater price discovery and
reduces margins. So I don't think we should be limiting who can
trade in the market beyond the position limits for individuals
that already exist on NYMEX now.
I have to offer one other thought on this that points out a
little bit of the confusion in this debate this discussion has
been taking place right now. We have been bouncing around
between futures and swaps like they are the same thing and they
are not.
Mr. Marshall. They are not.
Mr. Matheson. And we have to be real careful as we parse
these issues out that we address them in their appropriate way.
Different pieces of legislation look at these from different
angles. Quite frankly, my legislation only focuses on futures,
it only focuses on trading on foreign exchanges and creating
the transparency and disclosure of information, and the same
position limits, and the same CFTC regulations that exist today
for U.S. traders. And I think that it is probably an effort to
try to get more information and not in an overt way that may
drive business offshore. I think when you start trying to get
into the over-the-counter market and the swap market, we have
to be very, very careful because if we take action that creates
undue burdens on that marketplace here in this country, based
on technology today, this is today, this isn't 20, 30, 40 yeas
ago, those servers can move offshore like that. And the
business will still take place, and as you suggested in your
opening statement, you will have a more opaque situation. You
will have less certainty on what is going on, and that is the
challenge for this Committee, to figure out how to address this
issue.
So for me, it is not a question of is there excessive
speculation, the question is, is there market manipulation and
does our regulator, the CFTC, have the capability with the
information given to it and the tools at its disposal to assess
whether that market manipulation is happening; and I still
think that is the overall goal that this Congress ought to be
looking at.
Ms. DeLauro. Mr. Marshall, could I just use the CFTC's
definition on ``excessive speculation?'' When the market price
for a given commodity no longer accurately reflects the forces
of supply and demand. This is their definition, and that is in
essence what they are charged with policing under the Commodity
Exchange Act.
So I think we are not making up the definitions and the
terminology. The terminology exists within the mission, if you
will, of the agency that is charged with----
Mr. Marshall. And I am aware of the definition. I am trying
to figure out where is the excessive speculation in this kind
of setting? What is actually causing this problem? We
acknowledge that the problem has other aspects to it.
Ms. DeLauro. Exactly.
Mr. Marshall. It is hard to argue about that.
Ms. DeLauro. Right.
Mr. Marshall. So can we put our finger----
Ms. DeLauro. Well, my hope would be----
Mr. Marshall.--exactly what it is--if I could, Ms. DeLauro?
Ms. DeLauro. Sure.
Mr. Marshall. The CFTC, though I don't have the impression
that they have an ax to grind here. I had the impression they
are sincere, they are very informed, and they came before this
Committee 2 weeks ago, the Chief Economist and the Chief of
Enforcement, enormously experienced individuals. They said as
far as they can tell, they can't find that the price is being
manipulated inappropriately or that some sort of inappropriate
forces in the form of excess speculation are causing this
problem. That is what they said.
Ms. DeLauro. Well, I----
Mr. Marshall. I may be wrong----
Ms. DeLauro. No, but it may be that I believe that that is
what we have to be overseeing in our oversight capacity. This
is the agency that is charged with figuring that out. I want
the best and the brightest as I know you do and other Members
of this Committee do to be able to pinpoint what the
difficulties are here. They are charged with that, and I don't
know if it is the current set of people, well-meaning and
sincere, informed, and they can't get to the bottom of this,
then we need to find folks who can. I don't have an ax to grind
with them, either. I, like you, want answers to the issue
because we have to come to some sort of a conclusion. Not a
conclusion, we have to come to some understanding so that we
can apply some potential solutions to it.
Mr. Marshall. Mr. Chairman----
The Chairman. The gentleman from Iowa.
Mr. King. Thank you, Mr. Chairman. I want to thank all the
witnesses, too. This is a long afternoon for Members to sit in
one place, and I particularly appreciate Mr. Marshall's
questioning line. It covered a lot of the questions that had
arisen as I listened to your testimony, so I will try to focus
this down to a couple of things and perhaps leave a minute or
two for some of my colleagues who are still waiting patiently
as well.
A number of things go through my mind. As Mr. Marshall
mentioned, the weak dollar and global demand. I would point out
with global demand, I have a sheet here from Reuters that shows
that Chinese imports of gasoline this year are up 2,000
percent. So there is a global demand piece. We are looking at
how to get out of excessive speculation, and Mr. Van Hollen
says he doesn't know how much it is but he wants to wring it
out, wants to wring the margins out that are excessive
speculation. I am watching the focus of all the brain power you
have put on this, and it is not just this year when gas got
real high but it is an accumulation of effort over a period of
time. And you know, I have turned my focus to drilling in ANWR,
the Outer Continental Shelf, BLM land, more coal, more nuclear,
more ethanol, more wind, more biodiesel, all of these
alternatives that we have because I am a great believer of
supply and demand. I hear you talk about supply and demand, but
I am not convinced you all believe that supply and demand, at
least in the core of this free market economy, should drive
this and should set this price. Ms. DeLauro, you mentioned
about excessive effects of speculation that upset supply and
demand. And so do you all believe that the markets are set by
supply and demand and all these commodities we are talking
about? Does anybody disagree with that?
Mr. Stupak. I think this should be the basis for it. I
think we have lost that. When you see 119 percent from 2003 to
now----
Mr. King. Okay.
Mr. Stupak.--and $13 billion to $260 billion, it is not
supply and demand that is putting forth----
Mr. King. I recognize that from your testimony, Mr. Stupak,
and I appreciate that, but do we really believe? Does the panel
believe that, and I guess what really caught my attention is--
well, I will put it back this way and dig back through those
1,057 pages of Adam Smith's Wealth of Nations, not the one from
Washington, the one that published that in 1776. And he was
watching the price of gold at the time in the world, and gold
was high. And he made the point that gold got a lot cheaper in
the world because the price of everything is the sum total of
the cost of the capital and the labor, that they had figured
out how to take a lot of the labor costs out of gold by
importing it from the New World which really was stealing it
from the Native Americans, we recognize. But he showed how the
gold prices had plummeted. And I look at your testimony and it
says gold prices are not dependent upon supply and demand. I
just have a little trouble getting past that to get to the next
point, and I would ask you if you could support that statement
a little more.
Mr. Stupak. Sure. The IMF, if you take a look at it if you
want to put that back up there, Scott, when was the last time
we had a problem with oil? It was 1981, right? Look what
happened to gold. It has nothing to do with oil, but look what
happened to gold. It really spiked. So did oil. That is the
last time we saw it up that high, and it has tracked perfect.
Gold made in the New World in 1776, maybe we could take out the
labor costs but now with this global economy, gold is basically
not a supply and demand, it is a purely speculative, high-
priced metal as you indicated. And therefore, you don't see a
supply and demand. But why is oil tracking it?
Mr. King. Mr. Stupak, I heard you say that before but I
still don't understand your answer. How is gold independent
from supply and demand? Who demands gold? I mean, are you
submitting that it isn't utilized in a way that there is a
demand for it because I am thinking not only just for the
jewelry but the industrial uses we have for gold. So I would
say yes, that there is a demand out there and there is a
supply.
Mr. Stupak. What is gold used as? When is it hoarded? It is
hoarded as a financial asset, sort of hedging against future
problems within our economies, as it is right now. Well, isn't
that sort of the same thing oil is doing?
Mr. King. It is used as well for industrial purposes and
also for jewelry purpose. I mean, there is a functional use for
that. I didn't want to get into that particular debate, I would
just point out that you have to believe in supply and demand or
not. Ms. DeLauro?
Ms. DeLauro. Well, I wanted to address the issue of supply
and demand from not my perspective but from a small business
owner in Connecticut who will come to testify tomorrow. His
name is Tom Devine of Devine Brothers. He is a full-service
biofuel heating fuel dealer. These are direct quotes. I am not
in this business, he is. There are two quotes. ``We are no
longer confident that the markets are doing their job of
providing our industry and consumers with a benchmark for
pricing product that is based on economic dynamics of supply
and demand, and they no longer function as a risk-management
tool.'' On the issue of supply and demand, he says, ``My
customers often ask, are you guys running out of product?'' The
answer is no. There is no supply shortage. There is no sudden
upside demand shock. Simply put, we and our customers are being
forced to ride the speculative roller coaster in the futures
market. It is about time someone put some of the breaks on this
runaway train and brought the markets back to reality. This is
someone who is in the business. It is not me, and he is talking
about supply and demand. What were are telling him----
Mr. King. If I might, Ms. DeLauro----
Ms. DeLauro.--is that the markets are fine, working
properly, and we are doing everything that we can and that is
not the fact of life for this man.
Mr. King. Then just to make my concluding point and that is
you have convinced me that you don't believe in supply and
demand the way I believe in supply and demand. I think the
approach to solving this problem then is going to be different
than those of us who believe strongly in supply and demand. But
I thank you for your testimony and I yield back to the
Chairman.
The Chairman. I thank the gentleman. The gentlelady from
Ohio.
Mrs. Schmidt. This is very quick. Whatever we do to answer
the energy crisis, we have to do with complete understanding of
the picture; and from what I am gathering today, from what I am
trying to learn and glean on my own is that we really don't
have a total answer of this speculative role. My husband is in
the financial business, and I ask him all the time, are the
speculators driving up the price? And I talk to him about what
the CFTC mentioned 2 weeks ago in this Committee. And he said,
``There are so many other things out there that you can't
quantify. One is emotion, one is the attitude of the
speculators that are in the market. If they perceive a Congress
that isn't going to do anything, then they are going to drive
up the price.'' But he also cautioned me with this. He said,
``You can close the London loophole but you will just drive it
further offshore. People that are in the business of making
money will find ways to make money. If you take water, and we
know that water tracks generally downstream, and you change it
from one side of the street, it will go to the other side of
the street. If we limit Goldman Sachs in their portfolio to go
into this market, they are only going to create a subset of
Goldman Sachs in order to accomplish it.''
I, like you, want to stop the speculation. I, like you,
believe that speculators have a role in this. I can't say that
publicly because I can't prove it, but I have a feeling that if
it walks like a duck and talks like a duck, it's probably a
duck. And all I want to know is how are we going to find out
exactly what is going on so that we can move whatever portion
of your bill or another person's bill that is out there into
the right place so we don't end up making a bigger problem than
already exists.
Mr. Larson. Make them take delivery.
Mrs. Schmidt. Well, but you can't do that because they will
go offshore.
Mr. Larson. Why can't you?
Mrs. Schmidt. Because they will----
Mr. Larson. How will it go offshore?
Mrs. Schmidt. Because financial----
Mr. Larson. If you allow for the physical hedger to deal
with this as the market was intended to do, then by limiting
the positions as Mr. Stupak and others have said, that you find
yourself in the situation where now all of a sudden the true
price becomes established; and look, I believe there is a role
for speculators in the marketplace as well, but why not, as the
dealer that Rosa DeLauro just mentioned and Main Street
consumers and come to me, gas station guys, truckers, are they
all wrong? You know, I said it before jokingly, but it is true.
You feel like Eddie Murphy in the Trading Places where you
know, we are swapping this, we are hedging this. At Augie and
Ray's, they want to know whether or not their government is
going to level with them about what is going on with respect to
that.
Mrs. Schmidt. And I----
The Chairman. The gentlelady----
Mrs. Schmidt. What we want to do is find the bottom line of
this and really what is going on in the marketplace.
Mr. Larson. But your instincts are right.
Mrs. Schmidt. And I don't have the complete answer.
The Chairman. I thank the gentlelady. We have to get over
and vote, and I get the sense that Members are kind of wrapped
up here, so we appreciate the panel. I would just have one
closing comment. This Congress made it illegal to have a
futures market in onions in 1958. That is still the law. The
most volatile, the biggest increase of any commodity in the
United States, is in onions. Just as a word of caution.
Mr. Stupak. That will bring us all to tears.
[Whereupon, at 5:30 p.m., the Committee was adjourned.]
[Material submitted for inclusion in the record follows:]
Submitted Statement of Hon. Baron P. Hill, a Representative in Congress
From Indiana
Good Morning. First off, I would like to thank Chairman Peterson
and the rest of the Members of the Committee for their hard work in
studying the impact speculators are having on gasoline prices in the
United States. I appreciate the opportunity to present the Committee
with information about the bill I recently introduced, H.R. 6372, the
Commodity Futures Restoration Act, which addresses the lack of
transparency in U.S. commodity futures markets.
The rapid increase in gasoline prices here at home is having a
profound impact on all Americans. This year the average cost of
gasoline rose to $4 a gallon for the first time in history. When I
return home to Indiana, the central issue on the mind of my
constituents is how their families and businesses are suffering due to
rising fuel costs. I am sure my colleagues have had similar discussions
back home as well. I introduced this piece of legislation because I
believe providing oversight to the U.S. commodities markets is the most
surefire way to lower gas prices for American citizens.
Let me be clear; I do not believe reigning in excessive speculation
will solve our nation's energy crisis in the long term. Yet, after
meeting and hearing testimony from investors on Wall Street, oil
company CEO's, and economists, it is clear to me that supply and demand
fundamentals cannot fully account for the extreme rise in gasoline
prices. Instead, I believe the lack of oversight of the commodities
markets coupled with incredible growth of institutional investors is
artificially raising the price of gasoline for American consumers.
Since 2000, energy commodity trading has been systematically
deregulated and new loopholes have been created that have fostered
excessive speculation in U.S. commodity futures markets. As a result,
the CFTC's ability to detect market manipulation is currently being
hurt by critical information gaps that exist because many traders are
exempt from CFTC reporting requirements. Over the last 5 years,
commodity-index investing has increased by 183%. Economists estimate
excessive speculation is adding between $20 to $50 to the price of a
barrel of oil. Reform is needed to prevent a price bubble similar to
the one that caused the subprime housing crisis.
The bill that I introduced would simply restore the standards that
were in place prior to 2000 by closing the three harmful loopholes that
have destabilized the U.S. commodity markets. H.R. 6372 would make the
following changes:
1. Close the ``Enron Loophole'': The Commodity Futures
Modernization Act of 2000 (CFMA) exempted energy commodities
traded on electronic exchanges from regulation by the Commodity
Futures Trading Commission (CFTC). My bill would ensure CFTC
oversight by reestablishing the CFTC's jurisdiction over energy
commodities and require the CFTC to regulate energy commodities
just as agricultural commodities are currently regulated.
2. Close the ``Foreign Board of Trade/London Loophole'': This
loophole currently allows U.S. exchanges that are trading U.S.-
delivered energy commodities to be regulated by foreign
entities. As a result, the reporting data gathered from these
transactions is often insufficient and leaves American
consumers inadequately protected from fraud and manipulation.
My bill would require exchanges that trade U.S.-delivered
futures contracts, or ones that significantly impact market
prices, to register with the CFTC. Put simply, markets trading
U.S. commodities would no longer be regulated by overseas
entities.
3. Close the ``Swaps Loophole'': As of today, banks can hedge their
investors' positions without facing any position limits. The
swaps loophole permits institutional investors, who have no
regard for supply and demand fundamentals in the physical
commodity markets, to use banks to trade without facing
position limits. This is commonly referred to as the ``Swaps
Loophole'' because it has allowed unlimited speculation in the
commodities markets. My bill would reestablish the original
purpose of the Commodity Exchange Act which only allowed
purchasers, sellers, and legitimate users of commodities to
hedge on the market.
Additionally, H.R. 6372 requires the CFTC issue a progress report
within 90 on its ability to impose position limits on energy futures
commodities and its capacity to implement changes set forth in the
bill. The bill ensures the Federal Energy Regulatory Commission and
Federal Trade Commission maintains authority over natural gas oversight
and market manipulation respectively. The bill would take effect 6
months after date of enactment to provide investors and the CFTC
sufficient time to make the necessary changes.
I recognize many individuals have savings invested in the commodity
markets, which is why I believe it is so important this Congress
carefully considers the potential impact of any market reform. This
Committee's decision to hold hearings on the various pieces of
legislation is an important step to ensure we get this issue right. Our
economy cannot suffer through another crash like the one we saw after
the .COM and housing booms. My bill would stabilize U.S. commodity
markets before our economy suffers another financial shock. This will
benefit all investors in the long term, and provide the most immediate
relief to ease the pain of consumers at the pump in the short term.
I believe in free market principles, but without open accounting of
who is trading what, the U.S. commodity markets cannot function
properly. My bill would provide the necessary changes to calm the
instability in the markets and reestablish oversight to ensure that
prices on the futures market reflect the laws of supply and demand
rather than manipulative practices or excessive speculation. Hundreds
of billions of investment dollars enter the futures markets. If no
action is taken, gas and food prices will continue to rise.
______
Submitted Letter By Bart Stupak, a Representative in Congress From
Michigan
July 10, 2008
Hon. Collin C. Peterson,
Chairman,
Committee on Agriculture,
U.S. House of Representatives,
Washington, D.C.;
Hon. Bob Goodlatte,
Ranking Minority Member,
Committee on Agriculture,
U.S. House of Representatives,
Washington, D.C.
Dear Chairman Peterson and Ranking Member Goodlatte:
Thank you for the opportunity to testify on July 9, 2008, before
the Agriculture Committee regarding reforms to the Commodity Exchange
Act to prevent excessive speculation.
I am writing to respond to questions raised at this hearing
concerning the impact of 117 hedging exemptions on NYMEX. In
particular, Members asked me to explain how the 48 exemptions granted
to swap dealers and the 44 exemptions granted to those with combined
swap/hedge positions could be relevant to rising oil prices, when the
number of NYMEX-issued exemptions has decreased each year between 2006
and 2008. Since this data was marked business confidential by the CFTC,
I did not have it with me at the hearing and was unable to review it in
responding to your questions.
With respect to hedge exemptions for crude oil futures, the NYMEX
sets a 3,000 contract position limit for the 3 days prior to
settlement. NYMEX sets ``accountability levels'' of 10,000 contracts
for 1 month and 20,000 contracts for all months outside of that 3 day
window (20,000 contracts equals 20 million barrels of oil, or roughly 1
day of U.S. demand). However, unlike speculative position limits for
agricultural futures, accountability levels are not hard position
limits.\1\
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\1\ According to CFTC data, there were nine entities with positions
in excess of 20,000 crude oil contracts on June 6, 2008 (six had long
positions totaling 198,547 contracts, and three had short positions
totaling 87,753 contracts). This CITC data does not disclose whether
these are commercial or non commercial speculative positions.
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The purpose of my raising questions about the 48 exemptions granted
by NYMEX to noncommercial speculators was to question whether this is
justified and valid in the sea of various loopholes. However, there are
many causes of excessive speculation at this time, and I do not want to
leave the impression that these 117 exemptions explain the price
increase in oil by itself.
For example, these NYMEX position limits do not apply to futures
positions tied to commodity index investments. Indexers close out their
current month positions between the 5th and 9th day of the month, and
then roll these position over into the next month--long before the
position limits in the last 3 days ever kick in. As a result, indexers
do not encounter NYMEX position limits.
Since the futures market serves as a price discovery market every
day of the month, not just in the last 3 days prior to settlement, it
is unclear why CFTC does not require that speculative position limits
be set across the entire month.
To remedy this problem, we recommend that legislation require CFTC
to establish speculative position limits for all energy commodities,
aggregate all positions and extend these across all markets (designated
contract markets, exempt commercial markets, foreign boards of trade
operating in this country, swaps, and the over-the-counter markets.)
Hedge exemptions need to be limited to those with commercial interests
in the commodity, and the practice of allowing such exemptions to
noncommercial participants such as passive index speculators and their
swap dealers should be ended.
Please feel free to contact me if you have any further questions.
Sincerely,
Bart Stupak,Member of Congress.
Cc:
Hon. Bob Etheridge, Chairman, Subcommittee on General Farm Commodities
and Risk Management,
Hon. Jerry Moran, Ranking Minority Member, Subcommittee on General Farm
Commodities and Risk Management; and
Agriculture Committee Members.
______
Submitted Statement of American Soybean Association
The American Soybean Association (ASA) appreciates the opportunity
to provide comments on the futures markets issues before the Committee.
ASA is the policy advocate and collective voice of soybean producers on
domestic and international issues of importance to all U.S. soybean
farmers.
We support and believe that futures markets exist for the dual
purposes of price discovery and risk management. The main concerns for
everyone involved with using and/or regulating the commodity futures
markets should be accurate price discovery for commodities and
functional tools for price risk management. Many commodities are at
historically high price levels. That does not mean these prices may not
be accurate. We should not artificially hold down commodity prices nor
should we try to artificially inflate prices or allow the markets to be
manipulated. The current supply and demand situation, along with other
market factors, such as institutional investments and the value of our
dollar, should be considered when determining if the commodity markets
are performing accurate price discovery. Caution and foresight are
needed in view of our current agricultural commodity futures and cash
markets. Legislation or other regulations affecting the agricultural
markets must enhance price discovery and risk management for farmers.
Soybean producers, like producers of other commodities, are
concerned about changes in the way futures markets are operating and
their impact on risk management needs. Increased price volatility,
substantially higher margin requirements, lack of cash and futures
price convergence, and the influence of billions of dollars of index
fund investments have greatly altered traditional farmer hedge
strategies. For example, many lenders and elevators no longer offer
forward contracts more than 60 days out. When the ability to forward
contract soybeans for delivery in deferred months was lost, it became
clear that traditional risk management strategies were no longer
available. The margin requirements for grain elevators and farmers
using futures contracts to reduce price risk are so large they create a
financial burden. Funds normally used for general operations or to buy
inventory and supplies are consumed by margin calls. Lenders have been
forced to extend more credit than normal so elevators and farmers can
conduct their regular business transactions. This creates more
financial risk for everyone involved.
For the last 40 years, markets have operated in generally
predictable ways: Chief among these was that futures and cash market
prices would more or less converge at the end of a contract. The
assumption that cash and futures prices for the same commodity tend to
move in the same direction, during the same time period, and to
approximately the same extent, has stood the test of time. Now, we see
this assumption is not necessarily true. Lack of convergence, combined
with high prices and, for some commodities, the absence of a cash
market, have led to lack of confidence that accurate price discovery is
taking place. Now lenders look at the lack of convergence and say they
cannot accurately measure the collateral value of a hedge in the
futures market.
The unpredictability of convergence between the futures and cash
markets makes hedging an unreliable pricing tool. All of these factors
create a marketplace that severely limits farmers' abilities to manage
price risk.
Of course, there have been changes in the market that we support.
Higher prices and more participants in the market work to the farmer's
advantage. As we look toward 2009, we know we will continue to see
increases in input costs. That makes the need to have effective and
predictable risk management tools even more important. The challenge
for producers, Congress, and the CFTC is to ensure that markets offer a
way for all participants to share risk. It is not acceptable to expect
individual producers to take futures positions in a market environment
where the risk and capital requirements are so high that even large
multinational grain companies don't want to participate.
ASA expects the CFTC to continue open discussion of these issues
with all interested parties and to take judicious action to restore
confidence in the futures market. It is the CFTC's responsibility to
ensure the markets provide accurate price discovery and hedging
opportunities for farmers.
ASA previously offered the following short-term recommendations to
the CFTC and we were pleased to see the Commission adopt many of them:
We agree with the CFTC's decision to delay revision of
speculative position limits. As we stated in our December 2007
comments on this subject, ``If the changes could exacerbate
lack of convergence, ASA would be opposed to increasing the
limits.'' We reiterate our request that the CFTC analyze
whether increasing speculative position limits would negatively
affect convergence of cash and futures markets, and not proceed
with the increase if it is determined that such increases would
have negative effects.
We second the many calls for a moratorium on new hedge
exemptions, as well as a moratorium on expansion of the hedge
exemptions already approved. While markets are in such flux,
and while questions persist about whether index funds are
legitimate hedgers, placing a moratorium on further hedge
exemptions is the only reasonable course.
We support the request of the National Grain and Feed
Association (NGFA) for more detailed reporting in the
Commitments of Traders report.
We are greatly concerned that the extensive divergence in
the cotton futures/cash market in March that crippled the
industry could happen in soybeans and the other markets. We
strongly support an investigation into activities in the cotton
market during that time period.
We agree that food producers and other market participants
need to work together, rather than relying on more regulation.
We encourage the CFTC's leadership in facilitating that
dialogue, and recommend the Agricultural Advisory Committee as
the forum where that dialogue can continue.
We support analysis of whether the addition of more delivery
points would aid futures and cash price convergence, as well as
analysis of other changes in delivery terms that would
positively impact convergence.
We encourage the CFTC to analyze and then educate market
users about the potential impacts of clearing of ag swaps by
the CME, as well as cash settlement contracts. Producers have
little information about these tools and their potential
impacts.
Above all, we strongly encourage the CFTC to work
expeditiously with producers, the exchanges, and other market
participants to develop solutions and tools that allow
traditional hedgers to have greater confidence in futures
markets.
ASA appreciates the oversight of Congress on these issues. The
CFTC's role and responsibility should be to ensure the integrity of
futures markets and to provide the price discovery and risk management
functions needed by producers. We look forward to continuing a
productive relationship with other market stakeholders that leads to
renewed confidence in the market and marketing opportunities for all
farmers.
______
Submitted Statement of CoBank
Introduction: CoBank and Agricultural Lending
CoBank is a $59.2 billion cooperative bank that provides financing
to rural cooperatives and critical lifeline businesses--food,
agribusiness, water, electricity and communications--across the United
States. Part of the $197 billion U.S. Farm Credit System, the bank also
finances U.S. agricultural exports. CoBank is owned by its U.S.
customer-owners, approximately 2,200 agricultural cooperatives, rural
communications, energy and water systems, Farm Credit associations, and
other businesses serving rural America. CoBank is governed by a 16
member Board of Directors, the majority of which is elected by our
customer-owners. CoBank returned $245 million in patronage refunds to
its cooperative owners and paid $97 million in Federal income taxes in
2007.
We are pleased to have the opportunity to comment on the challenges
that the unprecedented developments in the commodity markets are posing
for country elevators * and other grain merchandisers, as well as the
agricultural lenders on which they depend.
---------------------------------------------------------------------------
* For the purposes of this discussion, the term ``country
elevator'' refers to country elevators and other grain merchandisers as
well as cotton cooperatives and private cotton merchandisers.
---------------------------------------------------------------------------
The issue of credit availability is of vital importance not only
for these businesses, but also for our agricultural economy and the
entire U.S. economy. We concur with a number of industry stakeholders
that a prudent and fiscally responsible official credit enhancement
program could ease the financial stress that rising commodity prices
are imposing on country elevators so that these businesses that are of
critical importance to our nation's food security and economic well-
being can continue to operate successfully.
The Impact of Rising Commodity Prices on Country Elevators
Country elevators play a vital role in the U.S. economy.
Cooperative and privately owned country elevators provide essential
services that allow farmers the ability to capitalize on market
opportunities by serving as an important intermediary between producers
and end-users. Country elevators provide farmers with storage,
transportation, and the ability to retain ownership of harvested crops
until they can be efficiently sold into the marketplace. The system of
country elevators in the U.S. has functioned successfully for many
decades and has assured fair and competitive pricing to farmers as well
as access to growing international markets that otherwise would be
unavailable.
Many country elevators are experiencing financial stress as the
result of rising and volatile commodity prices. This stress stems
primarily from the dramatic increase in the volume of funds required
for the ``hedging programs'' that country elevators have traditionally
used to mitigate price risk for farmers. Farmers traditionally have
been able to lock in a price for their crop by selling their future
production to country elevators through what is known as a ``forward
contract.'' Country elevators, in turn, protect themselves from the
risk that prices may fall before the crop is delivered to them by the
farmer by ``hedging'' on an exchange such as the Chicago Board of Trade
or Minneapolis Grain Exchange via ``futures contracts.'' A futures
contract essentially assures the country elevator a minimum future
selling price--and, presumably, a profit--on the grain it has agreed to
purchase from the farmer. If the actual price of grain (or cotton)
increases above the price in the hedging contract, the commodity
exchange requires the country elevator to post additional funds. This
requirement is known as a ``margin call.'' Like any party to a futures
contract, the country elevator must post the additional funds
immediately or the exchange has the right to liquidate the country
elevator's position in order to make up for any losses it may have
incurred on the country elevator's behalf. This would likely result in
a substantial and potentially serious financial loss for the country
elevator.
Such prudent hedging strategies have traditionally proven to be a
highly cost-effective and successful risk mitigation tool. But in
today's market, soaring grain prices are creating enormous margin call
requirements, often on a daily basis. Margin call requirements of this
magnitude have in turn caused hedging to become an extremely capital
intensive activity. This means that country elevators have been forced
to devote increasing volumes of funds to meeting margin call
requirements, which in turn has driven up their borrowing needs at an
unprecedented pace. Another factor driving the demand for credit is the
rising cost of agricultural inputs--seed, fuel, fertilizer, etc. Many
country elevators source these inputs in bulk and sell them at a price
that is lower than what farmers would pay if they were to purchase them
as individuals. Often, the country elevator sells these inputs to
farmers on credit. When the price of these inputs increases, so do the
borrowing needs of country elevators.
CoBank's Response to Our Customers' Credit Needs
CoBank is committed to serving our traditional customers in the
grain and cotton industries. We have taken extraordinary steps to
ensure a steady flow of capital to these customers during these
volatile market conditions. For example, in the last sixty days CoBank
has raised some $700 million in (non-voting) capital from outside
investors. This $700 million compares with $1.0 billion in outside
capital raised over the previous 6 years. The additional capital will
allow CoBank to increase its capacity to meet the borrowing needs of
our customers. CoBank has also increased its capacity to accommodate
new loans by working with other Farm Credit System institutions and
with commercial banks to source the capital required for meeting our
customers' credit needs through loan syndications (partial sales to
other financial institutions of loans originated by CoBank).
Reflecting the unprecedented demand for credit, CoBank's loans to
our ``middle market'' agribusiness customers increased from just under
$7 billion at the end of 2005 to nearly $18 billion at the end of March
2008, an increase of 158 percent (refer to Figure A). ``Grain marketing
and farm supply customers'' accounted for 72 percent, or nearly $13
billion, of the total (refer to Figure B). In addition, loans to these
customers increased by several billion dollars in the month of June
2008 alone, due to the impact on prices of flooding in the grain belt
and the need for country elevators and other farm supply cooperatives
to prepay suppliers for their 2009 agricultural input supplies. In the
past 6 months, CoBank has processed 649 ``rush'' requests for credit
line increases from our customers. This represents 85 percent of the
volume of such requests that were approved in all of 2007. In numerous
cases, our credit lines to individual grain and farm supply customers
have doubled or tripled--from $5 million to $15 million or $50 million
to $150 million, for example--while the equity capital and the debt-
carrying capacity of these customers has remained essentially
unchanged.
Figure A
Impact of the Credit Constraint on Country elevators and Producers
Historically, a country elevator's ability to offer forward
contracts to farmers has been constrained primarily by the availability
of storage space and transportation. Because of the rapid escalation of
commodity prices, credit availability has also become a limitation.
Accordingly, a country elevator may have to limit forward contracting
because it lacks the borrowing capacity to fund the margin calls that
would be required if prices increase further. If the country elevator
cannot fund margin calls, then it cannot hedge against a potential drop
in prices. The country elevator would therefore be assuming all of the
price risk associated with offering forward contracts to farmers. It is
important to remember that by avoiding excessive risk a farmer-owned
country elevator protects the investment of its farmer members in the
cooperative business.
For many months, country elevators and their lenders have
shouldered the bulk of the risk stemming from volatile and rising
commodity prices. For the reasons explained above, it is increasingly
difficult and expensive for a country elevator to maintain ``short
futures'' positions for multiple crop years, from the time it enters
into a forward purchase contract with a producer until it physically
delivers grain to an end-user. Even the major global grain
merchandisers have found the cost and risk of maintaining such
positions to be extremely difficult, in spite of their substantial
financial resources.
In principle, a farmer can himself lock in a future selling price
by opening his own hedging account, rather than by forward contracting
with a country elevator. This would subject the farmer, instead of the
country elevator, to margin calls on short futures contracts, if grain
prices increase. Farmers and their lenders have generally been
unwilling to take this approach, due to the potentially unlimited
funding requirements and in some cases due to a lack of information
and/or expertise. Accordingly, as country elevators scale back their
forward contracting practices due to the enormous burden of funding
margin calls, farmers may be left without the ability to lock in future
prices--a tool that traditionally has been crucial to their planting
and risk management decisions.
A Proposal To Address the Credit Constraint
CoBank remains committed to supporting the industry. There are,
however, limits to the concentration of risk that CoBank or any
financial institution can assume on a single borrower or industry
segment, as explained above. In view of the credit constraint facing
grain industry borrowers, we are concerned that some country elevators
may find themselves unable to meet the dramatically increased liquidity
demands that would result from another round of price increases in the
grain markets. Such a liquidity crunch would likely have significant
negative consequences for the grain industry and for U.S. agriculture.
A widespread liquidity crunch in the industry could entail serious
spill-over impacts on the commodity exchanges, the financial markets,
and the U.S. economy as whole.
CoBank is working with other concerned industry stakeholders to
formulate a solution to reduce the risk of a liquidity crisis in the
grain industry and to protect the ability of farmers to market their
grain. Among the solutions we are considering is an official guarantee
on loans to country elevators and other grain and cotton merchandising
businesses. A guarantee of this type would enhance the availability of
credit to grain merchandisers for margin calls and for other short-term
financing requirements, thereby allowing them to continue to fulfill
their traditional and vital role in the U.S. food production system.
Because only a fraction of the amount of any guarantees issued would be
``on-budget,'' this alternative would also be a cost-effective means of
reducing the risk of a potentially serious and much more costly
dislocation in the U.S. grain marketing system and of avoiding the
industry consolidation that would likely result from such a
dislocation.
In considering such a guarantee, we believe that the following
general parameters should guide any proposal:
Guarantees should be available in a timely fashion (we note
that USDA's Commodity Credit Corporation may have the
flexibility under existing law to provide a guarantee program
for grain and cotton merchandisers);
Guarantees should support only participants in the physical
markets;
Guarantees would apply to payments due to lenders, not
lender losses, to ensure continued liquidity in this highly
volatile market; and
Guarantees would be available regardless of the type of
regulated financial institution the grain merchandiser
utilizes.
Conclusion
These parameters constitute what CoBank considers to be the general
outlines of an effective official guarantee program. We welcome the
opportunity to work with this Committee, the Department of Agriculture
and other government agencies, industry trade associations and
stakeholders, and the commercial banking industry to assure that the
country elevator system in the U.S. can withstand the stresses that are
being placed upon it today. A sound and reliable country elevator
system is vital to the U.S. farmer's ability to continue to produce and
market the ample supply of grains, oilseeds, cotton and other essential
agricultural products from which the U.S. consumer has so greatly
benefited.
______
Submitted Statement of Woods Eastland, President and CEO, Staplcotn;
Member, Board of Directors, Amcot
Mr. Chairman and Members of the Committee, as President and CEO of
Staplcotn and a Member of the board of Amcot, I am pleased to submit
the following statement on behalf of Amcot, the trade association
representing the four major cotton marketing cooperatives in the United
States: Staple Cotton Cooperative Association (Staplcotn) of Greenwood,
Mississippi; Calcot of Bakersfield, California; Plains Cotton
Cooperative Association of Lubbock, Texas; and Carolinas Cotton Growers
Cooperative of Raleigh, North Carolina.
I appreciate the earlier opportunity to submit testimony to the
Subcommittee on General Farm Commodities and Risk Management for its
May 15, 2008, hearing regarding agricultural commodity futures markets.
In addition to summarizing that statement, which offered an analysis of
the outcomes and effects of the cotton futures markets events of late
February and early March, 2008, I would like to offer some suggestions
for the Committee's consideration for amending the Commodity Exchange
Act.
The public policy of the United States in regard to the practices
of regulated commodity exchanges is embodied in section 3 of the
Commodity Exchange Act (7 U.S.C. 5), which states:
(a) Findings.--The transactions subject to this Act are entered
into regularly in interstate and international commerce and are
affected with a national public interest by providing a means
for managing and assuming price risks, discovering prices, or
disseminating pricing information through trading in liquid,
fair and financially secure trading facilities.
(b) Purpose.--It is the purpose of this Act to serve the public
interests described in subsection (a) of this section through a
system of effective self-regulation of trading facilities,
clearing systems, market participants and market professionals
under the oversight of the Commission. To foster these public
interests, it is further the purpose of this chapter to deter
and prevent price manipulation or any other disruptions to
market integrity; . . .
Section 4a(a) of the Act (7 U.S.C. 6a(a)), ``Excessive Speculation
as Burden on Interstate Commerce'', further states, in pertinent part:
(a) Excessive speculation in any commodity under contracts of sale
of such commodity for future delivery made on or subject to the
rules of contract markets or unreasonable fluctuations or
unwarranted changes in the price of such commodity, is an undue
and unnecessary burden on interstate commerce in such
commodity. For the purpose of diminishing, eliminating, or
preventing such burdens, the Commission shall, from time to
time, after due notice and opportunity for hearing, by rule,
regulation, or order, proclaim and fix such limits on the
amounts of trading which may be done or positions which may be
held by any person under contracts of sale of such commodity
for future delivery on or subject to the rules of any contract
market or derivatives transaction execution facility as the
Commission finds are necessary to diminish, eliminate, or
prevent such burden.
The strongest evidence of whether a contract market satisfies its
obligation to the public interest of managing and assuming price risks,
discovering prices, or disseminating pricing information, and
preventing excessive speculation or unwarranted changes in the price of
such commodity so as to constitute an undue and unnecessary burden on
interstate commerce, is the relationship between the futures price and
the cash market price of the commodity. Not only is convergence during
delivery expected, but also a normal range of the spread (or ``basis'')
between the two markets during trading between delivery periods. A
normal basis spread over time is readily observable and should be
expected in a contract market meeting its obligations to the public.
When divergence between cash and futures of an abnormal degree occurs,
that contract market is failing to meet its responsibility to the
public under the Act, and its Board and management, and the Commission,
are statutorily bound to take immediate corrective action.
What we have seen in cotton futures markets is a persistent
divergence between the cash and futures market for cotton. This has led
to disruption in the markets which jeopardize their statutory purpose
and perhaps their fundamental existence.
Where Are We Today in Cotton?
(1) The futures and options markets today are not reliable
discoverers of prices. When the futures price increases
21.15 cents per pound in absolute terms (as it did between
February 20 and March 4, 2008) and 30.87 cents in synthetic
value over the same period, while the cash market (as measured
by the Seam's Grower to Buyer market) increases by only
4.21 cents/lb, any semblance of a reliable relationship upon
which business decisions can be made is destroyed.
(2) The futures and options markets are not reliable vehicles for
transferring risk. A buyer who bought physical cotton on the
Seam from a grower on February 20 at 63.38 cents/lb, hedged the
purchase at spot month futures of 72.19 cents, and then sold
the cotton on 3/04 at 63.40 cents and bought back his short
hedge would have lost 16.65 cents/lb, or 26.3% of the purchase
price. This certainly fits the Act's definition of an
unreasonable fluctuation or unwarranted change in the price of
the commodity that constitutes an unnecessary burden on
interstate commerce.
(3) Fear of a repetition of these events prevents the middlemen
between producers and mill consumers from entering into forward
crop contracts, unduly burdening interstate commerce in the
commodity.
(4) Fear of the repetition of these conditions and the potentially
ruinous margin calls inherent in such uncontrolled situations
prevents cooperatives from carrying out their customary risk
management practices for their members, wherein they would
normally sell futures contracts at target market levels.
During and since these occurrences, the management and Board of ICE
Futures U.S. failed to fulfill its self-regulation requirement under
the Act to meet its statutory obligation to the public, and the
Commodity Futures Trading Commission failed to fulfill its statutory
obligation under the Act to force the management and Board of ICE
Futures U.S., and other contract markets similarly impacted, to take
such action. I understand that the situation is not unique to cotton.
Thus we believe that amendments to the Act are necessary.
Why Do These Markets No Longer Serve As Acceptable Vehicles for Price
Discovery and Risk Transfer, and What Can Be Done To Restore
Them?
In governing an agricultural futures market, every decision must
recognize one salient fact--the number of true hedges of the physical
agricultural commodity that can be placed in the contract market is
finite because it is dependent on the size of the crop, and how much of
that limited supply remains unconsumed. All futures or options
positions in excess of that number are not true hedges of the
physicals. This is recognized in the Act and has historically been
recognized by placing limits on the size of the positions of every
class of market participant. What was historically achieved was a
careful balance between hedgers of the physical commodity and
speculators that kept the relationship between the price of the futures
contract and the cash commodity within a historically recognized range
that was generally accepted by the trade in their cash contracts, thus
not burdening interstate commerce. Achieving this balance was made
easier in that many classes of pooled money, such as pension funds,
chose not to trade in commodity markets under the belief that they were
too speculative. The agricultural commodity markets thus were governed
and regulated overwhelmingly in order to facilitate the flow of the
physical agricultural commodity through the distribution chain. The
fact that most of the approved contract markets were not organized for
profit meant that the owners and the Board they elected were concerned
most with achieving price discovery and risk transfer for themselves.
All this changed and has thrown things out of balance. Currently
there is an inherent conflict of interest between the management and
Boards of for profit exchanges and their self-regulatory obligation. To
limit market participants to achieve the requirements of the Act
potentially costs them trading volume, which costs them money. In
addition, there has been an exponential growth in the open interest
position of speculators and of traders defined by the CFTC as
``hedgers'', but who don't trade the physical commodity in interstate
commerce. Consider for instance that the dollar volume of investor
funds tied to the Standard & Poor's Goldman Sachs Commodity Index (S&P
GSCI) has grown from $60 billion in 2006, to $85 billion in 2007, and
is projected by some to reach $100 billion in 2008. (Source: Pastine,
Alejandro S., ``Speculation and Cotton Prices,'' Cotton: Review of the
World Situation, International Cotton Advisory Committee, Volume 61--
Number 4, March-April, 2008). This excellent analysis points out that
even though the dollar value of index traders' funds has increased
dramatically, in cotton at least, ``index traders have not been the
main force behind the increase in open interest for cotton futures and
options, but non-index traders speculators have.'' It includes the
following table:
Under current statute the CFTC must regulate these markets so that
a means is provided for managing and assuming price risks, discovering
prices, or disseminating pricing information through trading in liquid,
fair, and financially secure trading facilities; to deter and prevent
price manipulation or other disruptions to market integrity; and to
prevent excessive speculation or unreasonable fluctuations or
unwarranted changes in the price of the commodity. Failure to do so
places an unnecessary burden on interstate commerce. Currently, in my
opinion, the Boards and management of the agricultural commodity
markets through self-regulation, and the CFTC through regulation, are
failing in their statutory obligations to achieve these ends. Hopefully
these hearings are part of a process by which Congress will ensure that
the CFTC will meet its statutory obligations. Failure to do so will
result in these markets being managed and regulated primarily for the
purpose of providing investment vehicles to attract a flow of
investment funds. . Although some may desire this, it does not comport
with the Act's straightforward purposes for which the markets are to be
regulated: namely, price discovery and risk transfer.
Recommendations
At the CFTC's Agricultural Markets Forum held last month, the
members of Amcot respectfully urged the Commission to implement or
publicly respond to several specific recommendations by June 1, 2008.
While the CFTC has taken modest steps with regard to these
recommendations, in the main these concerns remain un-addressed. As
such, we respectfully recommend that the Committee act on the following
recommendations to protect our agricultural markets:
(1) Adopt an amendment to the Commodity Exchange Act to define
transactions that qualify as a ``hedge'', and market
participants that qualify as a ``hedger'', for purposes of the
agricultural futures markets. We offer the following draft
amendment to the Act for your consideration in addressing this
critical issue:
Amend section 1a of the Commodity Exchange Act (7 U.S.C. 1a) by
adding at the appropriate place the following definition:
``(xx) agricultural market hedger.--The term `hedger'
means a person that, in connection with its business--
``(A) can demonstrate that as a part of its
normal business practice it makes or takes
delivery of the underlying agricultural
commodity as part of the commodity's
production, distribution, or consumption; and
``(B) incurs risk, in addition to price risk,
related to the commodity''
We are keenly aware that this is a very complex area of the law. As
such, we offer this suggested draft language in good faith, and
in the expectation that we might work with the Committee to
improve and perfect this language to help to achieve the
desired effect of restoring and protecting the integrity of our
agricultural futures markets.
(2) Similarly, consideration should be given to whether the current
definition of ``speculator'' adequately and appropriately
captures the positions taken by the various speculative
participants in agricultural markets. We respectfully suggest
the Committee differentiate more than one type of speculator,
with appropriately differing position limits and margining
requirements for each.
(3) In addition, our cooperatives and their farmer owners are also
consumers of substantial quantities of oil and energy based
products that are also subject to the effects of futures
trading in those commodities. We leave to the Committee
whether, and if so how, to define in statute which transactions
in energy-related futures and/or in other physically settled
commodities outside of agriculture are hedge transactions and
which traders may be hedgers. We are inclined to believe that a
similar hedge definition would be helpful in these markets.
However, our experience and expertise in futures trading is
concentrated in the cotton and other agricultural futures
markets, and we feel strongly that these definitional
clarifications should, at a minimum, be applied to these
agricultural markets as soon as possible.
(4) Require that index funds be subject to the same speculative
position limits and speculative margin requirements as a
managed commodity fund, and that their positions be reported at
least weekly to the CFTC.
(5) Initial margin required should be mandated so that true
agricultural hedgers, as defined in recommendation number (1),
above, have the lowest margin requirements, and speculators the
highest. The spread of initial margin between these true
hedgers and the various classes of speculators must be
significantly greater than the current spread between hedgers
and speculators.
(6) Analyze what regulatory changes are necessary in order to
restore a balance in agricultural contract markets between the
positions of hedgers involved in production, distribution, or
consumption and all other categories of traders that will make
these markets meet the requirements of the Act as quoted above.
This would include, but not be limited to,
(a) Establish the maximum size of speculative limits
that can be approved for a particular market on a
market by market basis, and not on a ``one size fits
all'' basis. This should result in a decrease in CFTC
allowed maximum position limits for smaller contract
markets.
(b) Requiring market participants to report to the CFTC
weekly the positions held in the contract market that
are offsetting swap and OTC contracts, so that the CFTC
can have that information available to monitor possible
price disruptive behavior.
(c) Require that daily trading range limits be
established in agricultural contract markets for
futures and options on futures.
(7) Require that contract markets that are organized on a for
profit basis contract with an independent third party to
provide their market surveillance function and that all copies
of this independent third party's reports be forwarded to at
least two public members of the contract market's Board.
(8) Investigate the events in the cotton futures market of February
20&March 20, 2008, which in the opinion of this writer
constituted an undue burden on interstate commerce under the
Act, to determine what caused the unreasonable fluctuations and
unwarranted changes in price. Since the board and management of
the contract market and the Commission are statutorily bound to
prevent such trading, such an investigation is necessary so
that appropriate safeguards can be developed to prevent its
repetition in this or some other contact market.
(9) Finally, we renew our request that the Committee require the
Commodity Futures Trading Commission to report to Congress what
steps it has taken to require the management of contract
markets to operate their exchange in compliance with the Act.
On behalf of Amcot and the thousands of producer-members of our
cooperatives, we would like to sincerely thank the Committee for
continuing to investigate these complicated issues. They are of
critical importance to the immediate livelihood and the long-term
stability of our cotton and other agricultural markets. We look forward
to working with you to address these important issues.
______
Submitted Statement of USA Rice Federation and U.S. Rice Producers
Association
Introduction
Mr. Chairman and Members of the Committee, the futures markets are
intended to serve the primary roles of price discovery and risk
management for producers and users of agricultural commodities.
Unfortunately, for several months the markets have been volatile and
unsettled, resulting in a divergence between cash and futures prices
and significant increases in margin requirements. This has been
observed across almost all agricultural commodity contracts on the
various exchanges, but we will focus our comments on the rice market
and the Chicago Board of Trade rice contract.
Due to the critical importance of these markets to the marketing
plans and livelihood of rice producers and all of U.S. agriculture, we
appreciate the Committee conducting these hearings to review
legislation to amend the Commodity Exchange Act. On behalf of the U.S.
rice industry, we would like to take this opportunity to provide
several recommendations for your consideration in this regard.
Background
There are a number of fundamental factors in the market that are
leading to higher rice prices including:
tighter global supply based on lower production due to
weather events and acreage shifts to other crops and increased
demand;
increased costs of production; and
increased energy costs that lead to higher storage and
transportation costs.
The presence of all these factors should lead to convergence of
cash and futures prices, but we are experiencing a lack of convergence
due in part to increased participation by speculators in the market.
Speculator participation in these markets is important to provide
liquidity to the market, but there must be limits on participation.
There have been instances of funds owning more of some crops on paper
than will be produced during that crop year. This level of
participation has hampered the price discovery role of the market, has
damaged the cash market for rice, and has diminished rice producers'
profitability.
We are concerned that this lack of convergence will continue as
long as speculators and funds remain in the market to the current
degree as unrestricted buyers. As a result, we will continue to see
very few, if any, commercial marketers offering forward pricing
opportunities. Many commercial market participants have exhausted their
working capital and credit lines available for margin requirements and
are therefore no longer in the market. This is particularly damaging to
producers as they are no longer able to forward price their expected
harvest, leaving them exposed to significant price risk. Producers are
facing this price risk at a time of record high input costs. In fact,
many producers are still unable to lock in sales prices through forward
contracts for their expected crop production for 2009. Because of this,
it is clear that the futures market is no longer performing one of its
primary functions--hedging and price risk management.
The on-line Glossary of futures terms of the Commodity Futures
Trading Commission (CFTC) defines the term ``hedging'' as follows:
``Hedging: Taking a position in a futures market opposite to a
position held in the cash market to minimize the risk of
financial loss from an adverse price change; or a purchase or
sale of futures as a temporary substitute for a cash
transaction that will occur later. One can hedge either a long
cash market position (e.g., one owns the cash commodity) or a
short cash market position (e.g., one plans on buying the cash
commodity in the future).''
On its face this appears to be a common sense definition for the
hedging of agricultural commodities by commercial market participants.
However, over time the ``hedgers'' have grown to include large numbers
of entities other than commercial participants in the agricultural
industry.
Recommendation #1: Clearer Definitions of Agriculture Market Hedgers
and Speculators
For purposes of agricultural futures markets, hedgers should be
defined as those physical market participants tied to the physical
commodity. By contrast, those agricultural futures market participants
not tied to the physical commodity should be defined as speculators. In
addition, increased speculative margin requirements and tighter
position limits for speculators could also help improve the situation.
We believe an excessive level of participation by speculators is at
least partially responsible for the current market situation. This
includes entities other than commercial agricultural market
participants that the CFTC may currently define as ``hedgers''. Without
the improvements recommended above, we believe the market will continue
to be lacking in its ability to perform its two primary functions of
price discovery and hedging. This critical failure needs to be
corrected as soon as possible. These necessary steps must be taken to
ensure that commercials can reenter the market and perform their role
as hedgers for the physical commodity.
Recommendation #2: Speculative Margin Requirements
While it is important to insure there is adequate margin to cover
any default, we urge the consideration of a requirement of consistently
higher initial and maintenance margin requirements for speculators than
for hedgers (redefined as described in Recommendation #1, above).
Congress and the CFTC should consider more closely linking the margin
requirement in rice and other agricultural futures markets to both the
price level and the amount of market volatility in the market.
We are of the opinion that the rice market has suffered from being
``cornered'' in a non-traditional sense--not by one market
participant--but by the fact that hedgers can no longer afford to take
short positions (sell) in the market while speculators and funds
continue to take long positions (buy), creating a ``demand'' market in
rice that is self-fulfilling.
We completely agree that margin requirements must be sufficient to
insure performance, however we also suggest that Congress and the
Commission consider that only those that deal in or are tied directly
to the physical commodity--including producers, processors, merchants,
marketers, and end-users--be considered hedgers for determining
necessary margin requirements on this category of market participants.
On the other hand, index, pension, and other funds not tied to the
physical commodity should be considered speculators with different
(higher) margin requirements (with respect to both initial and
maintenance margin) and separate position limits.
Again, due to the increasing margin requirements resulting from
increased market volatility, more and more commercial agricultural
market participants are exiting the market as their available capital
and lines of credit are becoming increasingly stretched to the point
they can no longer afford to hedge their price risks. The result is
that the markets are failing in their ability to perform their two
primary statutory functions of price discovery and hedging.
Recommendation #3: Rice Futures Delivery System; Increased Storage
Rates; Cash Settlement for Rice Futures
We urge the Committee and the CFTC to review the delivery system
for rice futures contracts, and also to consider raising rice storage
rates. Some market participants believe that adding delivery points
would help improve convergence in the rice futures markets. In
addition, we would urge a review of whether the use of cash settlement
of rice futures contracts would better serve producers, hedgers, and
others using these vital markets.
Recommendation #4: Enhance Reporting and Transparency of Rice Futures
Trading and Markets
Add rice to the weekly CFTC supplemental Commitment of Traders
report, and provide reporting categories for speculators and funds that
are separate from the traditional hedgers (consistent with
Recommendation #1, above).
In order to maintain the integrity of these markets, it is
important to provide increased transparency of market activities. The
above actions would help to provide a more comprehensive view of what
is occurring in the rice futures market to the benefit of rice
producers, processors, and marketers.
Conclusion
In summary, we believe that the participation of speculators
(funds) in the market is leading to increased volatility and negatively
impacting the ability of the futures markets to perform its two primary
statutory functions of providing price discovery and hedging. As the
increased margin requirements, volatility, and lack of confidence cause
more and more commercials to withdraw from the market, the divergence
between cash and futures prices will only worsen. If and when the funds
begin to withdraw from the market, we could be in store for a severe
price correction that could lead to significant financial losses and
instability, which could further prohibit participation by commercials
and producers. Steps need to be taken to address this situation and to
prevent its reoccurrence in the future.
We appreciate the opportunity to share our views and
recommendations with the Committee, and look forward to working with
the Committee, the CFTC, and others in agriculture to help address the
current market situation so that all in the rice industry can once
again have confidence that the futures market will meet the industry's
price discovery and risk management needs.
Thank you again for convening these timely and important hearings.
If you have any questions or would like any additional information,
please contact Mr. Reece Langley at the USA Rice Federation at
[Redacted] or [Redacted], or Mr. Fred Clark on behalf of the U.S. Rice
Producers Association at [Redacted] or [Redacted].
HEARING TO REVIEW LEGISLATION AMENDING THE COMMODITY EXCHANGE ACT
----------
THURSDAY, JULY 10, 2008
House of Representatives,
Committee on Agriculture,
Washington, D.C.
The Committee met, pursuant to call, at 10:12 a.m., in Room
1300, Longworth House Office Building, Hon. Collin C. Peterson
[Chairman of the Committee] Presiding.
Present: Representatives Peterson, Holden, Etheridge, Baca,
Cardoza, Scott, Marshall, Herseth Sandlin, Cuellar, Costa,
Salazar, Ellsworth, Boyda, Space, Walz, Gillibrand, Kagen,
Pomeroy, Barrow, Lampson, Donnelly, Mahoney, Childers,
Goodlatte, Moran, Hayes, Johnson, Graves, Rogers, King,
Neugebauer, Boustany, Kuhl, Foxx, Conaway, Fortenberry, Smith,
Walberg, and Latta.
Staff Present: Adam Durand, Alejandra Gonzalez-Arias, Scott
Kuschmider, John Riley, Kristin Sosanie, Bryan Dierlam, Alise
Kowalski, Kevin Kramp, Josh Maxwell, and Jamie Weyer.
OPENING STATEMENT OF HON. COLLIN C. PETERSON, A REPRESENTATIVE
IN CONGRESS FROM MINNESOTA
The Chairman. The Committee will come to order. We welcome
the witnesses. What we are doing here today is to try to focus
in on the different areas that are under question that have
been addressed in different bills that have been introduced. We
tried to set these panels up to focus in on the specific areas
that have been raised during this debate. And we are trying to
do this in a way to focus in, not get off and mix up different
parts of this.
So the first panel here is dealing with swaps. All right.
The swaps and over-the-counter market and so forth. And we want
to welcome the panel: Mr. Greg Zerzan, Counsel and Head of
Global Public Policy, International Swaps and Derivatives
Association; Mr. Charles Vice, President and the COO, Chief
Operating Officer, of the IntercontinentalExchange, ICE, of
Atlanta, Georgia; Mr. Michael Comstock, the acting Director of
the City of Mesa, Arizona, Gas System on behalf of the American
Public Gas Association; Mr. Michael Greenberger, University of
Maryland School of Law, who teaches a course in this area, as I
understand it, and he has offered to maybe bring some of us in
as his students and try to educate us a little bit, which at
least I know I could use; Dr. Craig Pirrong, who is a Professor
of Finance and Director of Global Energy Management Institute
of Bauer College of Business, University of Houston, from
Houston, Texas.
So we welcome the panel, and I know at least this Member
has a lot to learn, and there are a lot of differences of
opinion. We are hoping that through this process we can sort
through some of this.
I spent 10 years or better trying to understand dairy
policy in this country, and it is one of those things that
whenever I would get to the point where I thought I understood
it, then I would learn something that would completely
undermine everything that I thought I knew. I am finding that
this issue is very much the same as that. And so we are hoping
that this exercise will help us to understand better the
situation and get to the bottom line.
[The prepared statement of Mr. Peterson follows:]
Prepared Statement of Hon. Collin C. Peterson, a Representative in
Congress From Minnesota
Good morning and welcome to today's hearing.
Today marks the second of three hearings this week to review
legislative proposals to amend the Commodity Exchange Act.
We have three full panels today and a lot of ground to cover, so I
will keep this very brief and not repeat what I said yesterday about
the purpose of these hearings.
Yesterday we heard from six of our House colleagues who have
introduced bills that would amend regulation of commodity futures
markets. Today and tomorrow, we will hear from stakeholder groups about
these and other legislative proposals, as well as the major issues
currently surrounding commodity futures and options markets.
What we intend to do over the next 2 days is have each panel
examine one of these subjects in detail. Today's three panels will look
at:
The swaps and the over-the-counter market;
Pension fund and index funds; and
Hedge exemptions and speculation position limits.
Today's witnesses will hopefully shed some light on these topics
and how legislation that has been introduced would affect them. Some
groups, of course, have vested interests in more than just one area,
and that will be reflected in their broader written testimony submitted
for the record. But with so much to get to today, we will try and keep
this as focused as possible.
At this time, I now yield to the Ranking Member of the Committee,
Mr. Goodlatte for an opening statement.
The Chairman. I recognize the gentleman from Virginia for a
statement.
OPENING STATEMENT OF HON. BOB GOODLATTE, A REPRESENTATIVE IN
CONGRESS FROM VIRGINIA
Mr. Goodlatte. Thank you, Mr. Chairman. I was just going to
ask if you had now mastered dairy policy.
The Chairman. No. But they say there are five people in the
United States that really understand it, and those five people
are lying.
Mr. Goodlatte. Well, thank you, Mr. Chairman, I look
forward to this testimony today. This is the second in a series
of hearings to try to uncover the truth about futures trading
and what impact it may be having on the price of energy,
particularly oil. And I think it is very important that we
learn from all of the witnesses that we have here today and
attempt to determine just exactly how well the Commodity
Futures Trading Commission and the laws they operate under are
working. So I will approach this with an open mind.
I will add, however, as I have at each of these hearings,
that while this is an important topic for us and is the
jurisdiction of our Committee, something that is not the
jurisdiction of our Committee is the most important thing that
we as a Congress can do to address the problem of the high cost
of energy, and that is to enact policies that would enable an
increase in the domestic supply of all sources of energy, be it
oil, natural gas, clean-burning coal, nuclear power, new
technologies, renewable fuels. All of these things could use
the Congress clearing the way to drill on Federal lands in
Alaska and the Rockies, offshore, to tap into what some believe
is the largest natural gas reserve in the world in the Gulf of
Mexico that is untapped. All of these things are the number one
thing that this Congress needs to be doing.
And I know I have a lot of agreement on that issue on both
sides of the aisle in this Committee. I just wish that that
would be reflected in the leadership of the House in allowing
some of the many bills introduced by Members on both sides of
the aisle to get to the floor of the House so that we could
address them and truly address the problem with the shortage of
energy that we have in this country. I think this is by far the
number one cause of rapidly rising prices of not just oil, but
other sources of energy as well. This is caused by the fact
that supply simply has not kept up with growing demand around
the world.
Thank you, Mr. Chairman.
The Chairman. I thank the gentleman.
If anybody else has any statement, they will be made part
of the record, without objection.
[The prepared statement of Mr. Graves follows:]
Prepared Statement of Hon. Sam Graves, a Representative in Congress
From Missouri
Thank you, Chairman Peterson and Ranking Member Goodlatte for
holding this hearing on speculation in the marketplace and its impact
on prices.
As I have mentioned in the past there is no silver bullet solution
to high energy costs, but rather a combination of things. Most
importantly, we must domestically produce fuel that we have available,
including in Alaska and in the Outer Continental Shelf. Opening
domestic resources for production can be done in an environmentally
safe way and can have a tremendous impact in reducing our reliance on
foreign sources of fuel. I agree with the majority of Americans that
this will help bring gas prices down.
I also believe that alternative fuels including wind, ethanol,
biodiesel, hydrogen, and others will help reduce our consumption of
traditional fossil fuels. Alternative fuels are not only cleaner for
our environment but their usage helps lower demand for crude oil and
will help bring prices down.
Today, we are looking at speculation in the market. I believe that
speculation has a role to play in discovering the true price of a
product. However, there are times when I feel that excessive
speculation, misinformation, and a lack of transparency can drive
prices up.
I have played an active roll in ensuring that traders are not
cheating the system. First by introducing legislation in the 109th
Congress, H.R. 1638, the Commodities Exchange Improvements Act of 2005,
then by co-authoring legislation in the 110th Congress, H.R. 3009,
Market Transparency Reporting of United States Transactions Act of
2007, and most recently by working with my colleagues in the farm bill
to shed more light on all energy commodities and how they are traded.
As you can see my record speaks for itself. I look forward to
working with my colleagues to ensure the American public and the people
of the 6th District are not being cheated by big traders in order to
make a buck.
Thank you.
The Chairman. So we will move to the panel. Panel members,
your statements will be made part of the record. We would
encourage you to summarize and talk to us in a way that we may
understand as best you can.
And so we will start with Mr. Zerzan, and we appreciate you
being with us today and taking the time to help educate us.
STATEMENT OF GREG ZERZAN, COUNSEL AND HEAD OF
GLOBAL PUBLIC POLICY, INTERNATIONAL SWAPS AND
DERIVATIVES ASSOCIATION, WASHINGTON, D.C.
Mr. Zerzan. Thank you, Mr. Chairman. And thank you, Members
of the Committee.
As this Committee knows, ISDA is the world's largest global
financial services trade association. We represent members in
the over-the-counter derivatives industry. We have over 830
members in over 52 countries around the world, and we routinely
deal with these types of issues in jurisdictions in Europe,
Asia, Latin America, as well as the United States.
As this Committee knows, over-the-counter derivatives are
primarily risk-management products. They were developed in the
United States in the early 1980s as a means of transferring
risk via the use of individually negotiated bilateral
contracts. Despite the fact that these contracts were first
invented in the U.S., the primary source of over-the-counter
derivatives business in the world now is the United Kingdom.
This Committee knows, because we spent most of last year
discussing one of the main topics that is of concern to ISDA in
the current debate, and that is proposals which would seek to
amend or repeal the protections from bilaterally negotiated
contracts. These are primarily found in sections 2(g) and 2(h)
of the Commodity Exchange Act. These provisions allow parties
to enter into a contract with the assurance that it will be
legally enforceable. And again, there is a long history of
these contracts, including a long history of case law upholding
the legal documentation which ISDA first developed.
And I won't dwell on the provisions of 2(g) and 2(h)
because this was the subject of multiple hearings and multiple
discussions in this Committee over the last year. And some of
the concerns regarding over-the-counter derivatives were, in
fact, addressed by the passage of the farm bill. Under this
Committee's leadership, greater transparency was extended to
electronic exempt commercial markets. And that legislative
provision was widely embraced both on a bipartisan basis, by
industry, by consumer groups, by end-users and by regulators.
And that achievement, which was less than 2 months ago,
deserves to be roundly applauded. So thank you for that.
The other provision which is of concern to ISDA are
proposals which would remove the ability of swap dealers to use
the futures markets to hedge their swap risk. And it is
important to understand that swap dealers are indeed hedging a
bona fide business risk. These are the risks that are passed on
to the swap dealers from their customers. In many cases those
risks are passed on to the swap dealers because the customers
either can't obtain protection through the futures markets or
are unwilling for a variety of operational issues to engage
futures.
And just a quick example of this is the case of airlines
who seek to hedge the risk of fluctuations in the price of jet
fuel, but there is no widely traded jet fuel futures contract,
so typically an airline will enter into a jet fuel swap, and
the swap dealer will then hedge its risk under that contract by
entering into a basis swap in West Texas Intermediate crude.
So, as you can see, the swap dealers are both performing a
valuable function which helps end-users and commercial
participants, and they are also hedging their own bona fide
business risk. So we are very concerned about any proposals
which would seek to prevent swap dealers from hedging these
risks.
Last, I would note that during the course of the debate
over the provisions that were enacted into the farm bill, this
Committee and this Congress showed great sensitivity to the
competitive issues that are associated with regulation of
financial markets. As you know, around the world there is
tremendous competition to attract the jobs and the revenues
that come with financial services, and there have been great
concerns expressed about America potentially losing its
competitive advantage in these areas. I am hopeful that
Congress will continue to bear in mind the dangers that are
posed to our country and our economy if we implement overly
restrictive measures which make it more attractive to do
business outside the United States.
I thank the Committee again for your leadership, and I look
forward to answering any questions.
[The prepared statement of Mr. Zerzan follows:]
Prepared Statement of Greg Zerzan, Counsel and Head of Global Public
Policy, International Swaps and Derivatives Association, Washington,
D.C.
Introduction
Thank you very much for inviting ISDA to testify today regarding
over-the-counter (OTC) derivatives, the Commodity Exchange Act and
recent activity in the commodity markets.
The Purpose and Role of OTC Derivatives in the Economy
As the Members of this Committee know, OTC derivatives are used for
a variety of risk management purposes. Initially developed in the
1980s, OTC derivatives have quickly become a core component of the risk
management operations of financial institutions, manufacturers,
producers, multinational corporations and investors both in the U.S.
and around the world. OTC derivatives are privately negotiated
contracts, with the material terms of a transaction worked out between
the parties. In this respect they differ significantly from exchange
traded futures and options, which are standardized and fungible
instruments subject to offset through the purchase of a contract with
the opposite exposure.
In the energy commodity space OTC derivatives are used by a broad
segment of market users looking to manage risks related to future price
movements of energy. For instance, a large producer that is exposed to
the price of oil through normal costs like fuel and the price of
fertilizer can hedge its risks by entering into a swap agreement
whereby it agrees to pay a fixed amount of money on a specified
quantity, for instance $140 a barrel, over a specified period in
exchange for receiving the floating price of crude over that same time.
In this way the producer will guarantee that its economic exposure is
no more than $140 a barrel and can budget its future operations on that
basis. Likewise a utility company that relies on natural gas to power
its generators can lock-in the future price of the commodity by
entering into a swap agreement with a counterparty such as a bank or
investment firm that is better equipped to deal with the risk of
floating prices.
OTC derivatives were invented to allow companies to mitigate price
shocks by passing on those risks to others that have the opposite
exposure, or are better suited to manage them. These risks can be
managed through custom-tailored contracts exactly suited to the
company's risk management needs.
In some cases OTC derivatives are used to gain exposure to some
underlying reference asset. For instance an institutional market
participant such as a pension fund or university endowment might
utilize an OTC derivative to benefit from the increase in the price of
a basket of stocks or commodities. The reasons an institutional market
participant might prefer to use an OTC derivative instead of futures or
stocks can vary, but could include such factors as costs, the ease with
which a swap agreement can provide diversification, legal constraints
on its ability to invest directly in certain asset classes, or the need
to custom tailor a transaction for portfolio management purposes. Cost
benefits are an especially important consideration; an investor can use
a total return swap to access exposure to an underlying commodity
without having to purchase and mange a bundle of futures contracts with
different delivery dates. Equally important is that OTC derivatives are
cash-settled, meaning an investor need not avoid physical delivery by
purchasing offsetting futures contracts (and incurring those
transaction costs as well).
OTC derivatives play a critical role in the global economy, and the
markets are international in scope. However, despite the fact that OTC
derivatives were first created in the United States, London has become
the center of the global OTC derivatives business with roughly 43
percent of the world's daily turnover occurring there.
Derivatives Are Not the Cause of Rising Commodity Prices
Recently there have been widespread accusations that derivatives
markets, and in particular speculators in derivatives markets, are
responsible for rising commodity prices.\1\ Some accuse speculators of
driving up the price of oil beyond levels justified by fundamental
economic factors, as well as increasing volatility. Others point to the
presence of investors in the market; it is asserted that even investors
with a long-term perspective enter as buyers and put upward pressure on
prices. And finally, because commodity derivatives, both exchange-
traded and over-the-counter, reduce the cost of transacting in
commodity markets, some call for restrictions on derivatives activity
as a way to reduce pressure on prices. Unfortunately these arguments
misunderstand the role of derivatives in informing commodity prices.
Putting tighter restrictions and further regulation on derivatives will
not reduce the price of oil, and might even make it more volatile.
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\1\&It is worth noting that prices for a wide range of commodities
for which there are no active exchange markets have likewise seen
tremendous price appreciation. Since 2001 cadmium and molybdenum prices
are up over 1,000%; rice has appreciated over 500%; iron ore and steel
have increased over 300%. Onions have increased over 300% this year
alone as of April 2008.
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Commodity derivative market participants can be divided into three
categories. The first category is ``commercial'' participants, which
include oil producers along with oil consumers such as airlines and
refineries. Commercial participants often, but not always, use
derivatives to hedge their exposures to prices and thereby reduce
risks. The second category is noncommercial participants, which
includes hedge funds, pension funds, and commodity trading advisers.
Noncommercials are often identified as speculators, that is,
participants that seek to take on risk in order to benefit from price
increases or decreases. The third category is intermediaries, also
known as dealers, which consist of banks and other financial firms as
well as energy trading subsidiaries of energy producers and utilities.
Intermediaries stand between hedgers and speculators in order to make a
market.
All three types of participants act as both hedgers and speculators
at different times, and all three types are necessary to an efficient
and liquid market. For hedgers to be able to transfer unwanted risk
there has to be someone to take on those risks. If dealers cannot find
another hedger with the opposite, offsetting risk then dealers will
look to speculators to take on those risks. In such a market,
restricting and otherwise raising costs to speculators will ultimately
raise costs to hedgers and make it more difficult to manage the
volatility of the prices they seek to manage.
A recent criticism of derivatives has been that prices are higher
than economic fundamentals would justify because both speculators and
investors place excessive upward pressure on prices. According to this
argument, investors use derivatives to enter as buyers in order to
enhance their returns and to hedge against inflation, while speculators
buy in anticipation of prices going even higher.
However, neither speculators, investors nor other derivative market
participants are the cause of the level and volatility of oil prices.
The reason is straightforward: physical possession of oil (or any other
commodity) is necessary to drive up prices. Evidence appears to be
lacking to support the necessary condition that speculators or
investors have been taking physical possession of oil and withholding
it from the global market.
The mechanics of the market can be explained as follows: assume
that a combination of speculators, hedgers, and investors all take long
futures positions. In isolation, all of these could potentially exert
upward pressure on prices were it not for the presence of two other
factors. First, for every long position there has to be a short
position (a seller) on the other side. Second, all speculators,
hedgers, and investors with long positions will be obligated to take
physical delivery of oil when the contract matures unless they exit out
of the contract beforehand. By selling contracts to exit their position
(and virtually all of these market participants will do so) downward
pressure will be placed on the price of oil. If the price were simply
high because of all the pressure from buyers, then the downward
pressure from the selling would cause the price to fall. But if the
price of oil were to remain high anyway (as has been the case
recently), it must necessarily be because there are participants with
long positions who are willing to buy and take possession of oil. And
this in turn could be either because someone has bought up oil supplies
so other buyers drive up the price--which is market manipulation and
therefore illegal--or because demand for the physical commodity has
increased relative to the supply available, thereby leading to a higher
price.
The above also applies with regard to over-the-counter markets such
as swaps. OTC derivatives are bilateral agreements, the vast majority
of which are cash-settled (and thus do not involve physical delivery).
Additionally many OTC derivatives are hedged using futures contracts,
which as explained above means the contracts are eventually sold prior
to maturity and thus exert downward pressure on prices.
Derivatives markets are price discovery markets; they reflect the
willingness of buyers and sellers to agree to a price for any given
commodity. While derivatives can help inform markets as to expectations
of future prices they are naturally checked by the actual physical
supply of the underlying commodity; in other words it is the market
forces of supply and demand, not derivatives, which are the cause of
rising commodity prices.
Recent Legal Developments and Legislative Proposals
(a) Recent Changes in U.S. Law
Since passage of the Commodity Futures Modernization Act in 2000
there have been efforts to amend the provisions of that law relating to
OTC energy transactions. Indeed, Congress has been very active in
increasing Federal oversight of the energy markets, such as the grants
of anti-fraud authority to the Federal Energy Regulatory Commission
over the natural gas and electricity markets (as part of the Energy
Policy Act of 2005) and to the Federal Trade Commission with respect to
the wholesale petroleum market (as part of the Energy Security and
Independence Act of 2007). It is worth noting that the precise
jurisdictional parameters of the FERC authority are still being
decided; meanwhile the FTC has just begun its rulemaking process.
Meanwhile less than 2 months ago Congress, lead by this Committee,
undertook the most sweeping changes to the Commodity Exchange Act since
the passage of the CFMA. As you are aware the amendments to the law
made by the CFTC Reauthorization Act of 2008, contained as a title of
the farm bill, occurred after a year of hearings, countless
conversations among policy leaders and market participants, consumer
groups and producers and manufacturers, and the consideration and
detailed recommendations of the President's Working Group on Financial
Markets. The amendments to the law were made within the context of a
thorough and carefully deliberated analysis of the current market,
changes in the industry since passage of the CFMA, and a careful
balancing of the costs and benefits of increasing oversight of the
energy derivatives business. Ultimately, led by this Committee, the
Congress passed legislation that won nearly unanimous praise from the
industry, consumer groups and the regulatory community.
The provisions of the recently passed farm bill made important
changes to how OTC markets are regulated, and are worth considering.
For this discussion the most relevant provisions of the law are those
relating to exempt commercial markets, which are markets among
sophisticated commercial users that operate electronically. Under the
new law those exempt OTC markets which list ``significant price
discovery contracts'' are required to submit themselves to a new,
principles-based regulatory regime that is modeled on those imposed on
fully regulated markets. However, recognizing the unique nature of
these markets and the fact they are limited to professional
participants, Congress chose to create a modified structure that
retains important regulatory measures such as monitoring for abusive
behavior, the ability to stop trading and the imposition of
accountability limits while at the same time permitting the maximum
amount of flexibility in order to encourage trading and accommodate
innovation. Congress also created large trader reporting for
significant price discover contracts as well as for agreements which
are treated as fungible with such contracts by a clearinghouse. These
provisions require substantive new reporting requirements for OTC
derivatives.
Congress carefully balanced the desire for greater oversight of
exempt commercial markets with a recognition of the global nature of
these markets, the reality of international competition for the
financial services business and an acknowledgement of the important
role these markets play in allowing U.S. companies to manage risk.
Over the last 3 years increased legal requirements have
significantly expanded regulatory oversight and knowledge about the
U.S. energy market. While some may feel these changes were overdue,
there can be no question that the rapid changes in the legal and
regulatory requirements for engaging in energy transactions have been
challenging for market participants. Because the exact scope and
requirements of these changes in the law are still being implemented by
regulators (and the precise compliance requirements still being
discovered by market users) it is not clear what effect these changes
will have on the markets. Nevertheless policymakers may be concerned
about the business cost of imposing too many changes too quickly; the
worst possible outcome would be one in which the ability of the market
to produce services useful to consumers is impeded by regulatory and
compliance issues.
(b) Current Legislative Proposals
A variety of approaches have been suggested for addressing rising
commodity prices and the role of derivatives in commodity markets.\2\
Some of these focus on the role of particular classes of market
participants such as institutional investors and speculators; others
would adjust margin requirements; some address the regulation of
foreign boards of trade; still others would modify or repeal existing
protections for OTC energy derivatives. ISDA's testimony will focus on
this last category.
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\2\&There are currently 23 proposed bills on this topic: Senate
bills numbered 2991, 2995, 3044, 3122, 3129, 3130, 3131, 3185, 3202 and
3205 and House bills numbered 6130, 6238, 6264, 6279, 6284, 6330, 6334,
6341, 6346, 6349, 6372, 6377, and 6406.
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H.R. 6264 makes it unlawful to enter into a transaction in an
energy commodity&\3\ in reliance on the 2(h) exemption or the 2(g)
exclusion, unless the party entering into the transaction certifies
that it has the capacity to take physical delivery of the energy
commodity. H.R. 6330 requires that ``included energy transactions,''
which are transactions in energy commodities for future delivery that
provide for a delivery point of the energy commodity in the U.S., be
conducted on a designated contract market (DCM) or derivative
transaction execution facility (DTEF); ``bilateral included energy
transactions'' are subject to record-keeping and reporting
requirements. The legislation would also curtail the CFTC's ability to
use its exemptive authority with respect to included energy
transactions. Separately, H.R. 6330 would expand the authority of the
Federal Energy Regulatory Commission to issue cease-and-desist orders
under the National Gas Act and the Federal Power Act; given the
continued jurisdictional uncertainty regarding the division of CFTC and
FERC authority one can envision a future in which market participants
are uncertain as to which orders from which regulator they must seek to
comply. H.R. 6341 would require all energy derivatives to be conducted
on a registered futures exchange by removing energy transactions from
the protections of the 2(h) exemption and the 2(g) exclusion. H.R. 6372
would remove energy commodities from the 2(g) exclusion and impose
position and transaction requirements on energy swaps.
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\3\&The proposed bills vary slightly in their definitions, but in
general an energy commodity may include coal, crude oil, gasoline,
diesel fuel, heating oil, propane, electricity, natural gas, any fuel
derived from oil, any transportation fuel, uranium, and any other
commodity as determined by the CFTC.
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These proposals are not new. Since passage of the CFMA bills have
regularly been introduced that would amend the protections for
bilateral, privately negotiated swap agreements contained in the law.
The above proposals were considered and rejected by Congress earlier
this year when it adopted the new oversight provisions contained in the
farm bill. Nothing that has happened in the last 2 months should
fundamentally alter the carefully considered judgment of this Committee
and Congress. Suffice it to say that the same rationale which led
Congress to reject calls to restrict the ability of American companies
to manage their very real risk of rising energy prices just 2 months
ago hold even more true today. The protections of 2(g) and 2(h) allow
parties to privately negotiate custom tailored risk management
contracts. The above proposals, which seek to remove American
companies' ability to do so, remain misdirected and potentially
harmful.
Another area of interest to participants in the OTC derivatives
markets are proposals to require separate disclosure or disaggregation
of trading by index traders and ``swap dealers''. In considering such
proposals it is important to remember that one of the benefits provided
by regulated exchanges is the anonymity they provide to traders;
futures markets reveal the prices market participants pay, not their
motivations in making trades. Measures which seek to remove that
anonymity could make traders seek markets which protect their ability
to not reveal their motivations or individual market positions.
Policymakers should carefully balance the legitimate desire of market
participants to keep their market strategies and identities
undisclosed. In any new reporting regime it should be ensured that no
disclosure is required which would put any class of market participant
at a disadvantage, including creating opportunities for other market
participants to ``front-run''.
One additional area of particular concern are proposals such as
those in H.R. 6330 to restrict or otherwise limit swap dealers and
other intermediaries access to the futures markets to hedge their
exposures to their counterparties. As already described, dealers and
intermediaries provide valuable hedging, risk management and customized
product offerings to their counterparties. A key part of these
undertakings is the ability of these dealers and intermediaries to
access the futures markets to lay off their exposures either on a case-
by-case or on a portfolio basis. Without ready access to futures
markets for hedging, these services would be more expensive and less
efficient. At the same time, the futures markets would miss the
important liquidity and pricing information these transactions provide.
Forcing dealers and intermediaries to use non-U.S. markets or to create
a network of bilateral hedging locations ill serves the dealers, their
counterparties or the U.S. futures markets.
Competitive Considerations
As noted previously, the OTC derivatives markets are global in
scope. Throughout the world governments have come to appreciate the
value a dynamic financial services industry provides to local
companies, as well as the significant benefits they provide to the
national economy. National governments throughout Europe and Asia are
actively competing to attract business and become financial centers.
Recent regulatory overhauls in the UK, the European Community, Japan
and South Korea all were guided in part by the desire to attract
international financial services while at the same time bolstering
local markets.
The U.S. has long been a world leader in financial services.
Currently the financial services industry provides one in every 20 jobs
in the U.S. while producing 8% of America's gross domestic product. The
financial services sector is also a source of high tech innovation and
a leading producer of ``new economy,'' knowledge-based jobs. A leading
example is the Atlanta-based IntercontinentalExchange (ICE), which
started in 2000 and now comprises one of the world's leading
derivatives markets. ICE operates both OTC and regulated futures
exchanges, and purchased the London-based International Petroleum
Exchange to extend its presence into Europe. From its beginnings as a
start-up company ICE is now a member of the S&P 500 and an employer of
hundreds of Americans. Without the changes in U.S. law created by the
CFMA it is fair to say that ICE would not have achieved such tremendous
success.
During discussion of the farm bill this Committee in particular was
sensitive to issues of U.S. competitiveness and the desire to ensure
America's position as a world-leading financial center was not harmed
by inappropriate or unnecessary changes to U.S. law. The competitive
threats to the U.S. have not disappeared since those deliberations.
Although some nations have moved to restrict derivatives markets in
response to rising commodity prices most of the U.S.'s immediate
competitors have adopted a wait-and-see approach. In the European Union
the European Commission has issued a white paper seeking to explore the
causes of rising prices that has stopped well short of formal proposals
to fundamentally alter the regulation of derivatives markets.\4\ In the
UK the Treasury Committee of the House of Commons also plans to
investigate recent increases in commodity prices. It is worth noting
that in the U.S. the CFTC has began a comprehensive inquiry into rising
commodity prices; whatever information the Commission receives will no
doubt prove useful in considering public policy choices.
---------------------------------------------------------------------------
\4\&See for example European Commission, Communication on Rising
Food Prices, (May 20, 2008). The Commission continues its deliberations
under the Markets in Financial Instruments Directive regarding the
application of that law to various types of commodity businesses.
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Given the global nature of the OTC derivatives markets and the
financial services industry in general, there is no question that the
imposition of overly restrictive regulatory requirements will lead to
the reallocation of financial services business from the U.S. to more
friendly jurisdictions. As damaging as these prospects might be to the
U.S. economy an even greater danger lies in the possibility that assets
will be priced in currencies other than U.S. dollars.
For example, currently the world price of crude is set in U.S.
dollars, a currency which America obviously owns a monopoly in
producing. There are many reasons the world prefers to price crude in
dollars, including a favorable investment climate in the U.S.; the
historic strength of the dollar relative to other currencies; the
widespread confidence the world has in the continued vitality of the
U.S. economy; and ultimately the faith market participants have that
the U.S. will honor its obligations. One particularly important reason
to price crude (and other assets) in U.S. dollars is the existence in
the U.S. of liquid, efficient markets for pricing assets. Without this
mechanism for establishing prices there would be inefficiencies in the
markets that would cause problems for producers, refiners, consumers
and financial market participants alike.
Measures which would impair the ability of U.S. markets to price
assets and attract investors would likewise remove a significant
incentive for the rest of the world to use dollars as the preferred
pricing currency. Such measures would need not include an outright ban
on derivatives (though it is worth noting that such a ban is not
without historical precedent);&\5\ measures which remove or limit
certain market participants could likewise remove liquidity and harm
the efficient functioning of the markets, thus forcing more market
participants out, creating a downward spiral. It goes without saying
that the pricing of assets in currencies other than U.S. dollars runs
contrary to America's national interest.
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\5\&In 1958 Congress adopted an outright prohibition on the trading
of onion futures in the United States, a ban which remains to this day.
As noted above (ante fn. 1), onion prices have risen 300% as of April
of this year. Fortune magazine recently ran an article quoting Bob
Debruyn, a Michigan onion farmer whose father had worked hard to create
the original onion-futures ban: ``I would think that a futures market
for onions would make some sense today, even though my father was very
much involved in getting rid of it.'' What Onions Teach Us About Oil
Prices, Jon Birger, Fortune June 2008.
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Conclusion
Over the last year Congress and this Committee have carefully
deliberated over the question as to what level of oversight is
appropriate for OTC energy markets. After multiple hearings and
considering the views of market participants, end-users, consumer
advocates and regulators, Congress less than 2 months ago passed broad
changes to the law which carefully balanced the needs of these groups
as well as concerns about the continued attractiveness of the U.S. as a
world financial center. These changes, which are still being
implemented, should be given time to work. Furthermore, Congress should
provide increased funding to the CFTC to ensure that the Commission has
the resources necessary to execute upon its new authority and the
numerous regulatory initiatives the Commission has recently announced.
As noted above, increasing regulation on over-the-counter
derivatives will not lower the price of energy or other commodities.
However, doing so will create incentives for relocating markets to
outside of the U.S., remove tools for producers and commercial users to
manage their risks, and harm the U.S. economy. This Committee has
historically been very sensitive to these dangers. ISDA thanks the
Committee for your careful examination of these issues, and your
continued leadership.
The Chairman. Thank you very much. And I am sure there will
be plenty of questions when we get to that point.
We now will hear from Mr. Vice from ICE.
STATEMENT OF CHARLES A. VICE, PRESIDENT AND COO,
IntercontinentalExchange, INC., ATLANTA, GA
Mr. Vice. Thank you, Mr. Chairman. I am Chuck Vice,
President of ICE. I appreciate the opportunity to appear before
you today to give our views.
As brief background, ICE operates several global
marketplaces and futures and OTC derivatives across the range
of product classes including agriculture and energy
commodities, foreign exchange and equity indexes. The ICE
holding company globally operates one OTC energy market and
owns three futures exchanges in the U.S., U.K. and Canada; each
was separately acquired over the last 7 years.
In hearing after hearing over the last few months, self-
styled experts have offered personal, largely impromptu
estimates of the contribution of speculation to the price of a
barrel of crude oil. Many of these witnesses estimated $50 or
$60 or more per barrel. Claims were made that additional
regulation would immediately reduce oil prices by these
amounts. None of these estimates, to my knowledge, were based
upon or referenced any objectively published research backing
such claims.
In one of the more egregious examples, Professor Michael
Greenberger, a fellow witness on this panel, testified before
the Senate Commerce Committee in June that prohibiting trading
on electronic OTC oil markets would bring down the price of
crude oil by 25 percent overnight. Despite the fact that there
is little to no electronic trading of OTC crude oil in the
U.S.; this and 28 other statements by Professor Greenberger
caused the U.S. Permanent Subcommittee on Investigations to
find his testimony so inaccurate and inflammatory that it felt
compelled to issue a joint analysis prepared by both Majority
and Minority staffs rebuking 29 statements.
In contrast to this rhetoric, thorough independent analyses
of crude oil prices have been published by agencies such as the
CFTC and the International Energy Administration. Neither found
evidence pointing to excessive speculation or manipulation as
the cause of high crude oil prices. Instead, the CFTC noted
that long positions held by those often accused of excessive
speculative buying, including noncommercials and swaps dealers,
were actually flat to lower during the recent 12 month period
in which the price of crude oil doubled. The recent IEA report
concluded that there was little evidence that investment flows
into futures markets were contributing to high oil prices, but
rather the market was projecting that global demand would
continue to outstrip global supply.
With no quick answers to supply and demand problems, focus
has shifted to closing perceived regulatory loopholes. First
there was the Enron loophole, which was, in fact, closed for
all energy commodities including crude oil in the recently
enacted farm bill legislation. Prompted by natural gas trading
on electronic OTC platforms like ICE, Congress now requires
that any electronically OTC energy swap that serves a
significant price discovery function be regulated like a
future. ICE's substantial obligations in this regard include,
among other things, requirements to monitor trading, prevent
manipulation, and enforce position or accountability limits,
including the liquidation of open positions and suspension of
trading.
The largest natural gas and electric power OTC markets on
the ICE platform account for roughly 90 percent of our total
electronic OTC volume. These key contracts are expected to be
deemed significant price discovery contracts by the CFTC under
the new law. We believe Congress and in particular this
Committee showed great understanding in passing legislation
that appropriately applied futures-style regulation on the
small number of large OTC contracts and not the hundreds of
illiquid OTC markets that constitute the last ten percent.
Now there is a renewed cry to reclose the already closed
Enron loophole in an effort to lower crude oil prices.
Ironically, with virtually no OTC trading in U.S. crude oil
occurring on ICE or any other electronic OTC platform, it would
be as impossible for this loophole to cause high crude oil
prices as it would be for increased regulation of the same to
lower them. The truth is that OTC trading of U.S. crude oil and
refined products remains the exclusive domain of voice brokers
and direct negotiation where ICE has no role.
A second loophole called the London loophole has been a
more recent target for increased regulation. This debate
focuses on ICE's wholly owned subsidiary, ICE Futures Europe.
Founded in London 27 years ago as the International Petroleum
Exchange and acquired by ICE in 2001, this market is a
regulated exchange under the supervision of the U.K. Financial
Services Authority, or FSA.
As the home of the ICE Brent crude and gasoil futures
contracts, ICE Futures Europe has since its inception been the
leading energy futures exchange in Europe. To complement its
Brent crude contract, the exchange, in 2006, added a future
that settles on the settlement price of the NYMEX WTI crude oil
contract. Offering Brent and WTI contracts on the same platform
allows commercial participants to hedge price differences
between these two. NYMEX has since listed a Brent crude oil
contract settling on the ICE Brent settlement price for the
very same reason.
ICE Futures Europe provides access to traders in the U.S.
as a foreign board of trade operating under a CFTC No Action
letter issued in 1999 and amended several times since. In
granting a No Action letter, the CFTC examines the foreign
board of trade status in its home jurisdiction, and its rules
and enforcement. Since Congress created this framework in 1982,
the CFTC has granted no action relief to at least 20 foreign
boards of trade. Other countries have reciprocal policies in
place upon which U.S. exchanges like the CME, NYMEX and ICE
Futures U.S. rely to offer access to their markets in over 50
jurisdictions around the world. Disregard for this mutual
recognition system would impair the competitiveness of U.S.
exchanges abroad and represent a major step back for global
cooperation.
Consistent with this framework, ICE Futures Europe has
shared WTI trader positions with the CFTC since the contract's
launch. On June 17, the CFTC closed the so-called London
loophole by modifying our No Action letter to require U.S.
equivalent position limits and accountability levels as a
reasoned condition for continued access to the ICE WTI contract
by U.S. traders.
Though politically popular, closure of this loophole is
unlikely to have any effect on crude oil prices. Most of the
recent growth in trading of WTI crude oil has been on the
NYMEX, not the ICE market. As a result, ICE has a relatively
small 15 percent share of total WTI open interests, while NYMEX
retains the remaining 85 percent. Such a small and, in fact,
declining market share hardly seems evidence of a meaningful
loophole.
In closing, we note that prices for virtually all
agricultural and natural resource future contracts, as well as
non-exchange-traded commodities such as iron ore and rice have
surged at rates similar to crude oil and in some cases even
more sharply and with greater volatility. Since none of these
other commodities are known to feature electronic OTC platforms
or foreign boards of trade offering cash-settled versions of
U.S. contracts, it would seem that other more fundamental
factors are to blame for all of these high commodity prices.
Regardless, we look forward to working with Congress and the
CFTC to ensure that all possible solutions to this crisis are
explored.
Mr. Chairman, thank you for the opportunity.
[The prepared statement of Mr. Vice follows:]
Prepared Statement of Charles A. Vice, President and COO,
IntercontinentalExchange, Inc., Atlanta, GA
Chairman Peterson, Ranking Member Goodlatte, I am Chuck Vice,
President and Chief Operating Officer of the IntercontinentalExchange,
Inc., or ``ICE.'' We very much appreciate the opportunity to appear
before you today to give our views on the over-the-counter (OTC) energy
markets
Background
ICE is a leading operator of global marketplaces with three
regulated futures exchanges and an OTC marketplace offering a wide
variety of contracts. As background, ICE was established in 2000 as an
electronic OTC platform to serve the energy markets. ICE was
established to bring transparency to OTC markets that were traded at
that time through opaque OTC voice brokers or through the flawed ``one-
to-many'' Enron On-Line trading model. In the Enron model, Enron served
as both the marketplace for trading and the counterparty to every trade
occurring in the market. In stark contrast, ICE sought to develop a
neutral ``many to many'' marketplace, in which we, the operator, take
no position in the market while enforcing strict best bid/best offer
trading protocols. Trading volume on ICE's OTC markets is almost solely
related to contracts for natural gas and power. Our electronic OTC
platform has a 0% share of trading in U.S. crude oil, heating oil, jet
fuel, and gasoline. ICE's electronic OTC markets have provided cost
savings and efficiencies to participants while delivering an
unprecedented level of OTC market transparency to both the Commodity
Futures Trading Commission (CFTC) and the Federal Energy Regulatory
Commission (FERC).
Since the launch of its electronic OTC energy marketplace in 2000,
ICE has acquired and now operates three regulated futures exchanges
through three separate subsidiaries, each with a separate governance
and regulatory infrastructure. The International Petroleum Exchange
(renamed ICE Futures Europe), was a 20 year old exchange specializing
in energy futures when acquired by ICE in 2001. Located in London, it
is a Recognized Investment Exchange, or RIE, operating under the
supervision of the UK Financial Services Authority (FSA). In early
2007, ICE acquired the 137 year old ``The Board of Trade of the City of
New York'' (renamed ICE Futures U.S.), a CFTC-regulated Designated
Contract Market (DCM) headquartered in New York specializing in
agricultural, foreign exchange, and equity index futures. In late 2007,
ICE acquired the Winnipeg Commodity Exchange (renamed ICE Futures
Canada), a 120 year old exchange specializing in agricultural futures,
regulated by the Manitoba Securities Commission, and headquartered in
Winnipeg, Manitoba.
ICE Operates a Transparent OTC Marketplace
Over-the-counter markets ranging from U.S. interest rate
instruments to foreign exchange and debt securities are increasingly
global and have migrated to electronic platforms due to their vast size
and global nature As I mentioned, in 2000 ICE developed an electronic,
many-to-many electronic marketplace for trading both physical energy
commodities and financially-settled over-the-counter derivatives based
on energy commodities. ICE in effect performs the same functions as
``voice brokers'' in the OTC market, but does so through a transparent
electronic trading platform with strict trading protocols. Voice
brokers offer limited transparency and tend to transact with only the
largest trading firms, and continue to serve as the primary venue for
OTC oil trading today. ICE's OTC model, though not active in U.S. crude
oil, provides equal access to high quality information to all market
participants, whether the smallest utility or the largest investment
bank, primarily for natural gas and power. ICE's marketplace offers
faster and more efficient trade execution while providing regulators
with a comprehensive audit trail with respect to orders entered and
transactions executed in the markets, none of which is available from
voice brokers.
The development of ICE's OTC marketplace has also promoted
competition and innovation in the energy derivatives market, to the
benefit of both market participants and consumers. The increased
liquidity offered by electronic trading has resulted in lower
transaction costs and tighter bid/ask spreads, reducing the cost of
hedging energy price risk and lowering operating costs for businesses.
The reliability of ICE's markets has also resulted in an increasing
preference for electronic trading in these markets. NYMEX, in its
recent testimony before the Senate Permanent Subcommittee on
Investigations (the ``Senate PSI''), noted that 80&85% of its futures
volume is now traded electronically, a development driven largely by
competition from ICE. The CFTC also pointed out, in its Senate PSI
testimony, that ``the ability to manipulate prices on either [NYMEX or
ICE] has likely been reduced, given that ICE has broadened
participation in contracts for natural gas.''
Like other electronic marketplaces, participants on ICE enter bids
and offers electronically. Transactions are matched in accordance with
an algorithm that executes transactions on the basis of time and price
priority. Participants executing a transaction on our platform may
settle the transaction in one of two ways--on a bilateral basis,
settling the transaction directly between the two counterparties to the
trade, or on a cleared basis through a clearinghouse using the services
of a futures commission merchant that is a member of the clearinghouse.
It is important to note that there are substantial differences
between ICE's OTC market, other portions of the OTC market, and the
NYMEX futures market. These differences necessarily inform and guide
the appropriate level of oversight and regulation of our markets.
First, ICE is only one of many global venues on which market
participants can execute OTC trades. A significant portion of OTC
trading in natural gas continues to be executed through voice brokers
or through direct bilateral negotiation between market counterparties.
Of the available forums, only ICE (and any other similarly-situated
ECM) is subject to CFTC jurisdiction and the CFTC's regulations, and to
limitations on the nature of its participants.
Second, participants in a given futures market must become members
of the relevant exchange or trade through a futures commission merchant
that is a member. In contrast, ICE's OTC market, by law, is a
``principals only'' market in which participants must execute trades in
their own names on the system. This market is designed solely for
sophisticated participants, and participation in ICE OTC markets,
unlike most other OTC venues is fully documented.
Third, the OTC market offers a substantially wider range of
products than the futures markets, including, for example, hundreds of
niche derivative contracts on natural gas and power at over 100
different delivery points in North America. The availability of these
niche markets on ICE has improved transparency and lowered transaction
costs via tighter bid-ask spreads, but volume nonetheless remains very
low at most points. The market reality, for most of these illiquid
points, is that participation is limited to the very small number of
marketers, utilities, and others that have some intrinsic supply or
demand interest in specific delivery points. Below is a chart&\1\ that
compares the relative size of NYMEX traded futures contracts and ICE's
largest electronic OTC energy markets.
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\1\&From the testimony of Jeffrey Sprecher,
IntercontinentalExchange, Inc. CEO before the U.S. Senate Permanent
Subcommittee on Investigations, June 25, 2007.
Greater Oversight Over Exempt Commercial Markets (ECMs)
As the OTC markets have grown and developed since passage of the
Commodity Futures Modernization Act, new regulatory challenges have
emerged. In May, as part of the farm bill, Congress, with strong
bipartisan support, passed legislation providing the CFTC with greater
oversight of electronic OTC markets, or ECMs. As a result of that new
law, ECMs are now obligated to apply market oversight principles
equivalent to those employed by fully regulated futures exchanges for
larger OTC contracts that, like futures contracts, serve a significant
price discovery function.\2\
---------------------------------------------------------------------------
\2\&This provision of the farm bill is commonly referred to as the
``Closing the Enron Loophole Act.''
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As part of its new authority, the CFTC will determine whether
contracts traded on ECMs serve a significant price discovery function,
which broadly includes contracts that are linked to a futures
exchange's contracts or which have independently been adopted by the
marketplace as a price reference for the underlying energy commodity.
If the CFTC determines that an ICE contract serves a significant
price discovery function, ICE will thereafter have self-regulatory
responsibilities with respect to such contract similar to those of a
DCM, or futures exchange. As a self regulatory organization, ICE will
be required to discharge seven core principles, which cover all of the
core principles discharged by futures markets other than those
applicable to brokers and intermediated trades, which by law cannot
occur in an ECM's markets. Specifically, the core principles state that
the ECM shall:
List only significant price discovery contracts that are not
readily susceptible to market manipulation;
Monitor trading in its significant price discovery contracts
to prevent market manipulation;
Establish and enforce rules have the ability to obtain
information to comply with the core principles;
Adopt position limits or accountability limits;
Adopt rules to give it the authority to liquidate open
positions and suspend trading in significant price discovery
contracts;
Monitor and enforce compliance with its rules; and
Establish and enforce rules to minimize conflicts of
interest.
Importantly, as I will explain further, the legislation provides
equivalent regulation for ``futures like'' OTC contracts, while
avoiding unintended the consequence of driving trading in illiquid OTC
contracts to the opaque, voice brokered parts of the OTC market. The
CFTC has virtually no visibility into these OTC markets because they
are not traded on an electronic platform like ICE.
One Size of Regulation Does Not Fit All Markets or Contracts
Even though Congress has increased the oversight and regulation of
ECMs, some have argued that all contracts should be traded on a
designated contract market. The problem with ``one size fits all''
regulation can best be illustrated by contrasting the historic nature
of futures markets (limited number of actively traded benchmark
contracts, all transactions executed through a broker who can trade for
its own account or that of a retail customer) with the ECM OTC swaps
markets (large number of niche products, many illiquid and thinly
traded, principals only trading). Recognizing the importance of futures
pricing benchmarks to the general public (a DCM is obligated to publish
its prices to be used by the broader market), and in recognition of the
potential for conflicts of interest due to members trading for their
own accounts alongside business transacted on behalf of customers, some
of whom were retail customers, DCM core principles were developed to
facilitate regulation of the markets by the DCM, which acted as a self
regulatory organization. The typical high level of liquidity in
benchmark contracts make application of core principles such as market
monitoring and position accountability and limits feasible and
appropriate.
Suggesting that these same DCM core principles, which were
developed with the futures exchange model in mind, should apply to all
OTC swap contracts traded on an ECM market is attempting to fit the
proverbial square peg in a round hole. Most of the energy swaps
available on ICE are niche OTC products that trade in illiquid markets
that are simply not amenable to the application of DCM core principles.
For example, does it make sense to publish a real-time price feed for a
market in which real-time bids and offers are rare and days pass
between trades? Also, how would an ECM actively monitor an illiquid
swaps market in an attempt to ``prevent manipulation'' where there may
be few or no trades due to the limited liquidity in the market? How
would an ECM swaps market administer accountability limits in a market
that has only a handful of market participants? Should the ECM question
when a single market participant holds 50% of the liquidity in an
illiquid market when the market participant is one of the only
providers of liquidity in the market?
It is important to analyze these questions not in isolation, but in
the context of market participants having alternatives such as OTC
voice brokers or overseas markets through which they can conduct their
business. Importantly, such OTC voice brokers can even offer their
customers the benefits of clearing through use of block clearing
facilities offered by NYMEX and by ICE. Faced with constant inquiries
or regular reporting by the ECM related to legitimate market activity,
and facing no such monitoring when it transacts through a voice broker,
market participants might choose to conduct their business where
transparency and reporting requirements are non-existent. It is for
these and other reasons that Congress and the Commission have developed
the carefully calibrated three-tiered regulatory structure applicable
to DCMs and ECMs. We believe that the judgments made by Congress and
the CFTC thus far have been prudent and should be maintained.
Conclusion
In conclusion, ICE remains a strong proponent of open and
competitive OTC markets and of appropriate regulatory oversight of
those markets. The recently passed farm bill places a significantly
higher level of regulation on electronic OTC energy platforms. In doing
so, Congress appropriately recognized the importance of focusing on the
relatively small number of larger OTC contracts that perform a
significant price discovery function, rather than the hundreds or even
thousands of OTC contracts that are rarely traded.
ICE recognizes the severe impact of high crude oil prices on the
U.S. economy and understands the Congressional desire to ``leave no
stone unturned.'' However, since our electronic OTC platform has a 0%
share of trading in U.S. crude oil, heating oil, jet fuel, and
gasoline, further regulation or even elimination of electronic OTC
markets by Congress is certain to have no effect on oil prices. Such
moves would, unfortunately, though, ensure that OTC oil trading
continues to be executed by brokers over the telephone in a manner
completely opaque to the marketplace and regulators.
Mr. Chairman, thank you for the opportunity to share our views. I
would be happy to answer any questions you may have.
The Chairman. Thank you very much for making time to be
with us.
Mr. Comstock.
STATEMENT OF MICHAEL COMSTOCK, ACTING DIRECTOR, CITY OF MESA,
ARIZONA GAS SYSTEM; VICE CHAIRMAN, BOARD OF DIRECTORS, AMERICAN
PUBLIC GAS
ASSOCIATION, MESA, AZ
Mr. Comstock. Chairman Peterson, Ranking Member Goodlatte
and Members of the Committee, I appreciate this opportunity to
testify before you today, and I thank the Committee for calling
this hearing on the important subject of trading in the over-
the-counter market.
My name is Michael Comstock, and I am the acting Director
for the City of Mesa, Arizona, Gas System, a not-for-profit
municipal utility. I also serve as the Vice Chair of the Board
of Directors for the American Public Gas Association.
The City of Mesa provides natural gas, electric, water and
wastewater service to its residents. We have provided gas
service to our customers for over 90 years, and we currently
serve approximately 53,000 homes and businesses.
I testify today on behalf of the American Public Gas
Association. APGA is the national association for publicly
owned not-for-profit natural gas retail distribution systems.
There are approximately 1,000 public gas systems in 36 states,
and over 700 of these systems are APGA members. Every Member of
the Committee, with the exception of Congressman Walberg of
Michigan, has public gas systems in their state.
There has understandably been a great deal of attention
focused on the high price of gasoline during the summer driving
season. APGA believes it is equally important to focus on the
price of natural gas in advance of the winter heating season.
This December, when natural gas customers open their heating
bills, the commodity cost is expected to have doubled from last
December. We, along with other consumer groups, have watched
with alarm over the last several years certain pricing
anomalies in the markets for natural gas. More recently we have
noted record run-ups in the price of natural gas. If gasoline
prices increased at the same rate as natural gas prices have
increased over the last 10 years, drivers would now be paying
more than $6.50 per gallon.
APGA's number one priority is the safe and reliable
delivery of affordable natural gas. To bring natural gas prices
to a long-term affordable level, we ultimately need to increase
the supply of natural gas; however, equally critical is to
restore public confidence in the price of natural gas. This
requires a level of transparency in natural gas markets which
assures consumers that market prices are a result of
fundamental supply and demand forces and not the result of
manipulation, excessive speculative trading or other certain
types of index trading strategies.
APGA would like to commend the Committee for its work on
the recently enacted farm bill and for including the language
to increase market transparency. Title VIII of the farm bill
reauthorizes the Commodity Futures Trading Commission and
includes language to increase the regulatory reporting and
self-regulatory provisions relating to the unregulated energy
trading platforms.
This language is a positive first step, but we also believe
more needs to be done to increase transparency. For example,
the over-the-counter market currently remains opaque to
regulatory scrutiny. This lack of transparency is in a very
large and rapidly growing segment of the natural gas market. It
leaves open the potential for a participant to engage in
manipulative or other abusive trading strategies with little
risk of early detection and for problems of potential market
congestion to go undetected by the CFTC until after the damage
has been done to the market.
Equally significant, even where the trading is not intended
to be abusive, the lack of transparency for the overall energy
market leaves regulators unable to answer questions regarding
large speculators' possible impacts on the market.
It is APGA's position that additional transparency measures
with respect to the transactions in the OTC markets are needed
to enable CFTC to assemble a full picture of the trader's
position and thereby understand the large trader's potential on
the market. Additional transparency will also enable the CFTC
to better detect and deter other types of market abuses.
Including, for example, a company providing false price
reporting information or a company engaging in watch trading by
taking large offsetting positions with the intent to send
misleading signals of supply and demand to the market. Such
activities are more likely to be detected or deterred when the
government is receiving information with respect to a large
trader's overall positions including their bilateral OTC
transaction. It would also enable the CFTC to better understand
the overall size and speculative positions in the market as
well as the impact of certain speculative investor practices or
strategies on prices.
APGA commends this Committee for its focus on the possible
impact the speculative investment has on the price of natural
gas and other commodities. With energy prices at their current
high levels, consumers certainly should not be forced to pay
speculative premiums. To the extent that speculative investment
may be increasing the price of natural gas or causing price
aberrations; we strongly encourage Congress to take quick
actions to expand market transparency in order to be able to
responsibly address this issue and protect consumers from
additional cost burdens.
Ultimately, in order to bring natural gas prices back to a
long-term affordable level, our energy policy must ensure that
supply is adequate to meet demand. This will require that
supply and demand for natural gas be unfettered by regulation.
Yet current statutory and regulatory policy, first, prohibit
the assessment of offshore reserves; second, restrict and limit
access to production in known area reserves; and third,
encourage the use of natural gas for new electric generation.
It makes no sense to encourage greater use of natural gas on
one hand while at the same time to impede the acquisition of
data that could point to areas of abundant new resources and to
obstruct production in areas of rich supplies. In light of
these facts, it is a wonder that speculators find these markets
attractive.
In addition to increasing transparency, APGA fully supports
immediate increased funding for the CFTC. We believe that CFTC
plays a pivotal role in protecting the American consumers;
however, its funding and staffing levels have not kept pace
with the complexity or scope of its job. We believe that this
needs to be addressed by Congress.
Natural gas is the lifeblood of our economy, and millions
of consumers depend on natural gas every day to meet their
daily needs. It is critical that the price that those consumers
are paying for natural gas comes through the operation of fair
and orderly markets, through appropriate market mechanisms that
establish a fair and transparent marketplace.
APGA looks forward to working with the Committee to
determine whether further enhancements are necessary to restore
consumer confidence in the integrity of the markets price
discovery mechanism.
Thank you, Mr. Chairman.
[The prepared statement of Mr. Comstock follows:]
Prepared Statement of Michael Comstock, Acting Director, City of Mesa,
Arizona Gas System; Vice Chairman, Board of Directors, American Public
Gas Association, Mesa, AZ
Chairman Peterson, Ranking Member Goodlatte and Members of the
Committee, I appreciate this opportunity to testify before you today
and I thank the Committee for calling this hearing on the important
subject of trading in the over-the-counter (OTC) market. My name is
name is Michael Comstock and I am the Acting Director for the City of
Mesa, Arizona Gas System. I also serve as Vice Chair of the Board of
Directors for the American Public Gas Association (APGA).
The City of Mesa provides natural gas, electric, water and
wastewater service to its residents. We have provided gas service to
our customers for over 90 years and we currently serve approximately
53,000 homes and businesses throughout Mesa and portions of Pinal
County. Strong growth in the region has made Mesa one of the fastest-
growing and respected municipal gas utilities in the United States.
I testify today on behalf of the APGA. APGA is the national
association for publicly-owned natural gas distribution systems. There
are approximately 1,000 public gas systems in 36 states and over 700 of
these systems are APGA members. Publicly-owned gas systems are not-for-
profit, retail distribution entities owned by, and accountable to, the
citizens they serve. They include municipal gas distribution systems,
public utility districts, county districts, and other public agencies
that have natural gas distribution facilities. Every Member of the
Committee, with the exception of Congressman Walberg of Michigan, has
public gas systems in their state.
APGA's number one priority is the safe and reliable delivery of
affordable natural gas. To bring natural gas prices back to a long-term
affordable level, we ultimately need to increase the supply of natural
gas. However, equally critical is to restore public confidence in the
pricing of natural gas. This requires a level of transparency in
natural gas markets which assures consumers that market prices are a
result of fundamental supply and demand forces and not the result of
manipulation, other abusive market conduct or excessive speculation.
We, along with other consumer groups, have watched with alarm over
the last several years certain pricing anomalies in the markets for
natural gas. More recently, we have noted a run-up in the price of
energy and other physical commodities. APGA has strongly supported an
increase in the level of transparency with respect to trading activity
in these markets from that which currently exists. We believe that
additional steps are needed in order to restore our current lack of
confidence in the natural gas marketplace and to provide sufficient
transparency to enable the CFTC, and market users, to form a reasoned
response to the critically important questions that have been raised
before this Committee during the course of these hearings.
APGA believes that the increased regulatory, reporting and self-
regulatory provisions relating to the unregulated energy trading
platforms contained in legislation that reauthorizes the Commodity
Futures Trading Commission (``CFTC'') is a critically important step in
addressing our concerns. Those provisions are contained in Title XIII
of the farm bill which has become law. We commend this Committee for
its work on the CFTC reauthorization bill. The market transparency
language that was included in the farm bill will help shed light on
whether market prices in significant price discovery energy contracts
are responding to legitimate forces of supply and demand or to other,
non-bona fide market forces. APGA believes that more can, and should,
be done to further increase transparency of trading in the energy
markets. Many of these steps would likely also be useful in better
understanding the current pricing trends in the markets for other
physical commodities as well.
APGA believes that these additional steps, a number of which the
CFTC has undertaken through administrative action, have the potential
either directly to address the concerns APGA has raised with respect to
lack of transparency in these markets, or to provide needed information
so that a consensus can be reached on the additional statutory or
regulatory steps, if any, that should be taken to responsibly and
effectively address the questions that have been raised regarding the
potentially adverse effects on these markets resulting from excessive
speculative trading.
Although the additional authorities which have been provided to the
CFTC under Title XIII of the 2008 Farm Bill will provide the CFTC with
significant additional tools to respond to the issues raised by this
hearing (at least with respect to the energy markets), we nevertheless
believe that it may be necessary for Congress to provide the CFTC with
additional statutory authorities. We are doubtful that the initial
steps taken by the reauthorization legislation are, or will be,
sufficient to fully respond to the concerns that we have raised
regarding the need for increased transparency. In this regard, we
believe that additional transparency measures with respect to
transactions in the over-the-counter markets are needed to enable the
cop on the beat to assemble a full picture of a trader's position and
thereby understand a large trader's potential impact on the market.
We further believe, that in light of the critical importance of
this issue to consumers, that this Committee should maintain active and
vigilant oversight of the CFTC's market surveillance and enforcement
efforts, that Congress should be prepared to take additional
legislative action to further improve transparency with respect to
trading in energy contracts and, should the case be made, to make
additional amendments to the Commodity Exchange Act, 7 U.S.C. &1 et
seq. (``Act''), to make changes in the administration of speculative
position limits in order to ensure the integrity of the energy markets.
History of Regulation Under the Commodity Exchange Act
Systemized trading in contracts for the future delivery of
agricultural commodities developed in the United States in the mid to
late 1800s from an economic need for risk shifting. Glaring abuses were
attendant with the advantages of trading, these included price
manipulations, market corners and extreme and sudden price fluctuations
on the organized exchanges. These abuses stirred repeated demands for
legislative action to prohibit or comprehensively regulate futures
trading. Although the first regulation of the grain futures markets
dates from the 1920's,\1\ the Commodity Exchange Act of 1936&\2\ was
the first statute to comprehensively regulate the futures markets.
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\1\&See, Grain Futures Act of 1922, Pub. L. No. 6&331, 42 Stat. 998
(1922).
\2\&Act of June 15, 1936, ch. 545 &5, 49 Stat 1494.
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Section 3 of the Act as it existed before to the 2000 amendments
explained the statute's purpose in relevant part as follows:
Transactions in commodities involving the sale thereof for
future delivery as commonly conducted on boards of trade and
known as ``futures'' are affected with a national public
interest. Such futures transactions are carried on in large
volume by the public generally and by persons engaged in the
business of buying and selling commodities and the products and
byproducts thereof . . . The prices involved in such
transactions are generally quoted and disseminated through the
United States and in foreign countries as a basis for
determining the prices to the producer and the consumer . . .
The transactions and prices of commodities on such boards of
trade are susceptible to excessive speculation and can be
manipulated, controlled, cornered or squeezed, to the detriment
of the producer or the consumer . . .
Section 4a(a) of the Act echoes the Congressional finding of former
section 3, providing that, ``Excessive speculation in any commodity
under contracts of sale of such commodity for future delivery made on
or subject to the rules of contract mar
kets . . . causing sudden or unreasonable fluctuations or unwarranted
changes in the price of such commodity, is an undue and unnecessary
burden on interstate commerce in such commodity.'' 7 U.S.C. &6a.
The CFTC in 1981 adopted a rule requiring all futures exchanges to
impose speculative position limits for all commodities that were not
subject to a Federal speculative position limit.\3\ In so doing, the
Commission explained the danger that unchecked speculative positions
can pose to the markets, saying:
---------------------------------------------------------------------------
\3\&The Commission subsequently modified this requirement,
permitting contract markets to impose ``position accountability rules''
in lieu of speculative position limits for certain contracts, including
the energy contracts.
It appears that the capacity of any contract market to absorb
the establishment and liquidation of large speculative
positions in an orderly manner is related to the relative size
of such positions, i.e., the capacity of the market is not
unlimited. Recent events in the silver market would support a
finding that the capacity of a liquid futures market to absorb
large speculative positions is not unlimited, notwithstanding
---------------------------------------------------------------------------
mitigating characteristics of the underlying cash market.
``Establishment of Speculative Position Limits,'' 46 Fed. Reg. 50938,
509040 (October 16, 1981).
The CFTC's conclusion in 1981 was that the ability of liquid
markets to absorb excessively large speculative positions without
suffering from artificial upward pressure on prices is not unlimited,
and based on that reasoning, required exchanges to adopt speculative
position limits for all contracts. That question, whether liquid
markets have the ability to absorb excessively large speculative
positions without suffering from artificial upward price pressure is
the same question that is before this Committee today.
Speculators' Effect on the Natural Gas Market
As hedgers that use both the regulated futures markets and the OTC
energy markets, we value the role of speculators in the markets. We
also value the different needs served by the regulated futures markets
and the more tailored OTC markets. As hedgers, we depend upon liquid
and deep markets in which to lay off our risk. Speculators are the
grease that provides liquidity and depth to the markets.
However, speculative trading strategies may not always have a
benign effect on the markets. For example, the recent blow-up of
Amaranth Advisors LLC and the impact it had upon prices exemplifies the
impact that speculative trading interests can have on natural gas
supply contracts for local distribution companies (``LDCs''). Amaranth
Advisors LLC was a hedge fund based in Greenwich, Connecticut, with
over $9.2 billion under management. Although Amaranth classified itself
as a diversified multi-strategy fund, the majority of its market
exposure and risk was held by a single Amaranth trader in the OTC
derivatives market for natural gas.
Amaranth reportedly accumulated excessively large long positions
and complex spread strategies far into the future. Amaranth's
speculative trading wagered that the relative relationship in the price
of natural gas between summer and winter months would change as a
result of shortages which might develop in the future and a limited
amount of storage capacity. Because natural gas cannot be readily
transported about the globe to offset local shortages, the way for
example oil can be, the market for natural gas is particularly
susceptible to localized supply and demand imbalances. Amaranth's
strategy was reportedly based upon a presumption that hurricanes during
the summer of 2006 would make natural gas more expensive in 2007,
similar to the impact that Hurricanes Katrina and Rita had had on
prices the previous year. As reported in the press, Amaranth held open
positions to buy or sell tens of billions of dollars of natural gas.
As the hurricane season proceeded with very little activity, the
price of natural gas declined, and Amaranth lost approximately $6
billion, most of it during a single week in September 2006. The
unwinding of these excessively large positions and that of another
previously failed $430 million hedge fund--MotherRock--further
contributed to the extreme volatility in the price of natural gas. The
Report by the Senate Permanent Committee on Investigations affirmed
that ``Amaranth's massive trading distorted natural gas prices and
increased price volatility.''&\4\
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\4\&See ``Excessive Speculation in the Natural Gas Market,'' Report
of the U.S. Senate Permanent Subcommittee on Investigations (June 25,
2007) (``PSI Report'') at p. 119.
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Many natural gas distributors locked-in prices prior to the period
Amaranth collapsed at prices that were elevated due to the accumulation
of Amaranth's positions. They did so because of their hedging
procedures which require that they hedge part of their winter natural
gas in the spring and summer. Accordingly, even though natural gas
prices were high at that time, it would have been irresponsible (and
contrary to their hedging policies) to not hedge a portion of their
winter gas in the hope that prices would eventually drop. Thus, the
elevated prices which were a result of the excess speculation in the
market by Amaranth and others had a significant impact on the price
these APGA members, and ultimately their customers, paid for natural
gas. The lack of transparency with respect to this trading activity,
much of which took place in the OTC markets, and the extreme price
swings surrounding the collapse of Amaranth have caused bona fide
hedgers to become reluctant to participate in the markets for fear of
locking-in prices that may be artificial.
Recently, additional concerns have been raised with respect to the
size of positions related to, and the role of, passively managed long-
only index funds. In this instance, the concern is not whether the
positions are being taken in order to intentionally drive the price
higher, but rather whether the unintended effect of the cumulative size
of these positions has been to push market prices higher than the
fundamental supply and demand situation would justify.
The additional concern has been raised that recent increased
amounts of speculative investment in the futures markets generally have
resulted in excessively large speculative positions being taken that
due merely to their size, and not based on any intent of the traders,
are putting upward pressure on prices. The argument made is that these
additional inflows of speculative capital are creating greater demand
then the market can absorb, thereby increasing buy-side pressure which
results in advancing prices.
Some have responded to these concerns by reasoning that new futures
contracts are capable of being created without the limitation of having
to have the commodity physically available for delivery. This explains
why, although the open-interest of futures markets can exceed the size
of the deliverable supply of the physical commodity underlying the
contract, the price of the contract could nevertheless reflect the
forces of supply and demand.
APGA commends this Committee for its focus on the possible impact
speculative investment has on the price of natural gas and other energy
commodities and for asking these tough questions. With energy prices at
their current high levels, consumers should not be forced to pay a
``speculative premium.'' However, APGA is not in a position to
determine which of the above two views is correct. More significantly
and profoundly disturbing, because of limitations with respect to
transparency of trading in these markets, the data and facts are
unavailable that would enable market observers, including both the
regulators and the public, to make a reasoned judgment about this
issue.
As we noted above, as hedgers we rely on speculative traders to
provide liquidity and depth to the markets. Thus, we do not wish to see
steps taken that would discourage speculators from participating in
these markets using bona fide trading strategies. But more importantly,
APGA's members rely upon the prices generated by the futures to
accurately reflect the true value of natural gas. Accordingly, APGA
would support additional regulatory controls, such as stronger
speculative position limits, if a reasoned judgment can be made based
on currently available, or additional forthcoming market data and
facts, that such controls are necessary to address the unintended
consequences arising from certain speculative trading strategies or to
reign in excessively large speculative positions. To the extent that
speculative investment may be increasing the price of natural gas or
causing pricing aberrations, we strongly encourage Congress to take
quick action to expand market transparency in order to be able to
responsibly address this issue and protect consumers from additional
cost burdens.
The Markets in Natural Gas Contracts
The market for natural gas financial contracts is composed of a
number of segments. Contracts for the future delivery of natural gas
are traded on NYMEX, a designated contract market regulated by the
CFTC. Contracts for natural gas are also traded in the OTC markets. OTC
contracts may be traded on multi-lateral electronic trading facilities
which are exempt from regulation as exchanges, such as the
IntercontinentalExchange (``ICE''). ICE also operates an electronic
trading platform for trading non-cleared (bilateral) OTC contracts.
They may also be traded in direct, bilateral transactions between
counterparties, through voice brokers or on electronic platforms. OTC
contracts may be settled financially or through physical delivery.
Financially-settled OTC contracts often are settled based upon NYMEX
settlement prices and physically delivered OTC contracts may draw upon
the same deliverable supplies as NYMEX contracts, thus linking the
various financial natural gas market segments economically.
Increasingly, the price of natural gas in many supply contracts
between suppliers and local distribution companies, including APGA
members, is determined based upon monthly price indexes closely tied to
the monthly settlement of the NYMEX futures contract. Accordingly, the
futures market serves as the centralized price discovery mechanism used
in pricing these natural gas supply contracts.
Generally, futures markets are recognized as providing an efficient
and transparent means for discovering commodity prices.\5\ However, any
failure of the futures price to reflect fundamental supply and demand
conditions results in prices for natural gas that are distorted and
which do not reflect its true value.\6\ This has a direct affect on
consumers all over the U.S., who as a result of such price distortions,
will not pay a price for the natural gas that reflects bona fide demand
and supply conditions. If the futures price is manipulated or
distorted, then the price consumers pay for the fuel needed to heat
their homes and cook their meals will be similarly manipulated or
distorted.
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\5\&See the Congressional findings in Section 3 of the Commodity
Exchange Act, 7 U.S.C. &1 et seq. (``Act''). Section 3 of the Act
provides that, ``The transactions that are subject to this Act are
entered into regularly in interstate and international commerce and are
affected with a national public interest by providing a means for . . .
discovering prices, or disseminating pricing information through
trading in liquid, fair and financially secure trading facilities.'' A
further question with respect to whether other speculative strategies,
or excessively large speculative positions is also distorting market
prices by pushing prices higher than they otherwise would be.
\6\&The effect of Amarath's trading resulted in such price
distortions. See generally PSI Report. The PSI Report on page 3
concluded that ``Traders use the natural gas contract on NYMEX, called
a futures contract, in the same way they use the natural gas contract
on ICE, called a swap. . . . The data show that prices on one exchange
affect the prices on the other.''
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Today, the CFTC has effective oversight of futures exchanges, and
the CFTC and the exchanges provide a significant level of transparency.
And under the provisions of the Title XIII of the farm bill, the CFTC
has been given additional regulatory authority with respect to
significant price discovery contracts traded on exempt commercial
markets, such as ICE. This is indeed a major step toward greater market
transparency. However, even with this additional level of transparency,
a large part of the market remains opaque to regulatory scrutiny. The
OTC markets lack such price transparency. This lack of transparency in
a very large and rapidly growing segment of the natural gas market
leaves open the potential for a participant to engage in manipulative
or other abusive trading strategies with little risk of early
detection; and for problems of potential market congestion to go
undetected by the CFTC until after the damage has been done to the
market.
Equally significant, even where the trading is not intended to be
abusive, the lack of transparency for the over-all energy markets
leaves regulators unable to answer questions regarding speculators'
possible impacts on the market. For example, do we know who the largest
traders are in the over-all market, looking at regulated futures
contracts, significant price discovery contracts and bilateral OTC
transactions? Without being able to see a large trader's entire
position, it is possible that the effect of a large OTC trader on the
regulated markets is masked, particularly when that trader is
counterparty to a number of swaps dealers that in turn take positions
in the futures market to hedge these OTC exposures as their own.
Regulatory Oversight
NYMEX, as a designated contract market, is subject to oversight by
the CFTC. The primary tool used by the CFTC to detect and deter
possible manipulative activity in the regulated futures markets is its
large trader reporting system. Using that regulatory framework, the
CFTC collects information regarding the positions of large traders who
buy, sell or clear natural gas contracts on NYMEX. The CFTC in turn
makes available to the public aggregate information concerning the size
of the market, the number of reportable positions, the composition of
traders (commercial/noncommercial) and their concentration in the
market, including the percentage of the total positions held by each
category of trader (commercial/noncommercial).
The CFTC also relies on the information from its large trader
reporting system in its surveillance of the NYMEX market. In conducting
surveillance of the NYMEX natural gas market, the CFTC considers
whether the size of positions held by the largest contract purchasers
are greater than deliverable supplies not already owned by the trader,
the likelihood of long traders demanding delivery, the extent to which
contract sellers are able to make delivery, whether the futures price
is reflective of the cash market value of the commodity and whether the
relationship between the expiring future and the next delivery month is
reflective of the underlying supply and demand conditions in the cash
market.\7\
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\7\&See letter to the Honorable Jeff Bingaman from the Honorable
Reuben Jeffery III, dated February 22, 2007.
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Title XIII of the farm bill, recently empowered the CFTC to collect
large trader information with respect to ``significant price discovery
contracts'' traded on the ICE trading platform. However, there remain
significant gaps in transparency with respect to trading of OTC energy
contracts, including many forms of contracts traded on ICE. Despite the
links between prices for the NYMEX futures contract and the OTC markets
in natural gas contracts, this lack of transparency in a very large and
rapidly growing segment of the natural gas market leaves open the
potential for participants to engage in manipulative or other abusive
trading strategies with little risk of early detection and for problems
of potential market congestion to go undetected by the CFTC until after
the damage has been done to the market, ultimately costing the
consumers or producers of natural gas. More profoundly, it leaves the
regulator unable to assemble a true picture of the over-all size of a
speculator's position in a particular commodity.
Greater Transparency Needed
Our members, and the customers served by them, believe that
although Title XIII of the farm bill goes a long way to addressing the
issue, there is not yet an adequate level of market transparency under
the current system. This lack of transparency has led to a growing lack
of confidence in the natural gas marketplace. Although the CFTC
operates a large trader reporting system to enable it to conduct
surveillance of the futures markets, it cannot effectively monitor
trading if it receives information concerning positions taken in only
one, or two, segments of the total market. Without comprehensive large
trader position reporting, the government will remain handicapped in
its ability to detect and deter market misconduct or to understand the
ramifications for the market arising from unintended consequences
associated with excessive large positions or with certain speculative
strategies. If a large trader acting alone, or in concert with others,
amasses a position in excess of deliverable supplies and demands
delivery on its position and/or is in a position to control a high
percentage of the deliverable supplies, the potential for market
congestion and price manipulation exists. Similarly, we simply do not
have the information to analyze the over-all effect on the markets from
the current practices of speculative traders.
Over the last several years, APGA has pushed for a level of market
transparency in financial contracts in natural gas that would
routinely, and prospectively, permit the CFTC to assemble a complete
picture of the overall size and potential impact of a trader's position
irrespective of whether the positions are entered into on NYMEX, on an
OTC multi-lateral electronic trading facility which is exempt from
regulation or through bilateral OTC transactions, which can be
conducted over the telephone, through voice-brokers or via electronic
platforms. APGA is optimistic that the enhanced authorities provided to
the CFTC in the provisions of the CFTC reauthorization bill will help
address the concerns that we have raised, but recognizes that more
needs to be done to address this issue comprehensively.
Additional Potential Enhancements in Transparency
In supporting the CFTC reauthorization bill, we previously noted
that only a comprehensive large trader reporting system would enable
the CFTC, while a scheme is unfolding, to determine whether a trader,
such as Amaranth, is using the OTC natural gas markets to corner
deliverable supplies and manipulate the price in the futures market.\8\
A comprehensive large trader reporting system would also enable the
CFTC to better detect and deter other types of market abuses, including
for example, a company making misleading statements to the public or
providing false price reporting information designed to advantage its
natural gas trading positions, or a company engaging in wash trading by
taking large offsetting positions with the intent to send misleading
signals of supply or demand to the market. Such activities are more
likely to be detected or deterred when the government is receiving
information with respect to a large trader's overall positions, and not
just those taken in the regulated futures market. It would also enable
the CFTC to better understand the overall size of speculative positions
in the market as well as the impact of certain speculative investor
practices or strategies on the future's markets ability to accurately
reflect fundamental supply and demand conditions.
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\8\&See e.g. U.S. Commodity Futures Trading Commission v. BP
Products North America, Inc., Civil Action No. 06C 3503 (N.D. Ill.)
filed June 28, 2006.
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Accordingly, APGA supports proposals to further increase and
enhance transparency in the energy markets, generally, and in the
markets for natural gas, specifically. APGA supports greater
transparency with respect to positions in natural gas financial
contracts acquired through bilateral transactions. Because bilateral
trading can in fact be conducted on an all-electronic venue, and can
impact prices on the exchanges even if conducted in a non-electronic
environment, it is APGA's position that transparency in the bilateral
markets is critical to ensure an appropriate level of consumer
protection.
Electronic Ti-lateral trading
One example of the conduct of bilateral trading on an all-
electronic trading platform was ``Enron On-line.'' Enron, using its
popular electronic trading platform, offered to buy or sell contracts
as the universal counterparty to all other traders using this
electronic trading system. This one-to-many model constitutes a
dealer's market and is a form of bilateral trading. This stands in
contrast to a many-to-many model which is recognized as a multi-lateral
trading venue. This understanding is reflected in section 1a(33) of the
Commodity Exchange Act, which defines ``Trading Facility'' as a ``group
of persons that . . . provides a physical or electronic facility or
system in which multiple participants have the ability to execute or
trade agreements, contracts or transactions by accepting bids and
offers made by other participants that are open to multiple
participants in the facility or system.'' On the Enron On-line trading
platform, only one participant--Enron--had the ability to accept bids
and offers of the multiple participants--its customers--on the trading
platform.
Section1a(3) continues by providing that, ``the term `trading
facility' does not include (i) a person or group of persons solely
because the person or group of persons constitutes, maintains, or
provides an electronic facility or system that enables participants to
negotiate the terms of and enter into bilateral transactions as a
result of communications exchanged by the parties and not from
interaction of multiple bids and multiple offers within a
predetermined, nondiscretionary automated trade matching and execution
algorithm . . . .'' This means that it is also possible to design an
electronic platform for bilateral trading whereby multiple parties
display their bids and offers which are open to acceptance by multiple
parties, so long as the consummation of the transaction is not made
automatically by a matching engine.
Both of these examples of bilateral electronic trading platforms
might very well qualify for exemption under the current language of
sections 2(g) and 2(h)(1) of the Commodity Exchange Act. To the extent
that these examples of electronic bilateral trading platforms were
considered by traders to be a superior means of conducting bilateral
trading over voice brokerage or the telephonic call-around markets, or
will not fall within the significant price discovery contract
requirements, their use as a substitute for a more-regulated exempt
commercial market under section 2(h)(3) of the Act should not be
readily discounted.
Non-Electronic Bilateral Trading
Moreover, even if bilateral transactions are not effected on an
electronic trading platform, it is nonetheless possible for such direct
or voice-brokered trading to affect prices in the natural gas markets.
For example, a large hedge fund may trade bilaterally with a number of
counterparty/dealers using standard ISDA documentation. By using
multiple counterparties over an extended period of time, it would be
possible for the hedge fund to establish very large positions with each
of the dealer/counterparties. Each dealer in turn would enter into
transactions on NYMEX to offset the risk arising from the bilateral
transactions into which it has entered with the hedge fund. In this
way, the hedge fund's total position would come to be reflected in the
futures market. Thus, a prolonged wave of buying by a hedge fund, even
through bilateral direct or voice-brokered OTC transactions, can be
translated into upward price pressure on the futures exchange.
As NYMEX settlement approaches, the hedge fund's bilateral
purchases with multiple dealer/counterparties would maintain or
increase upward pressure on prices. By spreading its trading through
multiple counterparties, the hedge fund's purchases would attract
little attention and escape detection by either NYMEX or the CFTC. In
the absence of routine large-trader reporting of bilateral
transactions, the CFTC will only see the various dealers' exchange
positions and have no way of tying them back to purchases by a single
hedge fund.
Given that the various segments of the financial markets that price
natural gas are linked economically, it is critical to achieving market
transparency that traders holding large positions entered into through
bilateral transactions be included in any large-trader reporting
requirement. As explained above, by trading through multiple dealers, a
large hedge fund would be able to exert pressure on exchange prices
similar to the pressure that it could exert by holding those positions
directly. Only a large-trader reporting system that includes positions
entered into in the OTC bilateral markets would enable the CFTC to see
the entire picture and trace such positions back to a single source.
If large trader reporting requirements apply only to positions
acquired on multi-lateral electronic trading platforms, traders in
order to avoid those reporting requirements may very well move more
transactions to electronic bilateral markets or increase their direct
bilateral trading. This would certainly run counter to efforts by
Congress to increase transparency. APGA remains convinced that all
segments of the natural gas marketplace should be treated equally in
terms of reporting requirements. To do otherwise leaves open the
possibility that dark markets on which potential market abuses could go
undetected would persist and that our current lack of sufficient
information to fully understand the impact of large speculative traders
and certain trading strategies on the markets will continue, thereby
continuing to place consumers at risk.
Better Categorizing of Positions and Administration of Hedge Exemptions
APGA also notes that it has advocated that the CFTC take additional
steps within its existing authorities to increase transparency,
particularly with respect to the categorization of trades as
speculative or not.\9\ The CFTC uses the information derived from its
large trader reporting system both for its internal analyses of the
markets as well as providing the public with certain aggregated
information in its weekly ``Commitments of Traders reports.'' For
purposes of this report, it classifies traders as ``commercials'' or
``noncommercials.'' It is assumed that commercial traders are hedging
in the markets and that noncommercials are speculators.
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\9\&For example, the CFTC recently amended its Rule 18.05 ``special
call'' provision to make explicit that its special call authority to
traders applies to OTC positions, including bilateral transactions and
transactions executed on the unregulated electronic trading facilities
where the trader has a reportable position on a designated contract
market in the same commodity. This amendment made explicit authority
that the CFTC has previously exercised under Rule 18.05 to require a
trader with a reportable position on a regulated exchange, upon special
call, to report related OTC positions.
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The CFTC in 2007 made certain enhancements to its Commitment of
Traders Reports by reporting separately the aggregate positions held by
long-only, passively managed investment funds. The CFTC recently
announced that it was extending this initiative to include information
relating to the crude oil markets. APGA is encouraged that the CFTC has
taken steps to expand these enhancements to their Commitment of Traders
Reports to include the crude oil contracts.\10\ APGA believes that it
is critical that this initiative include all physical commodities, and
in particular, all energy-related commodities. Enhanced transparency
with respect to large traders and the size, scope and composition of
their aggregate positions will improve our understanding of the
dynamics of the market at any particular time, potentially increasing
hedger's confidence in the markets' price discovery function.
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\10\& See, ``Recent Energy Initiatives,'' CFTC Statement, http://
cftc.gov/stellent/groups/public/@newsroom/documents/file/
cftcenergyinitiatives061708.pdf.
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The CFTC has also announced an initiative to examine the
classification of swaps dealers under the large trader reporting
system. The example discussed above of a speculative trader entering
into a bilateral transaction with a swaps dealer that then covers its
position in the regulated futures market illustrates why this
reclassification initiative is important to a full understanding of the
impact of speculators on the markets. Prior to the CFTC's initiative,
positions that were assumed for speculative purposes in the OTC markets
apparently could be reflected in the CFTC's futures market reporting
system as the positions of a ``commercial.'' This happens because the
swaps dealer may be covering its exposure in the futures market arising
from its OTC position as counter-party to a bilateral OTC transaction.
This was classified as a `hedge' of the OTC position by the
`commercial' swaps dealer. However, the original OTC position may have
been entered into for speculative purposes, by a hedge fund, for
example. Accordingly, despite the economic linkage between the
speculative OTC transaction and the regulated market, prior to the
CFTC's recent re-classification initiative, speculative OTC positions
have been reflected in the CFTC's COT futures market reports as non-
speculative, ``commercial'' positions. Similarly, when a long-only
index fund enters into a speculative OTC position with a swaps dealer,
the position of the swaps-dealer in the futures market has been
classified by the CFTC as the non-speculative position of a
``commercial.''
Equally profound, speculative position limits do not apply to
hedging activity by commercials. Thus, positions that would be subject
to a speculative position limit if entered into directly on the
regulated exchange are not so limited if the speculator enters into the
transaction in the OTC market and the swaps dealer in turn covers its
ensuing risk in the regulated market. In this way a speculator can
amass a larger position indirectly than it could by trading directly on
the exchange. The CFTC has also granted a number of staff No Action
letters exempting from speculative position limits certain passively
managed long-only index funds that have price exposure from their
obligation to track a commodity index.\11\
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\11\&See CFTC Letter 06&09 (April 19, 2006); CFTC Letter 06&19
(September 6, 2006).
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Part of the increased transparency that APGA has been seeking
includes a more nuanced approach to classification of positions so that
the impact of these OTC speculative positions on the regulated market
can be better understood. As noted above, the CFTC has recently
undertaken several initiatives to report more accurately the trading of
index funds and to better classify trading by swaps dealers. APGA
believes that these are important initiatives that will shed greater
light and understanding on the possible effects on the oil market
arising from speculative traders and from certain speculative trading
strategies.
It may be, however, that additional statutory changes would be
helpful in ensuring that the CFTC has sufficient authority and
direction to deepen and make permanent these steps and to apply them
with respect to all physical commodities, including all energy-related
products. APGA believes that although the issues discussed at this
hearing arise most acutely in today's oil markets, the issues apply
equally to all energy markets, including in particular natural gas. The
problems that are being noted in relation to the oil markets have also
been raised quite recently with respect to the natural gas markets and
have been noted in respect to the market for propane. APGA believes
that the problems that have been noted by this Committee are broader
than the oil markets and that other energy markets, including natural
gas, require continuing rigorous oversight and close attention.
CFTC Resources
The CFTC plays a critical role in protecting consumers, and the
market as a whole, from fraud, manipulation and market distortion. It
is essential that the CFTC have the necessary resources to monitor
markets and protect consumers from attempts to manipulate the market.
This is critical given the additional oversight responsibilities the
CFTC will have through the market transparency language included in the
farm bill and the additional transparency requirements that APGA is
proposing to the Committee.
Over the last several years, trading volumes have doubled while
CFTC staffing levels have, on average, decreased. In fact, while we are
experiencing record trading volumes, employee levels at the CFTC are at
their lowest since the agency was created. APGA is concerned that if
funding for the CFTC is inadequate, so may be the level of protection.
American consumers expect more than this form of regulatory triage.
Conclusion
Our testimony today is not meant to imply that the CFTC has not
been vigilant in pursuing wrongdoers. Experience tells us that there is
never a shortage of individuals or interests who believe they can, and
will attempt to, affect the market or manipulate price movements to
favor their market position. The fact that the CFTC has assessed over
$300 million in penalties, and has assessed over $2 billion overall in
government settlements relating to abuse of these markets affirms this.
These efforts to punish those that manipulate or abuse markets or to
address those that might innocently distort markets are important. But
it must be borne in mind that catching and punishing those that
manipulate markets after a manipulation has occurred is not an
indication that the system is working. To the contrary, by the time
these cases are discovered using the tools currently available to
government regulators, our members, and their customers, have already
suffered the consequences of those abuses in terms of higher natural
gas prices. Nor is it acceptable to be unable to make responsible
public policy decisions because of a lack of transparency in the
markets.
Greater transparency with respect to traders' large positions,
whether entered into on a regulated exchange or in the OTC markets in
natural gas will provide the CFTC with the tools to answer that
question and to detect and deter potential manipulative or market
distorting activity before our members and their customers suffer harm.
This hearing has raised issues that are vital to APGA's members and
their customers. We do not yet have the tools in place to say with
confidence the extent to which the pricing mechanisms in the natural
gas market today are reflecting market fundamentals or the possible
market effects of various speculative trading strategies. However, we
know that the confidence that our members once had in the pricing
integrity of the markets has been badly shaken.
In order to protect consumers the CFTC must be able to (1) detect a
problem before harm has been done to the public through market
manipulation or price distortions; (2) protect the public interest; and
(3) ensure the price integrity of the markets. Accordingly, APGA and
its 704 public gas system members applaud your continued oversight of
the CFTC's surveillance of the natural gas markets. We look forward to
working with the Committee to determine the further enhancements that
may be necessary to restore consumer confidence in the integrity of the
price discovery mechanism.
In addition to increasing market transparency, however, if we are
to bring natural gas prices back to an affordable level, it is equally
important that energy policy must ensure that supply is adequate to
meet demand. In addition to greater transparency in market pricing,
this will require that supply and demand for natural gas be unfettered
by regulation. Yet, current statutory and regulatory policies (1)
prohibit the assessment of offshore reserves; (2) restrict and limit
access to production in areas of known reserves; and (3) encourage the
use of natural gas for new electric generation.
It makes no sense to encourage greater use of natural gas on the
one hand while at the same time to impede the acquisition of data that
could point to areas of abundant new resources and to obstruct
production in areas with rich supplies. In light of these facts, is it
a wonder that speculators find these markets attractive?
Natural gas is a lifeblood of our economy and millions of consumers
depend on natural gas every day to meet their daily needs. It is
critical that the price those consumers are paying for natural gas
comes about through the operation of fair, orderly and transparent
markets. It is equally critical that regulatory policy support bringing
demand and supply into balance. Every winter, more than 65 million
residential and commercial homes and businesses are heated by natural
gas. More than 20% of our nation's electricity is generated by natural
gas, and that percentage will grow because America is unwilling to
adopt 21st century nuclear technology and other alternatives to replace
coal for electric generation. Increases in market transparency alone
will not address this problem.
The Chairman. Thank you, Mr. Comstock.
Mr. Greenberger, welcome to the Committee.
STATEMENT OF MICHAEL GREENBERGER, J.D., PROFESSOR, UNIVERSITY
OF MARYLAND SCHOOL OF LAW, BALTIMORE, MD
Mr. Greenberger. Thank you, Mr. Chairman. It is a pleasure
to be here. This testimony is my own personal view about, and
when I say personal, I emphasize personal. I represent nobody.
I am here on my own behalf. I have no clients that I am
representing, as my disclosure form makes clear.
I think the fundamental question this Committee has to
answer is whether the purpose of the Commodity Exchange Act,
which was established most clearly in 1936 to bar excessive
speculation, is still an active purpose of the statute. In the
1935 report of this Committee that brought forth the Commodity
Exchange Act, it was said, ``The fundamental purpose of the
measure is to ensure fair practice and honest dealing on the
commodity exchanges and to provide a measure of control over
those forms of speculative activity which too often demoralize
the markets to the injury of producers and consumers and the
exchanges themselves.''
President Roosevelt, in a message to Congress urging the
passage of what became the Commodity Exchange Act, said, ``It
should be our national policy to restrict as far as possible
the use of these exchanges for purely speculative operations.''
This bill authorizes the Commission to fix limitations on
purely speculative trades. There is a lot of talk in the air
about the speculative impacts on the price of crude oil. I am
not an economist. I have read a lot of economic studies about
this and statements. What I will say is I think you cannot
gainsay the fact that there is a dispute here of whether or not
speculation is playing a role.
When the Commodity Exchange Act was passed in 1936, it was
in response to farmers who, looking out at their fields, said,
``I don't really have any control over what I am growing. Those
guys back in Chicago, the locals,'' that is what they were
called, the speculators, ``control the price of what I am
growing.'' And there is a 1892 report of this Committee that
articulates a quote from a farmer with that very point. And the
thesis was that those guys in Chicago, because that is where
the trading was, could, by buying paper, paper trades, could
raise and lower the price of this at their will.
Now, did the Commodity Exchange Act bar speculation? No, it
did not. It recognized that speculators are needed to make a
liquid exchange. But it did bar excessive speculation, and that
excessive speculation has been fought with many tools, the most
clearest of which, especially today in the agricultural market,
are hard and fixed limits on the participation of speculators.
In the OTC market, or in the foreign board of trade market as
it stands today, there are real issues about whether those
limits on speculators are working or whether they are even in
place.
I don't believe it is the burden of the truckers, the
airlines, the farmers, the automobile manufacturers to prove
that there is no speculation. I believe that if it is in
question, there needs to be the appropriate transparency to
answer once and for all whether or not speculation is
dominating these markets.
If you try and trace the $260 billion which has entered
into the index swaps market since 2004, you can't go and find
where the money is. You can't trace that money. Why? Because
these markets are opaque. The same problem in the housing
meltdown. You have credit default swaps which were deregulated
by the Commodity Futures Modernization Act of 2000. The
Chairman of the Fed would love to know what the total scope of
those credit default swaps are, but they are buried all over
the economy, and they only come to light upon a bankruptcy or
some other transaction where they have to be fixed. You will
note that the Chairman of the Fed is now saying if a financial
institution, another major financial institution, fails, he
does not want it to go through a bankruptcy proceeding.
My view is that the legislative proposals, and I am happy
to talk about them in detail, would provide the transparency to
answer, once and for all, is the price of oil supply and demand
entirely, or, as many, many people have said, is there a
speculative premium being added?
I want to emphasize two final things. I do not argue that
the entire run-up of the price of crude oil or other
commodities including agricultural prices is entirely
speculation. What I do argue is if there is any part of it that
is due to excessive speculation, not manipulation, but
excessive speculation, we should put a stop to it. If it
reduces gas prices by four percent, five percent, whatever, the
American consumer should not be paying that speculative tax. If
there is no speculation, then we can all go and say the
argument is over.
One final point. Mr. Vice raised the analysis of my June 3
testimony before the Senate Commerce Committee. That analysis
is not on their website. I am perfectly prepared to answer,
under oath, any of the comments that were made in that
analysis, and the Chairman of this Committee has asked that I
provide him a letter doing so, which I have done. I sense from
the Senate side that this is not something that they want to
make into a public debate, as evidenced by the fact it is not
on their website. And I am prepared to tamp that down, but if I
need to defend myself, I will defend myself. I have written a
detailed letter to the Chairman on it point for point, and not
only do I believe I have not said anything in error, I believe
that that analysis is filled with errors.
Thank you.
[The prepared statement of Mr. Greenberger follows:]
Prepared Statement for July 10 and 11 of Michael Greenberger, J.D.,
Professor, University of Maryland School of Law, Baltimore, MD
Introduction
My name is Michael Greenberger.
I want to thank the Committee for inviting me to testify on the
important issue that is the subject of today's hearings.
After 25 years in private legal practice, I served as the Director
of the Division of Trading and Markets (``T&M'') at the Commodity
Futures Trading Commission (``CFTC'') from September 1997 to September
1999. In that capacity, I supervised approximately 135 CFTC personnel
in CFTC offices in DC, New York, Chicago, and Minneapolis, including
lawyers and accountants who were engaged in overseeing the Nation's
futures exchanges. During my tenure at the CFTC, I worked extensively
on, inter alia, regulatory issues concerning exchange traded energy
derivatives, the legal status of over-the-counter (``OTC'') energy
derivatives, and the CFTC authorization of trading of foreign exchange
derivative products on computer terminals in the United States.
While at the CFTC, I also served on the Steering Committee of the
President's Working Group on Financial Markets (``PWG''). In that
capacity, I drafted, or oversaw the drafting of, portions of the April
1999 PWG Report entitled ``Hedge Funds, Leverage, and the Lessons of
Long-Term Capital Management,'' which recommended to Congress
regulatory actions to be taken in the wake of the near collapse of the
Long Term Capital Management (LTCM) hedge fund, including Appendix C to
that report which outlined the CFTC's role in responding to that near
collapse. As a member of the International Organization of Securities
Commissions' (``IOSCO'') Hedge Fund Task Force, I also participated in
the drafting of the November 1999 report of IOSCO's Technical Committee
relating to the LTCM episode: ``Hedge Funds and Other Highly Leveraged
Institutions.''
After a 2 year stint between 1999 and 2001 as the Principal Deputy
Associate Attorney General in the U.S. Department of Justice, I began
service as a Professor at the University of Maryland School of Law. At
the law school, I have, inter alia, focused my attention on futures and
OTC derivatives trading, including academic writing and speaking on
these subjects. I currently teach a course that I designed entitled
``Futures, Options, and Derivatives.''
The question whether there has been excessive speculation of U.S.
energy futures markets in general, and futures based on U.S. delivered
crude oil contracts specifically, has been the subject of many
hearings. I have previously testified at six of those hearings, the
most recent held on June 24, 2008 before the United States Senate
Committee on Homeland Security & Government Affairs. To put the issue
of this Committee's hearings in context, I summarize and update the
points I made at that hearing immediately below.
Summary and Update of Prior Testimony
One of the fundamental purposes of futures contracts is to provide
price discovery in the ``cash'' or ``spot'' markets.\1\ Those selling
or buying commodities in the ``spot'' markets rely on futures prices to
judge amounts to charge or pay for the delivery of a commodity.\2\
Since their creation in the agricultural context decades ago, it has
been widely understood that, unless properly regulated, futures markets
are easily subject to distorting the economic fundamentals of price
discovery (i.e., cause the paying of unnecessarily higher or lower
prices) through excessive speculation, fraud, or manipulation.\3\
---------------------------------------------------------------------------
\1\&The Economic Purpose of Futures Markets and How They Work,
Commodity Futures Trading Commission, http://www.cftc.gov/
educationcenter/economicpurpose.html (last visited July 8, 2008).
\2\&See Platts Oil Pricing and Market-on-Close Methodology
Explained, Platts (July 2007) at 3, available at http://www.platts.com/
Resources/whitepapers/index.xml.
\3\&See, e.g., Jonathan Ira Levy, Contemplating Delivery: Futures
Trading and the Problem of Commodity Exchange in the United States,
1875&1905, American Historical Review 307 (2006) (``&`[T]he man who
managed or sold or owned those immense wheat fields has not as much to
say with the regard to the price of the wheat that some young fellow
who stands howling around the Chicago wheat pit could actually sell in
a day'&''(quoting Fictitious Dealings in Agricultural Products: House
Comm. on Agric. Committee Hearing Reports (1892)).
---------------------------------------------------------------------------
As the 1935 Report of this Committee stated: ``The fundamental
purpose of the measure [i.e., what was to become the Commodity Exchange
Act of 1936 (`CEA')] is to insure fair practice and honest dealing on
the commodity exchanges and to provide a measure of control over those
forms of speculative activity which too often demoralize the markets to
the injury of producers and consumers and the exchanges
themselves.''&\4\
---------------------------------------------------------------------------
\4\&Report No. 421, U.S. House of Representatives 74th Cong,
Accompanying the Commodity Exchange Act, March 18, 1935.
---------------------------------------------------------------------------
Indeed, President Roosevelt, when introducing what became the CEA
said: ``[I]t should be our national policy to restrict, as far as
possible, the use of these exchanges for purely speculative
operations.''&\5\ In this regard, this Committee then stated: ``This
bill authorizes the Commission . . . to fix limitations upon purely
speculative trades . . .''&\6\
---------------------------------------------------------------------------
\5\&President Franklin D. Roosevelt, Message to Congress, February
9, 1934.
\6\&Report No. 421, U.S. House of Representatives 74th Cong.,
Accompanying the Commodity Exchange Act, March 18, 1935.
---------------------------------------------------------------------------
The CEA has long been judged to effectively prevent excessive
speculation and manipulation. Accordingly, prior to the passage of the
Commodity Futures Modernization Act of 2000 (``CFMA''), ``all futures
activity [was] confined by law (and eventually to criminal activity) to
[CFTC regulated] exchanges alone.''&\7\ At the behest of Enron, the
CFMA authorized the ``stunning''&\8\ change to the CEA to allow the
option of trading energy commodities on deregulated trading platforms,
i.e., exchanges exempt from CFTC contract market registration
requirements, thereby rejecting the contrary 1999 advice of the
President's Working Group on Financial Markets, which included the
Secretary of the Treasury, the Chairman of the Federal Reserve Board,
and the Chairmen of the SEC and CFTC.\9\ This exemption from contract
market regulation is called the ``Enron Loophole.''
---------------------------------------------------------------------------
\7\&Philip McBride Johnson & Thomas Lee Hazen, Derivatives
Regulation 28 (Cumm. Supp. 2008).
\8\&Id. at &1.17.
\9\&Id. at 28; see also President's Working Group on Financial
Markets, Over-the-Counter Derivatives Markets and the Commodity
Exchange Act 16 (1999), available at http://www.ustreas.gov/press/
releases/reports/otcact.pdf (last visited July 8, 2008) (``Due to the
characteristics of markets for non-financial commodities with finite
supplies, however, the Working Group is unanimously recommending that
the exclusion [from regulation] not be extended to agreements involving
such commodities.'').
---------------------------------------------------------------------------
Two prominent and detailed bipartisan studies by the Permanent
Subcommittee on Investigations' (``PSI'')&\10\ staff concluded that
large financial institutions and wealthy investors had needlessly
driven up the price of energy commodities over what economic
fundamentals dictate, adding, for example, what the PSI estimated to be
@ $20&$25 per barrel to the price of a barrel of crude oil.\11\ At the
time of that estimate, the price of crude oil had reached a then record
high of $77. The conclusion that excessive speculation has added a
considerable premium to energy products has been corroborated by many
experts on,\12\ and observers of, these markets.\13\
---------------------------------------------------------------------------
\10\&Permanent Subcommittee on Investigations of the Committee on
Homeland Security and Governmental Affairs, The Role of Market
Speculation in Rising Oil and Gas Prices: A Need To Put the Cop Back On
the Beat (June 27, 2006) [hereinafter June 2006 Report]; Permanent
Subcommittee on Investigations of the Committee on Homeland Security
and Governmental Affairs, Excessive Speculation in the Natural Gas
Market (June 25, 2007) [hereinafter June 2007 Report].
\11\&June 2006 Report, supra note 10, at 2, 23.
\12\&See, e.g., Edmund Conway, George Soros: Rocketing Oil Price is
a Bubble, Daily Telegraph (May 27, 2008), available at http://
www.telegraph.co.uk/money/main.jhtml?xml=/money/2008/05/26/
cnsoros126.xml (last visited July 8, 2008) (quoting Mr. George Soros as
stating ``Speculation . . . is increasingly affecting the price'');
Written Testimony of Michael Masters, Hearing Before the Committee on
Homeland Security and Governmental Affairs, U.S. Senate 2 (May 20,
2008), available at http://hsgac.senate.gov/public/_files/
052008Masters.pdf (last visited July 8, 2008) (quoting Michael W.
Masters as stating ``Are Institutional Investors contributing to food
and energy price inflation? And my unequivocal answer is YES''); Oral
Testimony of Edward Krapels, Hearing Before the Committee on Energy and
Commerce Subcommittee on Oversight and Investigations, U.S. House of
Representatives, (June 23, 2008) (quoting Mr. Edward Krapels as stating
``I think the amount of speculation is really substantial [within the
crude oil market.]''); Oral Testimony of Roger Diwan, Hearing Before
the Committee on Energy and Commerce Subcommittee on Oversight and
Investigations, U.S. House of Representatives, (June 23, 2008) (quoting
Mr. Roger Diwan, responding to Rep. Whitfield's question: So you're
saying if we adopt these regulatory changes, we could almost cut the
retail price of gas in half in a relatively short period of time? ``I
don't know how quickly it takes to get prices down, but it's clear that
prices will reflect closer the marginal cost of producing oil.'');
Alejandro Lazo, Energy Stocks Haven't Caught Up With Oil Prices, Wash.
Post (Mar. 23, 2008), available at http://www.washingtonpost.com/wp-
dyn/content/article/2008/03/21/AR2008032103825.html (last visited July
8, 2008) (quoting Mr. Fadel Gheit as stating ``The largest speculators
are the largest financial companies.''); Michelle Foss, United States
Natural Gas Prices To 2015, 34 (2007), available at http://
www.oxfordenergy.org/pdfs/NG18.pdf (last visited July 8, 2008)
(asserting ``The role of speculation in oil markets has been widely
debated but could add upwards of $20 to the price per barrel.''); Tim
Evans, Citi Futures Perspective: PM Energy News & Views, at 2 (July 3,
2008) (quoting ``With the latest push to the upside, we see the crude
oil market becoming even more completely divorced from any connection
to fundamental factors and becoming even more obsessed with the simple
question, How high can it go?''); Advantage Business Media, Economist
Blames Subsidies for Oil Price Hike, Chem. Info (2008), available at
http://www.chem.info/ShowPR.aspx?PUBCODE=075&ACCT=
0000100&ISSUE=0609&ORIGRELTYPE= DM&RELTYPE=PR&PRODCODE=00000&PRODLETT
=M&CommonCount=0 (last visited July 8, 2008) (quoting Dr. Michelle Foss
as stating ``We have an overpriced commodity, and this is going to be
around for a while.''); Kenneth N. Gilpin, OPEC Agrees to Increase
Output in July to Ease Oil Prices, N.Y. Times (June 3, 2004) available
at http://www.nytimes.com/2004/06/03/business/03CND-
OIL.html?ex=1401681600&en=5dbd50c5b369795b&ei=5007&partner=USERLAND
(last visited July 8, 2008) (quoting Mr. Kyle Cooper as stating ``There
is not a crude shortage, which is why OPEC was so reluctant to raise
production.''); Upstream, Speculators 'not to blame' for Oil Prices,
Upstreamonline.com, (April 4, 2008), available at http://
www.upstreamonline.com/live/article151805.ece (last visited July 8,
2008) (quoting Mr. Sean Cota as stating ``It has become apparent that
excessive speculation on energy trading facilities is the fuel that is
driving this runaway train in crude prices''); Mike Norman, The Danger
of Speculation, FOXNews.com (Aug. 19, 2005), available at http://
www.foxnews.com/story/0,2933,166038,00.html (last visited July 8, 2008)
(Mr. Norman stating ``Oil prices are high because of speculation, pure
and simple. That's not an assertion, that's a fact. Yet rather than
attack the speculation and rid ourselves of the problem, we flail away
at the symptoms.'').
\13\&International Monetary Fund, Regional Economic Outlook: Middle
East and Central Asia 27&28 (2008) (``Producers and many analysts say
it is speculative activity that is pushing up oil prices now. Producers
in particular argue that fundamentals would yield an oil price of about
U.S. $80 a barrel, with the rest being the result of speculative
activity.''); see also Neil King Jr., Saudi Arabia's Leverage In Oil
Market Is Sapped, Wall Street J. (June 16, 2008), available at http://
online.wsj.com/article/SB121355902769475555.html?mod=googlenews_wsj
(last visited July 8, 2008) (quoting Saudi Oil Minister Ali Naimi as
saying skyrocketing oil prices were ``unjustified by the fundamentals''
of supply and demand).
---------------------------------------------------------------------------
The PSI staff and others have identified the Intercontinental
Exchange (``ICE'') of Atlanta, Georgia, as an unregulated trading
facility upon which a considerable amount of exempt U.S. energy futures
trading is done.\14\ For purposes of facilitating exempt natural gas
futures, ICE is deemed a U.S. ``exempt commercial market'' under the
Enron Loophole.\15\ For purposes of its facilitating U.S. WTI crude oil
futures on U.S. trading terminals, the CFTC, by informal staff action,
considers ICE, because of its wholly owned subsidiary, ICE Futures
Europe, to be a U.K. entity not subject to direct CFTC regulation even
though ICE maintains U.S. headquarters and U.S. trading infrastructure
(i.e., terminals and servers), facilitating, inter alia, @ 30% of
trades in U.S. WTI futures trades.\16\
---------------------------------------------------------------------------
\14\&See June 2007 Report, supra note 10, at 27.
\15\&See id.
\16\&See Written Testimony of Professor Michael Greenberger, Energy
Market Manipulation and Federal Enforcement Regimes: Hearing before the
S. Comm. on Commerce, Science, and Transportation, 3 (2008), available
at http://digitalcommons.law.umaryland.edu/cgi/
viewcontent.cgi?article=1026&context=cong_test (last visited July 8,
2008).
---------------------------------------------------------------------------
The Dubai Mercantile Exchange, in affiliation with NYMEX, a U.S.
exchange, has also been granted permission to trade the U.S. delivered
WTI contract on U.S. terminals, but is, by virtue of a CFTC No Action
letter, to be regulated directly by the Dubai Financial Service
Authority (``DFSA'').\17\ NYMEX describes itself as ``a founder and has
ownership share in [DME] and provides clearing services for that
exchange.''&\18\
---------------------------------------------------------------------------
\17\&Dubai Mercantile Exchange Ltd., CFTC No-Action Letter, 2007
CFTC Ltr. LEXIS 6 (May 24, 2007).
\18\&See Written Testimony of Jim Newsome, Hearing Before the
Committee on Energy and Commerce Subcommittee on Oversight and
Investigations, U.S. House of Representatives, at 6 (June 23, 2008)
[hereinafter June 23, 2008 Testimony of Jim Newsome].
---------------------------------------------------------------------------
NYMEX itself, the U.S. premier regulated energy futures contract
market capturing the overwhelming share, e.g., of the U.S. delivered
WTI futures market, has announced that it has applied to the United
Kingdom's Financial Services Authority to have a NYMEX London trading
platform registered with the that British agency,\19\ after which NYMEX
will apply for the kind of foreign board of trade no action relief that
has already been granted to ICE and DME. Providing NYMEX's London
trading platform with this kind of no action relief might very well
convert full U.S. regulation of the most important U.S. crude oil
futures contracts to considerable U.K. oversight.\20\ These staff
informal action letters, effectuating the exemptions for ``foreign''
owned U.S. trading terminals, by their own terms make it clear that
they may be instantly revoked by the CFTC.\21\
---------------------------------------------------------------------------
\19\&Id.; Jeremy Grant, Nymex's Long Road to the Electronic Age,
Financial Times (Feb. 17, 2006), at 39. (``Nymex has indicated that it
might be forced to move its electronically traded WTI to London so that
it can compete on a level playing field with ICE.'').
\20\&See June 23, 2008 Testimony of Jim Newsome, supra note 18.
\21\&See Written Testimony of Professor Michael Greenberger, Energy
Speculation: Is Greater Regulation Necessary to Stop Price
Manipulation?: Hearing Before the H. Subcomm. on Oversight and
Investigations 11&12 (2007) (providing a complete discussion of the No
Action letter process including termination), available at http://
digitalcommons.law.umaryland.edu/cgi/
viewcontent.cgi?article=1011&context=cong_test (last visited July 8,
2008).
---------------------------------------------------------------------------
One final gap in the oversight of excessive speculation in the U.S.
crude oil (and agricultural) markets has been illuminated by the
testimony of Michael W. Masters, Managing Member of Masters Capital
Management, LLC, at recent May 20 and June 24 hearings before the
Senate Committee on Homeland Security and Government Affairs.\22\ Mr.
Masters demonstrated that large financial institutions, such as
investment banks and hedge funds, which were ``hedging'' their off
exchange futures transactions on energy and agricultural prices on U.S.
regulated exchanges, were being treated by NYMEX, for example, and the
CFTC as ``commercial interests,'' rather than as the speculators they
clearly are.\23\ By lumping large financial institutions with
traditional commercial oil dealers (or farmers)&\24\ even fully
regulated U.S. exchanges are not applying traditional speculation
limits to the transactions engaged in by these speculative
interests.\25\ Mr. Masters has demonstrated that a significant
percentage of the trades in WTI futures, for example, were controlled
by noncommercial interests.\26\ These exemptions from speculation
limits for large financial institutions hedging off-exchange ``swaps''
transactions emanate from a CFTC letter issued on October 8, 1991&\27\
and they have continued to present day.\28\
---------------------------------------------------------------------------
\22\&Masters, supra note 12.
\23\&Id. at 7&8.
\24\&Gene Epstein, Commodities: Who's Behind The Boom?, Barron's 32
(March 31, 2008) ( ``The speculators, now so bullish, are mainly the
index funds. . . . By using the [swaps dealers] as a conduit, the index
funds get an exemption from position limits that are normally imposed
on any other speculator, including the $1 in every $10 of index-fund
money that does not go through the swaps dealers.'').
\25\&Masters, supra note 12, at 7.
\26\&Id. at 8, 11.
\27\&J. Aron & Co., CFTC Interpretive Letter, 1991 CFTC Ltr. LEXIS
18 (Oct. 8, 1991).
\28\&See Written Testimony of Michael Masters, Hearing Before
Committee on Energy and Commerce Subcommittee on Oversight and
Investigations, U.S. House of Representatives, at 5 (June 23, 2008)
available at http://energycommerce.house.gov/cmte_mtgs/110-oi-
hrg.062308.Masters-testimony.pdf (quoting ``assets allocated to
commodity index trading strategies have risen from $13 billion at the
end of 2003 to $260 billion as of March 2008, and the prices of the 25
commodities that compose these indices have risen by an average of 183%
in those 5 years!'').
---------------------------------------------------------------------------
Again, while the principal focus to date has been on skyrocketing
energy prices, Mr. Masters' testimony, aided by a widely discussed
cover story in the March 31, 2008 issue of Barron's,\29\ has made clear
that the categorization of swaps dealers outside of speculative
controls even on U.S. regulated contract markets has been a cause of
great volatility in food prices, as well as in the energy markets.
---------------------------------------------------------------------------
\29\&See Epstein, supra note 24.
---------------------------------------------------------------------------
Many parties are now urging this Congress to close the Enron,
London/Dubai, and Swaps Dealers Loopholes. On June 18, 2008, the Food
Conservation and Energy Act of 2008&\30\ (the ``Farm Bill'') was
enacted into law by a Congressional override of President Bush's veto.
Title XIII of the farm bill is the CFTC Reauthorization Act of 2008,
which, in turn, includes a provision that was intended to close the
Enron Loophole.\31\ This provision, while a good start, did not return
to the status quo prior to the passage of the Enron Loophole: i.e., it
did not bring all energy futures contracts within the U.S. futures
regulatory format. Rather, the farm bill amendment requires the CFTC
``at its discretion'' to prove on a contract-by-contract basis through
administrative proceedings governed by the notice and comment
provisions of the Administrative Procedure Act&\32\ that an individual
energy contract should be regulated if the CFTC can prove that the
contract ``serve[s] a significant price discovery function'' in order
to detect and prevent excessive speculation and manipulation.\33\ The
farm bill Amendment affords the CFTC 15 months after enactment to
implement that re-regulation process specified therein.\34\
---------------------------------------------------------------------------
\30\&Food Conservation and Energy Act of 2008, Pub. L. No. 110&246,
&13201; 122 Stat. 1651 (2008).
\31\&Id.
\32\&See Richard J. Prince, Jr., Administrative Law Treatise
424&25, 441&43 (4th ed. 2002).
\33\&Food Conservation and Energy Act of 2008, Pub. L. No. 110&246,
&13201; 122 Stat. 1651 (2008).
\34\&Id. at &13204.
---------------------------------------------------------------------------
The CFTC has publicly stated that it intends to apply the new
legislation to only one of ICE's many&\35\ unregulated ICE energy
futures contract, i.e., only ICE's Henry Hub natural gas futures
contract would be removed from the Enron Loophole protection and become
fully regulated.\36\ Thus, by this CFTC pronouncement, it now seems
that no crude oil, gasoline, and heating oil futures contracts will be
covered by the new legislation--not even the multi-billion
agricultural/commodity index futures funds premised upon the prices of
U.S. energy and agricultural commodities about which, inter alia,
Michael Masters has testified are destabilizing the economic
fundamentals of the agriculture and energy markets.
---------------------------------------------------------------------------
\35\&See Written Testimony of Jeffrey C. Sprecher, To Examine
Trading Regulated Exchanges and Exempt Commercial Markets: Hearing of
the Commodity Futures Trading Commission, (September 18, 2007),
available at http://files.shareholder.com/downloads/ICE/
325023768x0x132117/53a6f61e-b72b-47ca-8f8e-f8282c21c12b/
CFTC%20Testimony%20091807.pdf (last visited July 8, 2008).
\36\&See Written Testimony of Acting Chair Walter Lukken, Energy
Speculation: Is Greater Regulation Necessary to Stop Price
Manipulation?: Hearing Before the H. Subcomm. on Oversight and
Investigations, 4 (Dec. 12, 2007) available at http://www.cftc.gov/
stellent/groups/public/@newsroom/documents/speechandtestimony/
opalukken-32.pdf (emphasis added) (last visited July 8, 2008).
---------------------------------------------------------------------------
The CFTC has also made it clear that the farm bill amendment will
not cover any U.S. futures contracts relating to the price of U.S.
delivered commodities traded on the U.S. terminals of foreign exchanges
operating pursuant to CFTC staff ``no action'' letters. As mentioned
above, the Intercontinental Exchange (``ICE'') of Atlanta, Georgia, for
purposes of facilitating U.S. delivered WTI crude oil futures, is
considered by the CFTC, through an informal staff No Action letter, to
be a U.K. entity not subject to direct CFTC regulation even though ICE
maintains U.S. headquarters and trading infrastructure, facilitating,
inter alia, @ 30% of trades in U.S. WTI futures of its wholly owned the
London subsidiary on which the no action permission is based. Moreover,
the Dubai Mercantile Exchange (``DME''), in affiliation with NYMEX, a
U.S. exchange, has also been granted permission to trade the U.S.
delivered WTI contract on U.S. terminals, but is, by virtue of a CFTC
No Action letter, directly regulated by the Dubai Financial Service
Authority (``DFSA''). Again, even though the plain language of the farm
bill does not exempt contract markets engaged in the U.S. trading of
futures premised upon U.S. delivered commodities, the CFTC will not use
the farm bill amendment to close the ``London/Dubai'' Loophole.
Congress Should Insist Upon Full Market Transparency To Ensure That
Excessive Speculation Is Not Overwhelming Crude Oil Futures
Trading
As the Committee knows, there is debate over whether the U.S. crude
oil futures market is overrun by excessive speculation. As I have said,
my own view is that those independent observers who understand those
markets, by and large, concur that the markets have come unhinged from
supply/demand fundamentals in a manner that makes them no longer
useable by the physical hedgers who find prices to be ``locked in'' too
volatile and distant from market fundamentals.\37\
---------------------------------------------------------------------------
\37\&See the many opinions from those experts in note 12 supra.
---------------------------------------------------------------------------
I would argue, however, that even if this Committee has doubts
about whether excessive speculation or more serious malpractice are
occurring in these markets and thereby unnecessarily driving up the
price of crude oil, then those very doubts argue for legislation that
makes these markets fully transparent. If all of these markets (e.g.,
OTC, foreign board of trade U.S. trading terminals for futures
dependent on U.S. commodities, and swaps dealers) were required to
execute trades on U.S. designated contract markets or designated
transaction execution facilities, the real time and constant reporting
to both the CFTC and to the market's own self regulatory observers,
would make it indisputably clear whether the markets are functioning
solely on economic fundamentals; or whether excessive speculation is
placing an unnecessary financial burden on them and the American energy
consuming public.
As it is, those who reject transparency are those who ask the U.S.
energy consumer to accept on blind faith (and I would argue in the face
of substantial and reliable data pointing in the opposite direction)
that these markets are functioning smoothly.
A Prompt Return to the Time Tested Futures Regulatory Format Predating
the Enron Loophole Will Create Much Needed Crude Oil Market
Transparency
Whatever form legislation takes to increase transparency in all
U.S. traded energy futures, I would urge that the following principles
be embedded therein to reassure the American energy consuming public
that the price of crude oil is tied to market fundamentals rather than
excessive speculation.
Completely Close the Enron Loophole. While the farm bill amendment
was a good start, the radically rising price of crude oil even in the
last few weeks now augurs for returning all U.S. energy futures trading
to the safe harbor of fully transparent U.S. regulated contract
markets. A simple amendment to existing law would redefine an ``exempt
commodity'' as a commodity that does not include an agricultural or
``energy commodity,'' thereby bringing all energy futures, including
energy swaps based on the price of energy commodities, within the CEA's
regulated contract market trading requirement. An energy commodity
should include traditional energy products, inter alia, crude oil,
gasoline, diesel fuel, heating oil, propane, electricity, and natural
gas, as well as metals which have also seen a drastic run up in price.
The result of this legislation would return U.S. energy futures trading
to the same status as U.S. agricultural trading, which must be
conducted on the U.S. registered contract market.
U.S. Based Energy Futures Contracts Traded on U.S. Terminals Should
Be Traded on U.S. Regulated Exchanges. To address the concerns about
the ``London/Dubai'' Loophole, any futures contract premised on the
price of U.S. delivered energy futures and traded on U.S. trading
terminals should be required to be traded on U. S. registered contract
markets. This requirement would not affect the overwhelming number of
foreign exchanges now trading within the U.S. who have continued to
limit their trading to foreign futures contracts.
Grace Periods. Reasonable grace periods should be provided in this
kind of legislation to accommodate conversion of energy futures trading
not now under U.S. oversight. A grace period no longer than 6 months
should accommodate this conversion.
Aggregated Speculation Limits for Noncommercial Hedgers.
Consideration should also be given to requiring the CFTC to establish
uniform speculation limits for noncommercial futures transactions
involving the U.S. trading of energy futures contracts premised upon
the price of U.S. delivered energy commodities. This would require the
CFTC to ``fix limits on the aggregate number of positions which may be
held by any person'' for each month and in all markets under CFTC
jurisdiction. Under the existing regulatory regime, speculation limits
are only applied by each contract market, and ``aggregate positions''
are never imposed. These aggregated limits would prevent a trader from
spreading speculation over a host of markets, thereby accumulating a
disproportionately large share of an energy market while satisfying
each exchange's separate limits. The aggregated limits should not be
applied to ``bona fide hedging transactions'' involving the trading of
energy futures contracts by those having a true commercial interest in
buying or selling the underlying commodity.
Legislation meeting most or all of the above listed criteria
include H.R. 6341, introduced by Congressman Van Hollen and
Congresswoman DeLauro, requiring all energy futures contracts executed
in the U.S. to be traded on U.S. regulated contract markets, thereby
building on the farm bill amendment's closure of the Enron Loophole by
returning all energy futures trading, including the energy swaps
market, to where it was immediately prior to that provision's passage,
i.e., on regulated exchanges; and that legislation expressly requires
the trading on U.S. terminals of futures contracts premised upon U.S.
delivered energy commodities to be similarly subject to a U.S.
regulated contract market. The latter provision would close the
``London/Dubai'' Loophole.
Congressman Stupak has introduced H.R. 6330, which mirrors in
function the Van Hollen/DeLauro legislation, but, in what I refer to as
a ``belt and suspenders'' approach, specifically brings energy swaps
transactions into the regulated futures environment; nullifies after a
grace period all foreign board of trade No Action letters; imposes CFTC
imposed aggregated speculation limits on noncommercial interests for
energy futures trading; requires speculation limits to be imposed on
all traders except those who are hedging commercial interests related
to the underlying commodity (thereby eliminating the hedge exemption
from speculation limits for swaps dealers); and provides strict
Congressional oversight of any exemptions provided to energy futures
trading from the contract market requirements of the legislation.
Senator Nelson of Florida, with Senator Obama as a cosponsor, has
introduced S. 3134, which is similar to that portion of H.R. 6341
requiring all energy futures contracts to be traded on regulated
exchanges.\38\ Senators Cantwell and Snowe have introduced S. 3122,
which mirrors that portion of H.R. 6341 directed to closing the London/
Dubai Loophole by requiring all trading of futures based on U.S.
delivered energy commodity on U.S. platforms to be governed fully and
directly by U.S. futures law.\39\ S. 3205, introduced by Senator
Cantwell, is the Senate version of Congressman Stupak's H.R. 6330.
---------------------------------------------------------------------------
\38\&S. 3134, 110th Cong. (2008), available at http://
frwebgate.access.gpo.gov/cgi-bin/
getdoc.cgi?dbname=110_cong_bills&docid=f:s3134is.txt.pdf (last visited
July 8, 2008).
\39\& Policing United States Oil Commodities Markets Act of 2008,
S. 3122, 110th Cong. (2008), available at http://
frwebgate.access.gpo.gov/cgi-bin/
getdoc.cgi?dbname=110_cong_bills&docid=f:s3122is.txt.pdf (last visited
July 8, 2008).
---------------------------------------------------------------------------
Also worthy of consideration are Senators Lieberman and Collins
legislative options designed to undercut excessive speculation in these
markets through direct and aggregated controls on noncommercial futures
traders. One of their proposals would require the CFTC to establish
firm and aggregated speculation position limits on all U.S. speculative
futures trading no matter where the platform on which the trading is
geographically located.\40\
---------------------------------------------------------------------------
\40\&Discussion Draft to establish aggregate speculative position
limits (2008), available at
http://hsgac.senate.gov/public/_files/aggspeclimits.pdf (last visited
July 8, 2008).
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There Are No Legal Restraints to Barring the ``Foreign'' Impact of
Manipulation on U.S. Markets
Arguments have been advanced that there are legal impediments to
the CFTC applying U.S. regulatory protections on foreign boards of
trade which bring their trading terminals to the U.S. If that argument
were correct, it would be an impediment to much of the legislation
cited above requiring the CFTC to do just that. These arguments are
premised upon Section 4(b) of the Commodity Exchange Act (CEA). Section
4(b) provides in part:
No rule or regulation may be adopted by the Commission under
this subsection that (1) requires Commission approval of any
contract, rule, regulation, or action of any foreign board of
trade, exchange, or market, or clearinghouse for such board of
trade, exchange, or market, or (2) governs in any way any rule
or contract term or action of any foreign board of trade,
exchange, or market, or clearinghouse for such board of trade,
exchange, or market.\41\
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\41\&7 U.S.C. &6(b) (2008).
However, this clause has been construed only to mean that the CFTC
does not have jurisdiction over transactions conducted by foreign
persons in a foreign country on a foreign board of trade.\42\ Kleinberg
v. Bear Stearns,\43\ dealt with a situation where London traders were
committing acts of fraud on a London exchange.\44\ In that case, the
Court held that the CFTC did not have enforcement jurisdiction, but
explained, ``It has been consistently held, at least implicitly, that
CFTC may regulate and prosecute those who practice fraud in the United
States in connection with commodities trading on foreign
exchanges.''&\45\
---------------------------------------------------------------------------
\42\&Philip McBride Johnson & Thomas Lee Hazen, Derivatives
Regulation 988 (2004 ed.).
\43\&1985 WL 1625 (1985).
\44\&Id. at 1.
\45\&Id. at 2 (internal citations omitted)
---------------------------------------------------------------------------
To similar effect is the recent case of Mak v. Wocom
Commodities,\46\ concerning a Hong Kong resident placing futures trades
with the defendant commodity brokers, both of which are Hong Kong
corporations (Wocom).\47\ The claims were denied because they were not
sufficiently particularized.\48\ However, the court stated that
jurisdiction would have been extended if it had been clearly shown that
there was ``particularized harm to our domestic markets.''&\49\ With
ICE we currently have trading by U.S. customers in U.S. denominated
currency on U.S. terminals in the foremost benchmark U.S. crude oil
futures contracts with substantial evidence demonstrating
``particularized harm to our domestic markets.''
---------------------------------------------------------------------------
\46\&112 F.3d 287 (7th Cir. 1997).
\47\&Id. at 288.
\48\&Id. at 290&91.
\49\&Id. at 291.
---------------------------------------------------------------------------
Indeed these cases are consistent with a fundamental tenet of
Federal financial enforcement jurisprudence that Federal financial
regulatory jurisdiction extends even to wholly foreign transactions
when domestic financial markets suffer ``from the effects of [an]
improper foreign transaction[.]''&\50\ The leading commentators on U.S.
derivatives regulation have, accordingly stated: ``[E]ven without
substantial activity in the United States, jurisdiction will exist when
conduct abroad has a substantial affect upon U.S. markets and U.S.
investors.''&\51\
---------------------------------------------------------------------------
\50\&Des Brisay v. Goldfield Corp., 549 F.2d 133, 135 (9th Cir.
1977) (citing Schoenbaum v. Firstbrook, 405 F.2d 200, 206 (2d Cir.
1968), modified in other respects, 405 F.2d 215 (in banc), cert.
denied, 395 U.S. 906, 89 S. Ct. 1747, 23 L. Ed. 2d 219 (1969)).
\51\&Johnson & Hazen, supra note 42, at 984.
---------------------------------------------------------------------------
Confirmation of this broad sweep of U.S. jurisdiction to address
overseas malpractice significantly impacting U.S. markets is evidenced
most clearly by the Sumitomo case.\52\ In that case, the CFTC's
enforcement division reached a settlement agreement with a Japanese
corporation upon determining that the Japanese head copper trader of
the Sumitomo Corporation manipulated the price of U.S. copper almost
exclusively through trading done in London on the London Metals
Exchange.\53\ The CFTC imposed $150 million in fines and
restitution.\54\ Only a small portion of the trading was done in the
U.S. and the London Metals Exchange contact with the U.S. was limited
to a U.S. warehouse.\55\ Despite these limited U.S. contacts, ``the
penalty [assessed was then] the largest ever levied by a U.S.
Government agency,'' and it was widely recognized that the settlement
indicated that ``manipulation of any commodity traded in the [U.S.]
could be the subject of a C.F.T.C. action, even if no acts were
committed in this country.''&\56\
---------------------------------------------------------------------------
\52\&In the Matter of Sumitomo Corporation, 1998 CFTC LEXIS 96
(1998).
\53\&Id. at 2&3.
\54\&Id. at 24&25.
\55\&Id. at 11&14.
\56\&Floyd Norris, The Markets; A Record Penalty of Sumitomo, a
Lesson on Market Volatility, N.Y. Times (May 12, 1998), at D13
(emphasis added).
---------------------------------------------------------------------------
Clearly, then, trading done on trading platforms within the U.S.
would be subject to full CFTC regulatory authority. The fact that ICE
is headquartered in Atlanta with its trade matching engines in Chicago
and it controls through its U.S. terminals over 30% of the lead U.S.-
delivered petroleum contract only makes the jurisdictional question
that much easier. The same is true of the Dubai exchange that partners
with U.S.-based NYMEX to trade WTI contracts on U.S. terminals; and of
the prospect of NYMEX opening a London trading platform for its energy
futures products, but escaping U.S. regulation for that trading through
a staff No Action letter treating NYMEX as if it were a U.K. entity.
Even more important, Sumitomo and its progeny are an answer to
those many threats levied by large U.S. financial institutions that
assert, if their trading on ``foreign'' trading terminals located in
the U.S. is regulated, they will simply move that trading abroad. To be
clear, any trading done in the U.S. on foreign exchanges is a fortiori
covered by the applicable U.S. commodity laws.\57\ So when the threat
is made that the U.S. institutions will trade abroad, it means that it
will be done completely outside of the sovereign U.S. However, the
Sumitomo line of cases make clear that the CFTC, and for that matter,
United States Department of Justice for purposes of related criminal
prosecution,\58\ can enforce violations of U.S. laws abroad if U.S.
markets are significantly impacted by the wrongdoing in foreign
countries. In short, speculators cannot escape the reach of U.S. civil
and criminal law if they cause price distortions in U.S. commodity
markets.
---------------------------------------------------------------------------
\57\&Johnson & Hazen, supra note 42, at 984.
\58\&See Press Release, Department of Justice, U.S. Charges 47
After Long-Term Undercover Investigation Involving Foreign Exchange
Markets, (Nov. 19, 2003), available at http://www.fbi.gov/dojpressrel/
pressrel03/wooden111903.htm (last visited July 8, 2008).
---------------------------------------------------------------------------
Moreover, as I have testified elsewhere, no exchange, wherever
located, can develop liquidity in and maximize profits from trading
U.S. delivered futures products without having a substantial U.S.
presence.\59\ This is evidenced by the 18 CFTC staff No Action letters
issued to foreign exchanges from all over the world allowing the
placement of trading terminals in the U.S.\60\ In short, the threat
that trading in U.S. delivered commodities will be done exclusively
abroad is idle when confronted by both economic and legal realities.
---------------------------------------------------------------------------
\59\&Written Testimony of Professor Michael Greenberger, Energy
Market Manipulation and Federal Enforcement Regimes: Hearing Before the
United States Senate Committee on Commerce, Science, and
Transportation, 12 (2008), available at http://
digitalcommons.law.umaryland.edu/cgi/
viewcontent.cgi?article=1026&context=cong_test (last visited July 8,
2008).
\60\&U.S. Commodity Futures Trading Commission, Foreign Boards of
Trade Receiving Staff No Action Letters Permitting Direct Access from
the U.S., available at http://services.cftc.gov/sirt/
sirt.aspx?Topic=ForeignTerminalRelief (last visited July 8, 2008).
---------------------------------------------------------------------------
The IntercontinentalExchange Cannot Fairly Be Deemed British for
Purposes of Trading U.S. Petroleum Futures in U.S. Dollars on
U.S. Trading Terminals with U.S. Trading Engines
Of course, all of the above jurisdictional analysis assumes that
ICE (and DME) are ``foreign'' boards of trade. While ICE has a London
wholly owned subsidiary, that office is controlled by ICE's
headquarters in Atlanta; ICE's trading engines are in Chicago; it is
trading over 30% of the U.S. premier crude oil futures contract in U.S.
denominated currency. ICE's non-petroleum products, i.e., natural gas
futures contracts, are clearly traded within U.S. jurisdiction and are
subject to re-regulation under U.S. law by virtue of the farm bill's
``End the Enron Loophole'' provision.\61\ ICE also owns a fully
regulated U.S. exchange: formerly the New York Board of Trade (NYBOT);
now ICE Futures U.S. It defies all logic that such an exchange can be
called ``foreign'' based on the name given to its wholly owned
subsidiary (ICE Futures Europe) and maintaining a London office that
could as easily be operated out within the U.S.
---------------------------------------------------------------------------
\61\&Food Conservation and Energy Act of 2008, Pub. L. No. 110&246,
&13201; 122 Stat. 1651 (2008); Jessica Marron, House and Senate
Lawmakers Move to Close `Enron Loophole' with Amendment to Farm Bill,
Platts Global Power Report, (May 1, 2008) (stating that the ``initial
target of the [the Farm's Bill End the Enron Loophole Provision] is
ICE's financially settled Henry Hub swap contract'').
---------------------------------------------------------------------------
The same is also true of the Dubai Mercantile Exchange. Its
principal partner is the New York Mercantile Exchange (NYMEX), a U.S.
regulated exchange and a U.S. entity. The President of NYMEX sits on
DME's board. DME has authority to trade the U.S. delivered WTI contract
on trading terminals in the U.S. Under these circumstances, DME is
clearly a U.S. exchange.
The illogic of the FBOT staff no action process is highlighted by
NYMEX, a U.S. regulated exchange headquartered in the U.S.,
establishing a London futures trading platform under the United
Kingdom's regulatory regime and then applying for an FBOT staff No
Action letter to allow trading within the U.S. on its NYMEX London
platform. NYMEX will then have converted itself from a U.S. entity into
a British entity for purposes of U.S. trades on the platform with the
principal regulation of those trades in the hands of the United
Kingdom.
And, why should NYMEX not do this? It is following precisely the
ICE template. However, the proposal defies all good sense, and, even
worse, it will add darkness to the trading markets that affect the
price of crude oil, gasoline, and heating oil within the U.S.
Under the ICE, DME and London/NYMEX scenarios, each of these
exchanges are clearly U.S. exchanges and their trading terminals should
be regulated as U.S. regulated contract markets. Moreover, as U.S.
contract markets, they and the traders on those exchanges (no matter
whether they trade in the U.S. or abroad) are fully subject to both
CFTC civil jurisdiction and United States Federal criminal
statutes.\62\ For example, in Tamari v. Bache&\63\ the Seventh Circuit
held there was Federal jurisdiction to enforce the Commodity Exchange
Act, even though the trader and the trader's broker accused of fraud
were both situated in Lebanon,\64\ by stating: ``that Congress intended
to proscribe fraudulent conduct associated with any commodity future
transactions executed on a domestic exchange, regardless of the
location of the agents that facilitate the trading'' and thus there was
jurisdiction.\65\
---------------------------------------------------------------------------
\62\&Johnson & Hazen, supra note 42, at 986 (citing In the Matter
of Ralli Brothers Bankers, [1986&1987 Transfer Binder] Comm. Fut. L.
Rep. (CCH) &23, 314 (1986)).
\63\&730 F.2d 1103 (7th Cir. 1984).
\64\&Id. at 1104&05.
\65\&Id. at 1108; Johnson & Hazen, supra note 42, at 987.
---------------------------------------------------------------------------
The CFTC Has Consistently Viewed Foreign Exchanges Trading on U.S.
Terminals Subject to Full U.S. Regulation
It has been shown immediately above, that as a legal matter there
is no bar either within the CEA as now drafted nor within the case law
that prevents the CFTC from gaining full regulatory control, over any
futures trading done in the U.S. Even if one were to assume that ICE,
for example, is truly a foreign board of trade, Section 4(b) only bars
regulation of trading done by foreign citizens in foreign countries
trading foreign commodities on foreign exchanges when such trading does
not cause substantial dysfunctions to U.S. markets. Below it is shown
that this well established law has governed the CFTC's FBOT staff no
action process since its inception.
The staff no action process initiated in 1999 was not developed
under a view that, pursuant to Section 4(b), the CFTC could not
regulate foreign exchanges who wished to put trading terminals in the
U.S. To the contrary, the history is clear that those foreign exchanges
themselves recognized that, in the absence of an exemption under
Section 4(c) of the CEA,\66\ they would have to fully register as a
U.S. contract market. As their plain language made clear when they were
first issued in 1999, the FBOT No Action letters originated from a
rulemaking proceeding that, by its very terms, indicated that
permission to put terminals in the U.S. derived from Section 4(c)'s
exemption from full regulation and not from Section 4(b)'s absolute bar
against foreign regulation.\67\ It must be remembered that Section 4(b)
does not countenance exceptions to its general restriction. The No
Action letters include a myriad of regulatory conditions on the foreign
boards of trade that are completely inconsistent with the absolute bar
within Section 4(b).\68\
---------------------------------------------------------------------------
\66\&Written Testimony of Professor Michael Greenberger, Energy
Speculation: Is Greater Regulation Necessary to Stop Price
Manipulation?: Hearing Before the H. Subcomm. On Oversight and
Investigations, 14&15 (2007), available at http://
digitalcommons.law.umaryland.edu/cgi/
viewcontent.cgi?article=1011&context=cong_test (last visited July 8,
2008).
\67\&See, e.g., LIFFE Administration & Management, CFTC No-Action
Letter, 1999 CFTC Ltr. LEXIS 38, 4&5 (July 23, 1999); Access to
Automated Boards of Trade (proposed rules), 64 Fed. Reg. 14,159, 14,174
(Mar. 24, 1999).
As the proposed rules explained,
Section 4(c) of the Act provides the Commission with authority
``by rule, regulation, or
order'' to exempt ``any agreement, contract or transaction'' from the
requirements of Section
4(a) of the Act if the Commission determines that the exemption would
be consistent with
the public interest, that the contracts would be entered into solely
by appropriate persons and
that the exemption would not have a material adverse effect on the
ability of the Commission
or any contract market to discharge its regulatory or self-regulatory
duties under the Act. Id.
(internal citations omitted).
\68\&Among the conditions present in all of the No Action letters
are the following: the exchange will satisfy the appropriate
designation in its home jurisdiction, the exchange must work to ensure
fair markets that prohibit fraud and other abuses by providing adequate
supervision, continued adherence to IOSCO Principles for Oversight of
Screen-Based Trading Systems for Derivative Products, members and
guaranteed customers will only receive direct access if a clearing
member guarantees and assumes all financial liability, there are
sufficient safeguards to prevent unauthorized access or trading, at the
Commission's request recipients will provide market information
including access to books and records, and will submit all contracts to
be made available through the no-action process, the volume of said
trades and a list of names and addresses of all those using these
exchanges. See, e.g., LIFFE Administration and Management, CFTC No-
Action Letter, 1999 CFTC Ltr. LEXIS 38, 65&72 (July 23, 1999); IPE,
CFTC No-Action Letter, 1999 CFTC Ltr. LEXIS 152, 58&66 (Nov. 12, 1999);
Dubai Mercantile Exchange Ltd., CFTC No-Action Letter, 2007 CFTC Ltr.
LEXIS 6, 87&96 (May 24, 2007).
---------------------------------------------------------------------------
If there were any doubt about the above analysis, it was belied by
the actions of the CFTC on June 17, 2008 and July 8, 2008, when it
added four new conditions to the existing ICE Futures Europe and Dubai
Mercantile Exchange No Action letters.\69\ While these additional
conditions have only been applied to ICE and DME, Acting Chairman
Lukken's related comments show that the CFTC has the authority to
incorporate them in the now outstanding 14 other FBOT staff No Action
letters affecting every foreign board of trade with U.S. terminals, as
well as any FBOT that seeks an exemption from U.S. direct regulation in
the future.\70\
---------------------------------------------------------------------------
\69\&Amendment to No-Action Letter Issued to the International
Petroleum Exchange of London (now ICE Futures Europe), CFTC No-Action
Letter, (June 17, 2008), available at http://www.cftc.gov/stellent/
groups/public/@lrlettergeneral/documents/letter/08-09.pdf (last visited
July 8, 2008); Press Release, CFTC, CFTC Conditions Foreign Access on
Adoption of Position Limits on London Crude Oil Contract (June 17,
2008) available at http://www.cftc.gov/newsroom/generalpressreleases/
2008/pr5511-08.html (last visited July 8, 2008).
\70\&Press Release, CFTC, CFTC Conditions Foreign Access on
Adoption of Position Limits on London Crude Oil Contract (June 17,
2008) available at http://www.cftc.gov/newsroom/generalpressreleases/
2008/pr5511-08.html (last visited July 8, 2008). As Acting Chairman
Lukken stated,
These new conditions for foreign access will provide the CFTC
with additional oversight
tools to monitor linked contracts. This powerful combination of
enhanced trading data and ad
ditional market controls will help the CFTC in its surveillance of
regulated domestic ex-
changes, while preserving the important benefits of our international
recognition program
that has enabled proper global oversight during the last decade. This
raises the bar for all
future foreign access requests and will ensure uniform oversight of
linked contracts. Id.
If Section 4(b)'s absolute prohibition were applicable to FBOTs
with U.S. terminals, as some have argued as a predicate to limiting
legislative or administrative action in this area, how could the CFTC
add these new conditions to the outstanding No Action letters? Those
new conditions, inter alia, require large trader reporting and the
imposition of speculation limits.\71\ The failure of the FBOTs to
comply could result in the revocation of the No Action letters, thereby
requiring each FBOT to register as a fully regulated U.S. contract
market.\72\
---------------------------------------------------------------------------
\71\&Amendment to No-Action Letter Issued to the International
Petroleum Exchange of London (now ICE Futures Europe), CFTC No-Action
Letter, (June 17, 2008) available at http://www.cftc.gov/stellent/
groups/public/@lrlettergeneral/documents/letter/08-09.pdf (last visited
July 8, 2008).
\72\&See supra notes 68&70 and accompanying text.
---------------------------------------------------------------------------
Those who would attempt to limit Congressional and regulatory
controls on ICE, DME, and NYMEX/London have also relied upon a November
2006 policy statement issued by the CFTC on the FBOT No Action letter
process.\73\ Much is made about the fact that Section 4(b) is cited and
quoted therein. Whatever the purpose of that 4(b) reference, the
assertion that 4(b) presents an absolute bar is belied by the following
within that policy statement:
---------------------------------------------------------------------------
\73\&Boards of Trade Located Outside of the United States and No-
Action Relief from the Requirement to Become a Designated Contract
Market or Derivatives Transaction Execution Facility, 71 Fed. Reg.
64443 (Nov. 2, 2006).
[i]n the absence of no-action relief, a board of trade,
exchange or market that permits direct access by U.S. persons
might be subject to Commission action for violation of, among
other provisions, section 4(a) of the CEA, if it were not found
to qualify for the exclusion from the DCM designation or DTEF
registration requirement.\74\
---------------------------------------------------------------------------
\74\&Id. at 64,445 n. 23.
In short, the failure to gain no action relief would mean that, in the
absence of registration as a fully regulated contract market, the FBOT
would have to remove its U.S. terminals according to the CFTC's own
analysis. As the CFTC expressly stated in its June17, 2008 letter to
ICE imposing the new conditions on its no action status, if ICE
satisfies the four new conditions, the CFTC ``will not recommend that
the Commission institute enforcement action against [ICE] based upon
[ICE's] failure to seek contract market designation or registration as
a DTEF under Sections 5 and 5a of the Act.''
Again, the action of the CFTC adding further conditions to the ICE
No Action letter, including large trader reporting and speculation
limits, upon pain of an enforcement proceeding based on the failure to
register as a U.S. regulated contract market, clearly demonstrates that
the CFTC meant what it said in the above quoted reference from its 2006
policy statement, it has broad powers to require a ``foreign'' exchange
to fully register in the U.S. or terminate its presence in this
country.\75\ Section 4(b) provides no impediment to those powers.
---------------------------------------------------------------------------
\75\&Amendment to No-Action Letter Issued to the International
Petroleum Exchange of London (now ICE Futures Europe), CFTC No-Action
Letter, (June 17, 2008) available at http://www.cftc.gov/stellent/
groups/public/@lrlettergeneral/documents/letter/08-09.pdf (last visited
July 8, 2008).
---------------------------------------------------------------------------
Efforts Designed To Oversee and Improve the Foreign Regulation of U.S.
Delivered Futures on U.S. Terminals May Not Effectively Close
the ``London/Dubai'' Loophole
Congressman Etheridge of this Committee&\76\ and Senators Durbin
and Levin in the Senate have introduced legislation which ratchets up
the existing CFTC oversight of foreign boards of trade energy futures
trading on U.S. trading terminals (``FBOTs''). That legislation, while
a major improvement over the present regulatory environment, still
leaves primary and direct enforcement and oversight in the hands of the
foreign regulator, e.g., the U.K.'s Financial Services Authority in the
case of ICE; or the Dubai Financial Services Authority in the case of
the DME.
---------------------------------------------------------------------------
\76\&H.R. 6334.
---------------------------------------------------------------------------
It is my understanding the this legislation deferring to the
primacy of foreign regulators to oversee U.S. terminals operated by
FBOTs derives from a concern that section 4(b) of the Act bars U.S.
regulation of even those FBOTs in the U.S.\77\ As has been shown
above,\78\ section 4(b), whatever it means, is an absolute bar to any
U.S. regulation,\79\ whereas H. 6334 does ratchet up U.S. regulation of
the foreign exchange. Moreover, as shown above,\80\ section 4(b)'s bar
only applies to foreign trades on foreign exchanges of foreign
commodities not having a significant impact on U.S. markets. Therefore,
policy concerns about section 4(b) should not govern the regulation of
FBOT terminals in the U.S., especially when those terminals trade U.S.
delivered futures contracts; and even more so when the FBOTs
institutional ties are so closely affiliated with the U.S. and U.S.
institutions that the FBOT loses all claim to foreign status.
---------------------------------------------------------------------------
\77\&See supra notes 41&42 and accompanying text.
\78\&See supra notes 43&60 and accompanying text.
\79\&See supra notes 43&60 and accompanying text.
\80\&See supra note 42 and accompanying text.
---------------------------------------------------------------------------
Again, legislation such as that proposed by Congressman Etheridge,
is a major improvement of what had been the CFTC's oversight of FBOTs'
U.S. terminals.
This kind of legislation affords the CFTC the authority to enforce
the prohibitions of section 9 of the Act, concerning criminal
penalties, including anti-manipulation prohibitions therein, and ``to
limit, reduce, or liquidate any position'' on the FBOT in aid of
preventing, inter alia, manipulation and excessive speculation
enforcement.\81\ Imposition of restrictions on the FBOT, however, must
be preceded by consultation with the FBOTs foreign regulator.\82\
---------------------------------------------------------------------------
\81\&See S. 3130 &7, 110th Cong. (2008), available at http://
frwebgate.access.gpo.gov/cgi-bin/
getdoc.cgi?dbname=110_cong_bills&docid=f:s3130is.txt.pdf (last visited
July 8, 2008).
\82\&See id.
---------------------------------------------------------------------------
The CFTC ``may apply such record-keeping requirements [to the FBOT]
as the Commission determines are necessary,''&\83\ and before the CFTC
exempts an FBOT from full U.S. contract market regulatory requirements,
it must ensure that the FBOT operating the U.S. terminals ``appl[y]
comparable principles'' to those of the CFTC for ``daily publication of
trading information and position limits or accountability levels for
speculators'' and provides to the CFTC ``the information that the
[CFTC] determines necessary to publish a Commitment of Traders report''
for U.S. regulated contract markets.\84\
---------------------------------------------------------------------------
\83\&Id.
\84\&Id. at &6.
---------------------------------------------------------------------------
Legislation of the kind introduced by Congressman Etheridge also
requires the CFTC to conduct a review of FBOT no action status for
existing FBOTs between the first anniversary of the passage of S. 3130
and 1\1/2\ years thereafter to ensure FBOT compliance with the new
statutory requirements imposed by this legislation.\85\
---------------------------------------------------------------------------
\85\&Id. at &11.
---------------------------------------------------------------------------
In any event, recent actions taken by the CFTC to increase
regulation of ICE and DME may place the requirements of Congressman
Etheridge's bill in a new context.
CFTC's New Regulatory Requirements for Foreign Boards of Trade With
U.S. Terminals
For at least 2 years prior to May 20, 2008, the CFTC had repeatedly
assured Congress and market participants that the dramatic rise in
crude oil, natural gas, gasoline, and heating oil was caused
exclusively by supply/demand market fundamentals.\86\ The CFTC had
based its conclusions on its ``exhaustive'' research of all relevant
market data.\87\
---------------------------------------------------------------------------
\86\&Walt Lukken, Acting Chairman, CFTC, Prepared Remarks:
Compliance and Enforcement in Energy Markets--The CFTC Perspective
(Jan. 18, 2008), available at http://www.cftc.gov/stellent/groups/
public/@newsroom/documents/speechandtestimony/opalukken-34.pdf (last
visited June 21, 2008) (quoting Mr. Walter Lukken ``While speculators
play a integral role in the futures markets, the report concludes that
speculative buying, as a whole, does not appear to drive up price'');
Tina Seeley, Energy Market Not Manipulated, U.S. Regulator Says
(Update1), Bloomberg.com (May 7, 2008), available at http://
www.bloomberg.com/apps/news?pid=20601072&sid=aX0iaEd9bOMU&refer=energy
(last visited June 21, 2008) (quoting Mr. Walter Lukken, ``We have not
seen that speculators are a major factor in driving these prices'');
Ian Talley & Stephen Power, Regulator Faults Energy-Futures Proposal,
Wall St. J. (May 8, 2008) (stating that Mr. Walter Lukken commented
that his agency hadn't seen evidence indicating that speculators are
``a major factor'' in driving up oil prices); Oral Testimony of Walter
L. Lukken, Commissioner, CFTC, Before the Committee on Agriculture,
U.S. House of Representatives, (April 27, 2006) (quoting Mr. Walter
Lukken ``[B]ased on our surveillance efforts to date, we believe that
crude oil and gasoline futures markets have been accurately reflecting
the underlying fundamentals of these markets''); Sharon Brown-Hruska,
Chairman, CFTC, Address before the International Monetary Fund: Futures
Markets in the Energy Sector (Jun. 15, 2006), available at http://
www.cftc.gov/newsroom/speechestestimony/opabrownhruska-46.html (last
visited Jun. 21, 2008) (stating ``To date, the staff' findings have
shown that these large speculators as a group tend to inject liquidity
into the markets rather than having an undue impact on price
movements''); Sharon Brown-Hruska, Chairman, CFTC, Keynote Address at
the Managed Funds Association Annual Forum (Jun. 25, 2005), available
at http://www.cftc.gov/opa/speeches05/opabrownhruska34.htm (last
visited June 21, 2008) (stating the CFTC's study of the role of managed
funds in our markets, ``[C]ontradicts with force the anecdotal
observations and conventional wisdom regarding hedge funds and
speculators, in general.'').
\87\&See, e.g., supra note 86 and accompanying text.
---------------------------------------------------------------------------
Indeed, as recently as May 20, 2008, before the full Senate
Homeland Security and Government Affairs Committee, the CFTC's Mr.
Harris, testified: ``[A]ll the data modeling and analysis we have done
to date indicates there is little economic evidence to demonstrate that
prices are being systematically driven by speculators in these
[agriculture and energy] markets. . . . [O]ur comprehensive analysis of
the actual position data of these traders fails to support [the]
contention'' that there is excessive speculation or manipulation.\88\
Rather, he said ``prices are being driven by powerful economic
fundamental forces and the laws of supply demand.''&\89\
---------------------------------------------------------------------------
\88\&Written Testimony of Jeffrey Harris, Chief Economist, CFTC,
Before the Senate Committee on Homeland Security and Governmental
Affairs, United States Senate 20 (2008), available at http://
www.cftc.gov/stellent/groups/public/@newsroom/documents/
speechandtestimony/oeajeffharristestimony052008.pdf (last visited June
21, 2008).
\89\&Id.; see, e.g., Richard Hill, Lieberman Says He Will Consider
Legislation to Address Commodity Prices, 40 Bureau of Nat'l. Aff. 21
(May 26, 2008) (emphasis added), available at http://
corplawcenter.bna.com/pic2/clb.nsf/id/BNAP-7EVTDG?OpenDocument (last
visited June 21, 2008).
---------------------------------------------------------------------------
In a rather dramatic about face, the CFTC suddenly announced on May
29, 2008 (or just 9 days after Mr. Harris testimony) that that agency
is in the midst of an investigation into the crude oil energy
markets&\90\ and it will now begin to collect substantial amounts of
new data to determine what is undergirding high oil prices.\91\ This
reversal in course is almost certainly the product of intense pressure
placed on the CFTC by Congress to ensure that excessive speculative
activity is not being conducted on the principal market over which the
CFTC has declined primary responsibility, i.e., trading done on ICE and
on ICE's U.S. terminals.\92\
---------------------------------------------------------------------------
\90\&CFTC Commissioner Bart Chilton has acknowledged that the
public announcement within the May 29 release raises the specter that
``some people [will] head for the paper shredder [.]'' Tina Seeley,
CFTC Targets Shipping, Storage in Oil Investigation (Update2),
Bloomberg.com (May 30, 2008), available at http://www.bloomberg.com/
apps/news?pid=20601087&sid=aGzRMmD_b9MA&refer=home (last visited June
21, 2008).
\91\& Press Release, U.S. Commodity Futures Trading Commission,
CFTC Announces Multiple Energy Market Initiatives (May 29, 2008),
available at http://www.cftc.gov/newsroom/generalpressreleases/2008/
pr5503-08.html (last visited June 21, 2008).
\92\&See Letter from Twenty-Two Senators to Walter Lukken, Acting
Chairman, CFTC (May 23, 2008), available at http://cantwell.senate.gov/
news/record.cfm?id=298325 (last visited June 21, 2008) (insisting that
CFTC require ICE to demonstrate why it should not be subject to the
same regulation as other U.S.-based exchanges and warning, ``[a]bsent
expeditious Commission action, Congress may need to step in to protect
consumers and ensure that all markets trading U.S. delivered energy
futures are transparent and free of fraud, manipulation, and excessive
speculation''); Letter from Senator Jeff Bingaman to Walter Lukken,
Acting Chairman, CFTC (May 27, 2008), available at http://
energy.senate.gov/public/
index.cfm?FuseAction=PressReleases.Detail&PressRelease_id=0fdd0eb4-
4b1d-49f0-a3a2-f89fd0e4b1d3&Month=5&Year=2008&Party=0 (last visited
June 21, 2008) (expressing concern that that ``the Commission's
assertions to date--discounting the potential role of speculation in
driving up oil prices--have been based on a glaringly incomplete data
set'' and demanding an explanation of many CFTC activities); Energy
Speculation: Is Greater Regulation Necessary to Stop Price
Manipulation?: Hearing Before the House Subcomm. on Oversight &
Investigations, 110th Cong. (2007) (statement of Rep. Joe Barton,
Member, House Subcomm. on Investigations) (informing Walter Lukken,
Acting Chairman, CFTC, that Congress had empowered FERC to provide
additional regulation in some energy markets because they were
displeased with the CFTC's efforts).
---------------------------------------------------------------------------
As crude oil and gas prices continued to spike even after the
CFTC's May 29, 2008, announcement, the pressure on the CFTC did not let
up. Thus, by June 17, 2008, the CFTC once again increased its pressure
on ICE.
In a dramatic June 17, 2008 letter to ICE, the CFTC Director of
Market Oversight referenced the fact that ICE had moved its trading
platform from London ``to the ICE Platform operated by [ICE] in
Atlanta, Georgia,'' and that that U.S. platform was now trading three
U.S. delivered energy futures products (WTI, heating oil, and gasoline)
``each of which is cash-settled on the price of physically-settled
contracts traded on NYMEX.''&\93\ Most importantly, the June 17 letter
to ICE then stated:
---------------------------------------------------------------------------
\93\& Amendment to No-Action Letter Issued to the International
Petroleum Exchange of London (now ICE Futures Europe), CFTC No-Action
Letter 2 (June 17, 2008), available at http://www.cftc.gov/stellent/
groups/public/@lrlettergeneral/documents/letter/08-09.pdf (last visited
June 20, 2008).
A foreign board of trade listing for trading a contract which
settles on the price of a contract traded on a CFTC-regulated
exchange raises very serious concerns for the Commission. . . .
In the absence of preventive measures at [ICE], this
circumstance could compromise the [CFTC's] ability to carry out
its market surveillance responsibilities, as well as the
integrity of prices established on CFTC-regulated exchanges . .
. [T]he division retains the authority to condition further,
modify, suspend, terminate, or otherwise restrict the terms of
the no-action relief provided herein, in its discretion.\94\
---------------------------------------------------------------------------
\94\&Id.
In order to address the CFTC's ``very serious concerns'' that it
had ``compromise[d] [its own] ability to carry out its market
surveillance responsibilities, as well as the integrity of the prices
established'' thereon, the letter then outlined four new conditions
that it imposed upon ICE: ``position limits or position accountability
levels (including related hedge exemption provisions) as adopted by''
U.S. regulated contract markets; quarterly reports of any member
exceeding those levels and limits; publication of daily trading
information comparable to that required of U.S. contract markets; daily
reporting of ``large trader positions'' as provided by U.S. regulated
markets.\95\
---------------------------------------------------------------------------
\95\&Id. at 3.
---------------------------------------------------------------------------
ICE was given 120 days to come into compliance with the new CFTC
conditions.\96\ The CFTC acknowledged that the new ICE rules would have
to be approved by the FSA.\97\ The June 17 letter to ICE concludes by
stating that only if ICE complies with the conditions outlined therein
can ICE be assured that the CFTC will ``not recommend that the
Commission institute enforcement action against [ICE] or its members''
based on ICE's failure to register as a U.S. regulated contract
market.\98\
---------------------------------------------------------------------------
\96\&Id.
\97\&Id.
\98\&Id.
---------------------------------------------------------------------------
On June 17, 2008, the day that that letter to ICE was released,
CFTC Acting Chairman Lukken is reported to have told the Senate
oversight Committee: ``The CFTC will also require other foreign
exchanges that seek such direct access to provide the CFTC with
comparable large trader reports and to impose comparable position and
accountability limits for any products linked with U.S. regulated
futures contracts[.]''&\99\ On July 7, 2008, an identical CFTC staff
letter was written to the DME.
---------------------------------------------------------------------------
\99\&Nick Snow, US CFTC Unveils New Foreign Market Data Pact, Oil &
Gas J., (June 18, 2008), available at http://www.mapsearch.com/news/
display.html?id=332086 (last visited June 21, 2008).
---------------------------------------------------------------------------
It would seem that much of what the CFTC has done implements the
data collection requirements included in Congressman Etheridge's bill.
Indeed, the CFTC's threat of enforcement authority against ICE in its
June 17, 2008 letter, while limited for these purposes to failing to
register as a U.S. regulated contract market, would seem to make it
clear that that agency could enforce all civil and criminal penalties
asserted throughout the CEA against ICE and its members if appropriate,
thereby possibly even exceeding the grant of section 9 enforcement
powers afforded the CFTC with regard to FBOTs in S. 3130.
As will be shown below, however, the present skyrocketing cost of
crude oil and its derivative products, as well as the resulting
destabilization of the U.S. economy, would seem to counsel the use of
the full force of the CFTC's powers to bring ICE and similar
``foreign'' exchanges with trading terminals in the U.S. trading
futures premised on U.S. delivered energy commodities under complete,
direct, and real time U.S. regulatory control.
Deference to Foreign Regulators over U.S. Energy Futures Trading
Deprives U.S. Energy Markets and U.S. Energy Consumers of the
Full Weight of CEA Protections
The question arises whether the U.S. should continue to regulate
FBOT trading of U.S. energy futures on U.S. terminals principally
through foreign regulators while requiring more aggressive CFTC
oversight of that process. Or, should trading of U.S. delivered energy
products on U.S. terminals be deemed a sufficient nexus to the U.S. and
the well being of its economy to require direct U.S. supervision. If
Congress settles for the status quo as evidenced by the CFTC's most
recent actions if forsakes a wealth of traditional regulatory tools
that the CFTC has to ensure that U.S. energy markets and prices are
rooted in economic fundamentals.
The Lack of Emergency Authority to Intervene in Market Distortions.
The most substantial risk in following the CFTC policy of leaving ICE
and other similarly situated ``foreign'' exchanges under the principal
supervision of foreign regulators while those exchanges have U.S.
terminals trading critically important U.S. delivered energy products
is that the CFTC cannot exercise its broad emergency authority to
intervene immediately when confronted with emergencies and dysfunctions
on U.S. regulated contract markets.\100\
---------------------------------------------------------------------------
\100\&Johnson & Hazen, supra note 42, at 1218.
---------------------------------------------------------------------------
Described as the CEA's ``most potent tool,'' section 8a(9) provides
that ``whenever [the CFTC] has reason to believe that an emergency
exists,'' it may take such actions ``including, but not limited to `the
setting of temporary emergency margin levels on any futures contract
[and] the fixing of limits that may apply to a market position.''&\101\
An ``emergency'' is defined:
---------------------------------------------------------------------------
\101\&7 U.S.C. &2a(9) (2008) (emphasis added).
``to mean, in addition to threatened or actual market
manipulations and corners, any act of the United states or a
foreign government affecting a commodity or any other major
market disturbance which prevents the market from accurately
reflecting the forces of supply demand for such
commodity.''&\102\
---------------------------------------------------------------------------
\102\&Id. (emphasis added).
It should be born in mind that these emergency powers afford the CFTC
the immediate right to alter on a real time basis margin requirements
and speculation and position limits to deal with crises as they arise
``which prevent[] the market from accurately reflecting the forces of
supply demand[.]'' While section 8a(9) affords direct judicial review
of orders after they are issued in a Federal court of appeals, it does
not by its terms require emergency orders to be preceded by notice and
an opportunity to be heard, thereby ensuring speedy restoration of
normal market processes.\103\
---------------------------------------------------------------------------
\103\&Johnson & Hazen, supra note 42, at 1221&22.
---------------------------------------------------------------------------
When one reads this broad power afforded to the CFTC, one could
reasonably ask why it has not been used on days such as Friday, June 6,
2008 when the WTI crude oil futures prices rose nearly $11 per barrel
in a single day.\104\ That is best explained by the fact that the only
real time market data in the hands of the CFTC on that day was from
NYMEX--the fully regulated U.S. exchange with speculation limits in
place; perhaps if the CFTC had meaningful and real time ICE data on
that day, thereby seeing the entirety of the WTI crude oil market, it
might have seen a need to intervene under its emergency authority to
impose temporary position limits and margin requirements to cool down
what was widely viewed as breathtaking volatility.
---------------------------------------------------------------------------
\104\&See Simon Webb, OPEC hike unlikely at emergency oil talks,
ReutersUK, (June 20, 2008), available at http://uk.reuters.com/article/
oilRpt/idUKL2058919720080620 (last visited July 8, 2008).
---------------------------------------------------------------------------
Of course, even when it receives the ICE data within 120 days of
its June 17, 2008 requirements, the CFTC will still not have the
authority under the governing CFTC No Action letter to use its
emergency intervention powers on ICE even though over 60% of ICE U.S.
delivered WTI futures trading is done within our own country. Rather
than exercising real time emergency authority, the CFTC will have to
once again ``negotiate'' with the FSA to have that U.K. regulator
intervene to deal with, inter alia, ICE WTI trade matching systems
located in Chicago, Illinois.
Moreover, relying upon the FSA to intervene on a real time basis
for a ``major market disturbance'' on a U.S. delivered energy futures
contract traded on U.S. terminals is as problematic as a matter of
policy as it is as a matter of logistics. Unlike the robust emergency
authority given by Congress to the CFTC under section 8a(9), the FSA
emergency powers have been implemented in a quite lackluster fashion.
While its governing statute affords intervention power,\105\ FSA makes
clear on its website that the U.K. has translated any such authority
when ``major operational disruptions'' are detected on ICE, to a
``Tripartite Standing Committee'' that would convene the ``Cross Market
Business Continuity Group'' (CMBCG) to:
---------------------------------------------------------------------------
\105\&&313(A), Financial Services and Markets Act 2000).
``provide[] a forum for establishing senior-level practitioner
views . . . Its role is advisory: decisions will be for the
relevant official or market authorities or for firms themselves
either individually or collectively through the agency of the
CMBCG. The CMBCG may also have a role in pooling information to
help facilitate private sector decisions and workarounds to
alleviate pressures on the system.''&\106\
---------------------------------------------------------------------------
\106\&Developments in financial sector crisis management, FSA
Homepage, available at http://www.fsa.gov.uk/Pages/About/Teams/
Stability/crisis/index.shtml (last visited July 8, 2008).
This U.K. guidance for sharing ``views'' and for ``pooling
information'' in an ``advisory'' capacity to ``help facilitate private
sector'' decisions in London is what the U.S. industrial consumers of
crude oil and the U.S. gas consuming public are left to fall back upon
when WTI crude oil soon skyrockets to $150 per barrel as has been
predicted by Morgan Stanley, one of the founders of ICE.\107\ The
CFTC's June 17 imposition of new conditions on ICE do not convert the
U.K.'s lackluster emergency responses into the vigorous emergency
responses called for by U.S. law.
---------------------------------------------------------------------------
\107\&Tim Paradis, Stocks decline in jobs data, surge in oil
prices, Associated Press (June 6, 2008), available at http://
ap.google.com/article/ALeqM5gHs5OM3gFG_DytQQZFbWfgPT08MAD914K0H80 (last
visited July 8, 2008). Goldman Sachs, also one of the founders of ICE,
has predicted that the price per barrel of crude oil will surpass $200
by October of this year. Neil King Jr. and Spencer Swartz, U.S. News:
Some See Oil at $150 This Year--Range of Factors May Sustain Surge;
$4.50-a-Gallon Gas, Wall St. J. (May 7, 2008) at A3; Greenberger, supra
note 21, at 7.
---------------------------------------------------------------------------
Indeed, any effort by Congress to insist upon ``comparability'' on
emergency powers is futile. As the Financial Times has so aptly
commented on June 20, 2008, the U.K.'s futures regulator ``operates a .
. . system of `credible deterrence' of wrongdoing by engaging in a
dialogue with market participants. Since the FSA's creation in 1997, it
has brought no civil or criminal cases in energy markets.''&\108\ In
stark contrast, as Acting Chairman Lukken recently proudly reported to
Congress: ``[s]ince December 2002 to the present time, the [CFTC] has
filed a total of 39 enforcement actions charging a total of 64
defendants with violations involving the energy markets,'' having
referred ``35 criminal actions concerning energy market misconduct'' to
the Department of Justice.\109\
---------------------------------------------------------------------------
\108\&Jeremy Grant, ICE restrictions cold comfort for FSA,
Financial Times (June 20, 2008) (emphasis added), available at http://
www.ft.com/cms/s/0/2ba33a0e-3e35-11dd-b16d-0000779fd2ac.html (last
visited July 8, 2008).
\109\&Written testimony of Acting Chairman Walter Lukken, Hearing
Before the Senate Appropriations Subcommittee on Financial Services and
General Government And The Senate Committee on Agriculture, Nutrition
and Forestry 4 (2008), available at http://www.cftc.gov/stellent/
groups/public/@newsroom/documents/speechandtestimony/opalukken-41.pdf
(last visited July 8, 2008).
---------------------------------------------------------------------------
The contrast between FSA and CFTC enforcement activity in the
energy futures markets under their control is quite remarkable,
especially since ICE is responsible for nearly 50% of all crude oil
futures contracts traded worldwide and since the CFTC has not had
access to meaningful ICE data.\110\
---------------------------------------------------------------------------
\110\&IntercontinentalExchange, Inc., Annual Report Form (10&K) at
63 (Dec. 31, 2007) available at http://www.secinfo.com/dsVsf.tU7.htm
(last visited July 8, 2008) (showing that ICE's total crude oil futures
market share is 47.8%).
---------------------------------------------------------------------------
The American gas consuming public's trust in the FSA might also be
shaken by the U.K.'s response to the June 17, 2008 CFTC announcement of
the imposition of new transparency requirements on ICE's use of U.S.
terminals used as a critical part of ICE's control of over 30 % of the
U.S. delivered WTI contract. Mr. Stuart Fraser, head of policy at the
City of London Corporation, is reported in the Financial Times to have
called the CFTC June 17 letter ``American imperialism,'' and adding for
measure ``if a bunch of [S]enators want to get rude about the FSA,
that's fine, but don't interfere in our market.''&\111\
---------------------------------------------------------------------------
\111\&Jeremy Grant, Storm over push for regulatory reform on
positions at ICE, Financial Times (June 20, 2008) (emphasis added),
available at http://www.ft.com/cms/s/0/a00c6a00-3e62-11dd-b16d-
0000779fd2ac.html (last visited July 8, 2008).
---------------------------------------------------------------------------
Of course, the UK is wrong to think trading on U.S. terminals of
the U.S. WTI contract is ``their'' market. ICE is U.S. owned, operated
in Atlanta with trading terminals and engines in the U.S. and trading
over 30% of U.S. delivered crude oil futures market in U.S. dollar
denominated currency.
However, one could easily see how those officials in the U.K. might
mistakenly view WTI trading on U.S. terminals as ``their'' market when
the CFTC and ICE continue to refer to this self evidently ``U.S.''
market as being conducted on a ``foreign'' exchange. If the CFTC were
to flatly state the obvious ( i.e., ICE Futures Europe is wholly owned
by a U.S. concern, having brought the corpus of the old British
International Petroleum Exchange, for all intents and purposes, to the
U.S.). the UK might grasp the reality of the situation, rather than the
ICE perpetuated ``London'' myth.
Deferring to Foreign Regulators Undercuts the Self Regulatory and
Surveillance Requirements of U.S. Law.
Next to the inability to exercise the extraordinary emergency
powers afforded the CFTC to oversee its markets by deferring to the
foreign regulators to supervise U.S. energy futures products on U.S.
trading terminals, the most serious problem with further CFTC or
Congressional deference to FSA is the foregoing of the substantial self
regulation and surveillance provided by U.S. regulated contract markets
to assist U.S. regulators in policing futures markets.
The ``core principles'' within the CEA that must be followed by an
approved U.S. regulated contract market emphasize the importance having
those markets serve as the first line of defense for the CFTC in
detecting fraud, manipulation, excessive speculation, and other
unlawful trading malpractice.\112\ Without aggressive self-policing of
the entirety of the regulated U.S. futures markets, the CFTC simply
cannot do its job.
---------------------------------------------------------------------------
\112\&7 U.S.C. &7(d)(2)&(6) (2008); (2) (compliance with rules);
(3) (contracts not readily subject to manipulation); (4) (monitoring of
trading); (5) (position limits); (6) (emergency authority); 7 U.S.C.
&7a(d)(2)&(3) (2008); (2) (compliance with rules); (3) (monitoring of
trading).
---------------------------------------------------------------------------
The seriousness with which U.S. regulated markets take their
statutorily mandated self-policing and surveillance role is evidenced
by NYMEX's ``standards and safeguards'' concerning trade and market
surveillance. For example, NYMEX makes clear:
Market surveillance is required under CFTC regulations. Each
day, the compliance staff compiles a profile of participants,
identifying members and their customers holding reportable
positions. In addition, daily surveillance is performed to
ensure that Exchange prices reflect cash market price
movements, that the futures market converges with the cash
market at contract expiration, and that there are no price
distortions and no market manipulation . . . .\113\
---------------------------------------------------------------------------
\113\&NYMEX, Enforcement of Exchange Rules, available at http://
www.nymex.com/ss--main.aspx?pg=6 (last visited July 8, 2008) (emphasis
added).
---------------------------------------------------------------------------
As to trade surveillance, NYMEX provides:
Compliance department analysts are trained to spot instances of
misconduct, including ``front running'' or trading ahead of a
customer; wash or accommodation trading (transactions creating
the appearance of trading activity, but which have no real
economic effect); prohibited cross trading (trading directly or
indirectly with a customer except under very limited
circumstances, or matching two customer orders without offering
them competitively); prearranged trading; and non-competitive
trading.\114\
---------------------------------------------------------------------------
\114\&Id.
NYMEX reports that is has @ $6.5 million budget for oversight
market surveillance with an enforcement staff of @ 40 personnel.
No detailed analysis of ICE's self-regulatory and surveillance
system is required. Suffice it to say, that for all of ICE's worldwide
markets which are accessible by the U.S. trading terminals, including
the U.S. WTI contract, reports are that ICE employs no more than ten
individuals on its surveillance staff, i.e., a staff that is \1/4\ the
size of NYMEX. This staff monitors trading of a host of ICE contracts,
including those contracts which control over 47% of the world crude oil
futures.\115\ Of course, for those energy futures trades ICE executes
under the Enron Loophole (because those trades do not derive from the
old-IPE), such as the critical Henry Hub U.S. delivered natural gas
futures contract, ICE, as of now, has no self-regulation or
surveillance system.
---------------------------------------------------------------------------
\115\&See supra note 109 and accompanying text.
---------------------------------------------------------------------------
Moreover, leaving ICE's paltry surveillance resources to the side,
the principal regulator to which the CFTC is deferring to oversee
directly over 30% of U.S. delivered WTI contracts, the U.K.'s FSA, has
only ``two full time supervisors,'' monitoring all of the ICE contracts
under their jurisdiction.\116\ Again, this includes 47% of world's
energy futures contracts.
---------------------------------------------------------------------------
\116\&Grant, supra note 108.
---------------------------------------------------------------------------
In sum, even though the CFTC has ratcheted up ICE's regulatory
obligations by adding large trader reporting and speculation limits to
the WTI trading, it defers to the FSA for the remainder of the
oversight of ICE. In effect, this deference to the U.K. for U.S.
trading of the critically important WTI contracts surrenders emergency
authority to intervene when there are market dysfunctions to impose
temporary margin requirements and position limits; and it sacrifices
the real ``eyes and ears'' policing these markets (i.e., the regulated
exchanges themselves) by depending upon ICE's meager surveillance
systems.
In a time of economic distress for American industry and the
American consumer caused by skyrocketing energy prices, this country
cannot afford to outsource authority to the UK to oversee trading on
30% of our own U.S. delivered crude oil futures contracts, much of
which is consummated on U.S. based trading terminals and all of which
is trade matched in Chicago, Illinois.
Finally, it bears repeating that during last summer's subprime
mortgage crisis, Northern Rock PLC, one of the U.K.'s largest banks,
was required to borrow billions of dollars from the U.K.'s central
bank.\117\ After news of the bailout was released to the public,
thousands of customers wary of losing their savings stood in long lines
for several days outside of Northern Rock's branches to withdraw
deposits.\118\ With Northern Rock on the brink of collapse, the FSA
provided over $100 billion in loans to the bank and in February 2008,
the British government finally was required to nationalize it.\119\ In
March 2008, FSA published an internal report stating that its
regulation of Northern Rock ``was not carried out to a standard that is
acceptable,'' and highlighted its own failure to provide adequate
supervision, oversight, and resources.\120\ In addition to FSA's self-
criticism, in April 2008, the European Union opened a formal
investigation into FSA's restructuring of Northern Rock.\121\
---------------------------------------------------------------------------
\117\&See Rock Expects 30bn Loan this Year, BBC News (Nov. 7,
2007), available at http://news.bbc.co.uk/1/hi/business/7073556.stm
(last visited July 8, 2008).
\118\&See Crisis Deepens for Northern Rock, Reuters (Sep. 17,
2007), available at http://www.iht.com/articles/2007/09/17/asia/
17northern.php (last visited July 8, 2008).
\119\&See Stephen Castle, EU to Investigate Northern Rock
Nationalization in Britain, International Herald Tribune (April 2,
2008), available at http://www.iht.com/articles/2008/04/02/business/
rock.php (last visited July 8, 2008).
\120\& See British Regulator Admits Failings in Oversight of
Northern Rock, Announces New Procedures, Associated Press (March 26),
2008, available at http://www1.wsvn.com/news/articles/world/MI81198/
(last visited July 8, 2008).
\121\&See Castle, supra note 119.
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This episode, maybe more than any other, reveals that Congress
cannot afford to leave direct oversight of trading on U.S. terminals of
the most important futures contract in determining the price of oil,
gasoline, and heating oil. As demonstrated above,\122\ Congress has the
full authority to pass legislation placing those U.S. terminals under
U.S. regulatory control.
---------------------------------------------------------------------------
\122\&See supra notes 41&60 and accompanying text.
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Threats that the U.S. reassertion of regulatory control over
trading within the U.S. will drive trading overseas are undercut by the
reality of every major futures foreign exchange having set up shop in
the U.S.; and by the well documented law described above that even a
foreign trader in a foreign country who illegally disrupts U.S. markets
is subject to the full force and effect of that law.
Finally, contrary to the assertion of the City of London
Corporation, this is not a ``British'' market; it is a U.S. market
principally being traded in the U.S. by a trading entity controlled by
a U.S. corporation. The economic distress now being suffered by
Americans over high energy products cannot be placed in the hands of
foreign governments when those products are traded here and have such a
huge impact on our economy.
The Chairman. Thank you, Mr. Greenberger.
And I am in receipt of your response. And I, with your
permission, will make this available to all the Members of the
Committee. Is that okay? And we may have some questions about
that. So thank you for being here and your testimony.
Dr. Pirrong, you are on.
STATEMENT OF CRAIG PIRRONG, Ph.D., PROFESSOR OF
FINANCE AND DIRECTOR, GLOBAL ENERGY MANAGEMENT INSTITUTE, BAUER
COLLEGE OF BUSINESS, UNIVERSITY OF HOUSTON, HOUSTON, TX
Dr. Pirrong. Good morning. I am Craig Pirrong, Professor of
Finance and Energy Markets Director of the Global Energy
Management Institute at the Bauer College of Business at the
University of Houston. I deeply appreciate the Committee's
invitation to speak at this hearing, and hope that what I have
to say will contribute to the formulation of a prudent
legislative response to current conditions in the energy
market.
Before I begin, I should say that what I have to say is my
opinion alone and does not necessarily reflect the views of
UHGEMI or the University of Houston more generally.
I should probably start by telling you a little bit about
myself. I have been intimately involved in the commodity
markets and the derivatives markets for over 22 years as an
investment analyst, a teacher, a researcher, a consultant, an
expert witness in commodity market litigation. I have
particular expertise in the economics of market manipulation,
having published what is probably more than any academic has on
the subject over the past 15 years or so. In addition, I have
extensive practical experience in studying manipulation in my
roles as a forensic economist and a consultant to exchanges in
the United States, Canada and Europe.
Although I have studied commodity markets and especially
energy markets as an academic researcher, my practical
experience in one specific area is particularly germane to the
issues before the Committee and the Congress, generally.
Specifically, that is my experience in evaluating the delivery
mechanisms at various commodity exchanges, and my participation
in the design of contract delivery mechanisms for several
exchanges, most notably the Chicago Board of Trade.
Understanding the delivery process and its role in
commodity markets is critical to understanding the key issues
in the ongoing debate over the role of speculation and the role
of OTC markets and energy. The most important lesson is that
although it is commonplace to speak of the oil market or the
corn market, there is, in fact, a web of closely related but
distinct markets, each of which performs different functions or
serves different customers. The most important distinction is
between the market for a physical commodity and the market for
derivatives on that economy. The delivery mechanism links these
markets, but to understand how to design a delivery process,
you need to understand how these markets perform, how they
relate to one another and what very different functions they
perform.
They need to work together efficiently, but one market is
not a perfect substitute for another. Moreover, there are
multiple markets even within the broader category of
derivatives. Exchange-traded and OTC instruments are
substitutes in some respects, but imperfect ones in others, and
serve different categories of users. Moreover, these markets
are also complementary to some degree.
When an American motorist digs into his or her pocket to
pay for gasoline, the relevant market is the market for
physical oil, and the price that is relevant is a spot price
for a wet barrel. The price, or the role of these physical
markets, is to facilitate the flow of physical oil from
producer to refiner to consumer, and the role of prices in
these markets is to provide the scarcity signals that guide
these physical barrels to their most efficient use.
Derivative markets, both exchange-traded and over-the-
counter, are primarily markets for transferring risk and
discovering prices. The supplier of oil can hedge his price
exposure by selling a futures contract. A buyer of oil, an
airline for instance, can hedge against a price increase by
buying an over-the-counter swap. Neither the oil producer nor
the oil buyer is likely to use these future contracts or the
swap to obtain ownership of physical barrels. Indeed, in the
OTC contract this is usually impossible. Instead, these market
participants use the traditional physical market to obtain or
sell their physical energy and use the futures or swap markets
to manage the price risks inherent in their activities as
producers or consumers of energy.
The risk that a producer or consumer sheds doesn't
disappear. It must be transferred to somebody else. That
somebody is often, for a time at least, a market participant
who can be characterized as a speculator, someone who takes on
price exposure with the intent of earning a profit, at least on
average. This entity could be a dentist in Iowa, or it could be
a large financial institution. Risk transfer is the very reason
that derivatives markets exist, and since speculators play a
vital role in the risk-transfer process, unnecessarily
burdensome constraints on speculator participation undermines
the ability of these markets to perform their role. And make no
mistake about it, such restrictions will adversely affect, and
detrimentally, the ultimate consumer of energy. Firms wish to
reduce the cost of bearing risk. If you make it more difficult
for them to hedge by restricting speculation, you will make it
more costly for them to do so, and those higher costs will be
passed on to consumers.
The concern over the speculation in derivatives markets
including the OTC markets is based on a belief that speculation
somehow distorts the physical market for oil and the prices for
physical energy that consumers pay. The basic argument is
something like speculators are buying billions of dollars of
oil derivatives. Their buying is equivalent, but not greater in
volume, to the increase in demand from rapidly growing markets
such as China. These purchases represent demand for oil; and
hence they drive up prices.
This argument ignores the very fundamental distinction that
I just discussed, the distinction between the physical and the
derivatives markets. By ignoring this distinction, those making
this argument fail to answer the crucial question: What is the
channel by which speculative buying in derivatives markets is
communicated to the physical market?
I think it is very important to note, and I think if there
is one major takeaway from here, is that if excessive
speculation or manipulation is distorting prices, that will
become manifest in what goes on in the physical market. You
will see distortions in the amount of inventories, or you will
see distortions in the flows of oil in the interstate and in
the international markets.
To date, nobody, to my mind, has brought up any credible
evidence that these distortions exist, and given such absence
of evidence, there is really no firm basis to believe that
there is anything in the order of excessive speculation or
manipulation that is causing oil prices to be $140 or $130 or
$135 per barrel.
So I think that the key thing is, going forward we
shouldn't just look at prices, we should look at the real
market for oil. We should look at the physical market as well
as the derivatives market, understand the linkages between
these two markets, and proceed in a prudent and considered
manner, because intemperate or ill-thought-out actions to
constrain speculation could have very adverse effects on the
operations of both the physical and the financial markets.
Thank you.
[The prepared statement of Dr. Pirrong follows:]
Prepared Statement of Craig Pirrong, Ph.D., Professor of Finance and
Director, Global Energy Management Institute, Bauer College of
Business, University of Houston, Houston, TX
I am Professor of Finance, and Energy Markets Director of the
Global Energy Management Institute at the Bauer College of Business at
the University of Houston. I have been actively involved in the
commodity markets for the 22 years. I have published numerous articles
and two books on commodity market issues; these include several
articles on energy prices and energy trading. Moreover, I have taught
courses in futures markets, financial markets, and energy markets at
the graduate and undergraduate level. I currently teach a course in
energy derivatives for a Global Energy MBA program in both Houston and
Beijing. Furthermore, I am a member of the CFTC Energy Market Advisory
Committee and the CFTC Technology Advisory Committee.\1\
---------------------------------------------------------------------------
\1\&The opinions expressed herein are exclusively my own, and do
not reflect the views of the Global Energy Management Institute, the
Bauer College of Business, the University of Houston, or the CFTC.
---------------------------------------------------------------------------
The subject of market manipulation is a special area of expertise.
I have published seven articles and a book on the subject, and have
testified as an expert in several high-profile manipulation cases. I
have also given a 2 day seminar on manipulation to the staff of the
Federal Energy Regulatory Commission.
In addition to my academic research in commodity markets, I have
served as a consultant to several exchanges. In this role, I have
participated in the design of commodity futures contracts in the United
States, Canada, Sweden, and Germany. I also was the primary
investigator in a study (commissioned by a major energy consumer group)
of the impact of increases in speculative position limits on the
volatility of natural gas prices.
Based on my extensive study of, and experience in, commodity and
commodity derivatives markets and market manipulation, I offer this
testimony on the role of speculation and manipulation in affecting
energy markets, and the likely impact of restrictions on speculation in
these markets.
High prices for petroleum products impact American consumers in
every aspect of their lives. The direct consequences--higher prices at
the gas pump--are readily apparent, but oil prices affect the cost of
manufacturing and/or transporting virtually everything one buys, so the
indirect consequences of high prices are important too.
Given the salience of this issue, it is appropriate for legislators
and regulators to attempt to determine the causes of high prices for
oil and other energy products, and to craft the appropriate policy
responses. One factor--speculation in energy products--has received
intense scrutiny as a potential cause of high prices. The widespread
belief that speculation is causing oil prices to rise far above--some
say as much as $70 dollars/barrel above--the appropriate level has led
to numerous proposals in both the House and the Senate to reduce
speculation in energy markets.
Although I will touch on some pending and proposed legislation, I
will focus my analysis on the role and impact of speculation generally.
This analysis implies that anti-speculation efforts are misguided and
should be avoided, rather than implemented.
In my opinion, speculation is not the cause of high prices for
energy products; the arguments advanced in support of this view are
logically defective and at odds with an understanding of how the
markets work. Most importantly, there is no evidence to support claims
that speculation--or manipulation for that matter--is responsible for
high energy prices.
To the contrary, speculation plays a constructive and important
role in price discovery and the efficient transfer of risk. As a
result, restrictions on speculation like those proposed of late will
not alleviate price pressures, but will reduce the efficiency of the
energy marketing system. Such a move would set the stage for a raft of
unintended consequences that may be not only damaging to consumers and
businesses in the U.S., but to the global economy, in which oil, no
longer just a ``U.S. commodity'', plays a significant role. New markets
are forming across the globe&\2\ and capital will flow to where it is
least constrained by counterproductive regulations. Today that is the
U.S., but this is not guaranteed if Congress imposes unduly restrictive
burdens on participants in U.S. markets. Therefore, Congress would be
well-advised to avoid implementing rash measures to reduce speculation,
and to focus instead on policies that encourage increases in output and
efficient uses of energy.
---------------------------------------------------------------------------
\2\&As a recent example, the Hong Kong Futures Exchange just
announced its plans to launch energy futures trading.
---------------------------------------------------------------------------
More specifically:
In recent debates over energy prices, the word
``manipulation'' has been thrown around with abandon. There are
numerous allegations that manipulation by speculators is what
is causing the current high prices. Indeed, one of the bills
currently under consideration is called ``The Prevent Unfair
Manipulation of Prices Act'' (``PUMP.'') However, price
behavior in the oil market during the recent period of dramatic
price increases is not consistent with manipulation.
I base this conclusion on my extensive research on
derivatives market manipulation; indeed, I have published more
(numerous articles and a book) on this subject than any
academic economist. Moreover, I have designed futures contracts
with the specific objective of minimizing their vulnerability
to manipulation, and as a result, have extensive practical
experience in how manipulation works and how it can be
prevented and deterred.
In my research, I have found that the term ``manipulation''
is often used loosely. Indeed, this is true of discussions of
the energy market today, some of which remind me of what a
Texas cotton trader said during testimony before the Senate in
1923: ``The word `manipulation' . . . in its use is so broad as
to include any operation of the cotton market that does not
suit the gentleman who is speaking at the moment.''&\3\
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\3\&Cotton Prices: Hearings Before a Subcomm. of the Senate Comm.
on Agriculture and Forestry, Pursuant to S. Res. 142, 70th Cong., 1st
Sess. 154 (1928).
Certainly there are forms of conduct-notably a ``squeeze''
or ``corner''--that are properly considered manipulative. My
research demonstrates that such manipulative acts have distinct
effects on prices, price structures (e.g., the relation between
nearby and deferred futures prices), and the movements of
physical commodities in interstate and international trade.
These effects have not been observed in the oil market during
2007&2008. Moreover, existing regulatory and legislative
remedies, if employed vigorously and precisely, are sufficient
to address potential future manipulative attempts. Policymakers
would be well advised to utilize existing tools to fight
recognized forms of manipulation, rather than implement new
policies that will not appreciably reduce the frequency and
severity of real manipulations, but which will interfere with
the ability of the markets to discover prices and transfer
---------------------------------------------------------------------------
risks efficiently.
Constraining the positions that market participants can hold
can reduce the frequency of market power manipulations, but
such position limits are an inefficient tool for achieving this
objective. They are inefficient because they limit the ability
of speculators to absorb risk from speculators and are
difficult to set at a level that is sufficient to make it
difficult to corner a market without unduly constraining the
ability of the markets to transfer risk efficiently.
Based on long study and involvement in the derivatives
markets, I believe that corners and squeezes are a serious
concern--and not just in energy markets, but in financial and
other commodity markets as well. I further believe that corners
and squeezes should be punished severely, either through
criminal or civil penalties, or private litigation. That said,
I emphasize that: (a) there is no evidence that manipulation
properly understood explains the current high prices for energy
products, or (b) that position limits are not the most
efficient or effective means of reducing the frequency and
severity of manipulation.
Moreover, there are more efficient tools than position
limits available to deter corners and squeezes. These kinds of
manipulation are already illegal in both the futures and OTC
markets. Moreover, these types of manipulations can be detected
with a high degree of precision; as Judge Frank Easterbrook
(5th Circuit Court of Appeals) has written, ``an undisclosed
manipulation is an unsuccessful manipulation.''&\4\ Since
corners and squeezes are detectable, and those that carry them
out are usually not judgment proof, it is more efficient to
deter manipulation by imposing penalties after the fact on
those that engage in this conduct (through criminal or civil
penalties, or private litigation) rather than by constraining
the activities of all market participants before the fact
through position limits.
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\4\&Frank Easterbrook, Monopoly, Manipulation, and Fraud, 59 J. of
Business (1986), S107.
Vigorous head-to-head competition between similar futures
contracts is a distinct rarity. The ongoing battle between
NYMEX and ICE WTI contracts is one of the very few examples of
such competition in the global futures markets. Competition
generally redounds to the benefit of market users, and should
be encouraged. Any regulatory or legislative change that would
impair the direct access of U.S. customers to ICE Futures
Europe would either be ineffectual because global financial
institutions would merely shift their business to London, or
counterproductive because it would reduce competition in the
WTI market. Though the London-based exchange has only a 15%
share in the WTI crude market, it represents a tool for global
energy producers and banks to manage risk using a cash-settled
instrument, rather than in a physical oil contract. Moreover,
such measures would not materially reduce the vulnerability of
the oil market to manipulation. Such measures would, therefore,
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create costs without producing any corresponding benefit.
Historically, major shocks to commodity markets have been
blamed on speculators, and speculative excess. The response to
the current oil price shock is no exception. Assertions that
speculation by financial institutions, including investment
banks, hedge funds, commodity funds, and pension funds, have
inflated oil prices by as much as $70 per barrel are logically
defective and completely unsupported by any reliable evidence.
Almost without exception, trading by these market participants
does not contribute to the demand or supply of physical oil,
and hence their trading does not distort the physical oil
market. Many financial institutions trade cash-settled
derivative instruments, including swaps and the ICE WTI
contract, which cannot be used to take or make delivery of oil;
nor can these positions result in a physical claim on oil.
Those trading these instruments are by definition price takers,
not price makers. Moreover, even when financial institutions
trade delivery-settled instruments, such as the NYMEX WTI
contract, they typically offset their positions prior to the
delivery period, and hence do not contribute to the demand or
supply for physical oil. Even if they purchase in large
amounts, they subsequently sell in almost equal amounts as
contracts reach delivery. Hence, they typically exert no upward
impact on the ``spot'' price for oil which is crucial in
determining the prices that consumers actually pay.
It should also be noted that the oil market has not
exhibited one of the necessary indicia of speculative
distortion of prices--the accumulation of large and increasing
inventories in the hands of speculators. Attempts to hold
prices above their competitive level--such as the actions of
the Hunts in the silver market in 1979&1980, or the
International Tin Council, or the agricultural price support
programs of the U.S. Government in years past--require the
entity keeping the prices up to accumulate large inventories.
This has not been observed in the oil markets of late.
With regard to the notion that passive investors (including
``long only'' index funds) have dramatically impacted the price
of oil, there are some key factors that prevent this from being
the case. Most notably, commodity index funds buy and sell in
equal amounts on a regular basis as the futures contracts
expire on a monthly or quarterly basis during the ``contract
roll.'' Because they roll, they do not take delivery, and hence
do not affect the demand for physical oil. Indeed, they are
sellers as futures contracts near delivery, and hence are not
the source of any buying pressure in the physical market; if
anything, the reverse is true.
This phenomenon has been long understood. In 1901 (!) a
report from the United States Industrial Commission on ``The
Distribution of Food Products'' stated:
As we have attempted to show, it is a mistake to
represent speculation in futures as an organized
attempt to depress prices to the producers.
First. Because every short seller must become a buyer
before he carries out his contract.
Second. Because, so far as spot prices are concerned,
the short seller appears as a buyer not a seller, and
therefore, against his own will is instrumental in
raising prices.\5\
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\5\&Report of the Industrial Commission on the distribution of farm
products 223 (1901). Many Members of the House and Senate were members
of the Industrial Commission.
The concern addressed by the Industrial Commission was the mirror
of today's: in 1901, it was widely alleged that speculative
short selling depressed the prices of corn, wheat and oats,
whereas today it is asserted that speculative buying inflates
the price of energy. The Commission's analysis is directly on
point nonetheless; speculators who offset their positions
(short sellers who buy futures, or buyers who sell them) do not
distort spot prices--the prices that consumers pay and
---------------------------------------------------------------------------
producers receive.
Of note, what many experts claim are massive inflows to
commodity index funds over the decade is largely the price
appreciation of the assets in the commodity index rather than
``new money''. The assets attributable to commodity index funds
represent a small portion of these aggregate markets.
Interestingly, in the markets where index funds are most
concentrated, such as the cattle futures markets, prices have
been flat. Wheat futures traded on the Minneapolis Grain
Exchange are not included in an index, but have experienced
dramatic increases in price. Finally, these index funds take no
supply off the market, thus do not impact the physical market
where spot prices are set.
It has been asserted that oil may be in a speculative
bubble. However, speculative bubbles are less likely to occur
in the market for a physical commodity, than a market for
financial assets, such as growth stocks in new industries. The
discipline of physical delivery that connects derivative
instruments--such as futures contracts--to the market for the
physical commodity makes it far more difficult for commodity
prices to become untethered from fundamentals as in the case
for Internet stocks, to name but one example. Moreover, extant
economic research suggests that goods and assets with active
futures contracts are actually less susceptible to bubbles than
those lacking liquid futures markets. Hence, it would be
particularly misguided to attack an alleged bubble by impeding
the trading of oil derivatives. Finally, economic models of
speculative bubbles imply that during a bubble, futures prices
should exceed spot prices by the cost of carrying inventory;
this was not observed during the period of rapid oil price
increases in recent months.
Some proposed legislation is intended to constrain the
ability of financial institutions such as investment banks,
pension funds, and index funds, from participating in the
commodity markets. Such efforts are misguided because the
participation of financial institutions in the commodity
markets in general, and the oil market in particular, is a
laudable development. Improved integration of the financial and
commodity markets facilitates the efficient allocation (and
pricing) of commodity price risk. That is, it facilitates
hedging by energy producers and consumers, which in turn helps
consumers; pension funds and index investors can often bear
risk more cheaply than others (because of their ability to
diversify), and hence their participation in the market reduces
the cost that hedgers incur to shed this risk. Moreover, by
trading commodity derivatives, including exchange traded
commodity futures, investors can improve the performance of
their portfolios by reducing risk without sacrificing return--
and without putting claims on physical inventories. Indeed,
this very ability to improve portfolio performance is what
permits these investors to take on risk from hedgers more
cheaply Therefore, impeding the ability of financial
institutions and investors to utilize the futures markets would
harm hedgers and investors, again without generating any
benefit for American consumers of oil products in the form of
lower prices.
Moreover, some speculators devote effort and resources to
researching market, geopolitical and seasonal fundamentals.
Their participation in trading ensures that the information
they produce is incorporated in prices. Such trading
facilitates price discovery, contributes to the informational
efficiency of prices, and thereby encourages efficient use of
scarce energy resources by providing producers and consumers
with more accurate measures of the true value of oil.
The role of margins in futures markets is to ensure that
parties to futures contracts are willing and able to perform on
their contractual commitments; in essence, margins are
performance bonds (collateral). Margins have costs; they
require traders to hold more in low yielding assets (such as
Treasury bills and cash) than they would absent such margin
requirements. Exchanges, clearinghouses, clearing members, and
brokers have incentives to set margins efficiently to trade-off
these benefits and costs. Exchanges and clearinghouses use
sophisticated methods to set margins efficiently, and based on
these methods, adjust margins to reflect changes in price
volatility.
It would be imprudent to increase margin levels dramatically
by regulatory or legislative fiat to choke off speculative
activity in the energy markets. There is no reliable empirical
evidence that margin increases reduce price volatility, or
reduce disparities between market prices and prices justified
by fundamentals. Changes in margins would affect both long and
short speculative activity, and hedging activity, and thus
could lead to either increases or decreases in futures prices
relative to expected spot prices. Moreover, raising the cost of
speculation through margin changes would tend to reduce market
liquidity and increase the costs of hedging. Furthermore,
raising margins affects the activity of market participants
based on how much cash they have--not how much information or
smarts they possess. In addition, raising margins on exchange
traded instruments is likely to encourage a migration of
trading to off-exchange venues where parties can freely
negotiate collateral levels. Even if speculation was distorting
prices--and I repeat that there are neither convincing evidence
nor arguments to support this view--regulation of margins would
be an extremely blunt tool to control speculation, and would
likely have detrimental effects on the efficiency of the
futures market as a hedging and price discovery mechanism.
Over-the-counter (``OTC'') instruments play an important
role in virtually all financial and commodity markets. Indeed,
the volume and open interest of OTC contracts is typically
higher than corresponding figures for their exchange traded
counterparts. Like exchange traded futures, OTC swaps permit
hedgers and speculators to trade risk efficiently. Revealed
preference indicates that for many market participants, OTC
swaps and options offer advantages over exchange traded
instruments. That is, market participants can often achieve
their risk management objectives more efficiently using swaps
than using exchange traded instruments. OTC market participants
are already proscribed from manipulating any commodity traded
in interstate commerce, so it is incorrect to say that these
markets are unregulated. Additional regulation, such as
limiting participation in OTC energy markets to those capable
of making or taking delivery of an energy commodity, or to
those who produce it, would interfere with the ability of these
markets to perform their essential risk transfer function
without materially reducing the frequency of manipulation. OTC
markets facilitate the trading of risk, and many of the most
efficient bearers of risk are not the most efficient handlers
of the physical commodity. Indeed, since most OTC contracts are
financially settled, they cannot even be used to transfer
ownership--they are used exclusively to transfer commodity
price risks. Limiting participation in these markets to those
who produce, consume, or otherwise handle, the physical
commodity therefore largely defeats their very purpose. By
eliminating from the market those who can most efficiently bear
risks, such measures would make hedgers--who do handle the
physical commodity--worse off.
In evaluating the role of energy speculation, and energy
derivatives markets more generally, it is imperative to
remember one crucial fact: derivatives markets are first and
foremost markets for risk, rather than markets for the actual
physical product. Derivatives markets effectively permit the
unbundling of price risks from the actual physical commodity.
It is this unbundling that makes hedging work. The derivative
market for oil and the physical market for oil are of course
related, and indeed, the delivery process in the futures market
ensures that futures prices at maturity reflect the actual
value of physical energy. As long as the integrity of the
delivery process is protected against the manipulative exercise
of market power, however, financial trading of energy
derivatives permits efficient allocation of energy price risks,
but does not impede the orderly and efficient operation of the
market for physical energy. Indeed, by facilitating the
efficient allocation of risk and the discovery of prices,
derivatives trading--including derivatives trading by
speculators, investors, and financial institutions--actually
makes the physical market more efficient. It allows energy
producers and consumers to shift the risks to those best suited
to bear them, and to focus their efforts on producing,
transporting, marketing, and using energy as efficiently as
possible. This benefits energy consumers in the U.S.
In summary, energy derivatives markets play an important risk
transfer and price discovery role. Speculation is a crucial element of
an efficient derivatives market; speculators provide services that
redound to the benefit of producers and consumers of energy looking to
reduce risk, and hence to the customers of those producers and
consumers. Assertions that manipulation, or speculation, or
manipulative speculation, are causing high oil prices are not based on
sound economic reasoning, and find no support in the data. Policies
based on such mistaken beliefs will do nothing to alleviate energy
price pressures. Indeed, such policies are likely to harm U.S.
consumers and investors by impairing the ability of the energy
derivatives markets to discover prices and transfer risk.
The Chairman. Thank you very much.
Mr. Zerzan, for the benefit of the Committee, would you
tell us what a swap looks like? I mean, is it an actual
contract? Can you send us a copy of one of these so we can see
what it looks like? Are they all kind of alike, or are they
different?
What I am trying to understand is exactly--I think there is
confusion on the part of Members and myself about just what
this is, and I don't think they are all alike. Some people are
doing these swaps that actually are in the business, and then
you have people that rather than go to Las Vegas, they deal
with you guys apparently. So as somebody said, ``The problem is
we don't know what is what here.'' But could you explain to us
how this works?
And then, as I understand it, these swaps mostly are offset
with some over-the-counter offset, and they net these things
out before they end up going over to the NYMEX. Could you just
explain that maybe in terms that the Committee would
understand?
Mr. Zerzan. Sure. Your typical over-the-counter derivative
arrangement has essentially three parts. The first part is what
is called a master agreement, and it defines the scope of the
relationship. So let's say I am ABC investment bank, and on the
other side I have XYZ airline. XYZ airline wants to hedge its
risk of the rise in prices or the fluctuations in the price of
jet fuel. So, the investment bank and the end-user will enter
into a master agreement which defines the overall contractual
terms; what happens in the case of a default; what happens in
the event that some of the parties to the transaction decide
they want to enter into other transactions.
So under the master agreement you then have a credit
support document, and the credit support document outlines the
collateral between the transactions, between the parties. If I
am going to enter into a relationship with a counterparty, I
want to know that if they back away, I have some security, I
have some sort of recourse. And so we will have a credit
support annex which defines the type of collateral which I can
try to obtain if my counterparty decides it is going to walk
away.
Any individual transaction, like the swap that I want to do
with the airline, is documented by a confirmation, and each
individual transaction is confirmed via a confirmation. All of
these are written contracts. And we will be happy to provide
the Committee with examples of these. They are written
contracts. They are generally referred to as ISDAs within the
trade, because ISDA developed the general framework.
But within the context of the actual documents, the
material economic terms are always negotiated. These terms
include, obviously, the price, the size of the transaction,
such things as I mentioned: the collateral; what type of
collateral must be posted; and what events would constitute a
default under the contract, for instance. So although you have
standardization in terms of the framework, the actual terms of
the agreement that relate to the actual transaction, the
economic exposures, are all individually negotiated, and they
are, in the case of each transaction, confirmed by a written
confirmation, which is a contract like any other contract.
The Chairman. Well, and are these normally just by
themselves, or are sometimes a bunch of these put together and
then offset by some other institution that picks up that risk,
or does one of these credit default swaps--or is that--how does
that work?
Mr. Zerzan. If I am a swap dealer, I will have transactions
with XYZ airline, ABC trucking company, CDF producer. And this
gives me an overall net portfolio exposure. So as opposed to my
trying to seek to offset each individual transaction, I will
try to offset the exposure in my entire portfolio, and I may go
to the futures market to do that. In fact, I will likely go to
the futures market to try to offset some of that exposure. But
this is done primarily as a means of risk management.
And so when we talked about the hedge exemption, you can
see, if you are an investment bank, you have a very real need
to hedge your risk by going to the futures market as part of
managing your overall portfolio, and that allows you to enter
into contracts on commodities like jet fuel that an airline
can't otherwise obtain protection on.
The Chairman. Well you have airlines and truckers and so
forth; they have a business of being in the market. But we have
these other people that apparently buy these things that have
no interest in ever owning oil or have no connection to this at
all. They are just apparently getting into this because they
think they can make money. Am I right?
Mr. Zerzan. Well, you have people that are speculating
certainly.
The Chairman. Yes. And one of the problems is the CFTC
doesn't know how many of these contracts relate to actual
physical hedgers and how many are speculators, I guess. Do you
have any idea what that percentage is, how many of these swaps
are airlines and truckers and people that use this stuff and
how many aren't? And how much of the hedging is in the actual
futures market, and how much of it is in the over-the-counter
market? Do you have that information?
Mr. Zerzan. Well, one of the proposals that has been put
forward would require the disaggregation and the breaking down
of swap dealers and index traders and others. To the extent
that the Commission feels that that type of transparency is
important; and Congress feels that that should be done, then I
think the important thing to remember is you don't want to
create a situation where an individual swap dealer's strategy
or position in the futures market is laid open so that other
traders can trade ahead. And one of the concerns that have been
expressed is that you want to make sure you anonymize the
ability of individual firms to use the futures market to hedge
their bona fide risk.
When you ask what is the percentage of people doing
speculative trades versus what is the percentage of people that
are doing hedging trades, I actually think that would be
tremendously difficult to try to break out on any case-by-case
basis. On any given transaction, you might have a party that is
hedging one part of its portfolio. You might have another party
that is speculating. You might have an individual transaction
that in some light is seen as speculation and in another light
is seen as a hedge.
The most important question is whether or not the
speculation is driving up the price of the commodity. And I
think that Professor Pirrong noted there is no real evidence
showing that is the case.
The Chairman. Well, and if the Committee will bear with me,
I just want to finalize this. So these guys don't want to know,
they don't want anybody to know what they are doing. I can
understand that. That has been part of my puzzle about all of
this. And from what I can tell, some of these swaps and these
index funds are never, ever getting over into the futures
market. The only thing that is getting over there is the amount
that you can't lay off over-the-counter some other way. So
people are basically making this side bet over here between two
parties, and in the case of the indexes, they are using the
futures market as what they are betting against. But this money
never goes into the futures market. And if nobody knows what
they are doing, how can it affect the price?
That is what I cannot figure out. I mean, if the money
doesn't go in there, and if nobody knows what they are up to,
then how can it affect the price? The part of it that goes over
into the futures market could potentially affect the price, but
I just don't get the connection here. Am I missing something;
or does somebody actually know what these swap things are, and
then they use that information?
Mr. Zerzan. No, Mr. Chairman, I think you hit the point
precisely on the head. An individually negotiated contract
between two people, the price of which is known only to those
two people, doesn't affect any price of anything else. And to
the extent that you have swaps that are then being hedged in
the futures market, as you point out, that pricing information
is being fed into the futures market, and it is showing up in
the price of the contract.
But you have hit the issue precisely. These are not driving
up prices if they are contracts which are bilaterally
negotiated and the prices are known only to the two people to
the transaction.
Mr. Marshall. Mr. Chairman.
The Chairman. Mr. Marshall.
Mr. Marshall. Would you mind?
The Chairman. Yes.
Mr. Marshall. I just wanted to follow up on something that
you have already raised as a result of Mr. Zerzan's comment
concerning the problem with more transparency in this market.
And it is, in essence, as you described it, a worry by those
who are trying to hedge in the market that others will be able
to trade ahead of them. And what you mean by that is if word
gets out that XYZ airlines is working with ABC to cover a
particular risk. Where jet fuel is concerned, ABC's costs go up
if ABC knows that it is going to be more difficult for it to
then lay off that risk someplace else because the word gets out
that it is going to be trying to do this. This is a huge
position that will have to be taken, and consequently people
get there ahead of time, and it becomes more expensive for them
to lay off the risk. Is that basically the concern?
Mr. Zerzan. Yes, sir.
Mr. Marshall. I am describing this adequately?
There wouldn't be a problem with sharing information
concerning the swap position confidentially with the CFTC to
enable the CFTC itself as a regulatory entity to have complete
transparency in real time with regard to what is going on in
the market. Wouldn't that be correct, because that would have
no effect on somebody trading ahead?
Mr. Zerzan. Well, for instance, your legislation where you
put forth the provision where swap dealers would be required to
report separately, I don't think that type of reporting would
be something that the firms would be unprepared to do. I think
they already have those records, and they would be able to do
so. And as you point out, the important issue is that it is
done in such a way that it doesn't individually point to each
firm's trading strategy.
Mr. Marshall. So the effect of adopting a rule like that
would be to increase the oversight burden for the CFTC for
sure, because they would be receiving all kinds of information
which they could probably arrange to receive in summary form,
in addition to the detail, but also in summary form. This is
pretty close to whatever it is on NYMEX, something like that.
To generally follow what is going in the market with a fair
amount of ease, CFTC may need a little more resources, but the
market itself wouldn't react badly to that as long as the
market had confidence that this information was going to remain
secret. And, so, you wouldn't have this problem of people
trading ahead and consequently making it more expensive to
hedge.
And in addition, frankly, having a regulatory regime where
there is a regulator that is seeing all of this could enhance
the confidence that people have in the market and be good for
the market as opposed to bad for the market, wouldn't you
think, Mr. Zerzan?
Mr. Zerzan. Again, I think it is important that we are
clear, when we are talking about a provision that shows the
over-the-counter positions as opposed to the futures positions,
then you are talking about a different regime. What your
legislation does is it talks about showing the hedges in the
future markets, broken down by the fact they are done as a
hedge on a swap.
Mr. Marshall. And my question goes further than that.
The Chairman. Mr. Marshall, we are way over my time, so I
recognize the gentleman from Virginia, the Ranking Member, Mr.
Goodlatte.
Mr. Goodlatte. Thank you, Mr. Chairman. And I want to thank
all the members of the panel.
Dr. Pirrong, yesterday we had a panel of witnesses who were
Members of Congress who have introduced legislation that they
believe would address some of the concerns that have been
raised regarding speculation in the futures market. One of
those witnesses used the Hunt brothers' attempt to corner the
silver market as an example of what is happening today. And I
wonder if you could compare and contrast what the Hunt brothers
did versus what we observe in energy and commodity markets
today.
Dr. Pirrong. I will be glad to, sir. In fact, I think that
that is sort of an excellent example of how things are very
different today from what happened with the Hunts or other
examples of manipulation that have happened in the past. And in
particular, it relates to a point that I raised during my
initial statement, which is relating to if manipulative acts or
speculative acts are distorting prices, you are going to see
distortions in the physical market.
The basic idea is prices send signals about scarcity.
People respond to price signals and do things with real things
in response to that. If you screw up prices, you are going to
screw up the allocation of resources, and you are going to see
that very clearly.
In the case of the Hunts, they amassed a massive position
in silver and started taking deliveries of huge quantities of
silver. Indeed, there are sort of anecdotal stories about
brides in India melting down their trousseaux of silver to have
them shipped to New York because the price of silver was so
highly distorted that it was better to have the Hunts sit on it
than to have it as part of their trousseau. There was a clear
evidence in the physical market that something was wrong and
that prices were distorted.
What you would look for today is sort of evidence of the
same sort of thing. You would look for evidence of oil, in this
instance, being accumulated, hoarded by speculators. You should
see an elevation in the level of oil inventories or oil stocks,
and there is no evidence that we see of that. And so that is a
very important thing. You just can't look at prices alone.
Let's look at the real side of the economy, too. Let's look
at quantities as well as prices. Every economist, when he puts
up a supply and demand diagram, there are two axes. There is a
price axis, but there is also a quantity axis. If speculation
is distorting prices, we will see that in some sort of quantity
data, like in inventories or in flows of the commodity. We saw
that with the Hunts. We don't see it now.
Mr. Goodlatte. Well, let me ask you about that inventory.
It was widely reported this week that the U.S. Energy
Information Administration said that for the week of July 4,
domestic crude stocks fell 5.9 million barrels to 293.9 million
barrels, the lowest since the week of January 25 when stocks
stood at 293 million barrels. Is this information consistent or
inconsistent with what you, as an expert, would expect to
observe if there were efforts to manipulate the market?
Dr. Pirrong. No. What we would expect to observe if the
market was being manipulated is that stock should be
increasing, that we should see hoarding. Stocks should see
ballooning, not declining.
Mr. Goodlatte. Thank you.
Mr. Greenberger, yesterday we heard testimony from Members
of Congress that support legislation that would address many of
the issues of concern that have been voiced by you and others.
You and others have cited hedge exemptions as a way for parties
to increase their speculative positions. The CFTC made data
available to us that allows us to analyze this.
In 2006, for swap agreements, 19 firms requested hedge
exemptions. Thus far in 2008, only four firms have requested
hedge exemptions, one on an annual basis and three temporary.
For a combination hedge and swap agreements, 23 firms requested
hedge exemptions in 2006. Thus far in 2008, eight firms have
requested hedge exemptions. For pure hedges, ten exemptions
were requested in 2006 and only two in 2008. During the time
that crude oil had a large run-up in price, the request for
hedge exemptions has fallen dramatically. How do we reconcile
that data with what we are hearing?
Mr. Greenberger. Thank you. I am happy to answer that
question. First of all, the relationship between hedge
exemptions and the skyrocketing speculative investments, you
will only need one hedge exemption. If Goldman Sachs has a
hedge exception, they are going to enter into the markets
billions of dollars under that exemption. So I don't think the
number of hedge exemptions tells you anything.
Second, the Chairman asked a very interesting question.
Mr. Goodlatte. Well, you said it in your testimony that
hedge exemptions were a way for parties to increase their
speculative position.
Mr. Greenberger. Yes. And I say if Goldman Sachs----
Mr. Goodlatte. But that is not apparently how they are
doing it now, if there are only a few.
Mr. Greenberger. I am saying if you only have one, if
Goldman Sachs has one, that is all they need.
Mr. Goodlatte. Is Goldman Sachs responsible for this large
run-up?
Mr. Etheridge. Would the gentleman yield?
Mr. Goodlatte. I would be happy to yield.
Mr. Etheridge. I am told that the very day that they offer
the exemptions, the stock of oil will fall, which doesn't
square with the fact that if you have an exemption it should be
going up, shouldn't it?
Mr. Greenberger. Let me answer that question as well. The
Chairman put his finger on the pulse of the issue. He says,
``Gee, I don't see all this money going to NYMEX.'' Now, if it
goes to NYMEX, the concern has been that when Goldman Sachs
tries to take its short positions from its swaps and convert
them into longs, they are buying long on NYMEX. The hedge
exemption is allowing them to be treated as an oil dealer
rather than as an investment bank who is laying off its risk
from all the bets it has taken in on the price.
Now, you have to understand when Mr. Zerzan says they are
netting things out, it is like a bookie. They have longs, they
have shorts, and they see how much overage they have. When they
have a lot of overage they have sold short to the people who
are buying long. And that is not a good way to be in this
market. So they have to find other avenues to lay off that
short risk and buy long.
Now, the Chairman says, ``Gee, I don't see all that on
NYMEX.'' They don't need a hedge exemption to lay that off on
the over-the-counter market. The over-the-counter markets are
not covered by hedge exemptions.
Now, if I can just follow my train of thought, Mr.
Goodlatte.
Mr. Goodlatte. Yes. My time has expired. I do want to give
Dr. Pirrong an opportunity to respond as well. But go ahead.
Mr. Greenberger. Okay. When they go out into the over-the-
counter market, everybody is saying, ``Gee, we don't know what
is happening in the over-the-counter market. So how can it
affect the price of crude?'' Well, what is happening in the
over-the-counter market is Goldman Sachs is going to people,
asking them to sell short. And that is all happening in the
over-the-counter market, which as Congressman Marshall is
saying, ``We don't have any information about.'' Well, those
shorts are being sucked out of transparency. So if you look at
NYMEX, all you are seeing is the long, the heavy long position
on NYMEX. You don't see everybody who is selling short on the
over-the-counter market. If those shorts were required to be on
NYMEX or another regulated exchange, you then all of the sudden
would see that people want to sell here, they just don't want
to buy.
Mr. Goodlatte. Let me ask Dr. Pirrong if he agrees with
your assessment.
Dr. Pirrong. No. Essentially this is just part of the
process where essentially risk is being allocated and
essentially in an efficient way. These markets are intimately
interconnected. To the extent that a swap dealer sees order
flow, he has the ability to trade that off in many markets. And
to the extent that the impact of that order flow isn't
reflected on some market where he can trade, that represents a
profit opportunity and he is going to basically trade on that
information accordingly. That means that information is going
to be communicated through these markets in a very efficient
and rapid way. These guys talk with one phone in one ear and a
phone in another ear--or one phone in another ear and looking
at their computer screen, and essentially are acting to ensure
that these prices are interconnected. And so the idea that
essentially stuff can happen over in one market and essentially
that is not going to be reflected in prices in another I just
think reflects a misunderstanding of the way these markets
work.
Mr. Goodlatte. Let me, if I might, Mr. Chairman, ask Mr.
Vice if he believes or he knows of evidence to support or
refute Mr. Greenberger's contention that what is not being seen
on NYMEX is heavy trading of shorts on the OTC.
Mr. Vice. I am not sure I followed all of Professor
Greenberger's remarks. But in trying to take a couple of
takeaways: no one has really differentiated yet in this
conversation that there is an electronic OTC market, of which
ICE offers, and there is a much larger non-electronic OTC
market which are through voice brokers or through direct
negotiation, as Greg just described. We obviously don't have
any information about the latter. On the former, as I said in
my testimony, there is no electronic OTC trading in U.S. crude
oil or any other U.S. refined product today on ICE or anywhere
else. So there is no data there to go get because there is no
trading.
As I understand it, Professor Greenberger is suggesting
that directly negotiated trades of the type that Greg described
earlier between airlines and Goldman Sachs, and any other swaps
dealer, should somehow all be moved onto a regulated exchange.
And I think Greg did a good job of describing these are
customized, privately negotiated deals that have sometimes very
unique terms to fit the risk management need of that particular
airline for a particular time frame or particular delivery
point that may not match up 100 percent with the terms of a
futures contract.
Mr. Goodlatte. Thank you. Thank you, Mr. Chairman.
The Chairman. I thank the gentleman.
The gentleman from Pennsylvania, Mr. Holden.
Mr. Holden. Thank you, Mr. Chairman. We obviously have a
difference of opinion on the panel how this Committee should
move legislatively or move at all. And some of my questions
have been answered already, but I am sure all of you are
familiar with the panel we had yesterday of our colleagues, Mr.
Stupak, Ms. DeLauro, Mr. Larson, Mr. Van Hollen, and their
proposals that they have introduced into the Congress. I am
just curious, what do you think would happen if one of those
proposals, or parts of that proposal would be enacted into law
in the marketplace? Would the money go someplace else so we
would never have a chance to know what is going on in the
marketplace? I am just curious as to your opinion if any of
those, or parts of those, were enacted into law.
Mr. Zerzan. Thank you, Congressman. It is virtually certain
that proposals that would drive the derivatives business away
from the over-the-counter markets or drive it off-exchange
would not lower the price of energy. They would, however,
relocate jobs and revenue overseas and they would remove the
ability of producers to manage their price risks, which would
mean ultimately that those price risks would be passed on to
consumers. So it is fair to say that provisions which would
harm the ability of the derivatives markets to allow people to
manage risk will not result in lower prices.
Mr. Holden. Mr. Greenberger.
Mr. Greenberger. First of all, the commercial users, if you
talk to them, if you talk to the airlines, the truckers, the
farmers, they can't use these markets anymore. They are so
volatile that any price they are locking in means nothing to
them. In fact, I just saw yesterday that the Chicago Mercantile
Exchange has asked for an exemption from the bar of
agricultural swaps in the statute to start selling agriculture
swaps for soybeans. I forget the other agriculture thing.
Soybeans stuck out in my mind because the farmers can't use the
regular exchanges. They are so divorced from what the farmers
believe are economic reality. I think they are walking into a
trap there myself because the swaps market is only going to be
more devoid of reality.
If you impose speculative limits is this statute going to
continue to control speculation? The speculators will have to
find other forms of investment to the extent that they are
driven from these markets. And a lot of people believe, for
example, the pension funds who are pouring money into Goldman
Sachs, to buy long in these products they will then have to go
back to conventional investments like the stock market. Don't
forget these are bets, these are bets on the direction of where
prices are going to go. It is like going to Las Vegas and
betting on who is going to win a football game. It has nothing
to do with building the economy. If you invest in stocks, you
are growing a company, if you loan money to a company on a debt
market, you are helping them grow. When the pension fund puts
this in and, god bless them, they feel this is the way they are
going to make money, they are betting. They are not buying the
commodity. They are only betting on the price of the commodity.
And I find it interesting that in the Commodity Futures
Modernization Act state gambling laws were preempted. They had
to be preempted because these swaps are giving the swap dealer
money and in return he is swapping either the upward price or
the downward price of a commodity, crude oil, soybeans. It is
essentially a gamble. You are gambling on the price. There is
so much of that happening, $260 billion have gone into the
crude oil markets since 2004, that it is self-evidently putting
wind at the back of those who want to drive the prices up.
Now, somebody made the analysis, ``Gee, inventories went
down, of course, that means prices are going to go up.'' People
are forgetting that 3 weeks ago the Saudis said we will
produce, produce, produce. That has been forgotten, the next
day oil went up. Oil is not responding to supplies and Dr.
Pirrong says, ``Gee, this isn't hoarding. There are no
inventories there.'' Of course, I am not saying it is hoarding,
but one of the reasons there may not be inventories is because
nobody is producing because why produce now if the price is
going to go higher later on? And in fact that has been the
thesis that OPEC has traditionally given for why they are not
going to produce more, that they are only selling at a price
that is not the direction of where the market is going to go.
Now, it is true the Saudis surprised everybody 3 weeks ago
and said, ``We will produce anything you want.'' I mean, they
had limits. It was a shocking announcement. The next day, that
was a Sunday, I believe, the price of oil went up. What really
is happening there is OPEC, who is under tremendous pressure to
produce, wants to make a point. We can promise you all the oil
you want, but that is not going to undercut the price. The
price has become detached from supply/demand fundamentals. Why
is it detached? Because if you take the swaps dealer funds,
people are pouring money into those funds long. And then
Goldman Sachs, which is going short to deal with that long, has
to go out into the market and buy long to cover its short bets.
And that is distorting this market.
Mr. Holden. Thank you.
The Chairman. We will let him respond.
Dr. Pirrong. Thank you. A couple of things. First of all,
in terms of specific proposals, the proposals to dramatically
increase margins on futures would tend to drive activity off
the futures exchanges towards over-the-counter markets where
people can negotiate their own collateral. And I think that
would be highly disadvantageous in terms of if you want to
promote price transparency and transparency in the market, that
that would have a very pernicious effect.
In terms of the participation of financial institutions in
the market, it just sort of points out the sort of yin and yang
nature of these markets. For one set of people to want to get
rid of risk, you have to have another set of people that want
to take on risk. And making it analogous to gambling or Las
Vegas or what have you, that is very entertaining, but,
essentially that is a vital role of the market. And if you want
somebody to hedge, there has to be somebody taking on that
risk. And frequently it is going to be a financial institution
or a pension fund or somebody that most effectively can do
that.
The Chairman. Thank you. The gentleman from Kansas, Mr.
Moran.
Mr. Moran. Mr. Chairman, thank you very much. I appreciate
the opportunity to further explore these issues. Professor
Pirrong, you in your testimony, which I have read, it seems to
me that words matter and you make an attempt to outline various
phrases and words. It seems to me as I read your testimony that
words matter to you. And one of the things that has troubled me
in the debate that we have had is that the words ``excessive
speculation'' seem to be interchangeable with market
manipulation. And I think your testimony, although I give you
the opportunity to confirm my understanding, points out there
is a significant difference. One is illegal and disadvantageous
to the economy. I am not sure whether ``excessive
speculation,'' whether that phrase has existed in either
economic or legal terms in the past. Do we study excessive
speculation in the schools of economics, are they written in
the rules and regulations of the CFTC or the laws?
Dr. Pirrong. Well, I think the phrase ``excessive
speculation'' is in the Commodity Exchange Act but certainly
not a concept that has a lot of traction in economics. We
understand what ``speculation'' is. We understand what it means
but drawing the line as to what is ``excessive'' and what is
not is very difficult.
What I would go back to is something I raised in my initial
remarks, which is to the extent that there is some distortion,
whatever label you want to put on it, there is some distortion
that is taking place as a result of activities in the
derivatives markets that would leave a very clear trail in
other data, in particular quantity data in terms of whether it
be production or inventory and things of that nature, and we
just don't see that.
Mr. Moran. In that regard, tell me the bad consequence from
speculation as compared to what I would call market
manipulation. To me, to have something bad, economically, occur
and someone take advantage of the circumstance, it would
require hoarding or hoarding mentality or collusion. How do you
get an increase in price just by the activity of speculating
between two individuals or two entities as to what the price is
going to be in the future?
Dr. Pirrong. Well, a couple of responses to that. First of
all, you are right, in terms of manipulation that results from
the exercise in market power. And that typically results from
one dominant trader or a group of dominant traders colluding
with one another to do something to distort the market. On the
other hand, if you have speculative activity, some people are
speculating on information. They have information, folks that
are speculating in the market, they do a lot of research to try
to figure out things about supply and demand to the extent that
their orders are informative, that will affect prices, but it
will have the tendency to drive prices to where they should be.
That is reflecting all the relevant information that is abroad
in the marketplace.
Mr. Moran. What is the value of speculation to the American
consumer? How do the futures market and off markets speculation
provide benefits to the American economy?
Dr. Pirrong. There are a variety of benefits. Most
importantly, it facilitates the efficient allocation of risk.
So it allows the transfer of risk from those that bear it at a
high cost, which may be, for example, a highly leveraged
airline, to those that can bear it a lower cost, which might be
a pension fund that sees an advantage in being able to
diversify and giving its investors a better risk-return
tradeoff. Also these markets in speculation facilitate the
discovery of prices. People go out, they commit resources to
investigating, doing research on supply and demand
fundamentals, take that information into account in their
trading, that affects prices and assures prices reflect those
fundamental factors and leads people to allocate resources
efficiently.
Mr. Moran. In earlier hearings, I was interested in the
topic of convergence. I walked in late for the testimony and I
am not certain that anybody has used that word in the testimony
today. But is there something that we should be looking at as
we look to see how the prices converge at the end of the
futures contract with the actual market price that would give
us a clear understanding that the markets are transparent and
efficient?
Dr. Pirrong. What I would say is absence of convergence can
sometimes indicate a manipulative distortion. So, for example,
when somebody is manipulating the market, executing a corner or
squeeze for example, that is going to cause the futures price
and the price of the deliverable to diverge from its normal
relationships. And that can be sort of a warning light that the
market is not working properly.
Mr. Moran. And is there evidence today in regard to
convergence in regard to the oil markets?
Dr. Pirrong. No, sir.
Mr. Moran. In other words, there is no divergence?
Dr. Pirrong. Yes, sir.
Mr. Moran. In the markets today?
Dr. Pirrong. Yes, sir.
Mr. Moran. Thank you. Thank you, Mr. Chairman.
The Chairman. Would you yield me----
Mr. Moran. I have no time, but of course I would yield to
the Chairman.
The Chairman. The discussion you just had assumes that
there is a free market and OPEC is not allowing this to be a
free market, is it? I mean, there is this question that we had
before about the supply of stocks. Well, they can store that
stuff in the ground as well as they can in a tank someplace and
you have this cartel that can control this thing basically and
how does that all fit into this? I mean, I am no expert on all
this oil stuff, but----
Dr. Pirrong. I think we can draw a very important
distinction here. Certainly OPEC might be able to take actions
that can cause the prices to be higher than they would
otherwise be. For example, extracting oil at an insufficiently
rapid pace to constrain supply. But that is fundamentally
different from speculation. If speculators were distorting
price--if they say, ``Hey, we are willing to pay this high
price and we are willing to get our Guccis dirty with gooey oil
to do it,'' they would be the ones that would end up holding
the oil. So what you would expect to observe is that with
speculators driving the prices, they would end up causing them
to be higher than they should be. They are the ones that should
be owning the supplies of physical oil. Conversely if it is
OPEC doing something, that could very well have an impact, but
it is not going to manifest itself in the same way.
Mr. Moran. Reclaiming the time I don't have, Mr. Chairman,
maybe the point of that is what Mr. Greenberger said about not
finding hoarding, that hoarding could be in the ground, that
makes sense to me. Maybe the point of this is that the culprit
may not be speculation, but the culprit is the cartel that is
withholding the supply. We are not having a hearing on the
cartel, we aren't having a hearing on OPEC and we aren't having
a hearing on that topic. But, is it not a greater factor in
determining the price of oil, OPEC, than it is the fact that
people are speculating in the future prices of petroleum?
Mr. Greenberger. I would just say this: As Dr. Pirrong has
said, and by the way I am not a doctor, I am a Juris Doctor,
but I can't call myself a doctor. The Act bars excessive
speculation for better or for worse and maybe if speculation is
good, that should be struck from the statute. I think that is
what you have to say to yourself. That was a fundamental
premise that was made. The farmers were getting burned in the
1930s by speculators. I think the airlines will tell you today
they are getting burnt by speculators. Maybe they don't know
what they are talking about. But if speculation is great, let
us get excessive speculation out of the statute. The way
excessive speculation finds its way into the regulated markets
is speculators have limits on how much they can participate.
So all I would say is if speculators are wonderful, then I
think we have to be candid and tell the truckers, the airlines,
the farmers to get the automobile manufacturers, you are wrong,
this speculation is terrific and the Commodity Exchange Act is
not going to deal with speculation.
Just to flip that around, these markets were designed for
businesses to hedge their business concerns. Yes, you needed
speculation to make these markets liquid, but the statute says
no to excessive speculation. It is absolutely true that you can
have problems here with no manipulation at all. But you have to
answer the question, if speculation is good and healthy, then
let us get rid of the excessive speculation bar in the statue.
If it is not good and healthy, then you have to go out into
these markets which are unregulated and we don't know anything
about and we can't find the information and say we have to
control your speculation because you are adversely impacting
the price.
And the Commodity Futures Trading Commission on its
website, it talks about the economic fundamentals of futures
markets, futures markets are price discovery mechanisms. You go
to the paper to see what crude oil is selling at and that
determines what crude oil is. The Chairman is correct, a lot of
this market is not being reported, but I think that is a
distortion in and of itself, that if it was fully reported
people would be seeing there is a lot more selling of oil than
buying of oil and that would affect the price. You essentially
are sitting here and I am sitting here making guesses about
what is going on in the markets that are dark.
And by the way, before the Enron loophole was passed in
December 21, 2000, every energy futures contract had to be on a
regulated exchange.
The Chairman. Mr. Greenberger, that is not true. You didn't
have to be. The problem was you didn't have legal certainty was
the only issue. You could still do it.
Mr. Greenberger. Mr. Chairman, when you say that is not
true, I really feel I have to answer that question.
The Chairman. It was happening before.
Mr. Greenberger. Can I answer your assertion since you have
made it?
The Chairman. Go ahead.
Mr. Greenberger. The assertion of it was happening before
because there was an energy swaps exemption.
The Chairman. But that is going to be there even with these
bills that have been introduced.
Mr. Greenberger. I understand that. And if I could answer,
I would like to be able to answer that question. The energy
swaps exemption was for individually negotiated contracts. You
could not have one economic term negotiated in advance. Now, if
this purpose is to have standardized contracts that can be
liquid. Now, maybe there was trading. Yes, I will tell you,
Enron opened Enron On-Line before they got the Enron loophole,
but that was not legal trading. And I would be happy to carry
this dialogue on further, but I stand by my proposition that
energy futures contracts, just like agricultural contracts
today, cannot be traded, could not be traded off-exchange. That
is why Enron wanted the Enron loophole. Agricultural products
today cannot be traded off-exchange. That is why the CME is
asking for an exemption to have agricultural swaps.
And I would finally say the Goldman Sachs index does trade,
part of it is swaps in agricultural products. I think that is
flatly in violation of the statute. And I think that will be
later shown to be.
The Chairman. We will investigate that. And what I wanted
to say earlier is that you need to understand what the
political situation was in 1935. Farmers were desperate. They
were looking for somebody to blame, whoever. And so I can
easily see why they would put excess speculation in there, just
like I have some letters from my fuel dealers and so forth,
from the airlines who want to have an answer for their Board of
Directors because the CEO is under fire. You know, we just need
to understand all of that. What I am trying to get to is, show
me the facts here that will tie this thing together. And I
still haven't seen that.
Mr. Zerzan, you wanted to say something and then we are
going to get to Mr. Etheridge. I apologize.
Mr. Zerzan. Thank you, Mr. Chairman. I would just point out
that the purpose of ISDA is not to create standardized liquid
documents. It was to create a framework of documentation, the
material economic terms of which any individual trade would be
negotiated between the parties. But ISDA is not in the business
of creating futures contracts. We are in the business of
helping facilitate the individual negotiation of bilateral
contracts.
The Chairman. The gentleman from North Carolina, Mr.
Etheridge.
Mr. Etheridge. Thank you, Mr. Chairman. Let me thank each
of the witnesses here today. I am sitting here trying to think
how to start. And I thought what I might do after all we have
heard is that we really are about setting a framework that is
fair to the consumer and fair to the producer, really and
truly. That is what it is about. Now, a lot of people in the
middle get in the game.
But on Sunday night, I got a call from a friend of mine who
is a lawyer. He employs nine employees. In March of 2007, he
was paying about $5,500 a week for fuel for five trucks and all
of his skidders in the woods. A year later, he shut down his
operation, laid all those people off and took a 3 month
sabbatical without pay because when he had paid his fuel bill
he had no money left. Now, you may say that is his problem, he
didn't hedge. The truth is, we are trying to get a handle on
this because it is really about those folks. The folks in
between who handle paper and do all the other stuff, they are
going to be all right. Now, he is back in business, he sold off
part of his equipment and ultimately at the end of the day, his
banker helped him heal the situation, the warehouser gave him a
little more allocation of fuel money if he would keep a list of
what he put on his skidder and what he put in the truck.
So we need to sort of keep a framework of where we are as
we deal with this because the public doesn't understand
futures, swaps or derivatives or anything else. But our job is
to try to get a framework that is fair and protects the
American people. That is really where we are and I hope we will
keep that focus. I could share a lot of other stories. But my
question, Mr. Comstock, is to you.
Given that APGA, as your testimony says, values the
different needs served by the more tailored OTC market, does
your organization or would you support legislation, of which
this Committee is going to be looking at, as soon as we finish
all the testimony, that it would eliminate the OTC market with
respect to energy commodities as some of these claim to do, or
just share with us your thinking on that. I think it is
important for us to have that as we try to get a handle on
these things.
Mr. Comstock. Mr. Etheridge, thank you for the opportunity
to comment. I don't believe that APGA supports the elimination
of OTC markets. But APGA does support the position that data
and information are important.
Mr. Etheridge. Transparency?
Mr. Comstock. Transparency, yes, sir, in a word, it is
important.
Mr. Etheridge. Those are two different things is the reason
I asked the question that way.
Mr. Comstock. The transparency is important to us to
provide information to know what is happening in those markets.
That is our position and that is what we would support.
Mr. Etheridge. Okay. Thank you. My colleague, from Kansas
raised the issue of OPEC. I wish you could be talking about
that today because when this issue came up in the 1970s, we
were importing far less oil than we are today. And they do set
the threshold of how much they will produce. The truth is when
they said they were going to increase the production here
recently, all they did was reduce production in another field.
So it was sort of a net-net.
Dr. Pirrong, we have heard comments that there is too much
liquidity in certain commodity markets and I think I have an
awful lot of constituents who really believe that. What are
your thoughts on this statement? Can there be such a thing as
too much liquidity? And if so, what does that look like? How
does that affect the market and how do we put in place
mechanisms to make sure there is adequate liquidity to make the
market work? As someone on a farm would say, ``Enough grease to
grease the machinery and make it work and not too much grease
to get it all over the axle and mess up everything else.'' I
think that is what we are about right here. We talk about it in
a lot of terms. But the real issue is having enough liquidity
to make the market work and not too much to mess up everything.
Dr. Pirrong. Yes, sir. Well, I think there is a market for
liquidity like there is a market for other things. And
essentially that market will typically work in a way that
ensures that the right amount of liquidity is there. Where does
liquidity come from? Liquidity comes from capital. To the
extent that people are demanding liquidity, the price of
liquidity is going to be high and that is going to attract
capital there. Conversely, to the extent that people don't
demand liquidity, hedgers aren't in the market, they don't
really need the liquidity, there will be a low demand and there
would be relatively less capital.
Mr. Etheridge. I understand that. I understand that
theoretic statement. My question is a little deeper than that.
You have to make sure if there aren't any regulatory schemes. I
think my question is, how much liquidity does it take,
otherwise every dollar will chase certain things. You and I
know that. My question is, how do you devise that framework so
that you have adequate liquidity to make it work and not too
much to over-stimulate so that others suffer? Does that not
necessitate putting in some kind of framework that limits the
lubrication, so to speak, to adequate and not excess?
Dr. Pirrong. First of all, I think we should be somewhat
clear about the use of liquidity, because it is frequently used
in different ways. For example, the central bank, the Federal
Reserve provides liquidity to the economy, and it is arguable
that over the last years that the Fed has been too liberal with
that and the Feds actually contributed to problems in the
economy, for example, the weakness in the dollar and so on.
Mr. Etheridge. It lost about 43 percent.
Dr. Pirrong. And that is sort of a different issue than
talking about liquidity when you are talking about a market.
And liquidity basically means how expensive is it to trade? If
I want to buy, am I really going to jack the price up? If I am
going to sell, am I really going to drive the price down? In
terms of a framework, I think we can rely on the market to
provide the right amount of liquidity. And what we need is a
framework that basically ensures that people do not do
economically inefficient things, most notably that they don't
manipulate the market by exercising market power. I think if
you have that sort of framework in place, that the market will
serve to allocate capital to provide the right amount of
liquidity, not too much, not too little, be just like Goldie
Locks and get it just right.
Mr. Etheridge. You are saying but without total
transparency, it is kind of hard to know that is happening?
Dr. Pirrong. Well, not necessarily. If what you mean by
total transparency, but in a sense that you can have a market
that is liquid and you can be confident that the market is
liquid, even if the regulator can't observe every nook and
cranny and position of what is going on in the marketplace. So
usually more transparency is better, but I wouldn't believe
that essentially having complete transparency would lead to
that much of a better operation in the market, and particularly
I don't think it would lead to better liquidity. In fact,
having too much transparency, and this goes back to a point
that was raised earlier by Mr. Zerzan, actually impairs
liquidity and make markets less liquid because again concerns
about front running and so on.
Mr. Etheridge. Thank you, Mr. Chairman. I always happen to
believe a little sunshine helps a lot of things. It has a way
of purifying a lot things. Thank you, and I yield back.
The Chairman. The gentleman from Louisiana, Mr. Boustany.
Mr. Boustany. Thank you, Mr. Chairman. I still believe that
the fundamental problem is a lack of supply and very tight
supply and demand coupled with a weak dollar and the absence of
a comprehensive energy policy for this country. I want to thank
my colleague from Kansas for pointing out the distinction
between excessive speculation and market manipulation because
market manipulation is really the culprit that we are concerned
about.
Another point I want to make is that in looking at the
Commodity Exchange Act, there is no definition of ``excessive
speculation.'' So I would ask Mr. Greenberger, does he have a
definition?
Mr. Greenberger. The definition of ``excessive
speculation'' in the Commodity Exchange Act, if you go to any
farmer who trades on an exchange, he will tell you that the way
it is defined is that every contract there is a speculation
limit. So that the exchange works out with the traders, how
much speculation do we need in this market to make the market
liquid. And in the ag market, they are hard and fast spec
limits. But even in the crude oil markets on Dr. Newsome's
exchange, NYMEX, there are accountability levels, position
limits. They have never defined it because it is like defining
some algorithm on a contract-by-contract basis. The way it is
worked out in the real world is the exchange, if it is
regulated, has a process where they limit the amount of
speculation through a speculation limit. It is different. There
are thousands of these contracts and there is a limit on every
different contract.
Mr. Boustany. It seems to me that those limits are set to
prevent default.
Mr. Greenberger. Well, I read to you from the Commodity
Exchange Act report in 1936.
Mr. Boustany. I have the definition here with regard to
``excessive speculation'' and ``limits on trading,'' and there
is no definition of ``excessive speculation.'' It just simply
says, ``Excessive speculation in any commodity under contracts
of sale of such commodity for future delivery made on or
subject to the rules of contract markets or derivatives
transaction execution facilities causing sudden or unreasonable
fluctuations or unwarranted changes in the price of such
commodity is an undue and unnecessary burden on interstate
commerce on some commodity.'' So it just lays out the need for
regulation, but it doesn't define it.
And I want to thank Dr. Pirrong for actually giving us
something to work with here because he makes the distinction
between the physical markets and the derivative markets and
says there is an empirical metric that we can use and that is
to look for distortions in inventories and supply. And I think
that was a very useful statement that you made to help us in
terms of trying to understand this and to set policy. I think
this is a useful metric.
Earlier, Mr. Greenberger, you mentioned the Saudi
announcement that they would produce 200,000 additional barrels
of oil per day. And yet we did not see a drop. We saw perhaps a
rise. And that would undermine your argument. We still have a
major supply problem. And 200,000 additional barrels of oil a
day is not going to take care of that. And I would suggest that
if they were making that--if you saw a lot of market
manipulation-type activities, we would have seen drops.
So again I think we really need to look at the inventories
and supply, as Dr. Pirrong mentioned, because we can't get our
hands around something that is tangible to understand what is
going on. We really haven't had any discussion here today about
the impact of the weak dollar. And just this week, the dollar
showed strengthening against the Yen and the Euro and we saw a
$5 drop in the price of crude oil. So I would ask each of you
maybe to comment on that and the impact of the weak dollar on
this problem. Mr. Zerzan.
Mr. Zerzan. Thank you, Congressman. I think you have aptly
stated the problem. The weak dollar has certainly contributed
to the rise in the price of oil for the U.S. consumer.
Mr. Boustany. Thank you. Anybody else want to comment on
that? Again, I would say if you look at the weak dollar,
coupled with the lack of a comprehensive energy policy and
tight supply and demand, I think you have to go beyond just the
actual physical commodity. We have a workforce shortage in the
oil and gas industry. The other commodities, such as steel, rig
materials and so forth, there are shortages there. I think
these are all factors that come into that calculation of the
paucity of supply that is creating this fundamental problem.
Mr. Greenberger. With regard to steel, you should know that
I understand the steel industry is taking the position that
there should be no steel futures contracts because it will
distort the price of steel. And also with regard to the Saudis,
I don't have the statistics in front of me. They may have said
200,000, but they had a program going all the way out for a
couple of years and I think it was a lot more than that. And I
must say everybody I knew and I myself was sure that the day
after they made that announcement there would be a drop.
Mr. Boustany. Mr. Vice, you were going to make a comment.
Mr. Vice. I was just going to add that if you look at the
full price curve that the futures markets are telling you, it
is not indicating a bubble, it is not indicating a short-term
bottleneck in supplies. It is $135 or $140 out through 7 or 8
years. It is sustained. I am not an economist or expert, but in
my view I agree completely with you. There are fundamental
factors here that short term, medium term, long term, the
marketplace is recognizing there has been a long, under-
investment in supply and the infrastructure to refine that
supply and get it to market. And it is my belief that this is
what that is reflecting.
Mr. Boustany. We have seen a decline in almost all
producing fields, whether you are talking about Venezuela,
Nigeria, Mexico and on. So I appreciate your comment. Thank
you. My time is up. I yield back.
Mr. Holden [presiding.] The gentleman from Georgia, Mr.
Marshall.
Mr. Marshall. Thank you, Mr. Chairman. Dr. Pirrong, I think
you can help us out a little bit. We have had a lot of
testimony and it is not just yesterday and today, but
previously, on the possible impact of pension, sovereign
wealth, you name it, money moving into commodities and taking
positions. Whether it is buying ETS, whether there is actually
an underlying commodity that is being purchased and held, or
whether it is an index fund or something like that. There are
those who say that the market, talking about oil, would proceed
apace, it would not be distorted by this phenomena at all. You
wouldn't see the distortions that you are suggesting. You would
have to see if there is some sort of market manipulation or
something else going on here, other than sort of normal day-to-
day process. But what would happen, some say, is that the
overall price goes up because so much money is in there that is
long. If the mechanism chosen to give a position in oil is in
essence a long position in the futures market, whether it is
OTC or it is the regulated markets, the effect of that is to
pull--since there is not as much money on the short side to
start out. With all this money coming in long because that is
the investment ploy that the money managers think is wise under
their circumstances, taking into account all things, including
their expectations concerning the future where commodities are
concerned with a globe that is becoming more and more
populated. The folks who are on the short side see this
phenomena and they are going to move up also. And the price
generally will move up as a result of that phenomenon.
Could you comment on that?
Dr. Pirrong. Yes. First of all, I want to draw this
distinction between the physical and the financial markets.
Even on a commodity like oil, there is a financial oil market
and there is a physical oil market. The concern expressed
earlier about the gentleman having to pay so much for his gas,
his fuel bill that he couldn't operate his business anymore,
that is really what is going on in the physical market. And if
you look at the connection between the physical and the
financial side of the business, most of the money, virtually
all of the money that is going in the financial side of the
business; they are price takers, they are not price makers. So,
for instance, the indexes, which we have heard a lot about,
they rule their positions as their contracts move towards
maturity. They are sellers, not buyers. Even if they are
originally long and they are going to sell their futures
positions as they----
Mr. Marshall. If I could interrupt. What we have been told
by some is that the strategy is one that ignores price and
says, ``We are going to be long indefinitely. We are passively
long. And the idea here is our strategy will be to roll every 3
months or 5 months and whatever the price is, we are just going
to stay on the long side.'' And it is a lot of money doing
that. That is what we have been told. And what I have a hard
time seeing is what impact, if any, that kind of strategy might
have on our markets. It is the only thing at this point that
seems really anomalous, and it is something that has occurred
in the last year or two and it has really increased
dramatically. At the same time we have seen these price
increases that we don't understand increase phenomenally. And,
frankly, when you talk to OPEC and Big Oil, they can't figure
out why the price is going so high.
Dr. Pirrong. First of all, OPEC sometimes has an incentive
to try to point the finger at somebody else. What is more, I
still think it is very important. If speculators, or index
funds, or passive long funds, if they were the ones that are
keeping the price high because they say, ``Hey, we are not
price sensitive, we are willing to outbid anybody else.'' If
they are having an impact on the physical market, they would
have to be the ones outbidding everybody else in the physical
market and they would have to be the ones that were holding the
oil. That still comes down to the key issue here. And again if
you just look at the mechanics, when oil becomes prompt or when
a corn contract moves towards expiration, this passive money is
selling the nearby, they might be rolling in and buying the
deferred, but their demand is not translating to the physical
market, which is essentially what determines the price that we
are going to pay at the pump or the grocery store.
Mr. Marshall. The participants in this market are quite
sophisticated and we are told there is just about virtually
nobody who didn't look to see what is going on in the futures
market in part as a means to determine what sort of price
should be offered on the spot market. And there wouldn't be any
distortions in the actual process, in the physical market, if
the participants generally were doing that sort of thing. And
we are told that they are doing that sort of thing. Do you
discount that possibility?
Dr. Pirrong. I don't think that these statements are
necessarily inconsistent. But at the end of a day as a contract
moves towards delivery, and that is what I essentially was
referring to when I was talking about my experience in
designing delivery mechanisms, when a contract moves towards
delivery, people have to say, ``Hey, here is the price of the
expiring futures, do I want that oil or not, do I want to be a
buyer or a seller.'' That oil price, that futures price is
going to accurately reflect the fundamentals in the
marketplace. So given that people are confident that with a
well operating unmanipulated delivery process that the price in
the futures market as a contract moves towards expiration
reflects fundamentals, they are going to be more than willing
to base their pricing decisions on what they see going on in
the futures market.
So I would actually say that that argues for essentially
the market's confidence that the futures prices are accurately
reflecting physical market fundamentals as opposed to a
situation where they believe that it is not reflecting physical
market fundamentals.
I will give you an example. Back in 1989, there was a
manipulation of the soybean market. People were wildly
concerned in May and July that the soybean futures price was no
longer representative of fundamental cash market conditions. So
what did major grain dealers like Cargill and others do, they
said, ``Hey we are not going to make our pricing decisions on
the basis of the May and July contracts anymore because we
believe that those are manipulated, that those do not reflect
fundamentals.'' The fact that market participants indeed still
rely on these futures markets to base their prices indicates
the high degree of confidence in the accuracy of these markets
in reflecting fundamentals.
Mr. Vice. Congressman, if I could add one point. I think
too, a lot of what I will call dumb, long, only passive
investment money coming into these markets, that is the kind of
situation that active traders look forward to, quite frankly,
because they are not trading in a dumb manner. They are
studying the fundamentals, short-term, long-term fundamentals,
and to have a counterparty on the other side of a trade who is
not doing that is a big advantage for them. So typically what
you will often see in the history of any prices as it moves
around and you have any kind of phenomenon that is causing that
type of investing, that is a profit opportunity for people that
are studying the fundamentals. I think what you are seeing is
those active, informed traders are looking at the fundamentals
and they are not seeing fundamentals that argue for lower
prices and they are not coming in in the same high volume. This
is my own opinion. I am not basing this off numbers I have
seen. But in the same manner they might if they thought this
was actually that this dumb money did just happen to be right
in this situation.
Mr. Marshall. Thank you, Mr. Chairman.
The Chairman [presiding.] Thank you, Mr. Marshall.
Mr. Conaway, I guess you are the last standing over on that
side.
Mr. Conaway. Thank you, Mr. Chairman. I appreciate our
panel being here today. I am no OPEC apologist. I grew up in
west Texas and I was trying to make a living when the price of
crude oil fell from whatever it was to $8 for sour crude and
$12 for sweet crude in 1999, 8 years ago. But as we continue to
bash OPEC, that bashing seems to be based on a premise that we
have some right to their oil, that we have some mechanism that
we can demand them to sell us stuff that is their property. And
at the same time, I would argue that the U.S. is probably the
single largest hoarder of crude oil and natural gas by the fact
that we have restricted access to our own supply. We refuse to
produce our own supply of crude oil and natural gas. And the
net hoarding on behalf of the United States is contributing to
the folks that Mr. Vice talks about who look at the actual
things that are going on.
Just a quick question. Does everybody make money in the oil
stuff?
Mr. Zerzan. No, Congressman. For every long, there has to
be a short.
Mr. Conaway. So folks are losing money in your world as
they take these risks or try to lay these risks off?
Mr. Vice. Trading is a zero sum game.
Mr. Conaway. There you go. And also some great history
lessons for Mr. Greenberger about the 1930s and the 1940s. I
suspect today's information that is available limits the kinds
of things that were going on with the locals that they were
doing in Chicago and it was a closed loop and those guys were
just hanging out in a small group. So I think today is
fundamentally a different day.
Mr. Greenberger. Mr. Conaway, could I respond to that,
please?
Mr. Conaway. I would like the record to reflect, Mr.
Greenberger, that you have spoken more today than any other
single person here.
Mr. Greenberger. I would disagree with that, but if----
Mr. Conaway. Thank you. It does not surprise me that you
disagree with it. I have a limited amount of time.
Mr. Greenberger. You referenced me and I would like to be
able to----
Mr. Conaway. You got your word in. Again, you have spoken
more today--you might ought to run for the Senate. I don't
think speculators are doing what is going on. I think there is
a supply issue and a demand issue. Because my producers will
sell every barrel they have at $140 a barrel. There is a
refinery out there that has got to buy that at $140, convert
that into product that he or she can sell across a wide
spectrum of uses and try to make money at that. If that can no
longer be done, then those refiners are going to quit buying
oil at $140 and somehow the physical market is going to drop, I
would suspect. How do I answer the folks who say it as if it is
a self-evident statement that speculators are causing this
problem? In fact, if you look at the supply issues over the
last 15 months versus demand issues, yes, demand is coming up
and supply is just holding its own. But, there is not a
dramatic reduction in supply that would double the price of
crude oil.
And one other comment I made. The Saudis say they are going
to increase production by 200,000 barrels a day. There is 86
million barrels produced every day. And I am not real good at
math. I am a CPA, but I am relatively good at math. That is not
much of an interest against 86 million. How do we answer the
folks who say, ``Supply and demand, yes, there is a tension
there but it is not a lot different than it was in January of
2007 when the price was much less than it is right now.''
Anybody.
Mr. Vice. I would say clearly the demand is very inelastic
there. We also, for example, host electric power markets in our
marketplaces. And given that power can't be stored and given
that everyone also feels they have a right to light and heat
and that demand is very inelastic, so you can see very small
imbalances in supply and demand, which actually you can't even
have in the power market. But to the extent you are at the
maximum capacity of what the system can provide, you can see
dramatic price changes there. I think that is probably the most
extreme example because it can't be stored.
Mr. Conaway. What about crude oil?
Mr. Vice. Same thing. Again, there are not a lot of
alternatives. If you have to drive to your workplace, that is
what you have to do. You don't have a lot of choices right now
in terms of alternative technology, alternative transportation,
and it is going to take some time before these price signals
are perceived as being semi-permanent and there is real
behavior change in terms of demand.
Mr. Conaway. Thank you, Mr. Chairman. I yield back.
Mr. Vice. It is not an answer anyone wants to hear.
Mr. Conaway. Let the record reflect I yielded back on time,
please.
The Chairman. We appreciate it, Mr. Conaway. The gentlelady
from Kansas.
Mrs. Boyda. Thank you very much, Mr. Chairman. And I have
so many questions. If we could go real fast. I really am trying
to figure out which this is on. So, clearly we need to increase
supply. I don't think anybody disagrees with that, the supply
of oil, the supply of alternate fuel, supply, and supply in
general. So let me state that as a given.
But it is interesting, why, do you think, when we were just
talking with Mr. Conaway, 100,000 barrels when Nigeria is
having trouble. What happened that day? And yet, 100,000
barrels the other way, 100,000 barrels is 100,000 barrels. We
did the SPRO. So clearly there is some psychological stuff that
is going on. It may not actually be manipulation. Let me just
state that.
In January of 2008, $450 million a week was going into the
oil speculation, and in March of 2008, $3.4 billion was going
in a week. I got a briefing from CRS last week. I am trying to
get this all figured out. What did we see happen when that much
speculation went into the market in that short amount of time?
Does anybody know? Basically we saw a tenfold increase in the
amount of dollars going into the market. Do we have an idea of
what happened with the price in that period? If somebody could
get it for me for the record, I would appreciate it.
Mr. Greenberger. I can say the price has gone up very, very
substantially. I will supply something for the record, but my
memory is that in the last year, the price has gone up,
something like 100 percent.
Ms. Boyda. In 3 months, according to CRS data, we saw
tenfold, nine-fold, let's round up to tenfold increase in
dollars just going into that marketplace. And if anybody would
like to just give me what you think are those, what you think
it is if it should have gone up more, if it was speculation, if
it did go up or whatever I would appreciate knowing that. If
this is manipulation, and excess speculation, whatever words
that we want to use, and I understand those are hard. If it
were not market driven, does that mean there is a bubble, and
if so, when would we expect to see it burst? I mean, how much
longer does this go on.
Mr. Greenberger. Many people, Congresswoman, have said that
it is a bubble. This is, of course, the debate. And that the
bubble will burst. Many people say the bubble will burst when
people like Mr. Etheridge's trucking company finally doesn't
get another loan from the bank and Weyerhauser doesn't extend
more credit. And these companies will, as you are going to hear
from the airline companies, they will go down. Boeing will go
down with them because they won't be buying planes. There will
be a serious economic dysfunction and the bubble will burst.
And the question I pose is, do you want to wait for that to
snap? Or do you want to go back to the way we had done before?
Ms. Boyda. So in your estimation, if this is speculation,
you think it could go on, there won't be anything that will
show it for speculation until we see some kind of real
correction in the entire economy.
Mr. Greenberger. I hope I am wrong about that. And I only
know what I read. But a lot of people, I am not saying
everyone, says that it will, this bubble will only burst when
we go through a very serious recession.
Ms. Boyda. Okay. Thank you. Mr. Comstock, would you just
summarize for me what do you think we ought to do? Just, I know
we need to increase supply. We all agree on that. What else do
we ought to do? Should we do?
Mr. Comstock. Boy, that is a----
Ms. Boyda. And you have 1 minute and 21 seconds. Actually,
I would rather that you not even use all of that.
Mr. Comstock. I appreciate that. I think APGA'sposition is
an increase in transparency. We need to see what is going on.
Ms. Boyda. What does that mean specifically?
Mr. Comstock. To understand what is going on in the
markets, to see how the trades fluctuate, where the information
is. I think the Chairman hit it early on in his statement, to
find what is happening out there. And I am not sure we have
that information.
Ms. Boyda. So when Mr. Greenberger is talking about, the
longs are transparent but shorts aren't, do you agree with that
statement?
Mr. Comstock. No, not necessarily, I do not. I am not sure
that we have----
Ms. Boyda. What would you like to make transparent?
Mr. Comstock. The overall market itself. I am not sure that
we have enough information in front of us to understand exactly
how the overall process happens. And that is what we are
looking at. I am not sure what total transparency means. I
heard that earlier. We don't have a good definition of what
total transparency means. When we get that maybe we will know
what we have in terms of that definition, but at this point, I
am not sure we have moved far enough in the idea of
understanding what is going on to know that we are transparent
enough to understand the process and the market.
Ms. Boyda. I think we all agree, transparency is good.
Supply is good. I am just trying to get my hands around what
transparency, what specifically, what transparency we are
looking for. I do believe that we can do harm when we try to
insert ourselves too much into this market. So this is very
difficult, and I appreciate each one of your being here today.
The Chairman. I thank the gentlelady. The gentleman from
Michigan, do you have questions?
Mr. Walberg. Thank you, Mr. Chairman. I apologize for being
late, but I was interested in hearing some of the responses
thus far. And I just, in fact, in a meeting I just came from,
some information was provided to me that I think I would like
to ask the panel to respond to. I think we all agree that
supply is necessary. And when we have seen in the United
States, consumption decrease, and yet the costs continue to
rise, of course, that says to us that if we are unwilling to
compete, unwilling to produce, unwilling to increase our
supply, that has impact.
But the issue of subsidies, and I don't know if that has
been brought up yet today. But I would like some comment or
response on it when I see, according to this report here, that
total demand in subsidized regions of the world has increased
from 28 million barrels per day, that is a 37 percent of global
demand in 2000, to an estimated 36 million barrels per day or
42 percent of global demand in 2008. It seems like when you
have that type of subsidized energy, that that is going to have
a direct impact on the United States if we are unwilling to
compete by being unwilling to produce more and develop a
greater supply. I look at a report here that says that China,
for instance, well, let's go from the bottom up. India, whose
demand continues to expand geometrically, is at a total
subsidized demand growth of ten percent. Latin America is at 19
percent of total subsidized demand growth; the Middle East, 29
percent; and they are paying what, a $1.25 a gallon, 29 percent
total subsidized demand growth. And China, at 36 percent, even
though they have reduced a bit of their subsidy right now
because they can't afford it, but nonetheless reduced, they are
still at 36 percent of total subsidized demand growth. Again,
with us, unwilling to increase supply, unwilling to compete,
and we have countries we are competing with, who are
subsidizing huge proportions right now, what does that say to
us? Jump on in.
Dr. Pirrong. If I might, sir, I think that is a very
important issue and that is actually one that I have sort of
been blogging about for the last year. And it also relates to
the issue of Mr. Conaway's question, why do seemingly small
price disruptions have such big price impacts? The consumers in
those countries that you are speaking about, they don't see
price signals. So when the world price goes up, their price
doesn't go up, so they don't cut back on their consumption.
What that means is that demand is going to be very insensitive
in those countries to price changes, and that actually can
exaggerate, and exacerbate volatility in the marketplace.
So that is a very important issue. Also, if you look at
these countries, oil exports have been flat or declining in a
lot of these countries because of just what you discussed,
which is they are subsidizing their consumption. So we have
this phenomena where the exporting countries are consuming more
and more of their own oil and probably in a very wasteful way.
So I think it is a very important feature in the market, and it
is contributing to the high and volatile prices that we are
seeing.
Mr. Walberg. I see my time is up. Thank you, Mr. Chairman.
The Chairman. I thank the gentleman. The gentleman from
Wisconsin.
Mr. Kagen. Thank you, Mr. Chairman, for holding these
hearings, which are critically necessary to better inform
Congress in terms of which way to go. But let's not forget why
we are here. This energy crisis that we are in today is
something that was totally predictable. It was predictable
since 1973. We are also here today because government has
failed. Our government has failed to come up with a meaningful
and successful national energy policy to make us an independent
nation, once again, as we once were in days gone by. So we are
here because the failure of government and it is the failure of
leadership of the current Administration to put together an
energy policy that is anything other than drill and burn and
drill and burn.
So I thank you for being here today to testify. But I want
to lay the predicate. Last week I had the honor of listening to
the people I represent in northeast Wisconsin, which is largely
a rural district. We live in our cars. A farm family, a mother
of several children, told me that one out of four of her
paychecks goes directly to gas just to get to work off the
farm.
A cook who has several jobs has a part time job just to get
the money to pay for his gasoline to get to his full-time job.
And a waitress who is getting paid $2.43 an hour plus whatever
tips come in is telling me that she has a difficult time
raising her children and paying for her gas bill at the same
time as her food and her mortgage bill. This is a very real
crisis and it is something that we have to take very seriously.
And I am very interested in hearing your answers to just a few
questions.
First of all, I have to comment, Dr. Pirrong, I strongly
disagree with you. You are the only one I know that thinks we
have an open and free oil marketplace when you have people in
OPEC controlling supply and determining price. So I strongly
disagree with you. But Mr. Zerzan, I have a question for you
about whether or not you believe position limits for hedge
funds, for swap dealers and institutional investors would be a
good thing for the people I represent in northeast Wisconsin.
Mr. Zerzan. Thank you, Congressman. Position limits are
routinely imposed on traders. The provisions that are being
proposed, however, in the law, currently, would remove the
hedge exemption that swap dealers are currently able to avail
themselves of. What that ultimately would mean would mean that
the swap dealers counterparties, be they producers or be they
commercial entities, wouldn't be able to obtain protection from
swap dealers. They would be subject to the risk of rising
prices and the inability to pass on that risk to swap dealers.
Mr. Kagen. Let me just ask it differently. What would be
the effect to Mike, who is a cook in Marinette and to some farm
families I represent and people in Green Bay if limitations
were applied to your industry on these people?
Mr. Zerzan. Ultimately the effect of not being able to pass
on risk to swap dealers means you pass on risk to consumers. So
prices go up for the people that need to purchase these items
instead of those risks being passed on to people who are better
able to manage them.
Mr. Kagen. In your view, what do you think the appropriate
punishment should be for anyone who is caught cheating? Several
days ago here in this room, one of the Commissioners of the
CFTC said they caught 40 cheaters, law breakers, and they were
fined $40 million overall in the last 5 years. What sort of
jail time would you recommend for someone who violates the law?
Mr. Zerzan. Well, Congressman, the market participants that
ISDA represents are among the strongest believers that people
that try to cheat or try to game the system need to be punished
and need to be punished severely.
Mr. Kagen. As far as you are aware, has anybody gone to
jail for robbing and stealing us blind with these high oil
prices?
Mr. Zerzan. Well, Congressman, I am not sure I know how to
answer that question.
Mr. Kagen. It is sort of a yes or no. Are you aware of
anybody that has gone to jail for violating these rules?
Mr. Zerzan. I don't personally know anyone who has gone to
jail, no.
Mr. Kagen. All right. What do you think the effect would be
of Mr. Larson's bill about limiting OTC transactions to those
who are capable of taking possession?
Mr. Zerzan. I think that would remove a substantial amount
of the liquidity from the market and mean that people couldn't
hedge their risk.
Mr. Kagen. So you think that would punish the consumer?
Mr. Zerzan. I think that would ultimately result in prices
being passed on to consumers.
Mr. Kagen. Would you agree with me that part of the problem
that we have here is a speculative bubble simply because the
ability of people to pay these impossible prices has been
exceeded, at least in my district? And I had a meeting with
people that distribute oil to over 1,500 gas stations. I have
met with mass transit officials, school district operators,
mayors and county executives. Everybody I am listening to says
that we can't afford these high energy costs; they are busting
our budgets. So wouldn't you agree there is a speculative
bubble involved here?
Mr. Zerzan. Well, Congressman, I would agree that prices
are rising to levels that are hurting American consumers. But
the separate question is whether or not limiting the ability to
pass on these risks through derivatives would actually help or
hurt consumers, and ultimately it would hurt consumers.
Mr. Kagen. Interesting. Mr. Vice, do you have an opinion on
that?
Mr. Vice. I guess I would generally add that, as someone
said before, a market exists to transfer risk, particularly
futures markets and largely the OTC market, not to procure a
given commodity, but rather to people that want to get rid of
price risk give it up to someone who wants to take on that
price risk. I think speculators, whether they are swap dealers
or other types of participants that are willing to that risk on
are a critical and necessary part of a market. I would also add
that, in general, the more liquidity the better. The more
liquid a market is, the more broad the participation, the less
likely it is for anyone to manipulate that market.
Mr. Kagen. Well, Congress has already passed two pieces of
legislation to try and attempt to do this. In fact, three of
them. But in particular, the farm bill helped to close part of
the Enron loophole, but it didn't do anything about the swaps.
Do you think that swap loophole with regard to dealers and
institutional investors has to be closed? Has to be addressed?
Mr. Vice. My view is that the----
Mr. Kagen. Another way of saying it is, was the farm bill
sufficient to mollify the marketplace?
Mr. Vice. Well, I don't know if it is going to mollify the
marketplace. It starts with the premise that there is an answer
in more regulation, and I don't think that is the case. But
ignoring that, to the extent you want to, ``close the Enron
loophole,'' I think the farm bill does that in a very well
structured manner. It recognizes that the OTC market is a very
diverse marketplace in terms of some contracts that trade
electronically and they have sort of a price discovery
function, and they should be, or it is appropriate to regulate
them like a future, which is what the farm bill does.
It also recognizes that there is a tail, a relatively small
part of the OTC market that consists of hundreds, even
thousands of different contracts that, in many cases, are
traded by only a handful of participants in different parts of
the world. They serve no price discovery function, and it would
literally be impossible for ourselves or anyone else to apply
exchange-like surveillance principles to such an illiquid
market.
Mr. Kagen. Mr. Chairman, if I could just ask another
question. Mr. Etheridge has another bill, H.R. 6334, and this
would seek to increase the ability of the CFTC to do its job.
Do you have any opinions with regard to his bill?
Mr. Vice. We definitely support additional funding and
additional staff for the CFTC. There is no question that is
needed. And I would also say that we fully support transparency
in any way, both in our OTC marketplaces and our regulated
futures marketplaces around the world. We have shared data
whenever asked or required to. We have not opposed and would
support, to the extent more transparency is required of us as a
marketplace, we are happy to provide that. And as someone said,
``Sunshine never hurt anything.''
Mr. Kagen. And I would just finally ask all of you if you
wouldn't agree that it would be a good idea for this Congress
and this President to come up with a meaningful energy policy.
In my view, much of the run up in the price here has to do with
people betting against the house, betting against the ability
of government to come up with a meaningful plan to begin to
move us away from fossil fuels and away from being dependent
upon foreign sources of energy. So if we did come up with this
meaningful plan that drove us towards energy independence,
wouldn't you agree that the price for OPEC's oil might go down?
Mr. Zerzan. Certainly reducing the pressures on supply and
developing an alternative source of supply would be a
meaningful step.
Mr. Kagen. And finally, wouldn't you agree that to whatever
extent we could argue about the percentage, but the declining
value, the declining purchasing power of the United States
dollar applies to this situation? The oil hasn't changed in
millions of years, but the dollar in your pocket certainly has.
It doesn't buy as much oil as it did before. Some have
estimated that 40 to 50 percent in the run up in the price of
oil is due to the declining value of the dollar. Would you
agree with that?
Mr. Vice. Yes.
The Chairman. I thank the gentleman very much. The
gentleman from California.
Mr. Cardoza. Thank you, Mr. Chairman. Mr. Zerzan, your
written testimony questions a need and wisdom for greater
disclosure of index traded traders and swaps dealers, mainly
because of concern that the market functions better as I
believe you said in anonymity. However, aren't traders on the
regulated market, i.e., the non-OTC markets, subjected to a
higher level of scrutiny than your members currently are? In
fact, the swaps dealers already have a front run on the market
participants.
Mr. Zerzan. Thank you, Congressman. The paragraph you refer
to in my written statement regards proposals which would break
out the positions on regulating future exchanges of swap
dealers and index traders. And the point of our concern is that
anything which would allow someone to see the trading
strategies of any individual market participant would put that
market participant at a disadvantage, and would also provide
opportunities for trading ahead or front running.
So the point of that concern is really that on-exchange
trading, to the extent that their proposals to increase
reporting of swap dealers or index traders, it should be very
carefully crafted so as to not allow any individual firm to be
disadvantaged.
Mr. Cardoza. I have been to all the exchanges, and I have
seen open outcry trading where everything is very transparent.
You don't know exactly, but you have a good idea who is making
bids and you can have an idea if someone is making plays.
Everybody shares the same information at the same time in those
kinds of markets. I support that. That is sort of a democratic
way of doing the free market. What I don't like is when people
behind the scenes have hidden advantages. And I think that is
what we are sort of talking about. Later today, Dr. Newsome, in
his testimony, supports the idea of restricting swaps dealers
from obtaining hedge exemptions for position limits if they are
conducting OTC transactions involving noncommercial
participants. Would your organization support such a change?
Mr. Zerzan. We would not support such a change. And I think
that that would actually tend to impair liquidity in the
markets and impair the ability of participants to transfer
risk.
Mr. Cardoza. Mr. Zerzan, this goes back to my earlier
question. I believe there is a legitimate place in the market
for swaps. And I am certainly not advocating restructuring the
entire OTC market. However, it is really difficult for me to
understand why your members can't bring themselves to this more
transparent place in the market.
Mr. Zerzan. Well the CFTC, in October 2007, addressed this
point, and said, ``Staff experience in surveillance of these
markets does not suggest that the OTC bilateral or voice broker
energy markets exhibits significant price discovery
attributes.'' Thus, the direct impact on other parties and
markets is limited.
Mr. Cardoza. Mr. Zerzan, that was 2007. We didn't have $4
gas in 2007. Now CFTC is saying they need 100 people to
regulate that market. You are talking about history when it
wasn't happening.
Mr. Zerzan. Well, Congressman, I think that prices were
rising through 2007 and the point is----
Mr. Cardoza. They weren't exploding like they are in 2008.
I guarantee you that. You talk to my constituents and they are
darn upset about what is happening in 2008.
Mr. Greenberger, I can't, as a University of Maryland
graduate, go without letting you comment on the last thing very
briefly because I have one more question I have to get to. Do
you have an opinion on what you just heard?
Mr. Greenberger. Can you just refresh my recollection of
what I just heard?
Mr. Cardoza. Well, the question was, does the swaps market
and the folks that Mr. Zerzan represents, do they get a hidden
advantage by being able to go first or to be able to hide their
maneuvers in the swaps market?
Mr. Greenberger. I think that the, there is a hidden
advantage, but the most important hidden advantage is that
nobody knows what is going on. That was not the way the
Commodity Exchange Act was set up. Everybody is guessing what
goes on on the bilateral or OTC market. Is it helping? Is it
hurting? And the easiest way to answer that question is for
transparency. Now, I am not saying transparency where
competitors can see what they are doing. But as you pointed
out, in the NYMEX or Chicago Board of Trade, large trader data
reporting goes to the exchange every day. And that is not only
useful to see whether there is excessive speculation. We are
all here saying excessive speculation is different than
manipulation, and I agree with that. And I believe we see
excessive speculation. But we can't tell whether there is
manipulation. I will tell you on the exchanges, the traders are
watched by their surveillance systems, that they not engage in
phony or fraudulent trading. We don't know what is going on. I
am not saying it is happening. But we don't know. And all I am
saying is let's find out. If everything is fine, terrific. But
let's get the information we need.
Mr. Cardoza. Mr. Vice, do you have an internal monitoring
system to avoid skirting around your position limits or other
requirements that you have on your exchange?
Mr. Vice. Let's clarify which market we are talking about.
Well, let me ask you, are you referring to our over-the-counter
market?
Mr. Cardoza. What stops traders from registering under
different names in your market? On all of the exchanges, or all
the different products that you trade?
Mr. Vice. Well, okay. We have a U.S. exchange which is just
ICE Futures, U.S. It doesn't trade energy. It trades
agricultural products and financial products. It is regulated
just like NYMEX, CME, has the same core principles it has to
enforce. We also have an over-the-counter market, OTC energy
over-the-counter market which is one of the requirements under
that regime is it is a principals-only market and it has, and
it is professionals only. It has high net worth, high asset
requirements, so it is essentially investment banks, funds,
companies like Mr. Comstock's or gas companies, power
companies, utilities, oil companies, they can trade
bilaterally, where they are taking each other's credit. You can
do that electronically, just as you can do it through a voice
broker. So clearly, they are establishing their credit with
each other outside of the service we provide them. They can
also trade that in a cleared manner where they give it up to a
clearing house.
We enforce the requirements of that marketplace as the CFTC
and the CFMA has required us to do. Requirements have been
enhanced as time goes on, ultimately in the farm bill where we
are in the process now of building these systems and the
processes to do the large trader reporting, Commitment of
Traders reports, position limit administration for contracts
that are deemed significant price discovery contracts.
I hope that answers your question.
Mr. Cardoza. Well, sort of, but I am going to ask it in a
different way or follow up in a different path here.
Following up on your testimony, you said, basically ICE
will fall under some new regulations that we imposed in the
farm bill. And I believe in your testimony you said that some
of these regulations will occur if and only if the CFTC decides
an ICE contract serves significant price discovery function,
and you will have a self regulatory requirement. However, a
number of those requirements seem to be in common sense
practices that should and could be implemented now, without
CFTC mandate, such as monitoring trading activity to prevent
market manipulation. You could adopt position limits, you could
minimize conflicts of interest. So my question to you is why
wait? Why wait for CFTC to mandate it? Why don't you just do it
now?
Mr. Vice. Well, we are not waiting. We are doing it now.
Those are substantial processes and systems to put in place. We
are working on that now. Our goal is to put that in place as
soon as possible. I think the Act had 180 days or 270 days. I
don't even know. We are hopeful to have it in place much sooner
than that. But it does take time to do.
Mr. Cardoza. You can't give us, the Committee, an estimate
today about when you are going to have those?
Mr. Vice. I can only tell you we are having to do something
similarly for our European futures exchange, which, through a
different no action process, now has similar requirements.
There is a shorter time frame on that of 120 days, so
eventually we are moving those projects along in tandem, and
our hope is to have both of them in place by that time frame.
Mr. Cardoza. Well, as usual, Mr. Chairman, I have several
more questions, but no more time. So I will turn it back over
to you.
The Chairman. I thank the gentleman. The gentleman from
Minnesota.
Mr. Walz. Thank you, Mr. Chairman. And thank you all for
coming here today. And Mr. Zerzan, I am going to ask you a
question. I know I am not piling on here. You are getting a lot
of questions. And I think it is clear, and I appreciate Mr.
Greenberger's point on speculation versus manipulation being
very clear on this. Everyone up here is representing about
700,000 constituents for whom this is a major concern of
theirs. We are trying to get to the heart of what this is, what
the situation is, understanding that we need to have the fossil
fuels, we need to understand the market needs to function and
all of that. But there are some questions of if it is
functioning correctly? So Mr. Zerzan, you have stated, and I
read your testimony and heard you just shortly here, market
forces supply and demand, not derivatives which are causing the
commodity prices. My job is to weigh different sides of this.
So here are a couple of quotes. One that said, ``We are in
a mode where the fundamentals of supply and demand really don't
drive the price.'' That was Lee Raymond at ExxonMobil. In
December, somebody said, ``The market is not controlled by
supply and demand; it is totally controlled by speculators who
consider oil as a financial asset.'' That was the Secretary
General of OPEC. How do you respond to them, and how do I
respond to constituents that when they are hearing some Members
of this body give them simplistic solutions that are going to
get us out of that? I am not looking for a simplistic solution.
I want to know what the role is. So how do you respond to that
when you hear this?
Mr. Zerzan. Well, Congressman, I read a report recently
that had the clearest answer that I can think of, and it was a
chart and it showed that the global daily demand for oil is
about 87\1/2\ million barrels. And the global supply of oil is
86 million barrels. So until you see a point where supply and
demand are in convergence, you are going to see increasing
prices for oil, and there is simply no other way around it.
Mr. Walz. And you think that the talk on speculation, I
just received, as a member of the frequent flier miles at
Northwest Airlines just sent out a letter to all of their
customers, it says, ``Since high oil prices are partly a
response to normal market forces, the nation needs to focus on
increased energy supply.''
However, there is another side to this story because normal
market forces are being dangerously amplified by poorly
regulated market speculation. How do you respond to Northwest
Airlines on that then.
Mr. Zerzan. You know, there were a series of articles that
have come out lately talking about Southwest Airlines, and how
Southwest Airlines has been able to hedge the price of fuel
going up by entering into over-the-counter derivatives, how
they have gained price protection, and thus been able to keep
their prices low. So when airlines send out notices like that,
and several airlines have, I would simply say you probably
should have gotten a swap agreement.
Mr. Walz. What is the main role of the commodity markets?
What are they supposed to do, in your opinion?
Mr. Zerzan. Commodity markets primarily serve the purpose
of informing market participants about prices.
Mr. Walz. But now we have this entire class of hundreds of
billions of dollars, pension funds, index funds, endowments and
all of that, as a ways to bump up returns. And I am hearing you
say that there is nothing involved in this. Just a few short
years ago, $13 billion in this, now a new $260 billion headed
maybe for a trillion. You don't think that change is going to
have any impact on price at all; that capital?
Mr. Zerzan. No. And frankly, there is a very simply way to
illustrate this. If Mr. Vice and I decide that we are going to
enter into an agreement whereby I am going to pay him $10
tomorrow and he is going to pay me the price of an umbrella
tomorrow, the price of that contract is going to be determined
based on whether or not it rains. If it rains tomorrow
umbrellas are going to be $11 and he is going to owe me a buck.
If it doesn't rain, I am going to owe him a buck because
umbrellas are going to be $9, and we could go a billion of
these contracts. But at the end of the day the price of the
umbrella is determined by whether or not it rains. Commodity
prices are determined by supply and demand. Derivatives allow
you to manage that risk but they don't determine the price.
Mr. Walz. So Exxon, my constituents, Northwest Airlines,
everybody is wrong but the commodity traders.
Mr. Zerzan. No, the commodity markets represent the price
at which someone is willing to sell something and the price at
which somebody is willing to buy something. And frankly, we
have not found a better method for figuring out what a price is
than that. So people can decry the prices that they come up
with. No one likes paying $5 for a gallon of gas. But at the
end of the day, it is not the markets that caused that.
Mr. Walz. Okay. I yield back, Mr. Chairman.
The Chairman. The gentleman from Texas.
Mr. Lampson. Thank you, Mr. Chairman. And thank you for
your indulgence and in allowing me to chair my own hearing
going on in another building a few minutes ago. And I was
unable to listen to the testimony, but I certainly appreciate
you all being here, and what I am hearing I wish that I had
heard more along the day. I will keep mine fairly simple and
pretty quick, Mr. Chairman.
Mr. Greenberger, recently on National Public Radio, you
said that there was one act of deregulation most to blame for
the problems caused by financial derivatives, more to blame
than the 1999 repeal of the Glass-Steagall Act is the Commodity
Futures Modernization Act of 2000 introduced by then Senator
Phil Gramm of Texas as a rider on to an 11,000 page omnibus
bill that passed Congress just before it adjourned for
Christmas in 2000. Who would you say, except for the drafters
of this bill, or that bill, understood what this legislation
did? And second, what effect would you say this bill had in
contributing to the current financial crisis around the
country?
Mr. Greenberger. It is my own belief that not many people
understood what the impact of that bill was. There were
endorsements of various parts of it. We are worried today if we
re-regulate there will be unintended consequences. I would say
the unintended consequences of that bill were enormous.
Chairman Peterson disagreed with me earlier, but my assessment
was, as a regulator, that before that bill passed, all energy
futures, including the bilaterals that Mr. Zerzan is now
talking about, if they are standardized, if they are
standardized, and by the way, the International Swaps and
Derivatives Association was the foremost proponent. They
understood what that bill did, that they had to be traded on
futures exchanges.
Now, if they were on futures exchanges we wouldn't be
guessing is there speculation here, and who is doing what.
There would be large trader data reporting coming to the CFTC.
There would be spec limits that Dr. Newsome would be applying
from his exchange. Those markets were functioning fine on
December 20, 2000. We weren't holding hearings about whether
there was excessive speculation. They allowed Mr. Vice's
exchange to get started in some respects, for example, natural
gas, to trade out of sight of the regulators. They allowed
Enron, who was the proponent of it, to establish Enron On-Line,
which has now been demonstrated through enforcement actions to
have driven up the electricity costs on the West Coast by
substantial numbers.
They allowed Amaranth, a hedge fund, to have its way, not a
big hedge fund, but a hedge fund to drive up natural gas prices
for 2 years until it got caught out. I believe because we don't
know what is happening in the bilateral market, we don't know
what is happening in the swaps market, we don't know what is
happening on a lot of ICE's going on. We, my only suspicion is
that things are not going on there that are helpful. Why do I
suspect that? Because I oversaw regulated markets for 2 years.
And even on regulated markets, it is like the wild west if you
don't police them. My fear is that when you take these markets,
which this Act did, out of transparency, things that are not
good for your constituents, Minnesota constituents or the
airlines are happening, and we are spinning out of control.
Now, just my final point, and I am bearing in mind, Mr.
Conaway's concern about my talking too much. My final point, is
it deregulated the financial swaps market. When you go and look
at the subprime meltdown, you will find credit default swaps
were at the heart of that meltdown. And why is that? The
mortgage lenders, the banks said to people who said, ``Oh my
gosh, you want us to buy a security in whether people who can
afford to pay their mortgages are going to pay them? That
doesn't make sense to us.'' And they said, ``Not to worry. We
are going to engage in a little swap here. You give us a
premium and we will guarantee that you don't lose money.''
Well, the problem is, classically shown by Bear Stearns, the
swaps dealer who was making the guarantee didn't have the money
to pay off the guarantee. They thought housing prices would
always go up. And when they went down there was no capital
reserves. We are now holding $29 billion of those Bear Stearns
obligations.
Mr. Lampson. Who understood that?
Mr. Greenberger. I would say there weren't enough people
who understood what was going on there. I think at the time I
did. I think at the time the International Swaps and
Derivatives Association did. We were promised, Senator Gramm
said when he introduced that thing, this would be a boon to the
national economy, and here we are today.
Mr. Lampson. Thank you, Mr. Greenberger. Thank you, Mr.
Chairman.
The Chairman. I thank you all. We just had votes called and
we have been sitting here a long time. We thank the panel for
coming in and sharing their time and expertise with us. We will
recess the Committee and go over and do these votes. Hopefully
you can grab a little lunch during the process. And we will
have the second panel start immediately after the series of
votes ends. The Committee is in recess.
[Recess.]
The Chairman. The Committee will come back to order. Do we
have the witnesses? They are all here, are they? I would like
to welcome the witnesses to the table.
This panel is going to examine pension funds and index
funds, issues surrounding those areas. First of all, we have
Ms. Robin Diamonte, Chief Investment Officer at the United
Technologies Corporation on behalf of the Committee on
Investment of Employee Benefit Assets; Dr. Scott Irwin,
Professor of Department of Agriculture and Consumer Economics
at the University of Illinois; Mr. Paul Cicio, President of the
Industrial Energy Consumers of America. Mr. Jeffrey Korzenik--
--
Mr. Korzenik. Korzenik.
The Chairman. I am a Norwegian. I can't say that.
Mr. Korzenik. Wait until you get to the name of my firm,
sir.
The Chairman.--Chief Investment Officer of VC&C Capital
Advisers. And Dr. Craig Pirrong, who was on the panel previous.
We would tell you that your full statements will be made part
of the record. We would ask you to summarize and talk in layman
language that we can understand as best you can. And we will
have 5 minutes available for each of you. And Dr. Pirrong, you
already gave your statement. We will just have four statements
and then we will get to questions.
Ms. Diamonte, you are on.
STATEMENT OF ROBIN L. DIAMONTE, CHAIRMAN,
SUBCOMMITTEE ON DEFINED BENEFITS, COMMITTEE ON THE INVESTMENT
OF EMPLOYEE BENEFIT ASSETS; CHIEF INVESTMENT OFFICER, UNITED
TECHNOLOGIES
CORPORATION, HARTFORD, CT
Ms. Diamonte. Good afternoon, Mr. Chairman, Ranking Member
Goodlatte, and others of the Committee. My name is Robin
Diamonte, and I chair the Defined Benefits Subcommittee of
CIEBA. Thank you for allowing us to testify on this very
important subject. The Committee of Investment of Employee
Benefit Assets, CIEBA, is the voice of the Association for
Financial Professionals on employee benefit plan asset
management and investment issues.
As the chief investment officers for most of the country's
largest pension funds, CIEBA members manage more than $1.5
trillion of defined benefit and defined contribution plan
assets on behalf of 17 million plan participants and
beneficiaries nationwide. According to the Federal Reserve
data, the $966 billion managed by CIEBA members in defined
benefit plans represents half of all the private defined
benefit plan assets.
The pension system has served millions of Americans for
over half a century. We owe it to the working Americans and
their families to ensure that any contemplated policy changes,
no matter how well intentioned, do not undermine the retirement
security.
The record prices for food and energy in the U.S. and
abroad are of great concern to all of us. We are sensitive to
the need to investigate this critical problem. Nonetheless, we
are deeply concerned about the prospect of any legislation that
would bar pension plans from investing in certain types of
assets.
Congress has long recognized the direct government
regulation of pension plan investments is ill-conceived. ERISA,
the primary law that regulates the investment of pension
assets, takes a very different approach. Rather than requiring
or prohibiting specific investments, ERISA imposes rigorous
fiduciary responsibilities on the persons that manage pension
plan assets. These rules require a plan fiduciary to act
prudently and to diversify planned investments so as to
minimize the risk of large losses. In addition, ERISA requires
that as a fiduciary, they act solely in the interest of plan
participants and beneficiaries.
Today, private pension plans invest in a wide range of
different asset classes. Plan fiduciaries use a variety of
investment techniques and tools, including derivative
instruments, to mitigate risk and enhance returns.
Other countries have taken different approaches to
investments of pension assets. Some U.S. public plans and
European defined benefit plans have had rigid investment
guidelines prohibiting certain types of investments and
requiring others. Many of these rules have now been discarded
because of the negative impacts such guidelines have on
investment returns and thus on employees' retirement income.
Put simply, mechanical approaches do not work as well as
the American approach of an investment flexibility paired with
strict fiduciary obligations. It is critical that pension plans
have the ability to invest in accordance with modern portfolio
theory and pursue the best investment strategy available.
The investment marketplace is constantly changing and plans
need to be able to adapt and evolve accordingly. Our concern is
both with specific restrictions on pension plan investments and
commodities and with the precedent that that action will set
for allowing the government to intrude on pension investment
decisions.
Today, commodity investments are not a significant part of
most private sector plan portfolios. Preliminary results
received through a 2007 profile survey show that plans have
less than one percent of assets invested directly in
commodities and natural resources combined. We firmly believe
that commodities may be a part of a prudent, well diversified
investment portfolio by providing a hedge against inflation and
minimizing volatility, but our primary concern is with the
principle that the government should not micro-manage pension
plan investments.
Political temptation to intervene in pension investments is
not unprecedented. However, Congress has consistently rejected
legislation that would subjugate the retirement security of
millions of Americans and their families to other social or
political concerns, no matter how worthy. In fact, when asked
about economically targeted investments, the Department of
Labor interpretation said, ``That a fiduciary must not
subordinate the interest of participants and beneficiaries to
unrelated objectives.''
Regulating pension investments would make it difficult for
plans to adequately diversify investments to hedge against
market volatility and inflation and consequently would put at
risk the retirement funds of the very workers the proposal is
intended to help. In effect, such a proposal could be a case of
robbing Peter to pay Paul.
Again, thank you for the opportunity to testify. Please let
me know if there is any additional information that you would
like to receive from us.
[The prepared statement of Ms. Diamonte follows:]
Prepared Statement of Robin L. Diamonte, Chairman, Subcommittee on
Defined Benefits, Committee on the Investment of Employee Benefit
Assets; Chief Investment Officer, United Technologies Corporation,
Hartford, CT
Mr. Chairman, Ranking Member Goodlatte, and other Members of the
Committee, my name is Robin Diamonte and I am the Chairman of CIEBA's
Subcommittee on Defined Benefits.
Thank you for providing this opportunity to testify. The Committee
on Investment of Employee Benefit Assets--CIEBA--is the voice of the
Association for Financial Professionals on employee benefit plan asset
management and investment issues. CIEBA was formed in 1985 to provide a
nationally recognized forum and voice for ERISA-governed corporate
pension plan sponsors on fiduciary and investment issues. CIEBA members
are the chief investment officers of most of the major private sector
retirement plans in the United States. CIEBA represents 110 of the
country's largest pension funds and its members manage more than $1.5
trillion of defined benefit and defined contribution plan assets, on
behalf of 17 million plan participants and beneficiaries nationwide.
According to Federal Reserve data, the $966 billion managed by CIEBA
members in defined benefit plans represents half of all private defined
benefit plan assets.
The pension system has served millions of Americans for over half a
century and tens of millions of retirees rely on defined benefit and
defined contribution pension plans as a critical element of their
retirement security. We owe it to working Americans and their families
to ensure that any contemplated policy changes, no matter how well
intentioned, do not undermine their retirement.
The record prices for food and energy in the U.S. and abroad are of
great concern to all of us. We are sensitive to the urgency with which
this issue must be addressed and we applaud the need to investigate
this critical problem. Nonetheless, we are deeply concerned about the
prospect of any legislation that would bar pension plans from investing
in certain types of assets.
Congress has long recognized that direct government regulation of
pension plan investments is ill-conceived. ERISA--the primary law that
regulates the investment of pension assets--takes a very different
tack. Rather than requiring or prohibiting specific investments, ERISA
imposes rigorous fiduciary responsibilities on the persons that manage
pension plan assets. These rules require a plan's fiduciary to act
prudently, and to diversify plan investments so as to minimize the risk
of large losses. In addition, ERISA requires that a fiduciary act
solely in the interest of the plan's participants and beneficiaries and
for the exclusive purpose of providing benefits to the plan's
participants. Fiduciaries who violate these obligations face a range of
civil and criminal penalties.
The sole instance in which ERISA directly regulates pension
investments is with respect to investments in employer securities--an
area where there are clearly unique considerations, including potential
conflicts of interest and the possibility of excessive concentrations
of investment risk. In fact, private pension plans today invest in a
wide range of different asset classes, including U.S. and international
equities, U.S. and international fixed income, emerging markets, real
estate, private equity, and natural resources. Plan fiduciaries use a
variety of investment techniques and tools, including derivative
instruments, to mitigate risk and enhance returns. Further, when
presented with emerging asset classes and investment strategies, the
Department of Labor--the Federal agency with oversight responsibility
for pension investments--has consistently given its blessing as long as
the investment is prudent and for the exclusive benefit of participants
and beneficiaries.\1\
---------------------------------------------------------------------------
\1\&See, e.g., Department of Labor Information Letter to Eugene
Ludwig, Comptroller of the Currency (Mar. 21, 1997) (permissibility of
investing pension assets in derivatives).
---------------------------------------------------------------------------
Other countries have taken different approaches to the investment
of pension plan assets. Historically, some U.S. state government and
some European defined benefit plans had rigid investment guidelines,
prohibiting certain types of investments and requiring others. Many of
these rigid investment rules were eventually discarded because of the
negative impact such guidelines had on investment returns and thus on
employees' retirement security. Even today, European pension funds
subject to more restrictions on plan investments have been shown to be
consistently outperformed by funds subject to regimes such as ours,
which pair investment flexibility with strict fiduciary obligations.
Put simply, mechanical approaches do not work as well as the American
approach. It is critical that pension plans have the ability to invest
in accordance with modern portfolio theory and pursue the best
investment strategy available. The investment marketplace is constantly
changing and pension plans need to be able to adapt and evolve
accordingly without having to comply with lists of permitted and
impermissible investments.
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 decisions.
Today, commodities investments are not a significant part of most
pension plan investments. Preliminary results for CIEBA's 2007 profile
survey show that plans have less than one percent of assets invested
directly in commodities and natural resources. It may be that the
actual percentage of assets invested in commodities is modestly greater
through indirect investment vehicles, such as hedge funds. However, in
total, CIEBA members reported that only 3.15 percent of their assets
were invested in the broad category of hedge funds in 2006. We firmly
believe that commodities may be part of a prudent, well-diversified
investment portfolio by providing a hedge against inflation and
minimizing volatility, but our primary concern is with the principle
that the government should not micromanage pension plan investments.
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.
Political temptation to intervene in pension investments is not
unprecedented. Congress in the past has considered legislation that
would bar plans from investing in particular investments or,
conversely, would require plans to invest in particular investments.
There are numerous instances in which there has been a first instinct
to require pension plans to make investment decisions with a view to
promoting social or political goals, such as protecting the environment
or stimulating business activity in certain geographic areas.
Congress, however, has consistently rejected legislation that would
subjugate the retirement security of millions of Americans and their
families to other social or political concerns, no matter how worthy.
In fact, when confronted with whether pension plans may take into
account social goals in considering economically targeted investments,
the Department of Labor interpreted ``the requirements that a fiduciary
act solely in the interest of, and for the exclusive purpose of
providing benefits to, participants and beneficiaries as prohibiting a
fiduciary from subordinating the interests of participants and
beneficiaries in their retirement income to unrelated objectives.''&\2\
---------------------------------------------------------------------------
\2\&29 C.F.R. &2509.94&2.
---------------------------------------------------------------------------
Moreover, the case for limiting pension investments in commodities
has simply not been made. As others, including the Commodity Futures
Trading Commission (``CFTC''), have testified, it is far from clear
that institutional investors in the commodities market are driving the
surging prices. The allegations that institutional investors engage in
harmful speculation in the commodities markets have been almost
entirely anecdotal and we are not aware of any substantial analysis
that supports the allegations. Before acting, it is imperative that
Congress step carefully and allow the CFTC to analyze the commodities
markets and gather data to facilitate an informed approach.
Various proposals to restrict investments in commodities do not
define commodity investing with any specificity. If interpreted
broadly, these restrictions could apply to direct investment in
commodities, any commodities futures transactions, commodity indexes
and even publicly-traded companies who produce or distribute energy or
agricultural commodities. Compliance with such a prohibition would
significantly disrupt pension plans' overall investments, thereby
hurting plan participants.
Finally, regardless of one's view of whether institutional
investors as a whole have been a driver of rising prices, it is
apparent that pension investments have not been a material cause of the
rising cost of food and energy. As previously mentioned, investments in
commodities are a small fraction of CIEBA member pension funds' assets.
Further, most plans will rebalance their investments periodically to
assure that they stay within their guidelines and do not inadvertently
get over-exposed to any single asset class. Plans with exposure to
commodities or commodity indexes are very likely to sell when prices
rise and buy when prices fall in an effort to maintain a constant
weighting with respect to the whole portfolio.
Regulating pension investments would make it difficult for pension
plans to adequately diversify investments to hedge against market
volatility and inflation and, consequently, would put at risk the
retirement funds of the very workers the proposal is intended to help.
In effect, such a proposal could be a case of robbing Peter to pay
Paul.
Again, thank you for this opportunity to testify. Please let me
know if there is additional information that you would like to receive
from us. We are happy to help you in any way we can.
The Chairman. Thank you very much. Dr. Irwin, I appreciate
you being with us.
STATEMENT OF SCOTT H. IRWIN, Ph.D., PROFESSOR AND
LAURENCE J. NORTON CHAIR OF AGRICULTURAL
MARKETING, DEPARTMENT OF AGRICULTURAL AND
CONSUMER ECONOMICS, UNIVERSITY OF ILLINOIS AT
URBANA--CHAMPAIGN, URBANA, IL
Dr. Irwin. Mr. Chairman, my name is Scott Irwin. I am a
Professor in the Department of Agricultural and Consumer
Economics at the University of Illinois, and I have had a
lifelong interest in commodities markets. I have been teaching
and studying about commodity markets now for almost 30 years.
And I also want to point out my interest is not merely
academic, as I also help to manage our family farm in Iowa, and
that gives me a real on-the-ground look at these questions as
well.
As you are well aware, the impact of index funds on
commodity prices is currently being hotly debated. It is
commonly asserted that speculative buying by index funds and
commodity future markets has created a bubble, with the result
that market prices far exceed fundamental values. A number of
bills have been introduced recently in Congress with the
purpose of prohibiting or limiting index fund speculation in
commodity futures markets.
And the first part of my remarks is devoted to the idea
that there was a lot of discussion this morning about how
things are new and changed, but I believe that there are, in
fact, important lessons that we can draw from history. And it
is interesting that a pervasive theme running through the
history of U.S. futures markets is skepticism or out-and-out
hostility about the role of speculators.
Rapidly increasing commodity prices at various times over
the last 125 years have been accompanied by assorted attempts
to curtail speculation. For example, just after World War II,
soaring grain futures prices, especially for wheat, attracted
political attention. In a statement that echoes those being
made today, President Truman proclaimed that, ``The cost of
living in this country must not be a football to be kicked
around by grain gamblers,'' and ordered the Commodity Exchange
Authority, the precursor of the CFTC, to require futures
exchanges to raise margins to 33 percent on all speculative
positions. A truly extraordinary level.
Like the current time period, U.S. and international
commodity markets during 1972 through 1975 experienced a period
of rapid price increases. Commodity price increases were widely
blamed on speculators and the growing futures industry.
Following these price increases, public and political pressure
to curb speculation resulted in a number of regulatory
proposals and the upward adjustment of futures margin
requirements.
In the boldest move against speculators and commodity
futures, trade in onion futures was banned by the U.S. Congress
in 1958. The ban, actually still in place, was due to the
widespread belief that speculative activity created excessive
price variation. Again, in language very similar to that heard
today, a Congressional report stated that, ``Speculative
activity in the futures markets causes such severe and
unwarranted fluctuations in the price of cash onions as to
require a complete prohibition of onion futures trading in
order to assure the orderly flow of onions in interstate
commerce.''
The evidence is thin at best that past attempts to limit
the impact of speculation have had the desired effect on market
prices. For instance, there is no historical evidence that
directives to increase futures margins were effective at
lowering overall price levels. The only consistently documented
impact at the higher margin requirements was a decline in
futures trading volume due to the increased cost of trading. So
while proposals currently being considered might, in fact,
curtail speculation through reduced volume of trading, it is
very unlikely that the measures will cure the problem of high
prices.
Let me now turn to a brief discussion of several facts that
are inconsistent with the existence of a substantial bubble and
commodity futures prices. First, let me note that for
speculation to be considered excessive, it must be considered
relative to the commercial hedging needs in the markets. The
available data indicates that long speculation in commodity
futures markets, including that by index funds, is not out of
balance relative to short hedging by commercial firms.
Second, some commodity futures markets with high
concentrations of index funds positions, such as livestock
futures, have not experienced large increases in price. Very
high prices have also been reserved for commodities without
futures markets, such as durum wheat and edible beans and in
futures markets that are not included in popular commodity
indexes such as rice and fluid milk. It is difficult to
rationalize why index fund trading would impact particular
commodity markets and not others.
Third, inventories for some commodities such as grains and
oilseeds have fallen sharply over the last 2 years while
inventories of other commodities such as crude oil have stayed
relatively flat or declined modestly. If index fund speculation
creates bubbles in commodity futures prices, inventory should
be rising, not falling or staying flat.
Fourth, index funds do not attempt to hide their current
positions or their next move. It is highly unlikely that other
large and well capped live speculators such as commodity
trading advisors and hedge funds would allow index funds to
push prices away from fundamental values when index trades are
so easily anticipated.
In conclusion, long only index funds provide liquidity and
risk bearing capacity for hedgers in commodity futures markets.
It is possible that long only index funds impact future prices
but the available evidence indicates that if there is any
impact, it is likely to be small and fleeting. Therefore,
policies aimed at curbing or eliminating speculation by index
funds are likely to be counterproductive.
In contrast, policy initiatives that aim to improve the
availability and transparency of information about index fund
positions in commodity futures markets are more likely to be
beneficial. The information gap is most glaring in the crude
oil futures market, and if reliable data can be collected for
this market, I believe it would go some distance towards
addressing many of the questions currently being asked about
the nature and impact of index fund trading.
Thank you for this opportunity to share this statement. I
look forward to questions.
[The prepared statement of Dr. Irwin follows:]
Prepared Statement of Scott H. Irwin, Ph.D., Professor and Laurence J.
Norton Chair of Agricultural Marketing, Department of Agricultural and
Consumer Economics, University of Illinois at Urbana--
Champaign, Urbana, IL
Mr. Chairman, my name is Scott Irwin. I am a Professor in the
Department of Agricultural and Consumer Economics at the University of
Illinois at Urbana--Champaign. I am also the holder of the Laurence J.
Norton Chair of Agricultural Marketing. Thank you for this opportunity
to comment on the potential impacts of speculation by long-only index
funds in commodity markets. As you are well aware, the impact of index
funds on commodity prices is currently being hotly debated. Rising
costs for energy and food are clearly a cause for general concern. It
is commonly asserted that speculative buying by index funds in
commodity futures markets has created a ``bubble,'' with the result
that market prices far exceed fundamental values. For example, it has
been alleged at recent Congressional hearings that the ``rampant''
speculation by commodity index funds has driven the price of crude oil
futures 25% or more above the true fundamental value of crude oil. A
number of bills have been introduced recently in Congress with the
purpose of prohibiting or limiting index fund speculation in commodity
futures markets.
In my comments, I want to first point out the lessons we can learn
from similar controversies about speculation in the past. Next, I will
examine the available evidence on the balance between speculation and
hedging in commodity futures markets over the last several years.
Finally, I want to explore a number of facts about the current
situation in commodity markets that are inconsistent with the existence
of a substantial bubble in commodity futures prices.
A pervasive theme running through the history of U.S. futures
markets is skepticism or out-and-out hostility about the role of
speculators. Rapidly increasing commodity prices at various times over
the last 125 years have been accompanied by assorted attempts to
curtail speculation or control prices. For example, just after World
War II, soaring grain futures prices, especially for wheat, attracted
political attention. President Truman proclaimed that, ``the cost of
living in this country must not be a football to be kicked around by
grain gamblers,'' and ordered the Commodity Exchange Authority
(precursor to today's Commodity Futures Trading Commission) to require
futures exchanges to raise margins to 33% on all speculative positions,
a truly extraordinary level. In a statement that echoes those being
made today, President Truman added, ``If the grain exchanges refuse,
the government may find it necessary to limit the amount of trading.''
U.S. and international commodity markets during 1972&1975, like the
current time period, experienced a period of rapid price increases,
setting new all-time highs across a broad range of markets. Commodity
price increases were widely blamed on speculators and the growing
futures industry. Following these price increases, public and political
pressure to curb speculation resulted in a number of regulatory
proposals and the upward adjustment of futures margin requirements.
These changes were accompanied by even more drastic measures--such as
Federal price controls and an embargo against soybean exports--aimed at
lowering commodity price levels.
In the boldest move against speculators in commodity futures, trade
in onion futures was banned by the U.S. Congress in 1958. The ban,
actually still in place, was due to the widespread belief that
speculative activity created excessive price variation. Again, in
language very similar to that heard today, a Congressional report
stated that ``speculative activity in the futures markets causes such
severe and unwarranted fluctuations in the price of cash onions as to
require complete prohibition of onion futures trading in order to
assure the orderly flow of onions in interstate commerce.''
The actions used to reign in supposedly damaging speculation in the
past run the gamut from requiring futures exchanges to raise margins to
an outright ban on futures trading. The historical evidence is thin, at
best, that measures to limit the impact of speculation had the desired
effect on market prices. For instance, there is no historical evidence
that directives to increase futures margins were effective at lowering
overall price levels. The only consistently documented impact of the
higher margin requirements was a decline in futures trading volume due
to the increased cost of trading. So, while proposals currently being
considered might in fact curtail speculation--through reduced volume of
trade--it is very unlikely that the measures will cure the ``problem''
of high prices. But, legislative and regulatory initiatives could
severely compromise the ability of commodity futures markets to
accommodate the needs of commercial firms to hedge price risks.
Let me now turn to available evidence on the balance between
speculation and hedging in commodity futures markets over the last
several years. The statistics on long-only index fund trading reported
in the media and discussed at earlier Congressional hearings tend to
view speculation in a vacuum--focusing on absolute position size and
activity. As first pointed out by Holbrook Working back in the 1960's,
an objective analysis of futures market activity must consider the
balance between speculators and commercial firms hedging market risks.
Instead of focusing solely on the question of ``Who is doing all the
speculative buying?'' it is equally important to ask ``Who is doing all
of the short hedging?'' A key insight from this framework is that
speculation can only be considered `excessive' relative to the level of
hedging activity in the market.
A look at the data provided by the Commodity Futures Trading
Commission (CFTC) is enlightening in this regard. Table 1 shows the
division of open interest for nine commodity futures markets for the
first 3 months of 2006 and 2008. The four basic hedging and speculative
positions are: HL = Hedging, Long; HS = Hedging, Short; SL =
Speculating, Long; SS = Speculating, Short. Note that index fund
traders are allocated almost exclusively to the HL category in Table 1
and that HL + SL = HS + SS. There is an important omission from this
table--crude oil futures. As the CFTC noted when it first began
publishing data on index fund positions, it is difficult to separate
out index fund transactions in energy markets because of the degree to
which many firms in these markets engage in multiple trading activities
that fall into different classifications and the degree to which firms
engage in internal netting of these activities.
As expected, Table 1 reveals that long speculation-driven by index
funds--increased sharply in all but one of the nine commodity futures
markets over January 2006 through April of 2008. However, the increase
in short hedging generally was of similar magnitude or exceeded the
increase in long speculation. Corn provides a pertinent example.
Speculative buying in corn--including commodity index funds--increased
by nearly 250,000 contracts; but, selling by commercial firms involved
in the production and processing of corn increased by an even greater
amount, around 500,000 contracts. While the increase in long-only index
fund positions has received the most publicity, the increase in the
size of short hedging positions is equally interesting. For instance,
the position of short hedgers during the first quarter of 2008 in corn
is equivalent to slightly less than 6 billion bushels, or about half
the size of the expected 2008 crop.
The data in Table 1 show that increases in long speculative
positions tend to represent speculators trading with hedgers rather
than speculators trading with other speculators. The former is
considered beneficial to overall market performance since speculators
are providing liquidity and risk-bearing capacity for hedgers, while
the latter may be harmful since speculative trading is not connected to
the risk transfer needs of hedgers. There is no pervasive evidence that
current speculative levels, even after accounting for index trader
positions, are substantially in excess of the hedging needs of
commercial firms. In fact, long speculation in many cases is inadequate
to balance the selling done by commercial firms. This result, though
surprising to many, is consistent with the historical record for
commodity futures markets.
If speculation is driving prices above fundamental values, the
available data indicates it is not obvious in the level of speculation
relative to hedging. Several other facts are inconsistent with the
existence of a substantial bubble in commodity futures prices. Figures
1 and 2, respectively, show the increase in commodity futures prices
over January 2006 through April 2008 and the average percent of open
interest held by commodity index funds for the same time period. Note
that data are presented for the same nine markets as in Table 1. The
charts show that price increases are concentrated in grain and oilseed
markets, but the highest concentration of index fund positions tend to
be in cotton and livestock futures markets. This is the reverse of the
relationship one would expect if index fund trading leads to bubbles in
commodity prices. Very high prices have also been observed for
commodities without futures markets, such as durum wheat and edible
beans, and in futures markets that are not included in popular
commodity indices tracked by index funds, such as rice and fluid milk.
It is difficult to rationalize why index fund trading would impact
particular commodity markets but not others.
Another stubborn fact has to do with inventories for storable
commodities. If index fund speculation creates a bubble in futures
prices for storable commodities, this also creates an incentive to
store commodities because prices in the future exceed levels normally
required to compensate inventory holders for storage. We should
therefore observe an increase in inventories when a bubble is present.
In fact, inventories for some commodities, such as grains and oilseeds,
have fallen sharply over the last 2 years, while inventories of other
commodities, such as crude oil, have stayed relatively flat or declined
modestly. The behavior of commodity inventories is not consistent with
large bubbles in commodity futures prices.
Still another difficult fact is the nature of commodity index
trading. In order for any trader group to consistently push futures
prices away from fundamental value their trading must be unpredictable.
Otherwise, competing traders can easily anticipate the buying and
selling by the group in question and profit by taking advantage of this
knowledge. Index funds do not attempt to hide their current positions
or their next move. Generally, funds that track a popular commodity
index (e.g., GSCI) publish their mechanical procedures for rolling to
new contract months. Moreover, they usually indicate desired market
weightings when the index is re-balanced. So, the only uncertainties
stem from the overall in-flow or out-flow of money to index funds. It
is highly unlikely that other large and well-capitalized speculators,
such as commodity trading advisors and hedge funds, would allow index
funds to push prices away from fundamental values when index trades are
so easily anticipated.
A related point is that large and long-lasting bubbles are less
likely in markets where deviations from fundamental value can be
readily arbitraged away. There are few limitations to arbitrage in
commodity futures markets because the cost of trading is relatively
low, trades can be executed literally by the minute, and gains and
losses are marked-to-the-market daily. This stands in contrast to
markets where arbitrage is more difficult, such as residential housing.
The low likelihood of bubbles is also supported by numerous empirical
studies on the efficiency of price discovery in commodity futures
markets. The vast majority of studies indicate that commodity futures
markets react efficiently to new information as it emerges. Where
pricing problems have been documented, they are often associated with
the delivery period of particular commodity futures contracts. However,
as noted in the recent CFTC background memorandum on the application of
its emergency powers, even this type of problem has been infrequent and
relatively short-lived.
My position is that there is very limited hard evidence that
anything other than economic fundamentals is driving the recent run-up
in commodity prices. The main driving factors in the energy markets
include strong demand from China, India, and other developing nations,
a leveling out of crude oil production, a decrease in the
responsiveness of consumers to price increases, and U.S. monetary
policy. In the grain markets, driving factors also include demand
growth from developing nations and U.S. monetary policy, as well as the
diversion of row crops to biofuel production and weather-related
production shortfalls. The complex interplay between these factors and
how they impact commodity prices is often difficult to grasp in real-
time and speculators historically have provided a convenient scapegoat
for frustration with rising prices.
In conclusion, commodity market speculation by long-only index
funds has increased markedly since 2006 in absolute terms. However,
most commodity futures markets experienced an equally dramatic or even
greater increase in selling by commercial hedgers. In these
circumstances, speculative buying facilitates legitimate business
transactions and enhances risk transfer for firms involved in commodity
businesses. It is possible that long-only index funds impact futures
prices, but the available evidence indicates that if there is any
impact, it is likely to be small and fleeting. Therefore, policies
aimed at curbing or eliminating speculation by index funds are likely
to be counter-productive.
In contrast, policy initiatives that aim to improve the
availability and transparency of information about index fund positions
in commodity futures markets are laudable. There is a need to study and
better understand the role of this new class of speculators in
commodity futures markets. The information gap is most glaring in the
crude oil futures market, and if reliable data can be collected for
this market, I believe it would go some distance towards addressing
many of the questions currently being asked about the nature and impact
of index fund trading.
For a more detailed analysis of analysis of speculation in
commodity futures, please see the following report:
Sanders, D.R., S.H. Irwin, R.P. Merrin. ``The Adequacy of
Speculation in Agricultural Futures Markets: Too Much of a Good
Thing?'' Marketing and Outlook Research Report 2008&02,
Department of Agricultural and Consumer Economics, University
of Illinois at Urbana--Champaign, June 2008.
The report can be downloaded on the Internet at:
http://www.farmdoc.uiuc.edu/marketing/morr/morr_08-02/morr_08-
02.pdf.
Table 1. Speculative and Hedging Positions in Commodity Futures
Contracts During the First Quarter of 2006 and First Quarter of 2008
------------------------------------------------------------------------
Market HL HS SL SS
------------------------------------------------------------------------
--# of contracts--
------------------------------------------------------------------------
Corn:
2006........ 328,362 654,461 558,600 208,043
2008........ 598,790 1,179,932 792,368 182,291
---------------------------------------------------------
Change.... 270,428 525,471 233,768 ^25,752
------------------------------------------------------------------------
Soybeans:
2006........ 126,832 192,218 183,105 107,221
2008........ 175,973 440,793 351,379 74,844
---------------------------------------------------------
Change.... 49,141 248,575 168,274 ^32,377
---------------------------------------------------------
Soybean Oil:
2006........ 66,636 124,134 92,515 35,599
2008........ 121,196 228,515 128,546 25,844
---------------------------------------------------------
Change.... 54,560 104,381 36,032 ^9,755
---------------------------------------------------------
CBOT Wheat:
2006........ 57,942 213,278 251,926 92,148
2008........ 70,084 240,864 300,880 121,578
---------------------------------------------------------
Change.... 12,141 27,585 48,954 29,430
---------------------------------------------------------
KCBT Wheat:
2006........ 43,993 110,601 80,158 13,560
2008........ 46,459 96,556 67,827 15,767
---------------------------------------------------------
Change.... 2,466 ^14,045 ^12,330 2,207
---------------------------------------------------------
Cotton:
2006........ 41,582 108,085 86,777 21,824
2008........ 107,826 296,434 200,773 18,918
---------------------------------------------------------
Change.... 66,244 188,349 113,995 ^2,906
---------------------------------------------------------
Live Cattle:
2006........ 54,549 128,951 129,786 45,305
2008........ 34,970 144,549 198,211 80,303
---------------------------------------------------------
Change.... ^19,579 15,599 68,425 34,998
---------------------------------------------------------
Feeder Cattle:
2006........ 10,707 17,725 20,769 10,632
2008........ 6,310 13,435 28,284 18,111
---------------------------------------------------------
Change.... ^4,397 ^4,290 7,515 7,479
---------------------------------------------------------
Lean Hogs:
2006........ 15,949 65,438 93,522 40,036
2008........ 36,825 113,971 149,415 69,055
---------------------------------------------------------
Change.... 20,876 48,533 55,893 29,019
------------------------------------------------------------------------
Notes: HL = Hedging, Long; HS = Hedging, Short; SL = Speculating, Long;
SS = Speculating, Short. Long-only index fund positions are classified
as speculative. The data reflect average positions in the first
calendar quarter of 2006 and 2008, respectively. Source: Sanders,
Irwin, and Merrin (2008).
Figure 1. Percent Change (return) in Commodity Futures Prices,
2006&2008.
Figure 2. Average Percent of Open Interest Held by Index Funds in
Commodity Futures Markets, 2006&2008.
The Chairman. Thank you very much, Dr. Irwin. Mr. Cicio.
STATEMENT OF PAUL N. CICIO, PRESIDENT, INDUSTRIAL ENERGY
CONSUMERS OF AMERICA, WASHINGTON, D.C.
Mr. Cicio. Thank you, Mr. Chairman, Members of the
Committee, for the opportunity to testify before you. My name
is Paul Cicio, and I am President of the Industrial Energy
Consumers of America, a trade association and consumer advocate
for manufacturing companies who are significant consumers of
energy.
Mr. Chairman, I have a letter here from the President and
CEO of Tyson Foods, a member of my organization, that we would
like to submit for the record.
The Chairman. Without objection, so ordered.
Mr. Cicio. Thank you.
Consistent with my testimony today, Tyson Foods says they
are very concerned about the impact that noncommercial traders
and index funds are having on the agricultural markets and
urges reform to deal with excessive speculation in both ag and
energy commodities.
Mr. Chairman, we believe that Congress must decide whether
it supports families and American manufacturing businesses and
jobs, or index funds, hedge funds, pension funds, sovereign
funds and exchanges. It is just that simple.
Consumers across the nation are asking for proof that index
funds and Wall Street firms are not playing a role in causing
the significant rise in commodity prices. The burden of proof
is on the speculator, not on the consumer.
Each monthly commodity price is based on a given supply of
physical product. Think of each individual commodity as having
a swimming pool filled with product for delivery that month,
but more and more people jump into that pool. That is what has
happened to the commodity markets. In just 3 short years, index
funds have increased from almost nothing to $260 billion and
each month more and more are jumping into that same pool, which
has created a speculative bubble and higher resulting prices.
To consumers it appears that speculative bubble has benefited
the few at the cost of many, the American public and
manufacturing.
We believe there is a speculative bubble. The bubble will
eventually burst and prices will fall, either by government
action or by demand destruction. We urge government action. No
action on the part of Congress will result in continued demand
destruction by the price sensitive manufacturing industries
that belong to my organization. Higher prices will continue to
shut down manufacturing plants.
Higher energy costs have already significantly contributed
to the loss of 3.3 million manufacturing jobs since 2000, and
we have already lost 350,000 jobs just this year. We have lost
19 percent of all manufacturing jobs since the year 2000. For
IECA companies who use large quantities of natural gas, we want
proof that index funds have not increased natural gas prices
that have risen 128 percent in 1 year when domestic supply has
increased 7.1 percent in that same time period and is
continuing to increase and is in balance with demand for that
same time period.
And national inventories currently stand adequately at just
below the 5 year average; there has not been any supply
disruptions; and 85 percent of the market is supplied
domestically. U.S. natural gas prices are not linked to crude
oil prices and are not impacted by international supply
disruptions of crude oil, yet prices have surged along with
crude prices. If index funds did not cause the price increase,
we want to know what did. And we would ask the Committee to
help us.
We would like to point out that prior to the year 2000,
before CMFA, the futures market worked efficiently without
index funds and any changes to price were confidently the
result of supply and demand issues. We want that confidence
back. Index funds were not needed to make markets work before
and they are not needed now. We encourage you to restore that
confidence by returning these markets to physical producer/
consumer hedgers and eliminate index fund participation.
NYMEX is on record saying the index funds are not driving
up the price of commodities. Our question is, prove it. NYMEX
trading volumes are estimated by many to be as little as 25
percent of the trading volume. Plus NYMEX is in the business of
making money based on higher trading volumes. Given this, we
put little credibility on that testimony.
The CFTC is on record saying that index funds are not
driving up the price of commodities. If the CFTC has proof, we
would like to see it. Given that CFTC has admitted to having
very limited access to volumes of trades in dark markets, which
are estimated to be three to four times the size of NYMEX
volumes, we have a very hard time understanding how the CFTC
can confidently say that index funds are not playing a role.
In closing, Mr. Chairman, doing nothing creates demand
destruction and loss of jobs by the manufacturing sector. We
urge action to increase transparency, place limits on
speculation that is responsible and set responsible position
limits.
Thank you.
[The prepared statement of Mr. Cicio follows:]
Prepared Statement of Paul N. Cicio, President, Industrial Energy
Consumers of America, Washington, D.C.
Mr. Chairman and Members of the Committee,
My name is Paul N. Cicio. I am President of the Industrial Energy
Consumers of America. Thank you for the opportunity to testify before
you on the important issue of excessive speculation in energy and
commodity markets in general.
IECA is a 501(C)(6) national non-profit non-partisan cross-industry
trade association whose membership is exclusively from the
manufacturing sector.
IECA promotes the interests of manufacturing companies for which
the availability, use and cost of energy, power or feedstock play a
significant role in their ability to compete in domestic and world
markets. IECA membership represents a diverse set of industries
including: plastics, cement, paper, food processing, aluminum,
chemicals, fertilizer, brick, rubber, insulation, steel, glass,
industrial gases, pharmaceutical, construction products, automotive
products, and brewing.
Immediate action by Congress is needed to eliminate excessive
speculation in energy and food related futures markets and increase
domestic energy production.
At the heart of the matter is that every consumer in the country
assumes that the government is protecting their interests and that
commodity markets are operating with the public's interest at heart.
Nothing could be further from the truth. The futures market that is
relied upon for price determination in the spot physical market no
longer reflects underlying supply and demand fundamentals. Existing law
and government institutions that are in place have failed to protect
the public interest. Excessive levels of speculation are un-necessarily
raising the costs of energy for every homeowner, farmer and
manufacturer.
We urge the Congress to take action to eliminate excessive
speculation in futures markets and to increase the domestic supply of
energy. Removing excessive speculation will have an immediate short
term impact on commodity prices. The Congress cannot under-estimate the
impact this issue is having on our country through un-necessary high
energy costs and inflationary impacts. Make no mistake that excessive
speculation is occurring and futures markets have become over-run with
players that futures markets never intended as participants.
For energy, taking action to remove the moratorium on the Outer
Continental Shelf and provide access to the Alaskan National Wildlife
Refuge Reserve (ANWR) will increase domestic supply of natural gas and
oil in coming years. The combination of eliminating excessive
speculation, increasing domestic production, implementing cost
effective energy efficiency and responsible conservation will go a long
way in solving our nation's energy crisis.
The manufacturing sector is dependent upon globally competitive
energy to compete in the market place. We are substantial consumers of
natural gas for fuel and feedstock and also use large quantities of
electricity.
The high price of natural gas has significantly contributed to the
loss of manufacturing jobs. Since 2000, 3.3 million manufacturing jobs
have been lost which account for 19 percent of all manufacturing jobs.
According to the July 4, 2008 USA Today, manufacturers lost 33,000 jobs
in the month of June alone. It also reports that U.S. manufacturers
have lost 353,000 jobs so far this year despite the weak dollar that
has helped to make exports more cost competitive.
It is also important to note that natural gas prices set the
marginal price of electricity in a growing portion of the country. As
natural gas prices rise, so does the price of electricity. The two are
connected and the increase in the price of electricity is another
unintended consequence of higher natural gas prices because of
excessive speculation. High natural gas and electricity prices are
resulting in a new round of demand destruction that drives high paying
manufacturing jobs offshore.
The case for natural gas.
U.S. natural gas prices are not linked to crude oil prices and are
not impacted by international supply disruption concerns, yet prices
have surged along side crude prices in recent months.
Unlike crude oil that is priced globally, natural gas is a North
American market and is priced domestically. In most years, we produce
about 82 percent of our natural gas in the U.S., import about 15
percent from Canada and import about three percent in the form of LNG.
If global demand for crude oil exceeds supply, the price will rise
globally. If demand for natural gas rises or falls in the U.S., only
U.S. consumers will pay either higher or lower prices. Crude oil and
natural gas pricing are distinct and separate and there is
insignificant substitution capacity. Natural gas prices are
disconnected to crude oil prices in the physical markets.
There is no shortage of U.S. natural gas. Domestic supply is
meeting demand and expanding slowly. National inventories are slightly
below their 5 year average; LNG import capacity has increased and is
greatly under-utilized. There have not been any hurricanes or
production stoppages. However, despite this fairly stable supply and
demand picture, the price of natural gas has soared.
From 1 year ago, the price of natural gas has risen from $5.94 mm
Btu to $13.58 mm Btu, a 129 percent increase. Why, then, has the price
of natural gas risen so high so quickly? The answer is that larger and
larger quantities of capital have flowed into the futures markets by
means of index funds, institutional investors like pension funds, hedge
funds and sovereign funds.
To illustrate the point we have compiled the following information.
Using EIA 2007 data, the U.S. consumes on average 1,971,357,597 MM Btus
of natural gas per month. On July 3, 2008 50,731 natural gas contracts
were traded on the NYMEX for the August contract. At this rate, the
NYMEX trading activity in the prompt month (August) is eight times the
total U.S. monthly average consumption volume. But this is only the
NYMEX volume. It is a widely held view that the Over-the-Counter (OTC)
markets, the dark markets, trade three to four times the volume that is
traded on NYMEX. If the OTC market is three times larger, natural gas
traded volume is greater than 24 times the physical consumption. What
is frightening is that the rate of trading volume continues to rise.
Excessive speculation must be stopped.
There is no question that excessive speculation has increased the
price of energy and commodities in general. Trading volumes are now
reportedly 22 times that of the underlying commodity volumes and, as a
result, speculators are trading with other speculators with no regard
to the underlying supply versus demand fundamentals.
According to one estimate, assets allocated to commodity index
trading strategies have risen from $13 billion from 2003 to about $260
billion in early 2008. Futures markets were never intended to be used
as an inflation hedge or an asset class. Futures markets were
established to serve price discovery for sellers and buyers of the
commodity.
We strongly encourage you to include provisions that will do the
following.
1. Ensure only bona fide physical hedgers qualify for hedge
exemptions.
Direct the CFTC to re-examine the definition of ``hedging'' to
ensure that hedge exemptions are only available to bona fide hedgers
and not to speculators. This will prevent speculators from using this
exemption to avoid position limits.
2. Prohibit pension funds, index funds funds from speculating in
commodity markets.
Futures were never intended to be used as an asset class for
investment purposes. Using futures as an `asset class' to hedge against
inflation or to feather the performance of pension funds destroys the
underlying functioning and efficiency of price determination for which
we rely on futures. In the past, gold was used as a hedge against
inflation, but using energy or food commodities directly and negatively
damage families, farmers and manufacturers. The Congress must decide
whether it supports families and American businesses or hedge funds,
pension funds and sovereign funds. It's just that simple.
3. Fully close the Enron loophole.
Require that all energy exchanges be subject to appropriate Federal
regulation, including reporting requirements and position limits, by
prohibiting any energy contracts from being traded on exempt commercial
markets. This includes Swaps. Speculative position limits must ``look-
through'' the swaps transaction to the ultimate counterparty and hold
that counterparty to the speculative limits.
4. Close the foreign exchange loophole:
(a) Require all foreign exchanges offering energy commodities
through a U.S.-based terminal to be subject to the same
regulatory requirements applicable to U.S. exchanges,
including position limits, margin requirements, and
reporting.
(b) Subject U.S. traders trading energy derivatives on non-U.S.
markets to the same reporting and record-keeping
requirements as those trading on U.S. exchanges. This
prevents them from avoiding CFTC oversight by trading
oversees.
5. Provide greater transparency on energy swaps.
Direct the CFTC to impose reasonable record-keeping and `large
trader' reporting requirements on all energy swaps made in the U.S. or
made by U.S. traders anywhere in the world, while taking steps to
ensure that participants' information is kept confidential and not
disclosed to competitors.
6. Enhanced reporting requirements.
Direct the CFTC to devise new classifications of trades to break
out speculators or swaps as a separate category, and direct the CFTC to
enhance its Commitments of Traders reports to include trades using the
Intercontinental Exchange (ICE) in Europe and other similar exchanges.
7. Disclosure requirements.
Require companies who promote market positions (such as market
analysts) to disclose their positions if they talk publicly. Or ban
conflict of interest such as analysts' statements that enrich analyst's
portfolios.
8. Lower position limits and margin policies to benefit physical
hedgers.
We believe that individual entities from the hedge funds, index
funds, and sovereign funds can provide more capital for trading then
most energy producers or sellers. It is paramount that we prevent a few
entities from developing market power.
9. Identify sovereign fund positions.
Require the CFTC large trader report to identify sovereign funds
and their positions. The participation of sovereign funds in commodity
markets must be made clear to the CFTC because financial derivative
price movements have a direct impact on the price of the physical
commodity. A cause and effect.
10. All companies must register and file reports to Security
Exchange Commission.
Require all companies who participate in U.S. commodity markets,
including hedge funds, to register and file reports to the Security
Exchange Commission just like all other companies.
11. Ensure that the banks are not borrowing capital from the
Federal Reserve at low interest rates to speculate in the
futures market.
We encourage the Congress to ensure that Federal Reserve monetary
policy is not causing higher energy and food costs by providing cheap
money to banks to speculate on commodities. Attached charts show an
almost linear relationship between lower Federal Reserve interest
rates, increased borrowing by banks and corresponding higher commodity
prices. We are concerned that the timing is not coincidental.
Thank you.
Appendix
July 9, 2008
Hon. Collin C. Peterson,
Chairman,
Committee on Agriculture,
U.S. House of Representatives,
Washington, D.C.;
Hon. Bob Goodlatte,
Ranking Minority Member,
Committee on Agriculture,
U.S. House of Representatives,
Washington, D.C.
Dear Chairman Peterson and Ranking Member Goodlatte:
I commend the Committee for its attention to the critical issue of
excessive speculation in the commodity markets and want to offer the
view of Tyson Foods, Inc. on possible actions to remedy this problem.
As you know, we have seen tremendous increases in the cost of
grains as well as energies over the last few years. While attributable
to a number of factors, Tyson Foods is very concerned with the impact
that noncommercial traders and index funds are having on the
agricultural commodity markets. As of June 17th, open interest in corn
futures has increased 114 percent over the last 3 years and open
interest in soybeans has jumped 93 percent. Wheat has also seen
considerable growth. All of these numbers are in excess of the growth
we have seen in crude oil.
Looking closer, if you examine the June 17th Commitment of Traders
report, which is attached, you will note that overall corn holdings for
noncommercial and index funds are equivalent to roughly 32 percent
ownership of the estimated production for this year's crop. These are
market participants that do not physically use these commodities. We
are very concerned that the percentage holding in corn will only
continue to grow. We base that concern on the premise that
participation from the noncommercial and index funds in other
agricultural markets is already higher than in corn. For example,
soybean holdings for noncommercial and index funds are almost 50
percent of estimated production for this year's crop and for wheat, the
percentages are even higher.
While the energy markets have rightly received a tremendous amount
of attention in recent months, we are convinced that the data shows
that excessive speculation is a problem in many of the markets under
the CFTC's jurisdiction. For this reason, Tyson Foods urges that any
reforms considered by this Committee and ultimately adopted by the
House of Representatives be applied to all commodity markets and not
just the energy markets. A standardized approach to all commodity
markets to reduce the role of excessive speculation is warranted.
To be clear, Tyson Foods does recognize the necessary role of
speculation in the commodity markets and does not support banning
particular participants from these markets. We recognize that
speculators provide liquidity to the commodity markets but believe that
they must provide that liquidity with transparency and under clearly
defined limits. For this reason, we urge strong action to address
excessive speculation, including:
Ensuring that only true physical hedgers qualify for hedge
exemptions--hedge exemptions should be available only to true
hedgers that have a physical underlying exposure to a
commodity. Speculators should not be allowed to use this
exemption to avoid position limits. For example, a financial
trading subsidiary for an investment bank or an index fund
should not qualify for a hedge exemption. Neither entity has a
natural long physical ownership or short physical need for
commodities.
Fully closing the Enron Loophole--all commodity exchanges
should be subject to appropriate reporting requirements and
position limits, no commodity contracts should be traded on
exempt commercial markets.
Providing greater transparency on commodity swaps--the CFTC
should be directed to impose reasonable record-keeping and
reporting requirements on all commodity swaps made in the U.S.
or made by U.S. traders anywhere in the world.
Requiring enhanced reporting requirements--the CFTC should
be directed to devise new classifications of trades to break
out index speculators or swaps as a separate category.
Closing the foreign exchange loophole--all foreign exchanges
offering commodities through a U.S.-based terminal should be
subject to the same regulatory requirements applicable to U.S.
exchanges, including position limits, margin requirements, and
reporting. Further, U.S. traders trading on non-U.S. markets
should also be held to the same regulatory requirements as
those trading on U.S. exchanges.
I appreciate this opportunity to offer Tyson Foods' views on excess
speculation in the commodity markets and thank the Committee for its
thorough examination of this important issue. If you require any
additional information related to my comments please do not hesitate to
contact me.
Sincerely,
Thank you very much. Jeff.STATEMENT OF JEFFREY D. KORZENIK, CHIEF
INVESTMENT OFFICER, VC&C CAPITAL ADVISERS, LLC, VITALE, CATURANO &
COMPANY, LTD., BOSTON, MA
Mr. Korzenik. That is fine. Thank you, sir.
The Chairman. We appreciate you being with us.
Mr. Korzenik. I am pleased to be here. Thank you, Mr. Chairman and
Members of the Committee. My name is Jeff Korzenik. I am the Chief
Investment Officer of Vitale, Caturano & Company in Boston, and they
are a registered investment adviser, VC&C Capital Advisers. My
background with commodities and derivatives goes back 22 years;
however, I don't believe that my firm or I would benefit or be harmed
by the policy changes being considered.
Until now I have never testified before Congress. I don't think I
have even stood up at a town meeting, my local form of government. But
I am here today because when I first began examining this issue, I came
to the conclusion this was a public policy concern.
The largest drivers of recent commodity price inflation are almost
certainly demand growth from developing economies and weakness in the
dollar. In the long run, too, markets find their price level based on
commercial production, usage and inventory changes.
In short to intermediate periods, however, speculators can be
disruptive, influencing prices and hurting consumers. Pension and index
investment has become a third force in stoking commodity inflation and
damaging the structural integrity of the futures markets. Their
activities can fairly be said to represent excessive speculation. These
new participants, and I am going to follow the lead of others, are
commonly called index speculators. When I use terms like ``excessive
speculation,'' it is in the neutral technical sense. I am not intending
to apply any judgmental labels.
These index speculators of course represent managers of pensions,
endowments, other investment pools that aren't normally associated with
speculation. These money managers are seeking portfolio efficiency by
blending noncorrelated productive assets. The .COM bust and the
parallel interest in alternative investments led many of them to
consider commodities as a portfolio addition.
Regardless of the merits of this approach, there is an overriding
practical concern. The commodity markets and the futures exchanges were
meant to serve the needs of commodity producers and users, not
investors. This marketplace is ill-suited for index speculation.
All this must be understood in the context of how index speculators
differ from traditional ones. They are overwhelmingly oriented to the
long side of the market, commonly do not deploy leverage and hold
positions for long period of time. They add substantial interest to the
long side of the market without actually creating much trading volume.
In essence, they actually reduce market liquidity.
Part of the problem is relative market size. Index speculators are
draining funds from an ocean of traditional investment assets
represented by thousands of stock and bond issuers into what are
effectively small ponds, about two dozen futures markets.
It is important to note that this impact will only grow. Many
institutions have been only testing the waters and are increasing their
allocations to the strategy. Institutions that have not yet
participated will increasingly follow the lead of others who have. The
$260 billion currently allocated by index speculators is only the
beginning of a trend. We can reasonably expect the holdings of index
speculators to increase more than tenfold and perhaps as much as
fifteen-fold.
From a policy perspective we must assess not only the current
impact, but the future as well. There are those who claim that index
speculators have no real impact on future prices since for every buyer
there must be a seller. This misses the point, which is what determines
the price at which those two participants meet? Is there any market in
the world where the net addition of $260 billion on the long side of
the market wouldn't move prices higher? Maybe a lot higher, maybe just
a little, but higher nonetheless?
Some concede that futures prices may be impacted by index
speculators but claim this has no bearing on the cash market. The
mechanisms by which futures prices influence physical prices vary both
by commodity and environment. In some cases, there is a clean arbitrage
transaction so that a rise in the futures will directly translate into
higher physical prices. Sometimes futures impact cash less directly by
providing a reference or index price on which physical transactions are
based.
There may be some instances where index speculation indeed
influences futures prices disproportionately more than cash prices.
However, this is harmful in another way. Commercial users of the
futures markets need to rely on predictable relationships between cash
and futures. When these relationships break down, commercial
participants either flee the market or are forced to bear or pass along
additional costs.
In all these considerations, one can argue in good faith whether
index speculators create a large or small impact. Those who believe
there is eventual minimal influence should consider a future when these
index speculators will command far greater assets.
There are numerous proposals before Congress to address these
concerns. In my opinion, imposing speculative position limits on both
futures and swap desk transactions appears to be the best solution.
This would require more transparency in the swap markets than we
currently have.
It may be that position limits alone are insufficient to curb the
distorting influence of index speculators and some sort of aggregate
limitation should be imposed. I don't think this view is currently
supported by the evidence, and position limits are an appropriate and
productive first step. This would, of course, restrict the use of index
speculation as a portfolio strategy. Portfolio managers do have
alternative tools for inflation protection and exposure to commodity
pricing. Not identical to be sure, but reasonable nonetheless.
Each marketplace has its own rules. Traditional equity and bond
managers should be expected to play by the rules of the commodity
market when they trade futures, and those rules should and
traditionally have included speculative position limits.
Thank you.
[The prepared statement of Mr. Korzenik follows:]
Prepared Statement of Jeffrey D. Korzenik, Chief Investment Officer,
VC&C Capital Advisers, LLC, Vitale, Caturano & Company, Ltd., Boston,
MA
Thank you, Mr. Chairman and Members of the Committee. My background
with commodities and derivatives goes back 22 years. However, I do not
believe that my firm or I would benefit or be harmed by the policy
changes being considered. I am here because, when I first began
examining this issue 6 months ago, I came to the conclusion that this
was public policy concern.
The largest drivers of recent commodity price inflation are almost
certainly demand growth from developing economies and weakness in the
dollar. In the long run, too, markets find their price level based on
commercial production, usage, and inventory changes. In short to
intermediate periods, however, speculators can be disruptive,
influencing prices and hurting consumers. Pension and index investment
has become a third force in stoking commodity inflation and damaging
the structural integrity of the futures markets. Their activities can
fairly be said to represent ``excessive speculation.''
These new participants--and I'll follow the lead of others--are
commonly called ``index speculators.'' When I use this term, and terms
like ``excessive speculation,'' it's in a neutral, technical sense; I
don't intend these to be judgmental labels. These index speculators
represent managers of pensions, endowments, and other investment pools
that aren't normally associated with speculation. These money managers
are seeking portfolio efficiency by blending non-correlated, productive
assets. The .COM bust and the parallel interest in alternative
investments led many of them to consider commodities as a portfolio
addition. Regardless of the merits of this approach, there's an
overriding practical concern--the commodity markets and the futures
exchanges were meant to serve the needs of commodity producers and
users, not investors. This marketplace is ill suited for index
speculation.
All this must be understood in the context of how index speculators
differ from traditional ones. They are overwhelmingly oriented to the
long side of the market, commonly do not deploy leverage, and hold
positions for long periods of time. They add substantial interest to
the long side of the market without actually creating much trading
volume. In essence, they actually reduce market liquidity.
Part of the problem is relative market size. Index speculators are
draining funds from an ocean of traditional investment assets,
represented by thousands of stock and bond issuers, into what are
effectively small ponds: two dozen futures markets. It's important to
note that this the impact will only grow; many institutions have been
only ``testing the waters'' and are increasing their allocations to
this strategy. Institutions that have not yet participated will
increasingly follow the lead of others who have. The $260 billion
currently allocated by index speculators is only the beginning of a
trend. We can reasonably expect the holdings of index speculators to
increase more than ten fold, and perhaps as much as 15 fold.\1\ From a
policy perspective, we must assess not only the current impact, but the
future as well.
---------------------------------------------------------------------------
\1\&University endowments have led the embrace of alternative
investments, with other investors following. According to the latest
survey of the National Association of College and University Business
Officers, large endowments already allocate 3.6% of assets to ``Natural
Resources.'' Using this as a proxy for index speculation, and in light
of the approximately $100 trillion global pool of publicly traded
stocks and bonds, a potential global allocation of $3.6 trillion can be
estimated. A report by the British regulator, FSA, (Growth in Commodity
Investment, 3/26/07) infers that a higher percentage may be possible.
---------------------------------------------------------------------------
There are those who claim that index speculators have no real
impact on futures prices, since for every buyer there must be a seller.
This misses the point, which is, what determines the price at which
those two participants meet? Is there any market in the world where the
net addition of $260 billion on the long side of the market wouldn't
move prices higher? Maybe a lot higher, maybe just a little, but higher
nonetheless.
Some concede that futures prices may be impacted by index
speculators, but claim this has no bearing on the cash market. The
mechanisms by which futures prices influence physical prices vary both
by commodity and environment. In some cases, there is a clean arbitrage
transaction, so that a rise in the futures will directly translate into
higher physical prices. Sometimes, futures impact cash less directly by
providing a reference or index price on which physical transactions are
based.
There may be some instances where index speculation indeed
influences futures prices disproportionately more than cash prices.
However, this is harmful in another way. Commercial users of the
futures markets need to rely on predictable relationships between cash
and futures. When these relationships break down, commercial
participants either flee the market or are forced to bear or pass along
additional costs.
In all these considerations, one can argue in good faith whether
index speculators create a large or a small impact. Those who believe
that there is only a minimal influence should consider a future when
these index speculators will command far greater assets.
There are numerous proposals before Congress to address these
concerns. In my opinion, imposing speculative position limits on both
futures and swap desk transactions appears to be the best solution.\2\
This would require more transparency in swap markets than we currently
have. It may be that position limits alone are insufficient to curb the
distorting influence of index speculators, and some sort of aggregate
limitation should be imposed. I do not think this view is currently
supported by the evidence, and position limits are an appropriate and
productive first step.
---------------------------------------------------------------------------
\2\&Raising speculative margin requirements appears to be a
particularly risky policy. For a more thorough review of this, please
see the Appendix, which includes my article, ``Margin Madness,''
published on MarketWatch on June 10, 2008.
---------------------------------------------------------------------------
This would, of course, restrict the use of index speculation as a
portfolio strategy. Portfolio managers do have alternative tools for
inflation protection and exposure to commodity pricing--not identical
to be sure, but reasonable nonetheless.\3\ Each marketplace has its own
rules. Traditional equity and bond managers should be expected to play
by the rules of the commodity market when they trade futures, and those
rules should, and traditionally have, included speculative position
limits.
---------------------------------------------------------------------------
\3\&TIPS are a well recognized portfolio tool for providing
inflation protection. Preliminary research suggests that an equity
index like the Morgan Stanley Commodity Related Equity Index offers a
strong alternative to index speculation, offering high correlation with
commodity rallies, and lower correlation in declines.
---------------------------------------------------------------------------
Appendix
As published on MarketWatch on June 10, 2008.
Margin Madness
Commentary: Proposed regulatory cure will only worsen the crisis
By Jeffrey D. Korzenik
Last update: 6:18 a.m. EDT June 10, 2008.
Jeff Korzenik is Chief Investment Officer at VC&C Capital Advisers,
the registered investment advisory of Vitale, Caturano & Company Ltd.,
a Boston-based wealth management, accounting, and business services
firm.
BOSTON (MarketWatch)--Last Friday's startling spike in oil prices
has refocused attention on the role of futures speculators in driving
inflation. Higher energy prices are likely to renew calls to raise
margin requirements for speculators in an effort to moderate prices.
Those calling for this approach have misdiagnosed the problem and
prescribed the wrong cure. Higher speculative margin requirements could
well result in higher prices and the further decay of the structural
integrity of the futures markets.
Unfortunately for consumers and for concerned policy makers,
there's no ``quick fix'' that strengthens the dollar or increases oil
production to meet demand from the developing world. Policymakers
instead are focusing on the role of noncommercial participants in the
commodity futures markets. Much has been made of the supposed role
played by ``speculators,'' but this term no longer adequately describes
the full breadth of noncommercial participation in today's market.
There are indeed still speculators of the traditional variety--
highly leveraged players who play both the long and short side of the
market and move quickly in and out of positions. However, today's
commodity futures activity is marked by the presence of a new type of
noncommercial participant. These new players treat commodity futures as
an investment asset class, and they represent some of the largest
pension funds and asset managers in the country.
These ``commodity investors'' behave very differently from the
speculators. They are overwhelmingly oriented to the long-side of the
market, commonly do not deploy leverage, and hold positions for long
periods of time. Policy makers seeking to moderate commodity prices
need to distinguish between speculators and these new commodity
investors.
There has been a recent debate about the impact of these commodity
investors. There is a strong argument to be made that these new
investors both push commodity prices higher and disrupt the market.
Unfortunately, some of the debate has been informed more by sentiment
than by fact--after all, we instinctively think of ``investment'' as
good and ``speculation'' as bad. In the futures world, the opposite is
true. Speculators, with their high levels of margin and short-term
trading, create a tremendous amount of volume with a limited amount of
capital, ensuring critical market liquidity. Investors, on the other
hand, provide little benefit to the futures world, and lots of
problems.
The commodity markets operated quite efficiently without
``investors,'' who have only entered the arena in any size within the
last few years. The introduction of roughly $260 billion dollars of
long-only investment has effectively created an order imbalance--
futures prices have had to move higher to draw out opposing short
interest. The capital pools upon which the investors draw upon are
quite deep. In contrast, traditional speculators have limited trading
capital. Commercial participants are constrained by both the size of
their working business capital and by the amount of physical commodity
they can control. The capital committed to commodity investors is large
and growing, and if current trends continue unchecked, it could grow to
several trillion dollars.
Much has been made of the investors' position size relative to the
physical marketplace, but it is also worth considering the size of the
investor commitments relative to the speculator commitments. The chart
below illustrates data from the
There are three mechanisms by which the order imbalance created by
commodity futures investors can drive prices higher in the physical
market:
1. Higher futures prices directly impact those who contract to buy
or sell on a forward basis (e.g., airlines which contract for
future fuel needs, either directly through futures hedging or
through physical sellers who price on the basis of the futures
market).
2. When futures prices are bid up independent of the physical
market, this stimulates an arbitrage trade, where cash goods
are purchased and futures are sold, locking in price
differentials but driving up cash prices
3. The imbalance within the futures markets disrupts traditional
cash/futures relationships which ultimately adds risk,
uncertainty and cost along the commodity supply chain. This is
ultimately reflected in higher prices to the consumer.
In addition to these direct influences, there is also a case to be
made that the higher futures prices support an inflationary psychology.
We all face the bombardment of news of higher prices in energy, food
and precious metals. It may be that this increases the willingness of
commodity users to pay higher prices, and of commodity users to demand
increases as well.
What would happen if the regulators chose to raise speculative
margin requirements? How would this impact the order imbalance caused
by the investors' capital? The answer is unequivocal--higher
speculative margin would increase rather than decrease commodity
prices. Higher margin would decrease the ability of traditional two-
sided speculators to establish positions, and would not impact the
long-only, unleveraged commodity investors. This would increase the
ratio of commodity investors to traditional speculators. To the degree
this order imbalance is causing higher commodity prices, it would only
get worse.
Policymakers would be well advised to consider other tools at their
disposal. At the end of the day, commodity investors are using the
futures markets in a way that they have never been used before--and for
which they are ill-suited. It is a legitimate question of public policy
whether this should be constrained or even permitted. The investment
community, too, should reconsider the legitimacy of consumable goods as
a core asset class. After all, the last time we considered an
agricultural good a great investment, the commodity was tulips.
The Chairman. Thank you. We maybe don't have all of the
right people on this panel for this question, but I have been
asking this question. I still haven't gotten an answer that has
gotten through my head anyway; that is, as I understand these
index funds, that is some kind of an instrument or security
actually that is created and is priced off of the index or off
of the futures market. And, people buy these things and the
money does not go into the futures market. Money goes to
whoever sold them this instrument, right? And it does not at
that point go into the market and these indexes are never going
to buy these commodities. Am I right so far?
Mr. Korzenik. If I may, sir. There are various vehicles and
various ways. The most basic would be, something like a gold
exchange traded fund. This was the first of these publicly
traded vehicles to gain a lot of attention. And it actually
bought physical bullion. To give you a sense of the power of
this investment capital flowing in, it currently holds more
gold than the reserves in the European Central Bank. But some
of the others will go into the futures markets. Some of the
others will effectively participate through swap desks, who in
turn are laying off their risk even----
The Chairman. That is the point I was getting to. But, I
mean, by and large, though, like in oil, most of these are not
going into the futures market and buying those positions in the
futures market.
Mr. Korzenik. Some are going in via swap desks.
The Chairman. So, then, whoever sold this investment, they
are going to lay their risk off someplace. And as I understand
it, generally it is in the over-the-counter market that they go
into and find somebody to take the other side, some bank,
Merrill Lynch or whoever. The only thing that actually goes
over into the futures market is whatever they cannot net out.
Am I wrong about that?
Mr. Korzenik. You are correct on the mechanics, sir. But
following the weak point of that argument----
The Chairman. It is not an argument. I am just trying to
understand.
Mr. Korzenik. I understand, sir. But there are those who
are arguing that because the swap desk transactions are
essentially balanced they don't have an impact on the
marketplace. That is another way of saying, and this is a
falsehood, that there is no price impact because there is a
seller for every buyer. The issue at hand is if these
transactions are being executed through a swap desk and you
have physical sellers of oil and you have an index speculator
on the long side, the question is what would happen if the
index speculator was not there. That short seller or the swap
desk would execute the short transaction that laid off their
risk through the futures market and without the index
speculator there. Of course the index speculator could go in
through the futures, or if that money was not there, the short
hedger would have to sell down to a price to attract buying
interest and long interest. So it really washes through. The
argument that what happens on the swap desk if it is balanced
doesn't matter is really saying that aggregate demand doesn't
matter, it depends where that demand is. And I believe that is
not correct. Aggregate demand is what is important.
The Chairman. I don't understand where the demand is coming
from because this money that has paid for this index goes to
the investment bank, not to the market and not to the oil
seller, right?
Mr. Korzenik. Ultimately it represents a long interest in
the market.
The Chairman. Well, a fictitious long interest that they
have created. It is not a real long interest. It is just
something they created and it is kind of like a casino that is
based on some deal that is going on over here and you are going
to say, ``Okay, we are going to make a deal or we are going to
use this and I am going to bet this way, you are going to bet
that way, and we are going to see who wins.''
Mr. Korzenik. Pardon me. Some of the references to gambling
and casino have some application to the futures markets. But at
the heart of the markets, these are contractual obligations. It
is not like saying at the roulette wheel where your wager
doesn't influence the roll of the wheel. These too have
influences. And what essentially happens is the index longs
crowd out the commercial longs. There are long hedgers as well
and they essentially get crowded out by this, which has an
upward pressure on price.
The Chairman. So I still am not tracking this because these
long hedgers that are getting crowded out, how are they getting
crowded out, out of where? Out of the futures market?
Mr. Korzenik. If there is on a swap desk--if there is a
short hedger----
The Chairman. You are talking within the swap operation?
Mr. Korzenik. There is some customization of the
marketplace. But, as Dr. Pirrong mentioned, there are also
things that keep the prices aligned to some degree in these
markets. On a look at it purely from the commercials, you have
commercial longs and you have commercial shorts. They have to
come together somewhere. If you add in new commercial longs,
whether they are commercial or they are index, there is an
upward pressure on where those transactions occur.
The previous panel had this umbrella analogy. Think of a
seller of an umbrella that someone else wants to buy. Add in
five new buyers who are really aggressive. That is going to
increase the price of that umbrella, to use the previous
panel's analogy.
Dr. Irwin. Mr. Chairman, maybe I can add a couple of facts
that may be helpful in this situation. In terms of the netting
of their laying off of risk, we do have some good data already
on the volume of that activity in our commodity futures markets
through the CFTC's commodity index trader reports. That gives
us some very useful market statistics already. Recently, the
index trader positions as a percent of open interest are
basically in the range of 10 to 25 percent of total market open
interest. That certainly is a change in the structure of the
markets. But it simply isn't any evidence that they are
overwhelming our commodity futures markets, and I would also
point out that there is a logical fallacy that seems to be
committed here. There is no limit to the number of futures
contracts that can be created, in the sense that you can't
crowd out someone else in a futures market because you can
create an infinite number of futures contract if you wanted. It
is like you said, you can create as many side bets as you want.
And the other interesting part of that point is our grain
futures market. I know it is very important in your district.
In fact the biggest change over the last 2 years in the
structure of open interest has been the extreme surge in short
open interest by commercials, the people that are taking the
other side of the positions from long only index funds. For a
transaction to occur, it is voluntary, you only have a
transaction if the short and the long can agree on a price
given available information. That is what has been going on.
The Chairman. The one thing about these index funds is that
they are being driven by a formula. I don't think they look at
what the price is. They are just wanting to get into the
market, right? I mean, they have decided that they can't make
any money in any other place, and so this is where they are
going to go. They have made good returns the last few years. I
think somebody is going to lose their shirt frankly at some
point, and I have a real problem personally with pension money,
I am sorry ma'am, being put in these commodity funds. I think
that is a bad idea. As someone who used to be Chairman of the
Pension Commission for the State of Minnesota, I know a little
bit about that because when this thing unravels, there are
going to be some unhappy folks. We don't have control over
that. So you don't have to worry.
Ms. Diamonte. Mr. Chairman, as you know, I am the CIO for
United Technologies. We don't have any direct investments in
commodities at all. But representing CIEBA, as I mentioned, on
looking at our survey for 2007, which manages $1.5 trillion
combined with natural resources and commodities, there is less
than one percent investing in this.
The Chairman. I understand that.
Ms. Diamonte. It is not a large percentage.
The Chairman. I know. I looked at that. But, personally,
that is one percent too much. And if you aren't invested, I
commend you. I think that is a good decision. And I know that
some of these pensions that are in for one percent are now
looking to put in more. And I know how this works. They all go
to these meetings and they talk to each other about where they
are making money. And I will guarantee you that this is going
to go up. And how far it will go, I don't know. But, I am not
sure that you want to put people's pension money in something
as volatile as the commodity market.
Ms. Diamonte. Mr. Chairman, there is a lot of study that
has been done over time and it depends on the end period of
whether commodities actually add value. A commodity is a
commodity. So is it really a valuable asset class that is going
to add return? But one fact is that it is extremely
uncorrelated with the stock market and uncorrelated with the
bond market. And for many pension plans who have liabilities
that are gauged to inflation for the benefits, commodities
moves with inflation.
The Chairman. I know what drives them.
Ms. Diamonte. There are a lot of valid reasons why some of
my colleagues are investing in them.
The Chairman. I know. And it might have been legislators or
whatever that put these benefits in that can't be sustained and
so these managers have to scramble around trying to figure out
how to pay for it because they have unfunded liabilities. I
understand all of that. And I sympathize with them, but I am
not sure this is a good strategy in the long term.
Mr. Cicio. Mr. Chairman, you pointed out a very important
thing. Index funds generally don't care what the price of the
underlying commodity is, and that is a problem for commodity
markets. It may not be a problem for stock markets, bond
markets, I don't know. But for commodity markets, it is
different, it is about a physical delivery of a product. And
that product needs to reflect underlying value. What is really
important to a producer of, let's say, natural gas, they don't
want the price to be too low to ensure that they have a profit
to produce more. They don't want the price to be too high
because then they get demand destruction and they lose markets.
For us consumers, we care a great deal because we don't
want the price to be too low so that the producer can't
continue to produce it. But at the same time, it can't be too
high that it drives us out of the market and we are not
competitive. We care. The basic hedgers, the physical hedgers,
have skin in the game and hedgers and index funds do not.
The Chairman. Mr. Neugebauer.
Mr. Neugebauer. Ms. Diamonte, as a manager, I assume your
responsibility is to manage a pension fund; is that correct?
Ms. Diamonte. Yes, it is.
Mr. Neugebauer. And so when you look at return, the people
that are depending on your investments are looking for an
after-inflation return on their investment?
Ms. Diamonte. You know, I really think it depends on the
plan sponsor. As you know, many corporations have different
expected returns, and many of them have different benefit
designs. And there are some corporations that have put cost-of-
living adjustments into retirement benefits, so they are tied
to trying to get inflation numbers. There are others that
don't, are not being raised by inflation, and therefore don't
worry about that hedge.
Mr. Neugebauer. It might not be important to the companies,
but it is certainly important to the retirees; is that correct?
Ms. Diamonte. Absolutely.
Mr. Neugebauer. And so what is, in your opinion, one of the
best hedges against fairly rapid inflation that we are having
right now?
Ms. Diamonte. Well, studies show that there are very few
asset classes that actually are highly correlated with
inflation. In other words, as they increase, gain prices
increase. Commodities is one of them; real estate is another
one, and we all know what the valuation is in the real estate
market. So it is very hard for pension funds like ourselves to
try to invest in assets that actually are very correlated.
Treasury index inflation bonds is another one. The prices of
that have actually been low, so it is difficult to actually get
good inflation hedges.
Mr. Neugebauer. But it is important to.
Ms. Diamonte. It is extremely important.
Mr. Neugebauer. So really one of the things that has
happened in our economy right now is we have had a huge decline
in our dollar, which has caused huge inflationary pressures,
and particularly it has caused a tremendous decrease in the
value of investment for companies that are holding dollars
because the dollar has obviously gotten weaker. Should we
prohibit people from being able to look for opportunities to
hedge or to protect themselves from these inflationary times?
Ms. Diamonte. I think it is our opinion that we really need
to adhere to good portfolio modern theory, which means that you
need to look through all the different markets and find the
best asset-allocation policy that meets your long-term
liability needs. So I would say no, not to prohibit in any
asset class. And we have many opportunities to invest
internationally on an unhedged basis, so if the dollar does go
down, we still can maintain some of that return.
Mr. Neugebauer. Now, I tell you what. This panel, with the
exception of one, has got the name thing a little tricky here.
I wasn't here for the introductions, but is it Mr. Cicio?
Mr. Cicio. Yes.
Mr. Neugebauer. You seem to be advocating that we should
only let people that have skin in the game be in the
marketplace. And so I think one of the things that we have had
a difficult time here is who are people that have skin in the
game?
For example, in my former life I was a land developer, and
in the land development business, I used a lot of plastic pipe
that is oil based. The asphalt that I was purchasing in large
quantities was oil based. The diesel that was being used to do
the excavation and all of the operations necessary to put in
that infrastructure was oil based. And so under the current
scenario that I hear some of the testimony, I would be a
speculator. When, in fact, I might have been trying to hedge a
business position because of the tremendous amount of intensity
that my business relied on oil-based products. So are you going
to throw me out?
Mr. Cicio. Absolutely not. It sounds to me like what you
described is someone that is a business person who has a real
hedge opportunity. You are doing something in relationship to
your business that is associated with the underlying commodity.
That is who should be playing in these markets, as I contrast
that to index funds, who, as I say, they don't care what the
price is. They are just throwing mounds of money into it, and
they have a different intent, a different strategy than
historical participants, buyers and sellers for a physical
future delivered product.
We need speculators in these commodity markets. Don't
misunderstand what I am saying. I pointed out earlier
everything worked pretty well in these futures markets prior to
the year 2000, prior to when we made changes to the Commodity
Futures Modernization Act. And that opened up the door to a lot
of increased speculation that now has picked up steam and is
rapidly accelerating for players that, as I say, don't have
skin in the game.
Mr. Neugebauer. I believe if I called up today and tried to
take a position to hedge in a futures contract, I would not be
a qualified hedger. I would be a speculator. I would like to
hear someone that knows a business in America today that is not
being impacted by higher energy prices.
Now, the other thing is that I don't have the expertise to
sit and trade hedges all day long. When I was in the land
development business, I needed to be out selling things,
because there is an old philosophy in my business that if you
don't sell anything, you don't get to eat. And most of my
family did like to eat, so I needed to spend more of my time
trying to sell something.
So one of the things that some of these investment vehicles
provide an opportunity is for businesses that don't want to be
involved in trading and don't want to have to make a margin
call, if the market is swinging. My final question is that the
term ``excessive speculation'' keeps being kicked around here.
What happens is about every 6 months we come up with buzzwords
in Congress, and so the buzzword du jour right now is
``excessive speculation,'' that it is somehow ruining the
world. What is ``excessive speculation?''
Mr. Cicio. Well, for natural gas I will tell you that when
the analysis we just did, the volume of natural gas is trading
in the neighborhood of 24 to 32 times the physical consumption
of, let's say, the August natural gas physical commodity. We
don't know what the right number is where excessive begins and
ends, but we look at 24 times and 32 times and say, ``That
sounds like excessive speculation to us.''
Mr. Neugebauer. Anybody else want a bite at that apple?
Dr. Pirrong. Essentially the key thing, is that that demand
is not translating into the physical demand that is affecting
the price that Mr. Cicio and his clientele are worried about.
Essentially if you look at deliveries, for example, they are a
trivial fraction of the kinds of volumes that he is talking
about here. And in terms of the swimming pool analogy, well, to
be quite honest, these index funds and everybody else are well
out of the pool by the time that these contracts go to
delivery. So these folks are not contributing the kind of
physical demand that would be causing prices to move away from
where they should be.
Dr. Irwin. I think you raise an excellent point that in our
history of the regulation of commodity futures market, we have
struggled from the beginning in the 1920s, when we first
decided that we needed to have regulation regulating the level
of positions in the markets. That means we needed to define
what was a hedger, and that has been a difficult debate now
running over 80 years.
For example, at the University of Illinois right now, in
responding to the farmers that we talked to, one of their
biggest concerns is rapidly rising production costs. Anybody
that is working with farmers knows that it, particularly
fertilizer, is skyrocketing. Our research shows that the item
that has most positively correlated with the increases in the
price of their cost of production is crude oil. So if they are
to hedge their input cost increases, it would be a very
reasonable thing for a farmer to do today. I want to protect
myself from that. What can they do? They need to buy something
that is very highly correlated with the movement of the crude
oil. And even though that is very important to their business,
that would be classified as a speculative move.
Mr. Neugebauer. Speculative, exactly. Every businessman,
unless he is taking delivery of hydrocarbon in a bulk sense,
would be classified as a speculator.
Dr. Irwin. It is in fact, actually quite difficult to
precisely define who is a hedger and who is a speculator. And
we have been trying to slice that for 80 years, I think fairly
unsuccessfully.
Mr. Neugebauer. One of the last points I want to make, and
someone can pick up on that, is that I am told in the last few
years, that for a long time the major oil companies did not
really deal in the commodities markets. They were producing,
but they were not doing as much hedging as a number of them are
today. I would like to get your reflections. What I am told is
because these price levels and the cost levels of going after
some of these deepwater drilling and some of the deep natural
gas wells that are now--that cost millions and millions of
dollars, that these folks have gone into a much more aggressive
risk management process. And so when we look at some of these
volume increases over what the volumes were 10 years ago, what
the volumes are today, is that it is just that people are
trying to use the commodity market for what they were designed
to do, and that is to protect those folks.
Mr. Cicio. That is one of the things that gives us great
concern is if you look at the forward curve of any of these
energy commodities, most of the volume is in the front month.
And what we need are speculators, buyers and sellers in those
future months. So the market could be working better, but
instead we have--as I will go back to this issue of the index
funds, it is all in the prompt month, and it is rolled over to
the next month. So you have this huge mound of money that keeps
getting bigger and gets rolled over, sold, rolled over to the
next month and then the next month, and we just have this
fundamental belief that if you keep throwing money at a
commodity, certainly that mound of money, it certainly is going
to have an impact and a speculating effect.
The Chairman. I thank the gentleman.
The gentleman from California. Do you have any questions?
The gentleman from North Dakota.
Mr. Pomeroy. I want to thank the panel. It has been
absolutely excellent, really very, very interesting. Thoroughly
knowledgeable experts reaching very different conclusions. And
so it is a little puzzling up here, but it certainly is
fascinating.
Dr. Irwin, you are clearly an expert and exponent of market
function. And so experts like you have helped me understand the
relationship of liquidity in terms of futures speculation, in
terms of easing price fluctuation, volatility in the
marketplace. Do you get to a point where you have so much money
coming in, where the market is so hyper-liquid, that the
legitimate price discovery function of the market can be
disrupted?
Dr. Irwin. My view is that, yes, that is theoretically
possible. We have to, as economists, admit that it is possible
for a futures market in commodities to become overspeculated.
The difficulty, of course, is then figuring out where that line
is and how do you determine what is--when it is too much.
In research that I have recently completed looking for the
kind of standards, what we did is we looked at the relative
levels of short hedging in these markets versus long
speculation, where the index funds would be located. And, in
fact, we find that the levels of commercial hedging seem to be
pretty similar to what we had seen many, many years ago. In
fact, they are very similar to what we saw going all the way
back to the late 1940s and into the 1950s. So the markets, as
best we can tell, based on historical standards, do not seem
out of balance. But again, I admit that it is possible.
Mr. Pomeroy. I am coming back to you.
Mr. Korzenik. If I may. I think one of the issues here, and
Dr. Irwin is quite right, is this theoretical overspeculated
marketplace. And I guess where I would disagree with him is, as
an academic construct, you can make more and more future
contracts. You have plenty of people to adjust for price
discrepancies. But, particularly in some of the smaller markets
is where you would start to see the problems first. And if you
look back and say, what happened to cotton in late February or
early March, and I know there is an ongoing CFTC investigation
to this, but you start to wonder whether we are running up
against some of the limits.
So, for instance, there are only so many short hedgers out
there. There is only so much product that can be short-hedged,
let alone the much smaller amount that is actually deliverable
into the contracts. And then speculative shorts, longs and
shorts are also limited by capital constraints. So, yes,
ultimately you can draw more in over time, perhaps.
Mr. Pomeroy. Would the fact that the Farm Program pays for
cotton storage have a--potentially a complicating factor here?
Mr. Korzenik. Yes, because anything is a change, a
disruption from total free market.
Mr. Pomeroy. It takes out some of the incentive to sell.
Mr. Korzenik. You know----
Mr. Pomeroy. That is really a matter for another day.
Dr. Irwin, you indicate that if indeed price becomes
separated from the fundamentals of supply and demand, that this
arbitrage incentivizes the profit taking and rationalizing the
market. Is that what you are saying?
Dr. Irwin. Correct. That, as Dr. Pirrong talked about this
morning, that in the real physical market, if you are creating
a bubble, and again you are creating it against other well-
financed, large, very smart, very good traders, somewhere,
someplace, somebody is going to then be holding the commodity
off the market, and that should be evident.
Mr. Pomeroy. Right. I am almost out of time.
Mr. Cicio, why don't you think that is working?
Mr. Cicio. Would you repeat the question?
Mr. Pomeroy. Sure. Basically the profit-taking
opportunities, if pricing becomes diverted from rational
pricing based on supply and demand. Essentially Dr. Irwin has
talked about the way the market corrects when trading creates a
situation where the pricing may not accurately reflect an
economically rational price based on supply and demand.
Mr. Cicio. Well, that is just it. When you have, as I said,
new players in the market, and index funds are relatively new
players, that don't care about the price, they are just
throwing money in, it just changes how that price is going to
come out the end. It just does.
Mr. Pomeroy. Dr. Pirrong, do you have a 30 second answer to
that?
Dr. Pirrong. Just to add to what Mr. Neugebauer said, which
was, ``Hey, we have all these oil companies out there. They
have huge capital. They have huge information. If they really
thought that the price of oil would be driven up to excessive
levels as a result of this index speculation, that would be a
great opportunity for them to make money. And they have the
financial wherewithal to do that.''
And again, also it is important to make the distinction
between the physical market on the one hand and the financial
market on the other hand. These players are out of the game.
They have cashed in their chips by the time this market goes
physical, so they are not contributing to the demand for that
product.
Mr. Pomeroy. Thank you, Mr. Chairman.
The Chairman. The gentleman from Mississippi, do you have
any questions?
Mr. Childers. Mr. Chairman, for the sake of time, I do not
have any questions.
The Chairman. Thank you very much.
The gentleman from North Carolina, and then we have a vote
here. We are going to take these questions, but we are going to
come back. Mr. Marshall has some questions of this panel, and I
may have some more, if that is okay. Thank you.
We have about 8 minutes. So we have time for your
questions, I think.
Mr. Etheridge. Thank you, Mr. Chairman. And, Mr. Chairman,
at the appropriate time I am going to have a couple of letters
I would like to submit for the record.
[The documents referred to are located on page 261.]
The Chairman. Without objection.
Mr. Etheridge. Because they are the real, live folks,
people who are major corporations now on the verge of going out
of business because of the commodity and fuel prices.
So my question goes back, very quickly, Ms. Diamonte, I
believe it is, how long have your folks been investing pension
and retirement funds in the commodities markets? Do you know?
When did that start?
Ms. Diamonte. CIEBA as a whole? I don't know the answer to
that.
Mr. Etheridge. Can you get that for us?
Ms. Diamonte. Sure. We have been collecting data for over
15 years, so I could show you the trend of that over time.
Mr. Etheridge. Maybe some graph as to when that increased.
Thank you, ma'am. I think that is important because I think
some of these are critical pieces. The letters I am going to
submit are letters that are real life view of people's lives.
They have lost a lot of jobs as a result of it.
Mr. Cicio, you asked that we ensure that the Federal
Reserve is not loaning capital at low interest rates to banks
which turn around and speculate those funds in futures markets.
And you also state in your testimony that you don't believe
that the almost linear relationship between lower Federal
Reserve interest rates, increased borrowing of banks and
corresponding higher commodity prices is a coincidence.
I would be interested in hearing you comment more on that
because I really thought the Federal Reserve checked to see how
loans it offered to banks are being utilized. And if not, we
sure need to have our corresponding work with that. And I guess
I want to know do you think the Feds are monitoring? If they
aren't, why shouldn't they be doing it? That is a serious
problem if it is true.
Mr. Cicio. Thank you.
We do not know if the banks who are borrowing Federal
Reserve money are speculating with it. We could not help,
though, when we saw the correlation of the timing of the lower
interest rates to the significant ramp-up of borrowing by the
banks and the relative correlation to the escalation of energy
commodity prices and commodities in general. And so we are not
accusing the banks of anything or the Federal Reserve of
anything. We are just raising the question.
Mr. Etheridge. Do you have any data on that?
Mr. Cicio. Well, we have more charts like the ones that
were in my testimony that showed these relationships. That is
all we have.
Mr. Etheridge. Would you make those available to this
Committee?
Mr. Cicio. Yes, sir.
[The documents referred to are located on page 262.]
The Chairman. Will the gentleman yield?
Mr. Etheridge. I yield.
The Chairman. When we cut the interest rates, I think
people expected the dollar to fall and potentially inflation to
take up. So weren't they just then shifting over, understanding
that this is a foolhardy policy probably, and they are going to
make use of it? I mean, the dollar has fallen how much since
then, and as I understand it, that is why a lot of people are
going into this market.
Mr. Korzenik. If I may, Mr. Chairman, there are a number of
theories relating to interest rates and commodity storage and
things like that. But a lot has been talked about the role of
the dollar, and there is no doubt that the dollar has had a
role. But there are other things at work.
For example, the dollar since mid-March has essentially
been trading sideways, yet oil prices, crude oil prices, are up
35, 40 percent since that time period. So one of the challenges
in trying to examine this whole index speculation issue or
speculation issues is you can analyze, you can guess, but you
can never know with certainty what fully causes a price move.
So there is certainly a role of the dollar. I don't think
anyone denies that. But I would argue that there are other
factors at work as well. In fact, the very close correlation
between the dollar and crude oil, for instance, during last
year was almost too close. Oil is not necessarily a currency,
and you had an almost exact correlation, which is unlike
previous periods. So if you go back 20, 30 years, the
correlation between commodities and the dollar is much, much
weaker than one would be led to believe by the press. It is
certainly a factor. I wouldn't deny that. I just think you
shouldn't walk away saying, oh, it is the dollar and nothing
else, and not look at these factors.
Mr. Etheridge. Let me get one final question in. Professor
Pirrong, on the following panel and in the written testimony,
Mr. White alleges that $167 billion in new inflows have gone
into the 25 commodities that make up the major indexes. Have
you seen this analysis?
Dr. Pirrong. Not that particular analysis, but I have seen
similar figures, yes.
Mr. Etheridge. I would be interested in your thoughts on
that, and also, if you believe these can be substantiated? I
think this Committee needs to have some basis for that. If you
don't, I would be interested in your thoughts on it.
Dr. Pirrong. Well, I have a couple of thoughts. First of
all, I mean, is this a bug or a feature, right? I think that is
essentially what we are asking; is this a good thing or a bad
thing? And in terms of the ultimate question, you have quite
eloquently talked about your concern about what effect this is
having on real people and what they are doing. And to be quite
honest with you, sir, I don't really think that it is causing
the pain that your constituents and other folks' constituents
are suffering.
Mr. Etheridge. So what do you think is causing that pain?
Dr. Pirrong. Oh. We have how many minutes before your vote?
I don't think we have enough time. But in a nutshell, in some
respects a perfect storm in terms of perverse policies,
particularly among developing nations that are subsidizing
consumption at the same time when political unrest and
essentially the harvest of lack of investment over the last 10
years has really put a cap on supply. Add that with a little
gasoline on the fire from the Federal Reserve and we have a
very difficult problem.
The Chairman. Well, thank you very much.
The Committee is in recess. We will take this up when we
get back.
[Recess.]
Mr. Marshall [presiding.] If everybody can take their
seats. Chairman Peterson has asked that I reconvene the
meeting, and I guess we should do that in the interest of
diminishing the amount of time that you are stuck here and
moving this thing along. And as it happens, I am the next
person to ask questions anyway.
Is Dr. Pirrong--here he is. Okay.
Before the Chairman adjourned so quickly, I was going to
try and intervene, lost my opportunity to do so. And had I had
an opportunity to do so, I was going to ask that the two good
doctors here, Irwin and Pirrong, get together with Mr. Korzenik
and the three of you agree on the nub of your difference of
opinion so that we can get right down to where it is that you
differ.
And it may be it is this burden of proof stuff that a
number of people have suggested to us. Nobody can really prove
their case, so cast the burden on the side of the other, and
that decides the matter.
And so if you guys could give that thought, let me ask Dr.
Irwin a question. In a follow-up to a response, you said that
you thought that there was some evidence out there that this
largely passive long index fund money that is coming in simply
because it wishes to take a position isn't influencing the
market all that much. And you cited two things, and I just
wanted to explore those two things. One, I think you said there
was 10 to 25 percent open interest by commodity index funds,
which is a relatively small thing, not overwhelming, is the way
that you put it, so it couldn't possibly be overwhelming the
market.
And then the second thing that you said was that as you
look at who is long and who is short, the index funds seem to
be long, but the commercials are short. Did I understand you
correctly?
Dr. Irwin. Yes, that is correct.
Mr. Marshall. And when you say commercials are short, you
are referring to people who actually have an interest in the
industry, they have oil to sell or something like that?
Dr. Irwin. Correct. And these were producers, processors.
And I am no expert here by any means. And you see all of us
sort of fumbling around trying to grasp what is pretty arcane
and complicated stuff, trying to just figure out what is the
right thing to do to try to help folks out where these prices
are concerned and at the same time not ruin these markets or
drive business overseas. It is a delicate balance that we need
to strike here.
Mr. Marshall. And when you cited as support for this
commodity money and long positions not being much of an
influence. The second point, I found myself wondering, and I
may be missing something altogether here, if it might not be an
argument for exactly the opposite conclusion or evidence to
support exactly the opposite conclusion. When what you are
saying is that the commercial side, the folks that are
typically in here for business reasons are on the short side
and the folks that are in there, intending to take a position
and hold long, but are not in there for typical commercial
physical market reasons are on the long side, doesn't that
suggest that those who are in the business normally think
prices should be a little bit less and they are willing to take
the short position because they see these prices and they
think, ``Good gosh, that is a better deal than I think the
market would normally give me. And so, yes, I guess I am going
to take that deal.'' And one after the other I guess they are
enticed to take that deal, to go ahead and agree to sell at
some later date at a certain price. They are inclined to do
that as the price gets pulled higher and higher and higher by
what you describe as ``open commodity long positions,'' folks
who don't have a commercial interest.
Could you set me straight? I am confused.
Dr. Irwin. It is an excellent question. I want to make sure
I am understanding your point that you are talking about. The
point I made was that the relative balance between the hedging
interests in the market, at least in agriculture and many other
markets, tend to be on the shorter selling side, that that is
not out of balance relative to the long speculation in the
market, which is where the long index funds----
Mr. Marshall. We have had lots of testimony that in order
for you to have a contract, people have to come together. So
the question is, at what price do they come together? And if
the commercials are saying, geez for that price I will sell
either side and the--what we are sort of focusing on as the
current crowd of speculators as opposed to the experienced ones
who have been providing liquidity for a long time and you
typically find on either side. I am going to go short this
time, I am going to go long next time, that sort of thing,
those kind of speculators have been in the market for a long
time. We want them in the market, they help provide liquidity,
they narrow the margins, they enable hedges that otherwise
wouldn't be available for the commercial side. Now we have a
whole bunch of money in the market that is just going long and
it sounds like this long money in the market, people want to
take positions because they want to be in commodities. You have
the commercials on the short side, them on the long side. It
sounds to me like that the commercials are going, ``Golly, if
you will pay that much for it, I will do it because I am not
going to get that kind of money from anybody else.'' And if
that is the case, isn't that evidence that the longs, in fact,
are pulling the market up as opposed to evidence, as you
suggested, evidence that no, they are not having any impact?
Dr. Irwin. Okay. What I would say in response to that is
that what we know from at least historical patterns in
commodity futures markets is that hedging, in essence,
speculative volume tends to follow hedging volume. That pattern
has been established for many, many years. Yes, you are
correct. That could be changing. This is a new type of trader.
So it does raise the kind of questions that you are raising.
But it would be different than the traditional pattern of the
speculation following the hedgers' volume and that is why the
balance doesn't seem out of balance.
The next response I would have is that we have to be
careful that anyone with a short position at that point in time
generally will have a view that prices are attractive to be a
seller. So as price goes up, there are always going to be a
concern, particularly if they are wrong. And that is a story we
know about as it has happened in agriculture a number of times.
Mr. Marshall. Can I interrupt? I am just trying to get you
to get to the nub of my question. It is a question, it is a
concern. I don't know. I am not an expert here. Hypothetically,
let us assume that there are, I know this isn't the case, but
let us assume that everybody who is short, are commercial types
that have historically been in the market for a long time. And
everybody who is long, are newbies, they are the commodities,
the index funds, et cetera. Let us hypothetically assume that
is the case. Would you say that is evidence that, and let us
also assume that prices are going up. I mean, we are observing
that. Would you say that is evidence that something must be
going on, that these longs, that this new money in the market,
different from the historical money in recent years, anyway,
that it must be pulling things up? Would you say that is the
case?
Dr. Irwin. I don't believe, no, that is sufficient
evidence.
Mr. Marshall. If all the commercials are on one side and
all the investment folks are on the other side?
Dr. Irwin. No, because they could all be reacting to the
same common information about underlying supply and demand.
Mr. Marshall. Dr. Pirrong, if you could weigh in on that.
Let us hypothetically say that is the case. And all the
commercial folks are saying, ``There is no commercial person
out there saying I want to buy at those kinds of prices,'' but
there are a lot of commercial folks out there saying, ``Hell,
yes, I will sell at those kind of prices.'' And they are the
ones that are traditionally in the market and the ones that
largely are the folks that are speculators that are
traditionally in the market and are also on the short side and
going, ``Whoa, heck, yes.'' And then on the long side is all
this passive, not as experienced money. Let us say,
hypothetically, that is the case. Would you say that prices are
being pulled up by this passive, not very experienced money?
Dr. Pirrong. Not necessarily. And here this might be a
little inside baseball. But I think it is important to draw a
distinction again between the physical market on the one hand
and the financial market on the other hand. Essentially what
economic theory tells us is that speculative participation is
primarily going to affect the futures price relative to what
the spot price is expected to be when that contract reaches
delivery. And essentially the difference between those two
things, the futures price on the one hand and the expected spot
price on the other is a risk premium. A risk premium is a cost
to the hedgers and essentially what can happen is you can have
a situation where the following is true. We have a flow of new
speculative money into the market that reduces the risk
premium, which if commercials are net short would tend to cause
the futures price to rise relative to the expected spot price.
That doesn't mean that the spot price, the price for what
barrels, in the case of oil, is being distorted or is too high
and it actually means that actually that increase----
Mr. Marshall. Doctor, it is hard for me to follow you and
you are trying to help me. So let me interrupt you and just ask
you this. You earlier had said that all these folks talked to
one another. I mean there is a rule here in politics, if three
people know it, it is no longer a secret. It is inconceivable
to me that somehow the physical market and the financial
market, the speculators around the globe, et cetera, just don't
know what everybody else is doing. So even though it is in what
we refer to as opaque, dark markets, there are an awful lot of
people playing who are playing in the futures market, which is
transparent to us and regulated by us, that know absolutely
what is going on in the dark markets; and folks in the dark
markets of course know what is going on in the others. And it
is very unlikely that there is some arbitrage to be had because
people are so stupid that they don't have information; isn't
that correct?
Dr. Pirrong. Yes, that is actually what I said earlier.
There would be information flow between these markets, yes.
Mr. Marshall. So what I don't understand is how all of the
people who are historically savvy and commercially involved in
my hypothetical could be on the short side and you wouldn't
conclude that this group on the long side, either because they
know something everybody else doesn't know, or they are in it
for a different reason and they don't really care about that.
They just want to take a position. But you couldn't conclude
that. Given that information is supposedly shared so everybody
knows everything, why would all the commercials in the
hypothetical, all of the commercials and all of the traditional
speculators be on one side and this new money be on the other
side?
Dr. Pirrong. Again, as Professor Irwin said earlier,
typically it is the case that commercials are net short and
they need somebody to lay off that risk to. One thing that
could have been happening recently is that these----
Mr. Marshall. I am not talking about recently. I am talking
about the hypothetical. I am trying to see whether or not it is
hypothetically possible with an experienced person like you,
that in a hypothetical like this, the price could be pulled up
by money coming in, taking that position that it is not
something that the rest of the market understands and they are
certainly willing to sell at those kinds of prices.
Dr. Pirrong. Again, though, it goes back to what I said
earlier. If this price were truly distorted, if it were away
from where fundamentals would justify, then the people that
were willing to pay the high price, they are going to end up
actually owning the physical stuff. And to the extent, if you
could document that, that would be----
Mr. Marshall. They may not own it. But they might regret
having taken the position, the willingness to buy at that
price.
Mr. Chairman, do you want to take over and wrap it up or do
you want me to wrap it up.
The Chairman [presiding.] We have to get to the next panel.
Mr. Marshall. Gentlemen, thank you. I am very interested in
hearing, could I do this, Mr. Chairman? Could the three of you
talk with one another and see if you can't come together--maybe
e-mail back and forth, and see if you can't come together with
a statement that you could give us that describes where you
fundamentally disagree so that we have a better handle on that?
Mr. Korzenik. I would certainly be willing to do that.
Mr. Marshall. Could you do that in just a couple of days?
Dr. Irwin. I would be happy to.
Mr. Marshall. By Monday?
Dr. Irwin. We will do our best.
Mr. Marshall. Thank you, Mr. Chairman.
The Chairman. Thank you, Mr. Marshall. We are going to
dismiss this panel. Thank you all very much for bearing with us
and making your time available, and it has been very valuable
to the Committee and we may be calling you again to clarify
things. So thank you very much.
We will call the next panel. We will try to get people out
of here by 5 o'clock. We have Dr. Jim Newsome, President of
NYMEX, who I think all of you know. Christine Cochran, the Vice
President of Government Relations for the Commodity Markets
Council. Mr. Joe Nicosia, President of the American Cotton
Shippers Association. And Mr. Adam White, the Director of
Research for White Knight Research & Trading. Welcome all to
the panel.
One good thing about being on the last panel, other than
you had to sit here all day, is that most Members are not
voting, it should go quicker. So, Jim, we appreciate you being
with us today and your testimony. To all of the witnesses, your
testimony will be made part of the record. And you can
summarize your statements in 5 minutes and we appreciate you
being here. Thank you.
STATEMENT OF JAMES E. NEWSOME, Ph.D., PRESIDENT AND CEO, NEW
YORK MERCANTILE EXCHANGE, INC., NEW YORK, NY; ACCOMPANIED BY
THOMAS LaSALA CHIEF REGULATORY OFFICER, NYMEX
Dr. Newsome. Thank you, Mr. Chairman. I appreciate the
invitation to be here today to testify. Certainly the ever
increasing cost of energy touches all aspects of our daily
lives and today is quite possibly the most important issue
facing both global and domestic economies. This panel is to
focus on speculative limits and hedge exemptions and, Mr.
Chairman, I will strictly address just those topics.
Speculative activity on U.S. regulated futures exchanges is
managed by position limits. These limits effectively restrict
the size of a position that market participants can carry at
one time. The limits are set at a level that greatly restricts
the opportunity to engage in manipulative or abusive activity
on NYMEX. Speculative limits adopted or adjusted by NYMEX are
submitted to the CFTC for review prior to implementation.
Hedge exemptions are being debated as a possible
contributing factor to what is perceived by some as excessive
speculation. NYMEX maintains a program that allows for certain
market participants to apply for targeted hedge exemptions from
the prior set position limits in place on expiring contracts.
Hedge exemptions are granted on a case-by-case basis, following
adequate demonstration of bona fide hedging activity involving
the underlying physical cash commodity or involving related
swaps contracts. A company is not given an open-ended
exemption. The exemption does not allow unlimited positions.
Instead, the extent of the hedge exemption is no more than what
can be clearly documented in the company's active exposure to
the risk of price changes in the applicable product.
Questions have been raised concerning whether or not
certain noncommercial customers or swaps dealers are in effect
circumventing speculative position limits by obtaining hedge
exemptions for noncommercial activity. Related to this issue,
we have heard both reckless and unsubstantiated claims that 70
percent of the NYMEX crude oil market is made up of
speculators. That 70 percent figure incorrectly assumes that
all swaps dealers are noncommercials and that all of their
counterparties are also noncommercials. This is simply not the
case.
However, this confusion highlights the need for the CFTC
large trader data to specify for energy futures the degree of
participation by noncommercials in the same manner as is done
now for agricultural contracts. This potential gap in the large
trader data compiled by the CFTC in its Commitment of Traders
report complicates efforts to determine the commercial and
noncommercial activity of swaps dealers.
More detailed information from index traders and swaps
dealers in the futures market is necessary to confirm that not
all over-the-counter energy swap activity undertaken by swaps
dealers involves noncommercial participants. In addition, NYMEX
believes that these data will allow the CFTC to better assess
the amount and impact of this type of trading on the markets.
NYMEX is concerned about restrictions that could be imposed
on swaps dealers that could limit the ability of commercial
participants to execute strategies to meet their hedging needs.
For example, commercial participants often need to have
customized OTC deals that can reflect their basis risk for
particular shipments or deliveries. In addition, the reality is
that not all commercial participants have the sufficient size
nor sophistication to participate directly in the futures
markets. Swaps dealers assume that risk and then manage it in
the futures market.
That said, Mr. Chairman, NYMEX would support a restriction
of the ability of a swaps dealer to obtain a hedge exemption
from a position limit for activity that concerns OTC
transactions involving noncommercial participants. This
targeted approach will address the concerns being raised in a
thoughtful and deliberate manner and will also reinforce the
underlying rationale for the maintenance of effective position
limits on speculative activity.
Thank you, Mr. Chairman.
[The prepared statement of Dr. Newsome follows:]
Prepared Statement of James E. Newsome, Ph.D., President and CEO, New
York Mercantile Exchange, Inc., New York, NY
Mr. Chairman and Members of the Committee, my name is Jim Newsome
and I am the President and Chief Executive Officer of the New York
Mercantile Exchange, Inc. (NYMEX or Exchange). NYMEX is the world's
largest forum for trading and clearing physical commodity-based futures
contracts, including energy and metals products, and has been in the
business for more than 135 years. NYMEX is a federally chartered
marketplace, fully regulated by the Commodity Futures Trading
Commission (CFTC) both as a ``derivatives clearing organization'' (DCO)
and as a ``designated contract market'' (DCM).
On behalf of the Exchange, its Board of Directors and shareholders,
I want to express our appreciation to the Committee for holding today's
hearing. The ever increasing cost of energy touches all aspects of our
daily lives and today is quite possibly the most important issue facing
global and domestic economies as well as U.S. consumers. Highlighting
the urgency of the matter, no fewer than 19 bills have been introduced
in the House and Senate over the last few weeks on this very topic.
The Committee has chosen to focus the discussion on several key
issues including margin requirements, hedge exemptions, swap dealers,
index funds and foreign boards of trade. NYMEX is pleased to provide
its views on the topics of interest that you have identified.
Margins
Futures exchanges serve a price discovery and risk management
function. Exchanges are neutral as to price levels. In the American
free market system, price is determined by the open interplay of market
opinion between buyers and sellers. Margin levels should not be used as
a tool by the government to artificially control prices. Moreover, any
attempt to use margin levels to do so will likely fail. The most
important function of margin is prudential--that is, to protect the
exchange from credit exposure to its clearing member brokers, and to
protect brokers from credit losses from their customers.
In futures markets, margins function as financial performance bonds
and are employed to manage financial risk and to ensure financial
integrity. Margin takes several forms in the futures industry. First,
there is original margin, which is the amount of money deposited by
both buyers and sellers of futures contracts to ensure their
performance against the contracts in their account. In addition, on at
least a daily basis and sometimes more frequently the futures exchanges
collect variation margin from both long and short participants to
reflect the shifting value of open positions in a given contract. All
open positions in regulated futures and options contracts are ``marked-
to-market'' on a daily basis; this daily settlement is a core feature
of the financial integrity process for U.S. futures markets because,
among other things, it prevents losses from building up beyond 1 day's
risk.
The current margin structure used by U.S. futures exchanges and
their clearinghouses has consistently demonstrated that it adequately
protects the financial integrity of transactions executed on regulated
markets. Indeed, no customer or other participant has ever lost money
in the history of the Exchange as a result of a financial default by a
clearing member.
A number of Congressmen have questioned why futures margin amounts
are not the same as securities margin amounts. Unlike margins for
transactions in non-exempt securities, futures margin is not a down
payment against the purchase price of the underlying product. An open
position in a futures contract is not an asset and does not result in
any ownership unless and until a market participant stands for delivery
following termination of trading in the expiring contract month.
Instead, futures margin represents a good faith deposit or performance
bond to ensure that adequate funds are available in each customer's
account to properly settle the trade when it is liquidated. These
deposits are intended to cover the financial risk associated with
maintaining a futures position by ensuring the financial integrity of
transactions cleared by a futures clearinghouse.
By contrast, securities margins are intended to cover the purchase
price of the underlying stock and regulation allows the investor to
borrow a percentage of that amount from his carrying firm. One short-
hand definition of securities margin is the amount of money an investor
deposits with a broker when borrowing from the broker to buy
securities. The remainder of the cost of the purchase would be financed
by the broker. Because securities margin is collected only from the
purchaser of the security, it should be noted that a seller would pay
no margin in a securities trade, whereas a futures transaction that
establishes a new position for buyer and seller would result in
collecting margin from both parties.
In addition, the settlement process for securities is notably
longer than for futures. While futures transactions are processed and
settled within a day of the transaction, securities trades historically
take 3 business days for settlement. Beyond the fundamentally different
purposes for futures and securities margins, the one-sided nature of
securities margins, as well as the longer settlement period, may also
account in part for differences in levels as between futures and
securities margins.
At NYMEX, margin levels are reviewed daily and are routinely
adjusted in response to market volatility. Margin generally is
collected to cover a 99 percent probability of a likely 1 day price
move, based on an analysis of historical and implied data.
Over the years, there have been proposals made to Congress to
increase margins to artificial levels that have no relation to risk
levels in order to deter participation in the market. For example, such
proposals were made around the time that the CFTC was founded in 1974,
as well as in the wake of the stock market crash in 1987. On each
occasion, after weighing the prospect of controlling market behavior
through margin levels, Congress ultimately rejected such proposals as
ineffective and as bad public policy. Thus, the latest proposals to
raise margin requirements to artificial levels are essentially
recycling theories that have been repeatedly disproven and rejected by
Congress in the past.
Nonetheless, those who would push for artificially higher margin
levels now are proposing solutions that are apparently premised on
three assumptions: (1) that speculators are the primary driver of
prices in futures markets, (2) that higher margin levels will drive out
speculators; and (3) that higher margins will result in lower prices.
Each of these assumptions reflects a fundamental misunderstanding of
futures markets and market participants.
The NYMEX Research Department has conducted extensive analysis of
WTI futures market data and found no support for an assumption that
speculators are pushing prices higher. Data analysis indicates that the
percentage of open interest in NYMEX Crude Oil futures held by
noncommercial participants (i.e., so-called speculators) relative to
commercial participants actually decreased over the last year, even at
the same time that prices were increasing. Noncommercial longs and
shorts consistently have been in the range of 30&35% of the open
interest. Moreover, noncommercial participants are not providing
disproportionate pressure on the long or buy side of the crude oil
futures market. Instead, noncommercials are relatively balanced between
open long (buy) and short (sell) open positions for NYMEX crude oil
futures. The attached chart indicates the percentage of open interest
in the NYMEX Crude Oil futures contract held by noncommercial longs and
shorts relative to that held by commercial longs and shorts. As can be
seen, during the last year, commercial longs and shorts have
consistently comprised between 65 and 70% of all open interest.
Moreover, on a macro level, speculators are not in a position to be
the drivers as to where prices are established in our markets. The
crude oil futures contract is a physically delivered contract for a
commodity for which OTC and cash markets exist that are each
approximately 8&10 times the size of the futures market. There is and
can be no credible argument among serious economists and academics who
study futures markets that futures prices are driven by developments in
the physical market and not vice versa.
NYMEX does not believe that raising margin levels is the
appropriate tool for dampening speculation. The Commodity Exchange Act
specifically directs the CFTC to utilize speculative position limits to
control excessive speculation in futures markets. NYMEX has raised
margin rates for its crude oil futures contract seven times since the
beginning of the year to reflect the increased credit risk from greater
price volatility in energy markets.
The base rate that NYMEX charges clearing member firms has risen
from $4,500 to $9,250, a 106% increase. Clearing members then collect
an even higher margin rate for member customers and a still higher
margin rate for non-member customers. The margin required to be posted
with such clearing members by non-member customers has increased from
$6,075 to $12,488, also a 106% increase. The rates were adjusted by
Exchange staff in direct response to the contract's increased
volatility.
Margin levels have increased substantially in response to increased
market volatility. Year to date, the settlement price of spot month
crude oil futures has risen from $99.62 to $140.93 (as of July 2,
2008), a 41% increase. This upward trend continued in spite of crude
oil margin being raised seven different times for a total of a 106%
increase. As such, the available data does not support the assertion
that increasing margins will lower prices.
Exchange staff has examined trends in margin levels at the Exchange
going back to early 2000. The data clearly indicate that higher margin
levels lead rather than follow increases in the price of crude oil
futures products. In other words, when Exchange staff, in exercising
their independent and neutral business judgment, determined to increase
margin levels in response to changes in crude oil volatility levels,
the higher margin levels were followed not by lower prices but instead
by yet higher crude prices.
Although higher margin levels do not result in lower prices, NYMEX
has grave concerns that a rash public policy course of action that
imposes new artificial margin levels will have a serious and perhaps
irreversible impact on a core mission of futures exchanges, which is to
provide reliable price discovery. By harming and deterring
noncommercial participants who effectively serve as liquidity providers
to commercial participants, artificial margin requirements will reduce
the attractiveness of U.S. futures markets for commercial participants
as compared to other alternatives. In addition, artificial margin
levels will clearly result in a distortion of the price discovery
mechanism of U.S. futures exchanges from their current robust levels.
All other things being equal, commercial participants will have a
strong incentive to shift their hedging activity to other markets that
have less distortion of the price discovery mechanism.
In a highly transparent, regulated and competitive market, prices
are affected primarily by fundamental market forces. Currently,
uncertainty in the global crude market regarding geopolitical issues,
refinery shutdowns and increasing global usage, as well as devaluation
of the U.S. dollar, are now relevant market fundamentals. Adjusting
margin levels significantly upward will not change the underlying
market fundamentals, and thus, will not affect price levels. Moreover,
by artificially increasing speculative margin levels, it is possible
that speculators with short positions may be forced to liquidate their
positions, putting even greater upside pressure on the market.
Furthermore, given the reality of global competition in energy
derivatives, increasing crude oil margins on futures markets regulated
by the CFTC inevitably will force trading volume away from regulated
and transparent U.S. exchanges into the unlit corners of unregulated
venues and onto less regulated and more opaque overseas markets.
As discussed above, increasing margins will not provide the
promised solution of ultimately reducing crude oil prices on regulated
futures exchanges. However, this action will have a number of
unintended but severe consequences that will harm the regulated
markets. Beyond the distortion of the financial risk management
process, imposing artificially higher margins would result in:
A cash and liquidity crisis for many market participants;
A decrease in liquidity and an associated increase in price
volatility;
A possible increase in intra-day trading to avoid overnight
margin requirements, resulting in heightening the impact of
short-term price changes, further accelerating price
volatility;
An increase in hedging and other transaction costs for
commercials trading on the regulated U.S. exchanges; and
A shift of business either to less regulated and transparent
overseas markets or to unregulated and non-transparent OTC
venues in the U.S.
For these reasons, NYMEX believes that Congress should consider the
real and perhaps irreparable harm that would result to regulated U.S.
futures exchanges from this ill-considered proposal.
Hedge Exemptions/Speculative Position Limits
NYMEX has numerous surveillance tools, which are used routinely to
ensure fair and orderly trading on our markets. Monitoring the
positions of large traders in our market is a critical component to our
market surveillance program. Large trader data are reviewed daily to
monitor reportable positions in the market. On a daily basis NYMEX
collects the identities of all participants who maintain open positions
that exceed set reporting levels as of the close of business the prior
day. Generally NYMEX identifies in excess of 85% of all open positions
through this process. These data, among other things, are used to
identify position concentrations requiring further review and focus by
Exchange staff. Any questionable market activity results in an inquiry
or formal investigation.
Speculative activity on futures exchanges is managed by position
limits. As stated in the CFTC's rules, position limits and
accountability levels are required ``to diminish potential problems
arising from excessively large speculative positions.'' These limits
effectively restrict the size of a position that market participants
can carry at one time and are set at a level that greatly restricts the
opportunity to engage in possible manipulative activity on NYMEX. For
the NYMEX WTI Crude Oil contract, the position limit during the last 3
days of the expiring delivery month is 3000 contracts. Breaching the
position limit can result in disciplinary action being taken by the
Exchange.
NYMEX also maintains a program that allows for certain market
participants to apply for targeted hedge exemptions from the position
limits in place on expiring contracts. Hedge exemptions are granted on
a case-by-case basis following adequate demonstration of bona fide
hedging activity involving the underlying physical cash commodity or
involving related swap agreements. A company is not given an open-ended
exemption, and the exemption does not allow unlimited positions.
Instead, the extent of the hedge exemption is no more than what can be
clearly documented in the company's active exposure (as defined by the
CFTC) to the risk of price changes in the applicable product. In a
number of instances, hedge applications are either reduced in number or
are denied because of staff's overriding focus on maintaining the
overall integrity of our markets.
Role of Swap Dealers
Turning specifically to data relating to the activity of swap
participants since October 2007 until early June 2008, these data
provide a very different result than what is being publicly asserted by
commentators who choose not to burden their arguments with the facts.
This is a key finding; a closer analysis of such data, including data
obtained from the CFTC, reveal that swap dealers participating in our
markets were in fact holding overall net short (sell side) positions.
In other words, unlike the public posturing of those who blindly assert
that swap dealers are providing upward pressure on price, the simple
reality is that, in the recent past, any price impact that may be
attributable to their open positions has generally been to lower prices
somewhat and not to raise them.
We have seen various representations made relative to participation
by speculators in our markets that directly contradict our data. One
such representation claims that 70% of our crude oil market is made up
of speculators. That analysis incorrectly assumes that all swap dealers
are noncommercials and that all of their customers who would be on the
opposite side of any energy swap that they might execute would also all
be noncommercials. This is simply not the case. However, this confusion
clearly highlights the need for the CFTC large trader data to delineate
for energy futures the degree of participation by noncommercials in the
same manner that such data are now being delineated for agricultural
contracts.
This potential gap in the large trader data compiled by the CFTC in
its Commitment of Trader's Report complicates efforts to determine the
extent of commercial and noncommercial activity of swap dealers. As a
result, questions are being raised as to whether hedge exemptions for
swap dealers are being used as a means of circumventing speculative
position limits. At this time, due to the manner in which the data are
reported, it is not clear whether this is true or not. In response to
these queries, the CFTC announced its intent to develop a proposal that
would routinely require more detailed information from index traders
and swaps dealers in the futures markets, and to review whether
classification of these types of traders can be improved for regulatory
and reporting purposes. NYMEX is confident that these data will confirm
that not all of the over-the-counter (OTC) energy swap activity
undertaken by swap dealers involves noncommercial participants. In
addition, NYMEX believes that these data will allow the CFTC to better
assess the amount and impact of this type of trading on the markets.
NYMEX is concerned about restrictions that could be imposed on swap
dealers that could limit the ability of commercial participants to
execute strategies to meet their hedging needs. For example, commercial
participants often need to have customized OTC deals that can reflect
their basis risk for particular shipments or deliveries. In addition,
not all commercial participants have the sufficient size or
sophistication to participate directly in active futures markets
trading. Swap dealers assume that risk and lay it off in the futures
market.
Nevertheless, NYMEX would support a restriction on the ability of a
swap dealer to obtain a hedge exemption from a position limit for
activity that concerns OTC transactions involving noncommercial
participants. This focused or targeted approach will address the
concerns being raised in a thoughtful and deliberate manner and also
will support and reinforce the underlying rationale for the maintenance
of effective position limits on speculative activity.
Role of Index Funds
Unfounded assertions have raised concerns about a perceived
dramatic increase in the level of participation by pension funds and
index fund participants in NYMEX's Crude Oil futures contract. As a
result, legislative proposals to limit the participation of such
entities in energy futures contracts are under consideration. While the
arguments advancing such assertions are riddled with errors, one rather
sophomoric error is particularly egregious and does not warrant
uncritical acceptance.
Specifically, some commentators with no obvious expertise in
futures markets have estimated levels of investment in Index Funds (or
structured instruments based on Indices). These estimates are, in part,
derived from data on participation in certain agricultural commodity
futures contracts and are wholly based on several assumptions including
one that the agricultural components of the index investments are
entirely hedged in related agricultural commodity futures contracts.
The commentators then make the leap in logic that any market exposure
related to investment in the index will always and automatically be
hedged by establishing positions in futures contracts for each of the
25 commodities comprising the index. It is possible this reflects
current practice for some or perhaps most of the agricultural
commodities.
In 2000, Congress declined an opportunity to provide the same level
of legal certainty to OTC swaps in agricultural products that are now
available to swaps in financial and energy products. Consequently, by
virtually all accounts, the market for agricultural OTC swaps is far
less developed than for energy swaps. Indeed, the OTC energy market
currently dwarfs the size of the regulated futures market for energy
products. So, while it would be understandable that index positions in
the agricultural commodities of an index would be hedged, at least at
present, on the regulated futures exchange, the OTC venue is far more
viable for energy products.
Thus, it is inaccurate to assume that energy markets operate in the
same manner as agricultural markets, and it is equally wrong to presume
that the same practice for agricultural commodities automatically will
carry over to index fund activity as it concerns energy futures. An
index fund provider could hedge its position either by establishing a
position in the related energy futures contract on a regulated exchange
or by entering into a swap or other derivatives transaction in the OTC
market.
The actual structure of energy derivatives markets is also
supported by recent statements by companies engaged in the index
business. Donald Casturo, an executive at Goldman Sachs, recently noted
that ``85% of this investment (Index investing) takes place on the OTC
market.'' (CFTC Energy Markets Advisory Committee meeting, Washington,
D.C., June 10, 2008). Rather than incur the cost of entering into
transactions on regulated futures exchanges for each of the 25
commodities comprising its index, companies such as Goldman Sachs find
it more cost-effective to hedge their exposure, at least with respect
to energy products, predominantly via one OTC swap transaction with
another swap dealer.
The consequence of this practice is that only a modest portion (at
best) of increases in participation in the index contracts results in
actual increases in activity in the NYMEX crude oil futures contract.
Furthermore, no credible empirical evidence has connected participation
in Index Funds with price impacts in the crude oil market. In fact,
independent analyses performed by the CFTC over different time periods
have indicated that participation by financial non-oil entities, even
when their net-participation is on the ``long'' side in futures, has
had no statistically significant impact. Thus, the sweeping and
dramatic claims and assertions being made by those commentators new to
the futures industry are not only wildly exaggerated; they are simply
wrong.
NYMEX does not believe that the case has been made to support a
finding that institutional investors are contributing to the high price
of crude oil; contrary assertions are founded upon false comparisons
that can be swiftly dismissed. It would be premature to adopt a
legislative solution for an unproven and unsubstantiated problem. NYMEX
recommends requirements to provide additional transparency to enhance
the ability to monitor these markets. This approach will avoid undue
harm to investors and to the markets. Finally, NYMEX believes that
prohibiting investment opportunities of institutional market
participants would effectively substitute the judgment of Congress for
the judgment of trained financial investment professionals. We urge
Congress to move with deliberation and caution in this area.
Foreign Boards of Trade
Over the last few years, new developments have occurred related to
products offered by non-U.S. exchanges (also referred to as foreign
boards of trade (FBOT)) to U.S. customers. FBOTs, which are permitted
by CFTC staff to offer their products to U.S. customers pursuant to
CFTC No Action letters, began listing futures contracts with U.S.
delivery points among their product slates. Historically, under the
CFTC staff's FBOT no-action process, such exchanges were permitted to
offer direct electronic access to their markets to U.S. customers based
on a determination by CFTC staff that the foreign regulatory regime
governing the FBOT was ``comparable'' to that of the CFTC.
Essentially, there is a system of mutual recognition among
regulators around the world as a means to facilitate access to global
markets. This approach worked effectively up until one FBOT listed the
look-alike of the NYMEX West Texas Intermediate (WTI) Crude Oil Futures
contract without the level of transparency and market surveillance
controls, such as positions limits, that are provided by U.S. markets
under direct CFTC regulation. It was not anticipated that the no-action
process would be used in this manner. The current policy, which permits
the FBOTs to list look-alikes of U.S. futures contract, has effectively
diminished the transparency to the CFTC of approximately \1/3\ of the
WTI crude oil market, and permitted an easy avenue to circumvent
position limits designed to prevent excessive speculation.
Two years ago, NYMEX cautioned that allowing a foreign exchange to
list a futures contract virtually identical to a contract traded on a
U.S. futures exchange without comparable regulations, such as position
limits, could be a slippery slope. We argued that the wrong policy
decision could threaten the CFTC's jurisdiction over an important price
discovery contract. At that time, the CFTC had jurisdiction over 100
percent of the WTI crude oil futures markets; today, it has
jurisdiction over approximately 60 percent of the WTI crude oil market.
In our recent experience, ``regulatory arbitrage'' is not a
hypothetical concern, but is a reality for certain NYMEX listed
products. Customers are making choices among the same or similar
products on the basis of differences in regulatory treatment rather
than on the basis of intrinsic distinctions in the products. For
example, customers can carry WTI positions above the position limits
for WTI contracts established on NYMEX by shifting their business to
ICE Futures Europe where position limits are not mandated by its London
regulator, the Financial Services Authority. Thus, regulatory arbitrage
potentially diminishes the breadth and depth of the CFTC's regulatory
authority and, consequently, reduces much needed market transparency.
Complete transparency to the CFTC should be a fundamental requirement
for markets that are linked.
Various legislative proposals have been introduced to address FBOTs
that list energy contracts that are based on commodities delivered in
the U.S. or are otherwise linked to contracts traded on U.S. futures
exchanges. NYMEX would support proposals that would require a
comparable regulatory scheme for FBOTs that list look-alikes of U.S.
futures exchange contracts or contracts that are otherwise linked to
U.S. contracts. Comparable requirements should include position limits/
accountability levels, large trader reporting and emergency authority.
Overall, we have argued that FBOTs offering linked products should be
required by the CFTC to provide the same level and quality of data and
with the same frequency that U.S. exchanges provide daily to the CFTC.
NYMEX believes that this targeted approach will effectively address the
regulatory gap that currently impedes the CFTC's ability to monitor the
entire U.S. WTI crude oil futures contract.
NYMEX would not support other more expansive proposals that call
for full registration by FBOTs offering U.S.-delivered or linked
contracts. U.S. exchanges, including NYMEX, have placed trading screens
in a number of foreign countries around the world to offer our products
to foreign customers. There is considerable risk of retaliation by
those countries, including a similar registration requirement in each
foreign location where we are offering our products. Such a result
would impede significantly the global competitiveness of U.S. markets.
The CFTC recently announced several initiatives to address the
growing concerns about an FBOT trading the U.S. benchmark WTI contract.
It has reached an agreement with the FSA and ICE Futures Europe to
receive enhanced data to allow the CFTC to see both U.S. participants
in the London markets and foreign traders that it would not normally
oversee. In addition, the CFTC announced that it would revise its FBOT
policy and require ICE Futures Europe to establish comparable position
limits and accountability levels on its crude oil contracts that are
linked to NYMEX crude oil contracts.
This would be a positive step and would provide an effective
mechanism to restrict speculative activity in those markets. This is
particularly important when the contract trading on the FBOT is the WTI
crude oil contract, which is a benchmark for crude oil pricing, and
which can have a substantial impact on U.S. consumers and the U.S.
economy. Indeed, we would support the imposition of position limits
even for listed contracts that are financially settled. We applaud the
CFTC's recent initiatives.
NYMEX continues to believe that the CFTC's no-action process for
offering foreign products to U.S. customers is an important vehicle for
global competitiveness of U.S. markets. Approximately 1 year ago, a new
futures exchange, the Dubai Mercantile Exchange (DME), commenced
operations in Dubai. NYMEX is a founder and has an ownership share in
this venture and provides clearing services for the new exchange. The
core or flagship crude oil futures contract is an Oman Sour Crude Oil
futures contract. The DME initiative provides competition and greater
transparency to crude oil trading in a critically important energy
region.
Although the DME does not yet list a WTI financial futures
contract, the DME has received a No Action letter from the CFTC staff
for this contract. The DME is currently finalizing a launch date for
that contract. It is our understanding that, when a launch date is
finalized on the DME WTI contract, DME will implement hard position
limits that are comparable to NYMEX's own limits on our WTI crude oil
futures contract. Also, as part of the NYMEX Clearing Order, large
trader reporting to both the CFTC and NYMEX is required.
In a more recent initiative, NYMEX has entered into an alliance
with a London-based clearinghouse, LCH.Clearnet Limited (LCH), under
which LCH will provide clearing services for two new product slates to
be launched later this summer either by NYMEX or by a NYMEX affiliate.
These new product slates are intended to provide greater competition to
other energy trading facilities that are active in this energy space.
One product slate, focusing upon natural gas and electricity contracts,
will be listed by a division of NYMEX in the exempt commercial market
tier. Applicable products in this category will comply fully with the
requirements for significant price discovery contracts contained in the
recently implemented CEA reauthorization farm bill.
The other product slate, focusing upon crude and crude products,
will be listed for trading by a NYMEX affiliate based in London that
will be regulated by the FSA. That affiliate will follow the path of
other exchanges regulated by other regulators and will apply for CFTC
no-action relief. Notably, the affiliate will provide large trader
reporting to the CFTC and also will impose hard position limits on any
listed contracts with U.S. delivery points.
CFTC Resources
The landmark Commodity Futures Modernization Act of 2000 (CFMA)
ushered in a period of phenomenal growth in U.S. derivatives markets.
The industry growth, however, has not been matched by increased
resources needed for the CFTC to oversee those markets effectively. We
believe that a compelling case has been made for immediate increases in
the size of the CFTC's operating budget. My own views on the need for
remedying this mismatch between duties and resources stem in part from
my service as Chairman of the CFTC from 2002&2004 during the period
when we were continuing to implement the provisions of the CFMA. As
anticipated, that law brought new competition and enhanced innovation
in derivatives markets, which contributed to the explosion in trading
volume. It is imperative that the CFTC have all of the tools that it
needs to carry out fully its obligation to maintain the integrity of
U.S. futures markets.
Conclusion
Complete transparency is fundamental for competitive markets. The
same level of transparency and position size controls present on
regulated U.S. futures markets should be the standard for foreign
markets offering products with U.S. delivery points and for OTC
contracts that serve a price discovery function. Additionally, NYMEX
believes that disaggregation and delineation of positions held by swap
dealers is necessary. This will provide important information to
determine whether speculative position limits are being avoided by
index funds and other institution investors and whether their activity
is influencing market prices. However, a case has not been made for
excluding institutional investors from participation in derivatives
markets, nor for eliminating hedge exemptions for swap dealers to the
extent the exemptions cover risks related to commercial activity.
Many factors are contributing to high energy prices. NYMEX
continues to believe that market fundamentals are a significant factor
that must not be discounted in this debate. Increasing margins to
dampen speculative activity will not change the fundamentals and will
inevitably drive business away from the highly regulated, transparent
marketplace. This will do more harm than good.
I thank you for the opportunity to share the viewpoint of the New
York Mercantile Exchange with you today. I will be happy to answer any
questions that any Members of the Committee may have.
Attachment
Thank you, Mr. Newsome. And next we have Christine Cochran. I
appreciate you being with the Committee.STATEMENT OF CHRISTINE M.
COCHRAN, VICE PRESIDENT, GOVERNMENT RELATIONS, COMMODITY MARKETS
COUNCIL, WASHINGTON, D.C.
Ms. Cochran. Thank you, and good afternoon, Chairman Peterson and
Members of the Committee.
The Chairman. Your mic is not on, I don't think.
Ms. Cochran. Thank you. Chairman Peterson, Members of the
Committee, good afternoon. My name is Christine Cochran, and I am the
Vice President of Government Relations for the Commodity Markets
Council. I would like to thank you for hosting this series of hearings,
as well as inviting us to participate.
CMC is a trade association that represents commodities futures
exchanges and exchange participants. Our membership includes the
complete spectrum of commercial users of the agricultural and energy
futures markets. I would like to emphasize that the businesses of all
of our industry members depend upon the efficient and competitive
functioning of the risk management tools traded on U.S. futures
exchanges.
CMC strongly supports your efforts and those of the Commodity
Futures Trading Commission to seek greater visibility into the
commodity markets, especially in the energy markets. We believe this
visibility will lead to improved market transparency and is the first
step to maintaining responsible commodity markets.
CMC has confidence in the CFTC's ability to gather and analyze this
data. For example, in 2006, we led the industry effort and worked with
the CFTC to increase transparency on the index traders in the grain
markets through the Commitment of Traders Supplemental report. Based on
data collected by the CFTC, the Commission has created a report that is
already one of the grain industry's most essential tools for analyzing
markets. We believe that applying this same principle to other
commodity markets will significantly benefit market regulators,
traditional market users, as well as the general public.
In the last decade, futures markets, especially in the enumerated
agricultural commodities, have grown immensely because of the relevance
of their product to the commercial hedging, financial hedging and
general international and trading communities. This includes hedge
funds, index funds and institutional investors. The increase in volume
has boosted liquidity, aided in price discovery and enhanced market
efficiency for all market participants.
CMC views the investment activity of institutional investors and
index funds as legitimate financial hedging, but we recognize that it
is passive in nature and not responsive to price levels. Some believe
that this activity is the reason for current price levels. However,
based on the data available to us at this time, CMC does not believe
that that is the case and therefore we cannot support proposals that
would ban any group of legitimate investors from participating in
commodity markets. Instead we believe that additional reporting could
allow the CFTC to identify possible manipulative behavior. It could
also help market participants better understand the role of these
investors in the market.
We encourage you to also weigh the possibility that banning or
severely restricting this type of participant will not accomplish the
intended purpose. The money is not going to disappear. Instead it may
move offshore and take with it valuable market liquidity, or it could
move into other markets and take with it valuable transparency.
CMC supports the CFTC's recent decision to take a go-slow approach
in expanding exemptions for this new class of investor. This decision
will allow the Commission and market users more time to thoroughly
evaluate the impact this passively invested money may have on commodity
markets. Futures markets today reflect global economic trends, not
speculative buying power. Based on the information that we have
currently available, CMC believes speculative activity in the futures
market may influence day-to-day prices as it always has, but it is the
fundamental forces of supply and demand that create and sustain the
price levels we see today.
To address the concerns surrounding the new investor in the
commodity markets, CMC has two policy recommendations. One, we believe
the Commission should continue to monitor index funds and be prepared
if necessary to examine the structure of the hedge exemption granted to
such funds. And two, we recommend that the CFTC initiate a study of the
trend towards alpha or enhanced return trading by index and hedge funds
because this type of investment is price responsive and not passively
managed. We believe it is speculative in nature and should be reported
as such on the supplemental report.
CMC also supports the efforts of the Commission to gather more
information regarding swap transactions and would support greater
transparency of such transactions. However, we also believe that swaps
contracts provide a legitimate and important commercial service. A
swaps contract is between two private parties. So it can provide a
highly customized service that cannot be obtained in an on-exchange
contract.
In conclusion, CMC believes that the commodity industry is in a
volatile period due to supply and demand fundamentals reaching new
thresholds. Our system of open and competitive markets, coupled with
proper government oversight, has positioned our market participants to
read, understand and respond to market signals efficiently. Before any
drastic changes are considered, we strongly urge you to seek additional
transparency and evaluation and have great confidence in the CFTC's
ability to provide that. More information will help regulators,
traditional market participants and the general public understand the
impact this new class of investor is having on the market.
Mr. Chairman, we compliment you and the Committee's efforts and we
look forward to working with you and answering any questions that you
may have.
Thank you.
[The prepared statement of Ms. Cochran follows:]
Prepared Statement of Christine M. Cochran, Vice President, Government
Relations, Commodity Markets Council, Washington, D.C.
Mr. Chairman and Members of the Committee:
Good morning. My name is Christine Cochran and I am the Vice
President of Government Relations for the Commodity Markets Council
(CMC).
Mr. Chairman and Ranking Member Goodlatte, the issues you plan to
address in this series of hearings are very important to the industry I
represent. I would like to thank you for hosting them and for inviting
CMC to participate.
CMC is a trade association that represents commodity futures
exchanges, regional boards of trade, and numerous industry counterparts
in the agriculture and energy businesses, including domestic and
multinational commodity merchandisers, processors, millers, refiners,
commercial and merchant energy companies, precious and base metal
trading firms, and bioenergy producers; U.S. and internationally-based
futures commission merchants; food and beverage manufacturers; major
transportation companies; and financial institutions.
Representing the complete spectrum of commercial uses of the
agricultural and energy futures markets, the activities of our members
range from grain and energy hedging by local country grain elevators to
highly sophisticated, high-volume hedging activities supporting
domestic and international grain and other agricultural product
merchandising, exporting, and processing operations. The businesses of
all our non-exchange member firms depend upon the efficient and
competitive functioning of the risk management products traded on U.S.
futures exchanges.
The passage of the Commodity Futures Modernization Act of 2000
(CFMA) shifted the regulatory philosophy from prescriptive regulations
to core principles. This shift explicitly recognized the success of the
self-regulatory organization (SRO) model and entrusted U.S. exchanges
with broad authority to offer products and services to expand their
businesses, attract customers, and compete domestically and globally.
Since that time, U.S. futures exchanges have grown rapidly and the
community of exchange users have benefited tremendously. U.S. capital
markets are also an important beneficiary of this dynamic growth. The
success of the U.S. futures business has helped sustain the U.S. as the
centerpiece of global risk management.
Before adopting any new proposals, CMC strongly encourages you to
consider increasing market transparency. Greater transparency, we
believe, is the first step to maintaining responsible commodity
markets. It will provide more accurate and useful information about all
classes of market participants. In 2005&2006, CMC led the industry
effort to increase transparency on index traders in the grain markets
through the Commitment of Traders (COT) Supplemental Report, which is
already one of the grain industry's most essential tools for analyzing
markets. We believe that applying the same principle to other commodity
markets will significantly benefit the market regulators, traditional
market users, and the general public.
The businesses of all CMC members depend on market integrity and we
strongly support the Commodity Futures Trading Commission's (CFTC or
Commission) efforts to investigate and prosecute market manipulation.
Ferreting out market participants that attempt to inappropriately
influence the market is critical to protecting customers and keeping
the trust of the trading public. Simultaneously, we need to ensure that
U.S. markets continue to serve as global benchmarks and continue to
provide efficient price discovery.
As you evaluate the complicated issues before you, CMC encourages
you to continue to follow the directions set by the core principles of
the CFMA.
Institutional Investors and Hedge Funds in Commodity Markets
CMC views the investment activity of institutional investors and
index funds as legitimate ``financial hedging,'' but we recognize that
it is passive in nature and not responsive to price levels or supply
and demand fundamentals. In 2005 and 2006, CMC worked closely with the
Commissioners and staff of the Commodity Futures Trading Commission
(CFTC) to deepen the industry understanding of the nature of index fund
activity in futures markets. The result of this collaborative effort
was the CFTC's release of a new Commitment of Traders (COT)
Supplemental report showing index fund financial hedges as a separate
and distinct category.
We believe the COT Supplemental Report provides greater
transparency in the grain market about the size and behavior of such
investors. Despite being a relatively young report, it is already one
of the industry's most essential tools for analyzing markets.
Some believe that the activities of large institutional investors
in futures markets are the reason for current price levels; however,
based on the information currently available, CMC does not believe that
this is the case. As an advocate for open competitive markets, we do
not support drastic proposals that ban any group of legitimate
investors from participating in commodity markets. At the same time,
CMC wants to emphasize that we in no way support or condone
manipulative behavior. With the information currently available to us,
CMC does not believe that pension funds or large institutional
investors are having a significant impact on commodity prices; however,
we strongly support increasing transparency. Additional transparency
would allow the CFTC to identify possible manipulative behavior, and it
would help market participants better understand the role these
investors may play in the market.
CMC also encourages you to weigh the possibility that banning or
severely restricting this type of participant will not accomplish the
intended purpose. The money will not disappear; instead, it may move
offshore and take with it valuable market liquidity. It is important to
be informed, thoughtful, and prudent as we evaluate restrictions on a
class of market participants.
The CFTC recently indicated that it will take a ``go-slow''
approach in expanding exemptions for this new class of investors. CMC
supports this regulatory approach because it will allow the Commission
and market users more time to thoroughly evaluate the potential this
passively invested money may have on commodity markets. The additional
transparency that we are calling for would provide the tools necessary
for market participants to evaluate the impact of this new class of
investor.
Equally important is the distinction between passive investment and
price-responsive investment. Typically index funds and institutional
investors engage in passive investments. They take a position and hold
it until a determined time. They do not change their position based on
market movements. Meanwhile, hedge funds tend to be more responsive to
market signals and act as a traditional fundamental trader. As such,
hedge funds are subject to position limits which are appropriate.
In the last decade, futures markets, especially in the enumerated
agricultural commodities, have grown immensely because of the relevance
of their products to the commercial hedging, financial hedging, and
general international and domestic trading communities--including hedge
funds, index funds, and institutional investors. This increase in
volume boosts liquidity, aids in price discovery, and enhances market
efficiency for all market participants.
Futures markets today reflect global economics and trends, not
speculative buying power. Based on the information currently available
to us, CMC believes speculative activity in futures markets may
influence day-to-day prices, as it always has. On the other hand, it is
the fundamental forces of supply and demand that creates and sustains
the price levels we see in the markets.
Policy Recommendations To Consider
To address the concerns surrounding this new investor in commodity
markets, CMC recommends:
1. Monitor Index Fund Positions. To maintain competitive markets,
exchanges and the CFTC should continue to monitor index fund
participation and be prepared, if necessary, to examine the
structure of the hedge exemptions granted to the funds.
In the agriculture futures markets, volume grew immensely in the
last decade and the increased liquidity benefited all market
participants. Fund investment contributed to this prosperity,
and CMC believes that the CFTC and lawmakers should move slowly
when adopting measures that will discourage such participation
in the markets.
2. CFTC Study Of Alpha Trading. CMC also recommends that the CFTC
initiate a study of the trend toward ``alpha'' or ``enhanced
return'' trading by index and hedge funds. Because this type of
investment is price-responsive and not passively managed, CMC
believes it is speculative in nature and should be reported as
such on the CFTC COT Supplemental Report.
3. Continued Product Innovation. As the markets evolve and learn to
adapt to the changing supply and demand dynamics, CMC would
support legislation and regulations that allow exchanges to
continue to innovate and create new products to manage risks.
CMC Grain Futures Performance Task Force
With unprecedented challenges facing the U.S. grain markets, CMC
brought together exchanges and exchange-users to discuss futures market
performance. The Task Force reviewed many market-related issues with
the participants and the role of institutional investors and hedge
funds was a significant point of discussion.
The overriding concern expressed by participants is the financial
impact of high commodity prices and increased price volatility--not
futures market performance. Most market participants agree that current
supply and demand fundamentals support high commodity prices. They do
not believe that institutional investors or hedge funds are pushing
price levels higher. Specifically, participants identified the
following as the primary reasons for current price levels:
1. Strong economic growth in developing countries such as China and
India resulting in increased demand for commodities.
2. Increased demand for commodities used for biofuel production and
government mandates on biofuel use that result in inelastic
demand for grains and vegetable oils.
3. Reduced yields in major producing regions due to weather events
that are resulting in historically low world grain stocks-to-
use ratios.
4. Export restrictions imposed by other nations.
5. A weakening U.S. dollar.
At the same time, the increased pressure in the credit markets is
increasing the need for consistent convergence.
Consistent convergence was the primary topic regarding technical
futures market performance. While most participants agree that basis
weakens in high price environments relative to more normal market
conditions as grain and oilseed handlers' increased risk is
incorporated in lower cash grain bids, participants still expect
consistent basis strengthening as futures markets approach expiration.
Some Task Force participants have disagreed on why convergence has been
inconsistent--citing either insufficient storage charges on futures
market receipts and certificates; index fund and/or speculative
activity in the market; or the multitude of external shocks hitting the
market. Most of those interviewed by the Task Force urged Exchanges to
not make drastic changes until the markets adjust to this new operating
environment.
The panel discussed a number of proposals that might improve
convergence, but no broad consensus emerged from the process.
Nonetheless, the largest number of participants generally supported
increasing storage rates. Participants also supported seeking CFTC
approval to clear OTC grain swaps.
The Role of Swaps in Commodity Markets
CMC supports the efforts of the Commission to gather more
information regarding swaps transactions and would support greater
transparency of such transactions. However, we also believe that swaps
contracts provide a legitimate and important commercial service.
A swaps contract is between two private parties, so it can provide
a highly customized service that cannot be obtained in on-exchange
contracts. For example, a commercial company may seek to secure a
hedging position that extends over a 5 year period, but on-exchange
futures contracts are not available that far out. In the over-the-
counter market, the company can enter into a swaps agreement with
another willing party for the desired terms. This arrangement meets the
hedging needs of the commercial company seeking the position. It also
creates risk exposure for the counterparty, which is often managed over
time on-exchange.
Aggregating Speculative Position Limits
Aggregating speculative position limits could cause serious harm
for existing markets by grouping contracts that serve distinct purposes
and by severing liquidity between markets.
It is critical that any policy seeking to aggregate speculative
position limits accounts for the difference between existing contracts.
Wheat is traded on the Chicago Board of Trade, Kansas City Board of
Trade, and Minneapolis Grain Exchange; however, each wheat contract is
distinct and provides a unique risk management solution. For example, a
company hedging soft red winter wheat flour on the Chicago Board of
Trade is hedging ingredients in pastries, cakes, and pie-crusts, while
a company hedging hard red spring wheat flour on the Minneapolis Grain
Exchange is hedging ingredients in bread.
Another possible consequence from aggregating speculative position
limits is the division of the liquidity that currently exists between
exchanges. If position limits in similar contracts are aggregated and
subjected to existing speculative position limits, then firms,
including commercial firms, may be forced to either reduce their
positions in each individual market or move their positions to one
market. This shifting of positions could severely reduce liquidity on
existing exchanges and negatively impact all market participants.
Some proposals currently being consider would apply aggregate
speculative position limits for on-exchange products and OTC products.
Given the customized nature of over-the-counter commodity contracts,
our members, who are active in both markets, we would appreciate
caution when examining such a proposal.
Margin Requirements
With commodity prices moving higher and higher, CMC shares the
concerns of many lawmakers, but we remain confident in the ability of
CFTC professional staff to monitor and evaluate trading in all
commodity markets, as well as their conclusions about the impact of
speculation on prices in those markets.
CMC is concerned about calls to require the CFTC to set
substantially higher margin levels in the energy markets. It appears
the intent of such proposals would be to lower prices; however, we
believe that increased margin requirements could force many market
participants off-exchange and into less transparent markets.
A margin payment, also called a performance bond, is the amount of
money or collateral deposited by either a customer with a broker, a
broker with a clearing member, or a clearing member with a clearing
organization. A margin payment does not serve as a partial payment on a
purchase, but rather serves to manage counter-party risk and ensure the
financial integrity of the markets. Raising margin requirements will
not reduce volatility or manage prices. It will increase the cost of
futures transactions and potentially push liquidity from the regulated
exchange marketplace.
In conclusion, CMC believes the commodity industry is in a volatile
period due to supply and demand fundamentals experiencing new
thresholds. Our system of open and competitive markets coupled with
proper government oversight positions market participants to read,
understand, and respond to market signals efficiently. Before any
drastic changes are considered, we strongly urge you seek additional
transparency and evaluation. More information will help regulators,
traditional market participants, and the general public understand the
impact this new class of investor is having on the market.
Mr. Chairman, we compliment you and Mr. Goodlatte for your efforts
and we look forward to working with you. Thank you.
The Chairman. Thank you, Ms. Cochran. Mr. Nicosia. Am I
right about that?
Mr. Nicosia. Nicosia.
The Chairman. I apologize.
Mr. Nicosia. That is okay.
STATEMENT OF JOSEPH T. NICOSIA, PRESIDENT, AMERICAN COTTON
SHIPPERS ASSOCIATION; CEO, ALLENBERG
COTTON CO., CORDOVA, TN
Mr. Nicosia. Chairman Peterson and Members of the
Committee, I am Joe Nicosia of Memphis, Tennessee. And I appear
today in my capacity as President to the American Cotton
Shippers Association. Accompanying me today is the Executive
Vice President and General Counsel, Neal Gillen.
I am the CEO of Allenberg Cotton Company and a member of
the Executive Committee of the Louis Dreyfus Corporation. I
oversee the worldwide trading of cotton and also trade grains,
oilseeds, livestock, currencies and energy.
My prepared testimony reviews the recent changes made by
the ICE exchange in the cotton contract and the recent action
by CFTC. The ICE has agreed to take our recommended changes to
margin futures-to-futures settlements and options-to-options
settlements. It has also agreed to the industry's proposal
regarding the expansion of trading limits.
While the CFTC has focused primarily on the monitoring of
energy markets, it has launched a comprehensive investigation
into the February and March trading in the cotton futures
contract. It has also developed a proposal to require more
detailed reporting from index traders and swap dealers and to
review whether classification of these types of traders can be
improved for regulatory and reporting purposes.
I would add that it was not possible for the Commission to
effectively regulate the futures market because it had never
used its authority to request such information. The lesson here
is that lacking the appropriate information, the markets cannot
be properly monitored.
More importantly, CFTC has agreed to review the trading
practices for index traders to ensure that this type of trading
activity is not adversely impacting the price discovery process
and to determine whether different practices should be
employed.
Mr. Chairman, this is the crux of the matter. Different
regulatory practices must be employed, and let me explain why.
From December to late February, the net long position in cotton
futures contracts of the noncommercial and index traders rose
by 9.5 million bales. At its peak during the last week of
February, the position reached 21\1/2\ million bales compared
to the entire U.S. crop of only 19.2 million bales, effectively
cornering the market. This huge position in cotton futures
contract had nothing to do with ownership of the physical bales
of cotton. And more importantly, in the 2 week period leading
up to the explosion in cotton prices, the passive index funds
increased their position by 16 percent and then reduced their
position by 10 percent the following week after the price
explosion. Their activity was anything but passive.
The current practices of providing a hedge exemption to
index funds is flawed, inconsistent with hedge requirements,
and leads to disruptive and divergent price action in both the
cash and futures prices. A traditional hedger can only trade
futures in excess of his speculative position limit to the
extent that he has valid cash sales or purchases of production
or consumption needs. If a hedger desires to have a position in
excess of these limits simply because it has more money put to
use or desires additional price exposure, that hedger will be
denied such right. And yet an index fund is granted that right
solely based on the fact that it has more money seeking price
exposure.
In addition, since an index fund with a hedge exemption is
not required to act with an economic purpose in regard to the
cash market, it is allowed to continue to purchase futures
levels that are not justified by the cash market. This causes a
breakdown in the traditional cash futures relationship and
impedes the proper convergence of price between the cash and
futures.
Normally this would provide a profit opportunity for the
hedger. However, the size of the index fund position is so
massive, and we have data that we can share with you, that
those positions are so massive that it overwhelms the
industry's capacity to arbitrage the divergence; and thus
convergence cannot take place. Therefore, by requiring an index
fund to adhere to the same requirements as a traditional hedger
would greatly enhance convergence as well as provide capital to
the cash markets.
As I stressed in our prepared statement, the CFTC needs to
aggregate all positions and market exposures to determine an
entity's total position. If I, as a commercial hedger, must
report full information, then so too should other trading
entities. It is not only logical, it is equitable, but the CFTC
and the trading public should also have this information so as
to make sound regulatory and trading decisions.
Another obvious reason that index funds can be used to
circumvent, is that they can be used to circumvent speculative
position limits. Index funds are able to take large investments
from any one entity with a total disregard as to whether that
investor measured as an individual may be over his speculative
position limits. If an entity wants to exceed its position
limits, it simply invests additional money into an index fund
or swap and completely circumvents the CFTC regulation.
While we are pleased that the CFTC has placed a moratorium
on granting further hedge exemptions to the so-called passive
investment funds, action must be taken to strike a balance
between those funds that are currently operating under a hedge
exemption. We submit that CFTC should take immediate action to
require that an index fund with a hedge exemption restrict its
position to a commodity in the commodity to the dollar
allocation, or to the percentage of funds allocated to that
commodity as defined in the fund's prospectus.
We also recommend that the CFTC monitor and oversee all
swap and OTC activity by requiring the reporting of all swap
and OTC contracts by market participants and that the CFTC
determine the aggregation of those positions from all sources,
including exchanges, ETFs, swaps, index investments, OTC and
other trading entities.
We also recommend that the CFTC require all nontraditional
hedge accounts, those not involved in the commercial enterprise
of physical trading of bales, to be reported as a separate
individual category.
In our view, these requirements would provide the CFTC and
the trading public with the necessary information on which to
make sound regulatory and market decisions. It will hopefully
attenuate the current situation in which these essential
markets have become investment vehicles for speculative funds
who act unimpeded by market fundamentals or regulation.
Again, Mr. Chairman, thank you for providing us the
opportunity to participate in these important hearings and for
your attention to our concerns. Hopefully your legislative
findings and recommendations will result in full market
transparency, revealing the necessary data that will allow the
CFTC to know firsthand what is taking place in the markets so
they can make sound regulatory decisions.
Thank you.
[The prepared statement of Mr. Nicosia follows:]
Prepared Statement of Joseph T. Nicosia, President, American Cotton
Shippers Association; CEO, Allenberg Cotton Co., Cordova, TN
Chairman Peterson, Ranking Member Goodlatte, and Members of the
Committee, I am Joseph T. Nicosia, of Memphis, Tennessee. I appear
today in my capacity as President of the American Cotton Shippers
Association (ACSA). Accompanying me today is ACSA's Executive Vice
President & General Counsel, Neal P. Gillen.
I am the CEO of Allenberg Cotton Company and a member of the
Executive Committee of the Louis Dreyfus Corporation. I oversee the
trading of cotton and also trade grains, oilseeds, livestock,
currencies, and energy.
The concerns and some of the recommendations expressed in this
statement are shared by the entire U.S. cotton industry--producers,
ginners, warehousemen, merchants, cooperatives, and textile mills. For
the past 4 months ACSA has been working closely with Amcot--the
association of marketing cooperatives, and the American Cotton
Producers of the National Cotton Council in addressing our concerns to
the IntercontientalExchange (ICE), the Commodity Futures Trading
Commission (CFTC), and the Congress.
Recent Developments
We are pleased to inform you that the ICE has been responsive to
our concerns, and so to has the CFTC, which has actively considered and
adopted some of the recommendations we made to the Commission's April
22nd Roundtable. Further, we appreciate the scheduling of this week's
hearings and the overall sense of urgency by many in the U.S. Congress
to determine what can and should be done. Your involvement is another
example of the concerns expressed by this Committee to effectively
oversee the futures markets by addressing these important issues.
Hopefully, your legislative findings and recommendations will result in
full market transparency revealing the necessary data that allows the
CFTC to know first-hand what is taking place in the markets so it can
make sound regulatory decisions providing for the orderly trading of
agricultural futures contracts.
Interest of ACSA
ACSA, founded in 1924, is composed of primary buyers, mill service
agents, merchants, shippers, and exporters of raw cotton, who are
members of four federated associations located in sixteen states
throughout the cotton belt:
Atlantic Cotton Association (AL, FL, GA, NC, SC, & VA)
Southern Cotton Association (AR, LA, MS, MO, & TN)
Texas Cotton Association (OK & TX)
Western Cotton Shippers Association (AZ, CA, & NM)
ACSA's member firms handle over 80% of the U.S. cotton sold in
domestic and export markets. In addition, our members also handle a
myriad of foreign growths of cotton, which is forward priced based on
the New York futures market. Because of their involvement in the
purchase, storage, sale, and shipment of cotton, ACSA members, along
with their producer and mill customers, are significant users of the
ICE's No. 2 Upland Cotton Futures Contract. Therefore, they are vitally
interested in a return to an orderly futures market reflecting market
fundamentals that are not grossly distorted by speculative interests.
Current Status of Cotton Contract
In ACSA's testimony to the General Farm Commodities & Risk
Management Subcommittee on May 15th, we reviewed the consequences to
the price run-up in the ICE No. 2 Contract in the period from mid-
February to early March and the resulting problems to the cotton
industry due to an unrealistically widened basis precluding the use of
the No. 2 Contract as a prudent hedging or risk management tool by
producers, cooperatives, merchants, and mills.
I am pleased to report, that while the industry is still suffering
from the repercussions of the disruptive market events of early March,
the ICE has listened to the cotton industry and has agreed to make our
recommended changes to margin the futures to futures settlements and
options to option settlements. It has also agreed to the industry's
proposal regarding the expansion of trading limits. These important
changes should provide the necessary certainty to our financing banks,
who had been reluctant to finance margin requirements under the
previous system that established margins not at the closing price of
the futures month, but at the ``synthetic'' level of the closing price
of the options month, which added on additional financial exposure.
The CFTC, while focusing mostly on the monitoring of the energy
markets, has launched a comprehensive investigation of the
February&March trading in the cotton futures contract. We have limited
knowledge of the investigation, but based on what we know, the CFTC's
Enforcement Division has detailed a top-flight team to this important
task. The Commission is also developing a proposal to require ``more
detailed reporting from index traders and swaps dealers . . . and to
review whether classification of these types of traders can be improved
for regulatory and reporting purposes.'' I might add that it was not
possible for the Commission to effectively regulate the futures markets
because it had never used its authority to request such information.
The lesson is that lacking the appropriate information the markets
cannot be properly monitored.
More importantly, the CFTC has also agreed to ``review the trading
practices for index traders . . . to insure that this type of trading
activity is not adversely impacting the price discovery process, and to
determine whether different practices should be employed.''
The CFTC Agricultural Advisory Committee is scheduled to meet on
July 29th Mr. Gillen and I have served as members of that Committee. At
that meeting, we expect to discuss a myriad of proposals on what can
and should be done to assure that the agricultural futures markets
function as Congress intended that they should.
Hedge Exemptions--Speculative Position Limits
In our earlier testimony we discussed the recent phenomena of the
participation of the index funds and the over-the-counter traders, who
have flooded the futures markets with record liquidity to the extent
that the resulting widened basis has in fact made the markets illiquid
to those for whom Congress created these markets. This has had the
effect of rendering the markets, particularly the cotton contract,
which has significantly different supply/demand fundamentals than the
other agricultural commodities, ineffective for hedging against price
risks and discovering prices. More importantly, this has adversely
impacted the physical markets since merchants or cooperatives cannot
offer price quotations to farmers or end-users because they cannot use
the contracts for hedging purposes.
Simply put, these markets, now overrun by cash, preclude the
convergence of cash and futures prices, hedging, and forward
contracting. The markets now lack the economic purpose that the
Congress required when it originally authorized the trading of
agricultural futures contracts.
Speculative Position Limits
The Congress through the CFTC has imposed speculative positions
limits in the futures contracts to reduce the potential for market
disruption or manipulation. But such limits are no longer effective for
two reasons, first, the CFTC has granted hedge exemptions to the
investment funds allowing them to exceed the limits, and second, large
traders were permitted by the Congress, through the swaps exemption, to
operate outside the regulatory framework through the swaps markets. The
transactions in these hidden markets are permitted to take place off-
exchange where each party mutually agrees to satisfy each other's
credit standards and to remit margins to one another as the underlying
market fluctuates. Such transactions have the characteristics of an
exchange-traded futures contract, but are traded ``over-the-counter''
(OTC) and are not subject to CFTC oversight.
Such transactions pose problems when one of the parties to the swap
has a ``hedge exemption'' that exempts his on-exchange futures trading
from position-size limits. The swaps dealer would take an equal and
opposite position in the futures market to the swaps trade. For
example, should a pension fund desire to purchase $20 million in long
exposure in cotton, it can purchase this exposure from a swaps dealer.
The dealer, now short the price of cotton via the swap, enters the
futures market to hedge his position by buying cotton futures. Given
that he is a ``hedger,'' CFTC allows him to trade futures in excess of
the normal speculative position-size limits. This has created a
situation where such large investors can trade in any contract in any
size they desire without regard to position limits. They are not
limited by the CFTC. Only a swaps dealer can limit such trades, and no
swaps dealer is going to turn a deaf ear to any financial entity awash
in cash.
These arrangements, along with the billions of dollars invested in
index funds, bring so much cash into a market that the traditional
speculators cannot take a short position to match the institutional
longs. This leaves it up to the commercials--cooperatives, the
merchants, and the processors to offset these positions. But lacking
the huge margin requirements they cannot do so. That is the situation
today as the funds continue to purchase futures. Unwilling to assume
such margin risks in such a volatile futures market the commercials
remain passive not only in the futures, but in the physical markets.
The result--markets with no economic purpose for the commercials.
Therefore, no business is done. Producers, lacking a price, cannot
properly plan and processors must buy hand to mouth. Simply put, the
investment funds have negated the real purpose of the futures markets
causing severe disruptions in the agricultural marketing process.
Recommendations
While we are pleased that the CFTC has placed a moratorium on
granting further hedge exemptions to the so-called ``passive''
investment funds, action must be taken--a balance must be struck--with
those funds currently operating with a hedge exemption.
We submit that the CFTC should take immediate action to require
that an index fund with a hedge exemption restrict its position in a
commodity to the donor allocation or the percentage of funds allocated
to that commodity as defined in the fund's prospectus and recorded with
the CFTC. Further, any variation should be subject to speculative
position limits, and that such funds should report their cash positions
on a weekly basis.
ACSA also recommends that the CFTC monitor and oversee all swaps
and OTC activity by requiring the reporting of all swap and OTC
contracts by market participants, and that the CFTC determine the
aggregation of positions from all sources, including the exchanges,
ETF's, swaps, OTC, and other trading entities.
We also recommend that the CFTC require that all non-traditional
hedge accounts, those not involved in the commercial enterprise of
physically trading bales of cotton, be reported as a separate
individual category. It is also recommended that only those involved in
the commercial enterprise of physically trading bales of cotton, shall
be eligible for hedge margin levels.
In our view, these requirements would provide the CFTC and the
trading public with the necessary information on which to make sound
regulatory and market decisions. It will hopefully attenuate the
current situation in which these essential markets have become
investment vehicles for speculative funds who act unimpeded by market
fundamentals or regulation.
Again, Mr. Chairman, thank you for providing us with the
opportunity to participate in these important hearings and for your
attention to our concerns.
The Chairman. Thank you.
Mr. White, welcome.
STATEMENT OF ADAM K. WHITE, C.F.A., DIRECTOR OF
RESEARCH, WHITE KNIGHT RESEARCH & TRADING, ALPHARETTA, GA
Mr. White. Thank you. Mr. Chairman and Members of the
Committee, thank you for the opportunity to share my research
on the threat to the U.S. economy from excessive speculation.
Erosion and elimination of speculative position limits has
allowed hundreds of billions of dollars of speculative money to
flow into the commodity futures markets, causing food and fuel
prices to skyrocket. This has damaged the price discovery
function by pushing prices far and beyond what supply and
demand would dictate.
Commodity futures markets are a unique hybrid form of
marketplace with two distinctly different types of market
participants. When physical hedgers are the dominant force,
then futures prices will accurately reflect the real world
supply and demand fundamentals that these hedgers are
experiencing directly in their own businesses. When speculators
are the dominant force, then futures prices often become
untethered from supply and demand and can reach irrationally
exuberant heights.
Today the agricultural and energy markets rely on the
futures prices as their benchmark for the pricing of nearly all
of their transactions to the real world spot markets. For many
commodities, when the nearby futures price rises by a dollar,
spot price rises by a dollar as well. In the last 5 years, a
titanic wave of speculative money has flowed into the commodity
futures markets and dramatically driven up both futures and
spot prices. Institutional investors have come to view
commodity futures as an investable asset class, giving birth to
a new form of speculator. I call them index speculators.
The first slide shows assets allocated to commodity index
trading strategies have risen twenty-fold from $13 billion in
2003, to $260 billion in March of 2008, and the prices of the
25 commodities that compose these indexes have risen by an
average of 183 percent.
The second slide shows that the commodities futures markets
are small markets. In 2004, their total size was only $180
billion. And over the next 5 years, as hundreds of billions of
dollars flowed into these markets, caused futures prices to
rise dramatically as the markets were forced to expand and
absorb this influx of money. Index speculators have bought more
commodities futures contracts in the last 5 years than any
other group of market participants. They are now the dominant
force in the commodities futures markets. And worst of all,
their buying has little to do with the supply and demand
fundamentals of any single commodity.
Since 85 percent of index speculators enter into commodity
swaps, these swap dealers have huge futures positions. Recently
released data shows that swaps dealers as a category are the
largest holders of NYMEX WTI crude oil futures contracts. This
slide shows that as their positions have grown, so has the
price of oil.
Now, I am not a legal expert, but I believe there are three
key elements that need to be part of whatever legislation
Congress does adopt. First, there need to be Federal
speculative position limits for all U.S.-based commodities
across all exchanges.
In 1936, Congress established speculative position limits
in order to ensure the dominance of physical hedgers and to
prevent speculative bubbles from forming. However, over the
years, these position limits have been raised or eliminated. I
recommend that a panel of physical hedgers be convened to
establish real, meaningful position limits, since they will set
limits that truly restrict speculation without restricting
necessary liquidity.
Second, speculative position limits must apply in the over-
the-counter commodity swaps market. Excluding swaps from
position limits would allow excessive speculation to continue
unabated and render existing limits meaningless.
Finally, the practice of commodity index speculation should
be prohibited because of the liquidity it consumes and the
damage it does to the price discovery function. Speculative
position limits worked well for over 50 years and carry no
unintended consequences. If Congress takes these actions, then
the speculative money that flow to these markets would be
forced to flow out. And with that, the price of commodities
would come down substantially. Until speculative position
limits are restored, investor money will continue to flow
unimpeded into commodity markets and prices will continue to
rise.
Thank you.
[The prepared statement of Mr. White follows:]
Prepared Statement of Adam K. White, C.F.A., Director of Research,
White Knight Research & Trading, Alpharetta, GA
Mr. Chairman and Members of the Committee, thank you for the
invitation to speak to you today. I first began to study the role of
institutional investment in the commodities futures markets, back in
early 2006, while I was employed by Masters Capital Management. Since I
formed my own independent research company I have continued to study
this issue in-depth. I have recently added the Air Transport
Association as a client but I am not representing them here today.
Instead I want to share the results of my research efforts. I am
co-authoring an in-depth research report with Michael Masters that we
hope to have completed in the next week or 2. My testimony today
essentially represents the executive summary of that report. With your
permission I would like to submit the full report to your Committee
when it is complete. [i]
The commodities futures markets are a unique hybrid form of
marketplace where two distinctly different categories of market
participants transact side by side. Physical Hedgers access the markets
to reduce the price risk of their underlying physical commodity
businesses, while Speculators trade in the markets to make maximum
profits.
When Physical Hedgers are the dominant force in the marketplace
then futures prices will accurately reflect the real world supply and
demand fundamentals these physical consumers and producers are
experiencing directly in their businesses. When Speculators are the
dominant force, then futures prices often become un-tethered from
supply and demand and can reach irrationally exuberant heights.
In 1936 Congress devised a system whereby speculative position
limits would restrict the size of Speculators' positions in order to
ensure the dominance of Bona Fide Physical Hedgers and to prevent
speculative bubbles from forming. [ii] Congress took this action
because they realized that the commodities futures markets were
essential to the health of the American economy.
Today the agricultural and energy markets rely on the futures price
as their benchmark for the pricing of nearly all their transactions in
the real world ``spot'' markets. [iii] For many commodities, when the
nearby futures price rises by $1, the spot price rises by $1 as well.
This is preferred by Physical Hedgers because they can use the futures
markets to hedge their price risk on a dollar for dollar basis.
Unfortunately the price discovery function of the commodities
futures markets is breaking down. With the advent of financial futures
the important distinctions between commodities futures and financial
futures were lost to regulators. The term excessive speculation
effectively came to mean manipulation. [iv] Therefore speculative
position limits were raised or eliminated because they were not deemed
necessary for the prevention of manipulation. [v]
Swaps dealers who trade derivatives in the completely unregulated
over-the-counter markets were given the same virtually unlimited access
to the futures markets that Bona Fide Physical Hedgers enjoy. These
swaps dealers turned around and convinced institutional investors that
commodities futures were an asset class that would deliver ``equity-
like returns'' while reducing overall portfolio risk. These investors
were encouraged to make ``a broadly diversified, long only passive
investment'' in commodities futures indices. [vi] And as a result a new
and more damaging form of speculator was born--I call them Index
Speculators.
As Chart One below demonstrates the result has been a titanic wave
of speculative money that has flowed into the commodities futures
markets and driven up prices dramatically. Assets allocated to
commodity index trading strategies have risen from $13 billion at the
end of 2003 to $260 billion as of March 2008, [vii] and the prices of
the 25 commodities that compose these indices have risen by an average
of 183% in those 5 years! [viii]
Chart Two below shows this has caused futures prices to rise
dramatically as the commodities futures markets were forced to expand
in order to absorb this influx of money.
The four largest commodity swaps dealers: Goldman Sachs, Morgan
Stanley, J.P. Morgan and Barclays Bank are reported to control 70% of
the commodity index swaps positions. [xiii] That would mean that on
average about one out of every four long positions on the exchanges is
controlled by one of these banks. [xiv] Recently released data from the
House Energy Committee shows that swaps dealers as a category have
grown to become the largest holders of NYMEX WTI crude oil futures
contracts. [xv] Chart Three on the next page shows that as their
positions have grown in size so has the price of oil.
First there needs to be Federal speculative position limits for all
commodities (except precious metals). These limits need to apply in
aggregate across all exchanges trading U.S. based futures contracts. I
recommend that a panel of Bona Fide Physical Hedgers be convened to
determine these position limits since they can be relied upon to set
them at levels that truly restrict speculation without restricting
necessary liquidity.
Second, speculative position limits must apply in the over-the-
counter (OTC) commodity swaps market. The commodity swaps market does
not need to be regulated per se but if swaps dealers want to access the
futures markets then they must report all their counterparties'
positions in order to ensure that no one is in violation of speculative
position limits. The OTC swaps market is many times bigger than the
futures markets so excluding swaps from position limits would allow
excessive speculation to continue unabated and render existing limits
meaningless.
Third, excessive speculation should be numerically defined as a
percentage of open interest. The same panel of bona fide physical
hedgers should also determine this figure. Then the CFTC can establish
a system whereby the individual position limits adjust based on the
overall level of speculation in the marketplace. This system would
prevent the commodities futures markets from ever reaching a level of
excessive speculation in the future.
Finally the practice of commodity index replication should be
prohibited. Index Speculators damage the price discovery function and
lock up large amounts of market liquidity by buying and holding futures
positions for the ultra long term. Congress would not allow someone to
hoard physical commodities so they should not allow institutional
investors to hoard commodities futures either. A way should be found to
prevent this damaging practice from continuing.
Speculative position limits worked well for over 50 years and carry
no unintended consequences. If Congress takes these actions then the
speculative money that flowed into these markets would be forced to
flow out and with that the price of commodities futures would come down
substantially. Until speculative position limits are restored investor
money will continue to flow unimpeded into the commodities futures
markets and prices will continue to rise.
Endnotes
[i] All of the data in my testimony today is calculated as of March
2008. When I submit the completed report the data will be updated
through July 1, 2008.
[ii] ``The fundamental purpose of the measure is to insure fair
practice and honest dealing on the commodity exchanges and to provide a
measure of control over those forms of speculative activity which too
often demoralize the markets to the injury of producers and consumers
and the exchanges themselves.'' Report No. 421, U.S. House of
Representatives 74th Congress, Accompanying the Commodity Exchange Act,
March 18, 1935.
``It should be our national policy to restrict, as far as possible,
the use of these exchanges for purely speculative operations.''
President Franklin D. Roosevelt message to Congress February 9, 1934
``The bill authorizes the Commission . . . to fix limitations upon
purely speculative trades and commitments. Hedging transactions are
expressly exempted. That this power of the Commission will be exercised
judiciously and for the purposes merely of preventing overspeculation
and a type of `racketeering' by a few large professional traders, may
be assumed as a matter of course.'' Report No. 421, U.S. House of
Representatives 74th Congress, Accompanying the Commodity Exchange Act,
March 18, 1935.
[iii] ``In many physical commodities (especially agricultural
commodities), cash market participants base spot and forward prices on
the futures prices that are `discovered' in the competitive, open
auction market of a futures exchange.'' ``The Economic Purpose of
Futures Markets and How They Work--Price Discovery or Price Basing,''
Commodities Futures Trading Commission website, http://www.cftc.gov/
educationcenter/economicpurpose.html.
``In the spot market, therefore, negotiations for physical oils
will typically use NYMEX as a reference point, with bids/offers and
deals expressed as a differential to the futures price. Using these
differentials, Platts makes daily and in some cases intra-day
assessments of the price for various physical grades of crude oil,
which may be referenced in other spot, term or derivatives deals.''
``Platts Oil Pricing and Market-on-Close Methodology Explained--A
Backgrounder,'' Platts, A Division of McGraw Hill Companies, July 2007,
page 3. http://www.platts.com/Resources/whitepapers/index.xml.
[iv] ``Excessive Speculation'' (7 U.S.C. 6a) and ``Manipulation''
(7 U.S.C. 13b) are separate sections of the Commodity Exchange Act.
Excessive Speculation is remedied by establishing speculative position
limits and is not a violation of the Act. Manipulation is a violation
and can result in monetary penalties and jail time. Yet on the CFTC
website it says ``In general, position limits are not needed for
markets where the threat of market manipulation is non-existent or very
low.'' http://www.cftc.gov/industryoversight/marketsurveillance/
speculativelimits.html#P8_883.
So their stance appears to be that position limits exist to prevent
manipulation. Contrast this with the comments of Johnson and Hazen in
their book ``Derivatives Regulation'' where they say ``However, Section
4a (7 U.S.C. 6a) is expressly concerned with `excessive speculation'
and thus is not specifically an
anti(-)manipulation provision. Rather, section 4a focuses upon market
disorders attributable to unbridled speculative activity, without
regard to whether that speculative frenzy has a manipulative purpose.''
Section 5.02[1] ``Derivatives Regulation,'' Philip McBride Johnson and
Thomas Lee Hazen, Aspen Press, 2004, page 1235.
[v] ``In general, position limits are not needed for markets where
the threat of market manipulation is non-existent or very low. . . . A
contract market may impose for position accountability provisions in
lieu of position limits for contracts
on . . . certain tangible commodities, which have large open interest,
high daily trading volumes, and liquid cash markets.'' http://
www.cftc.gov/industryoversight/marketsurveillance/
speculativelimits.html#P8_883.
In 1998 the CFTC allowed the futures exchanges such as the NYMEX to
replace ``speculative position limits'' with ``position accountability
limits'' which do not actually limit the size of positions but simply
represent a threshold above which the exchanges look closer at
positions to ensure that manipulation is not occurring. The result is
that NYMEX WTI crude oil does not have any speculative position limits
except in the last 3 days prior to expiration. 63 FR 38525 (July 17,
1998) http://www.cftc.gov/foia/comment98/foi98--028_1.htm.
[vi] ``Investing and Trading in the GSCI,'' Goldman, Sachs & Co.,
June 1, 2005.
[vii] ``Investing and Trading in the GSCI,'' Goldman, Sachs & Co.,
June 1, 2005, CFTC Commitments of Traders Report--CIT Supplement and
estimates derived there from.
[vii]
Commodity Futures Prices
March 2003March 2008
------------------------------------------------------------------------
------------------------------------------------------------------------
Agricultural:
Cocoa..................... + 34%
Coffee.................... + 167%
Corn...................... + 134%
Cotton.................... + 40%
Soybean Oil............... + 199%
Soybeans.................. + 143%
Sugar..................... + 69%
Wheat..................... + 314%
Wheat KC.................. + 276%
Livestock:
Feed Cattle............... + 34%
Lean Hogs................. + 10%
Live Cattle............... + 23%
Energy:
Brent Crude Oil........... + 213%
WTI Crude Oil............. + 191%
Gasoil.................... + 192%
Heating Oil............... + 192%
Gasoline.................. + 145%
Natural Gas............... + 71%
Base Metals:
Aluminum.................. + 120%
Lead...................... + 564%
Nickel.................... + 282%
Zinc...................... + 225%
Copper.................... + 413%
Precious Metals:
Gold...................... + 183%
Silver.................... + 331%
------------------------------------------------------------------------
Source: Bloomberg
[ix] Bloomberg did not have open interest data for the base metals
in 2004 so I used 2005 figures for 2004. This is conservative since
prices were rising during this time frame.
Average Daily Dollar Value of Open Interest in 2004
(millions)
------------------------------------------------------------------------
------------------------------------------------------------------------
Cocoa $1,569
Coffee $2,748
Lean Hogs $1,873
Live Cattle $3,556
Brent Crude $12,620
WTI Crude $33,620
Gasoil $5,461
Heating Oil $8,242
Gasoline $7,304
Natural Gas $25,897
Aluminum $12,286
Lead $677
Nickel $1,986
Zinc $2,696
Copper $11,864
Gold $13,221
Silver $3,745
--------------------------------
Total................................ $179,590
------------------------------------------------------------------------
Source: Bloomberg
[x] There is no publicly available data that shows the total amount
of inflows into commodity indexation trading strategies but some
approximations can be made. The total amount benchmarked to the S&P-
GSCI and DJ&AIG can be estimated and the annual performance of the
indices is known. Therefore the amount that the prior year's investment
has grown or shrunk can be computed. Then the difference in the yearly
change has to come from net inflows. When during the year the inflows
occurred is not known, so the assumption is made that all net inflows
occurred evenly throughout the year. Changing assumptions on net inflow
timing only affects the rate of growth for that year's inflow which
never amounts to more than a few billion dollars difference.
Estimated Annual Inflows
------------------------------------------------------------------------
S&PGSCI DJAIG Total
------------------------------------------------------------------------
2004 $16.20 $8.90 $25.10
2005 $4.80 $12.40 $17.20
2006 $28.30 $11.30 $39.60
2007 $14.70 $15.40 $30.10
2008 $35.10 $20.00 $55.10
--------------------------------------------------
Total.............. $99.10 $68.00 $167.10
------------------------------------------------------------------------
2008 figures reflect estimated inflows through March 12, 2008, figures
will be updated through July 1, 2008 with final report.
[xi]
------------------------------------------------------------------------
2003 Long Open Interest
-------------------------------------------------
Traditional Index
Physical Hedger Speculator Speculator
------------------------------------------------------------------------
Cocoa 71,300 5,673 2,710
Coffee 38,378 12,197 5,671
Corn 227,612 54,123 51,139
Cotton 52,529 23,633 9,518
Soybean Oil 76,717 33,449 3,272
Soybeans 98,696 58,567 13,733
Live Cattle 19,820 40,864 20,021
WTI Crude Oil 433,028 56,629 108,599
Heating Oil 69,363 14,063 26,217
Gasoline 44,252 20,698 25,555
Natural Gas 397,488 21,734 29,774
-------------------------------------------------
Total............... 1,691,579 416,042 404,785
------------------------------------------------------------------------
2008 Long Open Interest
------------------------------------------------------------------------
Cocoa 50,243 72,866 29,527
Coffee 41,159 56,866 63,133
Corn 505,627 300,017 441,197
Cotton 91,820 77,132 114,804
Soybean Oil 104,064 48,619 72,287
Soybeans 141,375 132,849 194,391
Sugar 359,427 180,670 411,510
Wheat 58,484 66,958 218,191
Wheat KC 35,629 31,201 30,299
Feeder Cattle 5,117 16,208 9,279
Lean Hogs 29,366 33,374 105,228
Live Cattle 27,898 51,798 135,451
WTI Crude Oil 1,161,063 203,280 606,176
Heating Oil 65,851 27,972 83,008
Gasoline 83,826 41,534 78,692
Natural Gas 480,964 77,462 214,641
-------------------------------------------------
Total............... 3,241,915 1,418,805 2,807,813
------------------------------------------------------------------------
Purchases Last 5 Years
------------------------------------------------------------------------
Cocoa ^21,056 67,193 26,817
Coffee 2,781 44,669 57,463
Corn 278,016 245,894 390,057
Cotton 39,291 53,499 105,286
Soybean Oil 27,348 15,169 69,015
Soybeans 42,679 74,282 180,658
Sugar 263,817 149,527 365,579
Wheat 33,639 41,260 184,231
Wheat KC 2,870 26,246 19,773
Feeder Cattle 1,253 10,969 6,637
Lean Hogs 24,049 25,997 89,711
Live Cattle 8,078 10,934 115,429
WTI Crude Oil 728,035 146,651 497,577
Heating Oil ^3,512 13,909 56,791
Gasoline 39,574 20,836 53,137
Natural Gas 83,476 55,728 184,867
-------------------------------------------------
Total............... 1,550,337 1,002,764 2,403,029
------------------------------------------------------------------------
Figures derived from data from Goldman Sachs, Dow Jones, Bloomberg, CFTC
Commitments of Traders report and the CFTC CIT Supplement. Non-
Directional Spreads and Non-Report (Unclassified) Positions are not
shown. Traditional Speculators accessing the futures market through
the ``swaps loophole'' are still classified as Physical Hedgers
because the CFTC does not distinguish. 2008 figures are as of March
12, 2008 and will be updated to reflect July 1, 2008 in the final
report.
[xii]
Commodities Futures Markets
Percentage of Open Interest
2008 Long/Demand Side
------------------------------------------------------------------------
Traditional Index
Physical Hedger Speculator Speculator
------------------------------------------------------------------------
Cocoa 33% 48% 19%
Coffee 26% 35% 39%
Corn 41% 24% 35%
Cotton 32% 27% 41%
Soybean Oil 46% 22% 32%
Soybeans 30% 28% 42%
Sugar 38% 19% 43%
Wheat 17% 20% 64%
Wheat KC 37% 32% 31%
Feed Cattle 17% 53% 30%
Lean Hogs 18% 20% 63%
Live Cattle 13% 24% 63%
WTI Crude Oil 59% 10% 31%
Heating Oil 37% 16% 47%
Gasoline 41% 20% 39%
Natural Gas 62% 10% 28%
-------------------------------------------------
Average............. 34% 26% 40%
------------------------------------------------------------------------
Source: CFTC Commitments of Traders reports, and estimates derived from
CFTC CIT Supplement, does not include Spreads.
Data represents an average from January 1, 2008 through March 12, 2008,
data in final report will reflect through July 1, 2008
[xiii] ``The Global Commodities Boom,'' Greenwich Associates,
Andrew Awad, Woody Canaday, et al., May 2008, page 1. ``Commodities:
Who's Behind the Boom?,'' Gene Epstein, Barron's, March 31, 2008. First
report identifies the four largest swaps traders and second article
references some ISDA data saying four largest swaps traders are 70% of
swaps market. Barron's also says and CFTC CIT supplement corroborates
that 85%&90% of all index trades are done through swaps.
xiv&According to calculations Index Speculators average
40% of the long open interest (excluding spreads) in U.S. based
commodities (see footnote [xii]), 85&90% is done through swaps and 70%
of swaps are done with the four largest traders. So .7*.875*.4=.245 or
24.5%. I cannot know for sure if this estimate is accurate since I do
not have access to this information.
xv&http://energycommerce.house.gov/Investigations/
EnergySpec.shtml.
The Chairman. Thank you all for your testimony.
Mr. Nicosia, in your testimony here, you are saying
something about the hedge exemption should be restricted to the
dollar allocation of the percentage of funds of the index. Is
that not what they are doing now? Do they get an exemption for
the whole amount of the fund but it is not done by commodity,
or what are you talking about there?
Mr. Nicosia. No. It is in their prospectus, they usually
show what percentage they are going to allocate to different
commodities. Our concern is that under the umbrella of a hedge
exemption, that they use discretionary trading which is not
passive. So as opposed to an index fund which is going to
allocate a certain dollar amount to an individual commodity,
have it invested and leave it there, the record, especially in
cotton, shows that they have not done that. As leading up to
the debacle that we had on March 3rd and 4th, where prices rose
11 limits in about 90 minutes, you can see that the index
position was very aggressive in the 2 weeks leading up to that
and then actually liquidated. In that particular case, I doubt
that the index funds had a 16 percent increase in their
allocation of money and then a ten percent decrease within a
week of their money. We know that the money continued to flow
in all through that time.
The Chairman. So they had some information and they went in
and they----
Mr. Nicosia. In other words, they didn't act as a passive
investor. In other words, they were using their hedge
exemptions to act as an extended arm of the regular
discretionary trader.
The Chairman. But I was told that most of these index funds
don't even put the money in the market.
Mr. Nicosia. Yes, I heard that earlier today. There was a
lot of disinformation you received from the other panels. That
is not true. There is massive amounts of index participation
directly into the futures market. So much so that there are
even funds that have been set up to counteract fund rolls that
exist from days 5 through 9 when they start to roll their
futures. There is massive participation.
The Chairman. Do you have any idea what the percentage is?
Mr. Nicosia. I found it interesting too that on the energy
side, although I am not an energy expert, the reports that
people have been using to try to gauge, whether it be
speculator involvement, the energy markets do not report on the
Commitment of Traders reports as they do in the ags. So it is
impossible to gauge that. Index funds, swap dealers are all
listed as hedgers on the energy markets. Therefore, the subset
is not divided out. So they are acting as if the speculative
community number may not be changing greatly, because the
number that would be added to it is hidden within the hedger
number. You don't even see it. In the agricultural commodity
markets, however, from the pilot program, CFTC does in fact
break it out. For example, in soybeans, if you took the
noncommercial long and the index trader today, they are long 50
percent of the entire United States crop speculatively. Now,
for someone to say that has no impact in price I think would be
fairly foolish. Today the speculative position in corn equals
over 2.15 percent of the amount of the total carryout that
exists in the United States at the end of the year. And if you
look at it as a percentage of open interest, 40 percent of the
entire open interest in soybeans is owned by the speculative
position, 35 percent in cotton. So the agricultural markets do
have the information split out from index funds. Energy markets
do not.
The Chairman. But we don't know what percentage of this is
index funds out of the whole money that is flowing into the----
Mr. Nicosia. We know that from the reports in agriculture,
absolutely.
The Chairman. But we don't know it in energy?
Mr. Nicosia. CFTC does not require that to be split out.
They did the pilot program. They only did it for agriculture.
The Chairman. Mr. White, that is how you tried to figure it
out. You took these numbers out of agriculture and extrapolated
based on how they are structured in these index and try to
figure out how much was oil, right? Is that what you told me?
Mr. White. Yes, that is exactly right. And I didn't invent
that, but many have done the same thing.
The Chairman. Surely none of you think that we should
decide what they should be. Is there anybody that thinks that
the Congress should decide what the position limits are?
Mr. Marshall. Mr. Chairman?
The Chairman. What? Do you think we should?
Mr. Marshall. No. There is another entity that could. It is
the CFTC, the CFTC I am pretty sure----
The Chairman. Go ahead.
Mr. Marshall. If I could. You are getting at the fact that
CFTC sets these limits not the exchanges?
The Chairman. No, no. I was trying to figure out what is
going on here. You are probably way beyond where I am at.
Mr. Nicosia. Mr. Chairman, if I could. Position limits
today are really pretty much a joke because there is no way to
enforce them because you can just circumvent them easily off
the exchange.
The Chairman. Even on the ag?
Mr. Nicosia. Even on the ags because--the swap situation is
not subject to those limits. And the only ones that are
required to report the swaps are actually the traditional
hedgers, the commercial hedgers who are in there. We actually
do have to report all of that information as part of a cash
transaction. But anyone who wants to exceed the limits can do
so very easily.
The Chairman. So was it you that recommended that you get a
bunch of people that are involved together and figure out what
these limits are? Was that you? Or was that you, Mr. White? I
was told by somebody that in the ag area, they get the people
together that are involved in this and they are the ones that
decide what these limits are. Is that true? Is that how that
works? I mean, does the CFTC do that? Do they get these people
to recommend and they set these limits; how does that work?
Mr. Nicosia. It does work in conjunction through the
exchange as well as through CFTC. I was a long-term Board
Member for the New York Cotton Exchange in the New York Board
of Trade. And the process that took place there is often the
CFTC would actually make recommendations back to us for the
size of position limits. They would often do that as a
percentage maybe of open interest or of trading volume or in
relationship to other markets. There are times that maybe the
exchange could also request of the CFTC an increase that took
place. Often at those points in time, many of the contract
committees in agriculture would have some response. At the New
York Board of Trade, the Board and the contract committees and/
or the trade were very involved in either okaying or not
okaying those speculative limits. The exchange also had the
right to accept those limits or lower ones.
The Chairman. Okay. So that process does go on in all the
agriculture area?
Mr. Nicosia. Yes.
The Chairman. And so who actually has the power to do this,
the exchange or the CFTC?
Mr. Nicosia. CFTC.
The Chairman. So in the end they could set the limits
wherever they want?
Mr. Nicosia. Yes.
The Chairman. Now in oil, does that happen? Is there
anybody, any process like that to set limits in oil?
Dr. Newsome. Yes, sir, there are not federally mandated
limits in energy, but there are guidelines in the Commodity
Exchange Act that say that limits should not be set any higher
than what would roughly be 25 percent of the underlying
deliverable of whatever commodity we are talking about. The
NYMEX position limits are set conservative as compared to those
guidelines, and the CFTC is involved in every step of the
discussion with NYMEX to determine what the appropriate limits
would be.
The Chairman. And in that case, does the CFTC in the end
have the final say or do you guys?
Dr. Newsome. The exchange has the final say----
The Chairman. It is different than agriculture?
Dr. Newsome. It is different than agriculture, yes.
The Chairman. And what would your position be if we changed
that so it is like agriculture?
Dr. Newsome. Well, I mean, first of all, we don't believe
that the position limits have been abused in the energy sector
on the regulated exchanges. And we like the flexibility created
of having a dialogue with the CFTC, based upon the guidelines
that are in the Commodity Exchange Act. Have we ever disagreed
with the CFTC at the end of the day? No. They are a Federal
regulator. But we do like having the flexibility and the
dialogue with them.
The Chairman. So you don't think there is a problem with
the position limits?
Dr. Newsome. Certainly not at the NYMEX, no, sir.
The Chairman. Mr. White.
Mr. White. I think it is important to point out that
position limits at NYMEX and WTI crude oil, my understanding
has only existed in the last 3 days of trading.
The Chairman. Suppose the index and swaps are out before
the last 3 days anyway.
Mr. White. That is right. So they are having their impact
in months other than the last 3 days.
The Chairman. Why is it set for the last 3 days, Jim? Can
you tell us that?
Dr. Newsome. Yes, sir. We have position accountability
across all months. And then we have the hard limits within the
last 3 days for both commercials and for speculative traders.
And the reason that the 3 days are important is that is when
the price is determined that the whole industry uses. And when
that final price is determined, which is the key price
discovery component, then the speculators are either completely
decreased or out of the market.
The Chairman. The gentleman from North Carolina.
Mr. Etheridge. How long has that been in force?
Dr. Newsome. Roughly 20 years, Congressman.
Mr. Etheridge. Thank you, Mr. Chairman. Since this topic is
on hedge exemption and speculation position limits, let me run
by you some numbers that we talked about yesterday. In 2006, 46
hedge exemptions were granted for West Texas Intermediate crude
oil contracts traded on NYMEX, some of which lasted just 1 year
and some for 1 month. In 2007, only 36 hedge exemptions were
granted. In 2008, to date, only 11 exemptions have been
granted. So as oil has climbed to almost $100 in 2007 and I
don't know what it cleared out today, $135 plus, demand for
hedge exemptions has declined. And when Mr. Stupak said that
because some exemptions lasted for a year, all 117 exemptions
granted for West Texas Intermediate crude from 2006 to today
were in effect. Now, I am afraid that is just not quite totally
accurate. But at no time between 2006 and now have 117
exemptions been in effect at the same time. I think that is
correct.
Dr. Newsome. That is totally correct.
Mr. Etheridge. So as the theory goes, if swap dealers are
using hedge exemptions to lay off the risk of all arrangements
they have with pension funds, index funds, et cetera, which
everyone believes is pouring money into commodities, shouldn't
we be seeing an increased need for swap exemptions instead of a
decline?
Dr. Newsome. Well, certainly.
Mr. Etheridge. I would like to hear from each one of you on
that, a short answer.
Dr. Newsome. Certainly from the exchange standpoint, we are
not the driver behind requests for exemptions. Those come from
the participants. We handle those on a case-by-case basis. And
they have to show the bona fide need for the exemption, whether
they are a commercial producer or a swaps dealer who has
assumed the risk of commercial entities and therefore needs the
exemption.
Mr. Nicosia. With all due respect, the number of those that
are requested have nothing to do with it. The number means
nothing. As you heard earlier, the size of any one individual
can more than overwhelm 20----
Mr. Etheridge. All the rest of them?
Mr. Nicosia. Exactly. So it is really the total number of
dollars that are involved, not the number of hedge exemptions
that are important.
Mr. Etheridge. So your recommendation would be dealing with
the dollar number versus----
Mr. Nicosia. It is much more important to deal with the
dollar number of the size of the positions that are being taken
place within the exemption.
Mr. White. I don't know enough about the hedge exemptions
to really know. It is one of those things that really sounds
like the devil is in the details. But to me the only reason you
need an exemption is in the last 3 days, because there aren't
any limits other than the last 3 days.
Mr. Etheridge. Okay. Comment?
The Chairman. Well, if you would yield.
Mr. Etheridge. Yes.
The Chairman. Didn't you say there was some other kind of
control before that?
Dr. Newsome. There are accountability limits that we use.
The Chairman. What does that mean?
Dr. Newsome. It means they are not hard limits, but they
are limits that are put on by the exchange that cover the total
limits that a participant can have across all months within
that sector. So again these limits that are granted are not
open ended. They represent only what that entity has shown that
they have the need to truly hedge. And at the end of the day,
based upon the CFTC guidelines, no more than 25 percent of the
overall underlying deliverable can be exempted.
So, I mean, there are steps that we follow to make sure
that what the concern that the Committee and others have does
not exist on the regulated market. Now, I would be very quick
to say that there are real differences between the agricultural
markets and the energy markets. In terms of competitive
exchanges there is a much, much larger over-the-counter
marketplace within the energy sector. So I don't think what you
say could hold true in ag necessarily holds true in energy.
Mr. Etheridge. Mr. Nicosia, do you have this kind of
information available for cotton?
Mr. Nicosia. Yes, we do.
Mr. Etheridge. Do you have that available just to share?
Mr. Nicosia. I sure do.
Mr. Etheridge. Would you make that available to the
Committee Chairman?
Mr. Nicosia. Absolutely. We have that and we also have the
current status information for the main five ags as of this
current week.
Mr. Etheridge. Okay. I think that would be helpful to have.
Very quickly, Mr. White, we have heard the figure of $260
billion in index trading tossed around lately. But what you
appear to be telling us today is that the $260 billion figure
is just a snapshot of the value of the index funds and that in
reality it is only $167 and new funds have been invested in
commodities since 2004; is that correct?
Mr. White. To be more specific, it was $13 billion in 2003.
And then $167 billion in new money flowed in; the $13 billion
from 2003, it grew; the $25 billion from 2004, it grew; the
$167 billion is the amount of inflows; the $260 billion is the
amount of the total today, in March.
Mr. Etheridge. Okay. All right. Thank you. I appreciate
that clarification.
Mr. Chairman, I yield back.
The Chairman. I thank the gentleman. The gentleman from
Texas.
Mr. Conaway. Thank you, Mr. Chairman. I am struggling like
you are to make sure I understand this. To me right now there
is still a disconnect between an automatic assumption that
volume and activity in the market is just the exact cause and
effect to drive these prices higher. I have a great respect for
Joe and Adam and others who are making that case. A little bit
of Joe's background with cotton and what happened in March, I
want to ask you about that in a second. I am still trying to
understand this deal. Jim, you mentioned large trader data that
needs to be--are there any implementation barriers to that? Is
that something that could be done relatively easily by the
various folks that would have to comply with that?
Dr. Newsome. It is a technical process that the
IntercontinentalExchange, which is the foreign board of trade
really in question here, has to implement. They are in the
process of implementing that now. Even though they have
supplied data in the past, it was not in the format that other
exchanges supply and therefore not as readily available and
usable for the CFTC. But they are working on supply and----
Mr. Conaway. Okay. Joe, you mentioned that in March, where
the price limit was up 11 times over a very short period of
time. Is that that the actual cash market was going up to catch
up with the futures prices?
Mr. Nicosia. The cash market never moved at all.
Mr. Conaway. Who got hurt in that regard?
Mr. Nicosia. Everyone that was in the industry. The
traditional hedger, the traditional user, the contract because
what would be a traditional basis relationship between the cash
and futures was totally divorced.
Mr. Conaway. But the folks who were long on those higher
prices got hurt? Who got hurt?
Mr. Nicosia. The person that got hurt was the person who
had bought products from the farmer. When he buys product, he
sells futures to hedge. So he has locked in a basis
relationship.
Mr. Conaway. He is long on the product himself. This is a
traditional hedger who is trying to hedge against his price?
Mr. Nicosia. Exactly. So, long on the product and short in
the futures. But what happens is that as the index fund and/or
speculative community is allowed to buy futures totally
unimpeded, they are able to stampede the price to levels that
had nothing to do relative to the cash market. If a traditional
hedger did what they did, we would go to jail because we are
required to act in an economic fashion. When the cash becomes
substantially cheaper than the futures, CFTC will not allow us
to continue to buy futures because they are saying we are
acting in an noneconomic manner, and yet the index funds are
allowed to do that as are speculators.
Now, the problem is that if someone is within their
speculative limit, you can argue that there isn't anything
wrong with that per se. But our contention is that amongst all
these commodities, is that that would be fine if the CFTC could
tell us that the aggregative positions from swaps, from the
ETFs, from all the other sources were still within their
speculative limits. Because today the exchanges do a reasonably
good job in keeping people and watching speculative limits. It
is what they don't see that they can't account for. CFTC also
does not see it. And therefore if you want to take a position
in excess of your speculative limit and/or to push prices
improperly; you can do so, and, one, within the law; and, two,
no one would even see it or monitor it.
Mr. Conaway. Later in your testimony you mentioned that you
had a breakdown of all the ag participants in the deal and yet
ag prices are up sharply. Are there other participants that are
driving that? I mean, it seemed like your solution was greater
transparency lets everybody know what all the positions are.
And you said that was happening in ag. But yet if you look at
ag, prices are up as sharply as oil, gas, or fuel prices.
Mr. Nicosia. Right. And I think there is a very important
difference you have to be able to draw. There is no doubt that
supply and demand fundamentals and many of these commodities
warrant a higher price. The question is whether that be crude
oil at $110 instead of $145; or soybeans at $13 instead of $16;
or whether wheat should have went to $17 versus $25. And there
are certain rules that are laid down. Our biggest concern is
that people play within the rules that they have because today
there is absolutely no way to find that.
Mr. Conaway. On the overall position limits, is that for
the entire commodity, the collective positions can only be 25
percent of 1 day's trading; or is that each individual
participant has a certain amount they could hold? How does it
mechanically work?
Dr. Newsome. That is as an entity, not for one specific----
Mr. Conaway. Is there an overall speculative limit for the
entire cotton market?
Dr. Newsome. I cannot speak to cotton.
Mr. Nicosia. No, there is not. Only for an individual.
Mr. Conaway. So all these limits that we are all talking
about--that are being discussed here is on individual
participants. So that if you had a lot of participants in the
market, who each of them had a certain limit and they all did
the limits you could still mechanically get to these higher
volumes of things that are going on?
Mr. Nicosia. Absolutely. I think the other problem that we
had in the earlier testimony was the idea that this excess
buying does not push prices up. I don't know how anyone can
come to that conclusion, whether it was a NASDAQ of 1999 or
whatever. Excess buying pushed prices up. Just as if we asked
today for all of that index money to disappear, what do you
think would happen to prices? They would all go down. They
would have to go down until they found someone else willing to
take the long side and assume the risk at a lower level. Today
the index funds are crowding out other buyers. If China wants
to come in and buy corn, beans, wheat or cotton, they have to
compete with an index. There is one bushel to sell. They are
both going to buy it. It is a bidding war between the two of
them. So it does affect prices. Maybe not improperly, but it
absolutely affects it. Whether they are in the delivery market
or not.
Mr. Conaway. Thank you, Mr. Chairman. I yield back.
The Chairman. Thank you. The gentleman from California.
Mr. Costa. Thank you very much, Mr. Chairman. I, like many
of my colleagues, am still trying to get my arms around this
complex issue that obviously is a cause of concern for many as
to the impacts not just on the general commodity markets but of
course on energy. Mr. White, you made a comment in your opening
statement that I am trying to figure out. Obviously we are all
concerned about adverse impacts of speculation and you seem to
believe that it has had a significant impact. And I don't know
how we would rate that. But in the charts that you use, that
you provided, out of the five major oil fields in the world,
four of them are all in decline, and one could maybe argue the
fifth is in decline as well, not to mention others. And we know
that demand for the product has risen rapidly as a result of
the economic growth of China and India and other parts of the
world.
So I am wondering how you discount that and what percentage
you are really able to make a determination because I believe
in part--well, I believe the laws of supply and demand are
impacting. It is one of the reasons I think we are in an energy
crisis. And I am trying to figure out how much blame, or
responsibility maybe is a better word, on the issue of
speculation.
Mr. White. Yes. Basically what you have is you have a
situation of supply and demand and demand. You have your normal
supply and demand and then you have this additional financial
demand. So exactly like Mr. Nicosia said, the index speculators
are demanding futures just like China or any other of the
physical commodity consumers would be demanding futures. And so
the problem is that, take 1998 for example, on average, 80
percent of the positions on long and short were held by
physical hedgers, 20 percent by speculators. So physical
hedgers outnumbered speculators four to one and the market
worked fine and prices reflected supply and demand. Today, on
average, index speculators are about 40 percent of the long
side. Traditional speculators are about 25 percent. And then
physical hedgers make up the difference, about 35 percent. So
index speculators are bigger in terms of long positions that
they hold than any other category. And together with other
speculators, they outnumber them two to one.
Mr. Costa. I don't know, maybe because of the opaque nature
of the group of investors that we are talking about, maybe it
is not possible to determine. But do we know what percentage of
those that are participating that you just indicated may be
investors from China. Or, have you heard from some of these
other places that are also--we are competing with for the
product, for the energy?
Mr. White. Let me understand the question. So you are
saying of the 40 percent of index speculators, how many of
those might be foreign index speculators?
Mr. Costa. Right.
Mr. White. I don't know the answer, but it raises a great
question and that is some people have said that sovereign
wealth funds could be anywhere from 10 to 20 percent of that
money, and so it would be very unusual to see petro dollars.
They make money when the price of oil is high and then they
turn around and buy an index. But that is the only number I
have ever looked at.
Mr. Costa. Carly Gavars likes to say that if in fact the
Chinese attacked Taiwan that we would have to borrow money from
the Chinese to protect the Taiwanese. That is not the subject
at hand of course. But to all four of you I want to ask the
same question. Think about it precisely and concisely. We have
had yesterday and I suspect you are familiar with them and
there are other pieces of legislation out there that all
attempt to provide a fix for the issue that you have just
testified for.
What do you precisely believe the fix ought to be if
Congressional action is taken that would address very simple--
because I am a layperson, and I am not into the weeds like all
of you are on this, but what are the one, two, three in
priorities, simply stated?
Mr. White. Okay. You are looking at me so I will--what we
need is we need speculative position limits, Federal
speculative position limits across all commodities, across all
exchanges, including the over-the-counter swaps market. If we
don't include swap, which are bigger than the futures, then we
have left out a big portion of it. That is the main thing. I
would also further say that I would like to see index investors
told that they can't index anywhere. They can actively invest,
trade, buy and sell, but no more indexation for what it does to
the market.
Mr. Costa. Okay. Mr. Nicosia. I assume that everybody
believes transparency is a good thing.
Mr. Nicosia. Without a doubt, the number one issue has got
to be transparency and closing the loopholes to circumvent CFTC
regulation and CFTC limits. Today it is just rampant and it is
easy. So you need to close the loophole.
Two, you need to open up the transparency of that
aggregative positions. So once you close the loopholes, you
also need the transparency and the reporting so that people can
look at the aggregate of all trading activity both on and off-
exchange.
And third, some type of limitation on index money. There
may be a space for an index product to be in there, but to
allow an index to put as much money it wants at any point in
time simply because it has more money, the same right that is
denied other participants, makes absolutely no sense to me. So
limiting on the index money would also be an appropriate
behavior.
Ms. Cochran. I will go back to the issue of transparency. I
think the first thing that we would like to see is that the
CFTC has access and visibility into all the markets that they
need to have access and visibility into. And then reporting to
the public through reports such as the Commitment of Traders
report, information that doesn't reveal obviously any
proprietary information but allows the market to understand who
has what positions and the impacts on those markets. We have
seen that on the ag side and it has been very efficient.
Mr. Costa. You are batting cleanup.
Mr. LaSala. Yes, I am Tom LaSala. I am the Chief Regulatory
Officer with NYMEX. I am filling in at the moment for Jim
Newsome. I think everyone before me has said transparency.
NYMEX is in favor of transparency, noting that, however, it
needs to be on a reasonable basis. The notion of getting
ingress to the OTC books is going to be extremely, extremely
difficult. Additionally, some of the action taken with regard
to the foreign boards of trade insofar as again transparency,
comparable regulatory handling, position limits, actions moving
on that, we support that. Additionally Dr. Newsome spoke to
NYMEX advocating limitations on hedge exemptions that would be
pursuant to the last 3 trading days for any swap dealer who has
exposure directly related to noncommercial counterparties. So
we would legislatively support that also.
Mr. Costa. Thank you very much, Mr. Chairman.
The Chairman. I thank the gentleman. The gentleman from
Virginia, the Ranking Member.
Mr. Goodlatte. Thank you, Mr. Chairman. I am sorry. What
was your name again?
Mr. LaSala. Tom LaSala.
Mr. Goodlatte. Mr. LaSala, I wanted to ask this to Dr.
Newsome, but you are the designated hitter. So let me ask it to
you. We are told by one of the Members of Congress that
testified yesterday that in 2000 physical hedgers accounted for
63 percent of the oil futures market and speculators accounted
for 37 percent. But by April of 2008, physical hedgers only
controlled 29 percent of the market and that 71 percent of the
market is now swap dealers and speculators. Meanwhile your
testimony, or Dr. Newsome's testimony I should say, states that
your data analysis indicates that the percentage of open
interest held by speculators relative to commercial
participants actually decreased over the last year, even at the
same time that prices were increasing. That noncommercial long
and short speculators, in other words, consistently have been
in the range of 30 to 35 percent of the open interest. This
would mean that hedgers make up the balance of 65 to 70 percent
of the market. It is much different than the 29 percent cited
by yesterday's testimony.
I wonder if you can help shed some light on exactly what
the available data is telling us, how do you define commercial
and noncommercial, and what is included in these categories?
Mr. LaSala. What Dr. Newsome was referring to was the
traditional noncommercial that the CFTC who categorizes the
parties in the Commitment of Traders reports as commercial or
noncommercial would be individual speculators. I believe they
would put index funds in there, wealth funds would be in there.
That would be noncommercial. And what Dr. Newsome spoke to was
that category's report about the CFTC in the past year as a
whole decreased during rising prices. However, the larger
percentage that you spoke to definitely bundled in effect
actively every bit of open interest that someone might
categorize as being applicable to a, ``swap dealer.'' We are
quite confident that that is not the case. We are quite
confident that when the CFTC, who has made calls to the swap
dealers to look at the underlying books, you will absolutely
confirm that that is not the case. And again, gentlemen, if you
think about it, people that are going to swap dealers, they are
absolutely commercial entities, whether they be airlines, or a
home heating oil dealer, laying something off on the heating
oil market. We are all familiar with that market where they are
looking for fixed price protection and they can't manage it
themselves. The swap dealers would be the ones prospectively
laying off in the futures markets their net. I stress to you
their net exposure. They are always going to look to
effectively balance their book internally with offsetting risk
and only effectively hedge in the futures market to the extent
their net exposure.
Mr. Goodlatte. So you would contradict the percentages that
were cited here yesterday?
Mr. LaSala. Absolutely.
Mr. Goodlatte. Let me ask you. Some have called for higher
speculative margins to tamp down on speculation. What has NYMEX
observed with your recent margin increases? Would a systematic
increase in margin reduce prices?
Mr. LaSala. Would a systematic increase in margins reduce
prices? No. It is going to prospectively have an effect on not
only noncommercials but commercials, potentially pricing people
out of the transparent market, pricing them out of hedging. I
think it could translate into a more volatile and higher priced
market. NYMEX does not set its margin, you referenced a number
of margin increases recently. I am quite frankly very closely
involved in the setting of the margins. Our margin setting
policies are not aimed at a percentage of the notion of value.
It is not aimed at controlling participation of the market. It
is aimed at covering risk. And we look at the volatility in the
market and we are looking to cover with 99 percent surety a 1
day move. That is how we have traditionally managed margins at
NYMEX. I think you would find that broadly speaking that the
futures industry has done this.
Mr. Goodlatte. Some of your fellow panelists have called
for limits on positions, particularly by the index funds. What
is your position on that?
Mr. LaSala. I think it was also noted, my position would be
this. Our hard position limits are in effect the last 3 days.
Broadly speaking, the index funds are long gone before then. I
would also say to you that broadly speaking, as a matter of
fact, we have in any 1 month accountability level of 10,000
contracts. During the pendency of the front month, when the
10,000 contract accountability level is in place, we certainly
look at the position of index parties and everyone. And I can
tell you that if someone were to go through the 10,000 and have
a substantive concentration, we would act upon it. And the best
demonstration of that is documented by the Senate Permanent
Subcommittee relating to the Amaranth matter. I directed a
reduction of positions and that wasn't subject to a position
limit violation. It was subject to their piercing the
accountability level.
So I think that effectively managing your use and
management of accountability is an effective means of
controlling speculation. You simply have to commit the time and
the effort and the money and the resource to do it. And I
believe we do that.
Mr. Goodlatte. Let me ask if any of your fellow panelists,
Mr. Nicosia, Ms. Cochran want to respond.
Mr. Nicosia. Yes. If everything was a perfect world and all
the information was on an exchange, then what was just said
would be absolutely true. The problem is that if you have a
10,000 contract limit of whether it is 5,000 in cotton, 10,000
in crude oil, the truth is you have no idea what that guy's
total position is today because all you see is the subset on
your exchange.
What he has in his own swap position, if he wants to exceed
that, he can do that tomorrow on two trades in the swap market.
So although ideally it is great if the exchange could be able
to control that, they don't have full information. Neither does
CFTC. How can we worry about a 5,000 or a 10,000 contract limit
when all they are looking at is one subset, and everybody knows
what those limits are and they can stay under them on the
exchange. When they want to exceed them, they go off-exchange.
Mr. Goodlatte. Mr. White, do you agree with that?
Mr. White. Yes, I agree with that. It goes back to the
point that if you put speculative position limits on the
exchanges but not on the swaps market, you haven't achieved
much because the swaps market is huge relative to the exchange.
Mr. Goodlatte. Mr. LaSala, what would you say in response?
Mr. LaSala. I am sorry I missed it.
Mr. Goodlatte. What would you say in response?
Mr. LaSala. I missed the point he mentioned. Forgive me.
Mr. White. I just said that if you put limits on the
exchange, but you don't put limits on the swaps then you
haven't achieved much because the swaps are so much bigger than
the exchange.
Mr. LaSala. My response to that would be that generally the
swap market is bigger, but, again the swap market is not the
preeminent pricing market that you see. It is not the
transparent market that the exchange is. And there are custom
tailored deals that are occurring in the swap market. While I
will say that there is an interrelationship, just like there is
an interrelationship between the futures market and physical
market like Dr. Pirrong said earlier, I don't think you have
that same absolute relationship. You are going to make a
transaction, take a position OTC which could be balanced by the
swap dealer with another counterparty and that that is
immediately going to translate into a push up or down, for that
matter, in the futures market.
Mr. Goodlatte. Mr. White, what do you have to say about
that? The Chairman asked an earlier panel the same question.
That is, if you have a private swap, how does that get
reflected in the price of oil overall? How does that drive the
market price upward?
Mr. White. Well I am glad that came up because I was
thinking about it through the first two panels. And I have an
analogy for you. Okay.
Mr. Goodlatte. My speech and debate coach in college said,
analogy is the weakest form of argument. But go ahead.
Mr. White. Okay. Well, with that, here is my analogy. Back
in the Middle Ages, the way they used to buy and sell
commodities is at the marketplace. It was in the city and they
would have fairs at harvest time. And all the farmers from all
around the countryside would come to the city. They would buy
and they would sell and they would see what the supply was,
they would see what the demand was from millers and brewers and
stuff for this commodity. And that is how the prices were set.
Now imagine if you had an enterprising grain merchant that
said, ``I am going to go set up a stall on the side of the road
and intercept people as they head into the city and offer them
prices, and maybe I will buy and maybe I will sell outside of
the city.'' And that is what swap dealers basically do. So in
other words, if you have a wheat farmer that is coming to the
city to sell his wheat but he never makes it because he did a
deal on the side of the road before he ever got there, then
that is less supply that exists in the city. That is less
supply that exists in the futures market because it was offset
in the swaps market.
Mr. Goodlatte. But isn't it also true that there is less
demand in the city because you also had somebody on the outside
who was willing to sell on the outside?
Mr. White. That is exactly right. You have somebody that is
willing to buy on the outside called an index trader that is
willing to buy in the swaps market and offset that supply that
would otherwise come to the exchange. And that is why prices
move up on the exchange in relationship.
Mr. Goodlatte. Why would they move up if you have also
taken some of the demand out of the market too because you have
a person who doesn't make it to market who was willing to pay a
certain price? You have less supply but you also have less
people there with the cash to buy.
Mr. White. The point is, it is all demand. It is all one
market effectively. From a swaps dealer's perspective, all I
care about is barrels. And if I can buy barrels for future
delivery on the futures on the futures exchange, I will do
that. If I can do it in an over-the-counter market, I will do
that. It is all one market to them. That is the way they see
it. So the point is is that an index trader going to the over-
the-counter market and putting their demand there will have the
same effect as an index trader going to the futures exchange
and having their demand there. So yes, their demand has an
impact whether it was on the futures exchange or whether it was
over-the-counter.
Mr. Nicosia. Mr. Congressman, could I answer that also?
Mr. Goodlatte. Sure.
Mr. Nicosia. I am not going to use an analogy. I am going
to use real life. Because we do do those transactions. And when
they come in, we take the opposite side of that and we
immediately go to the exchange and lay it off on that
transaction in the exchange. So it creates immediate activity
on the exchange. And if you happen to take a large retirement
pension fund, if they decide to put $1 billion at work into the
commodity market, it creates $1 billion of buying on the
exchanges, period.
Mr. Goodlatte. Would you like to respond to that, Mr.
NYMEX?
Mr. LaSala. Yes. And I will just simply note something that
was stated earlier. Following the gentleman's point, he said he
immediately creates this activity on the NYMEX or on the
exchange. Okay. So we are going to give merit to that activity,
let's assume in an upward--hypothetically--in an upward
fashion. But what happens when that position has to be
liquidated? Do we just completely ignore the liquidation? This
is one of the things that I am puzzled with. How is it that
everyone is willing to give merit to the presence of a buy in
the market but completely disregard the exodus?
Mr. Nicosia. The exodus will be just as great. You are
absolutely right. When they go to liquidate, the push down will
be just as great as the push up from where it is, from the
relative level of imbalance that has taken place. I mean, this
is fairly simple stuff. When you create extra money that flows
through from the buy side, the only way that you can
incentivize someone else to sell because you have to have a
buyer and a seller is to create a higher price to bring in a
seller at a higher level than he is willing to accept a risk to
take the short side of that transaction. And when this money
leaves, if it ever leaves, it will be just as disruptive on the
way down. Because he is right. It is a matter of money flow. It
is no different than it is in stocks as it is in commodities.
If you have more buying come through, prices will rise until
you reach a level that someone on the other side is willing to
accept the risk to go short.
Mr. Goodlatte. Let me ask all of you. One of the proposals
that we have heard about is requiring enhanced reporting
requirements that the CFTC should be directed to devise new
classifications of trades to break out index speculators or
swaps as a separate category. I can kind of guess how Mr. White
and Mr. Nicosia will view that. What is your view of that?
Mr. LaSala. We would support it. We have no problem with
that.
Mr. Goodlatte. Does everybody take that position?
Ms. Cochran. We do, too.
Mr. Nicosia. Absolutely.
Mr. White. I would just like to point out that that will
not bring prices down. That will do nothing to prices. But yes,
we are in favor of that.
Mr. Goodlatte. Well, we are trying to find out what will
bring prices down. And we have one opinion from you and one
opinion from you. So when we find something that people think
will help with some discovery, we are encouraged by that. But
then you say, that still won't help bring prices down, it makes
us wonder whether anything will bring prices down because the
real problem may be that the overall supply worldwide is not
keeping up with worldwide demand and that is the real cause of
prices moving upward.
Mr. White. Well, to me, it is really simple. It is the
money flowing in that pushes the prices up. An when the money
flows out, the prices will come down. And the money hasn't
flowed out. And what happens every month is the index traders
just roll to the next month. They don't exit the position. They
just roll it to the next month. So the money hasn't come out
yet.
Mr. Goodlatte. Well, let me ask you this: It has also been
proposed that we ensure that only true physical hedgers qualify
for hedge exemptions. Do you have a view on that?
Mr. LaSala. Sure. I would disagree with it. If you are
saying that you don't consider swap exposure per bona fide
hedge, we would absolutely, again, use your heating oil dealer.
Do you not want to get a price fix on your gallon of heating
oil? That pricing program that probably everyone in this room
has heard about from their home heating oil dealer, if he wants
to pass a fixed price along, he is going to, in many instances,
go to the swap dealer. So if you are saying that now that swap
dealer cannot prospectively do that across multiple heating oil
dealers in this example, you are cutting out a utility that is
in the market that would be just absolutely devastating.
Mr. Goodlatte. Even though that utility would not qualify
as a physical hedger?
Mr. LaSala. The heating oil dealer in my example could
qualify as a commercial. But what I was responding to was if he
got an OTC swap and you discounted the ability of a swap dealer
to get an exemption, I think that would be detrimental.
Mr. Goodlatte. Anybody want to respond to that? Mr. White?
Mr. White. I just wanted to respond to your question. I
think if I understand your question correctly, it was that the
proposal has been made that you only get a swaps exemption to
the extent that you have bona fide physical hedgers that you
have done the swap with.
Mr. Goodlatte. Yes. Hedge exemptions should be available
only to true hedgers that have a physical underlying exposure
to a commodity. Speculators should not be allowed to use this
exemption to avoid position limits. For example, a financial
trading subsidiary for an investment bank or an index fund
should not qualify for a hedge exemption. Neither entity has a
natural long physical ownership or a short physical need for
commodities.
Mr. White. I don't think we should get rid of the swaps
market. I think we should keep the swaps market. I think the
swaps market is important. And I do think that what Mr. LaSala
has been saying is true, that a lot of swaps involve commercial
bona fide physical players. And if you eliminate all
speculation from the swaps market, then it would be the same as
if you eliminate all speculation from the futures market. It
wouldn't have the necessary liquidity that it needs. So the
remedy for excessive speculation is speculative position
limits. It is not elimination of speculation.
Mr. Goodlatte. You would not ban index funds from
speculating?
Mr. White. Well, that is different. I would prohibit index
funds because they are passive, long only, broadly diversified.
Index is separate. Okay. So, in other words, keep the
speculators just put limits on them; keep all the bona fide
physical hedgers; keep the swaps market and the futures market
and everything else.
Mr. Goodlatte. Would you have the Congress set those
limits? Or would you allow the CFTC the discretion to set the
limits?
Mr. White. My personal recommendation is that we have the
bona fide physical hedgers in each one of those commodities set
the limits. We have the Mr. Nicosias of the world. We have a
panel on both sides, producers and consumers, you know six each
or whatever that make a recommendation to the CFTC. And then if
the CFTC wants to override it, then they can say why they want
to override it. But I think the actual physical hedgers are who
the market exists for. I mean, that is what these markets are
for is for the physical players, not the speculators.
Mr. Goodlatte. Let me ask one more. It has also been
proposed that we close the foreign exchange loophole. I guess
that is the so-called London-Dubai loophole. It has been
proposed that all foreign exchanges offering commodities
through a U.S.-based terminal should be subject to the same
regulatory requirements applicable to U.S. exchanges including
position limits, margin requirements and reporting. Further,
U.S. traders trading on non-U.S. markets should also be held to
the same regulatory requirements as those trading on U.S.
exchanges. Do you agree with that as a proposal; is it a good
idea? And what will be the consequence to the U.S. markets if
we do that? Will the business simply go overseas beyond the
reach of our regulatory controls? Mr. White, let me ask you.
And we will go right down the panel and everybody will answer
that.
Mr. White. If I understood it correctly, then basically I
just believe every exchange ought to play by the same rules.
Mr. Goodlatte. Correct. But the question is, can we make
other exchanges play by the same rules?
Mr. White. Sure. Absolutely.
Mr. Goodlatte. How?
Mr. White. If we want to. Anybody that is based in the U.S.
is subject to U.S. limits. Anybody that is residing in the U.S.
with a terminal in the U.S. is subject to U.S. limits.
Mr. Goodlatte. If they are speculators, in other words, if
they are an oil business, obviously that would easily apply to
them. But if they are simply speculators in the market, isn't
it very easy for them to transfer their assets to some other
location elsewhere in the world so that they can then
participate on an exchange that is not subject to those
regulations?
Mr. White. Yes. Basically physical hedgers today have no
limits; they never had them and they never will.
Mr. Goodlatte. They are out of the picture. We are talking
about speculators?
Mr. White. Right. So any speculator----
Mr. Goodlatte. Not going to take delivery.
Mr. White. That is below the limits has no incentive to go
elsewhere either. You would much rather be in the U.S. with
U.S. banking, U.S. financial system, U.S. regulation.
Mr. Goodlatte. Would you? Why?
Mr. White. Why? Because you have the physical hedgers here,
and they are the ones setting the prices that truly reflects
supply and demand. It is not a speculative casino in the sky.
It is a real market.
Mr. Goodlatte. Aren't there hedgers out there in the world
that are hedging----
Mr. White. Plus you want the liquidity.
Mr. Goodlatte.--based upon delivery in Europe or delivery
on the Pacific rim or delivery in China?
Mr. White. Yes. And my recommendations have nothing to do
with that. I mean Brent crude is going to trade in London and
it is trading now. It is Brent crude. It has nothing to do with
the U.S. I mean, Oman, sour crude, trade 'em up.
Mr. Goodlatte. What about oil that is coming into the
United States that is not produced in the United States?
Mr. White. Exactly. It is delivered in the U.S. It is U.S.
It can be regulated and the U.S. regulates anything coming into
its borders.
Mr. Goodlatte. Mr. Nicosia.
Mr. Nicosia. In regards to the first part of your question
as far as the overseas exchanges, I think that is mostly an
energy reference. And I don't have much of an opinion on that.
As far as the question you asked about the outflow of cash and/
or trading to other exchanges or to other places, I think that
it is a very weak threat and one that I would put very little
credence in. Money flows to opportunity and it is going to flow
to liquidity.
And the best liquid exchanges in the world are here in the
United States. It also has the best laws to protect those
tradings. It also has the best regulatory situation and
people's money is safe here. Continuously, other exchanges have
tried to open with numerous different contracts and different
locations and the majority of them all fail. So the money is
going to go where it is safe and where it is liquid. So to the
extent that if we are worried about our exchanges being in
trouble I am not worried about that in the least.
Mr. Goodlatte. Ms. Cochran.
Ms. Cochran. I would have to slightly disagree with Mr.
Nicosia. Our membership represents a broad spectrum of
commercial participants and noncommercial participants as well.
We have some individual speculators that are our members and I
have heard resoundingly from all of our members that they have
a lot of concern that while they want additional transparency
and reporting requirements on all of those things, if
regulations and laws aren't enacted, that makes doing business
on U.S. futures exchanges more expensive, that the money will
go somewhere else. Either it will go off-exchange or it will
move to other markets somewhere else in the world and outside
of the jurisdiction of the United States. And in a world of
electronic trading, that becomes easier and easier.
Mr. Goodlatte. Mr. LaSala.
Mr. LaSala. I will follow up and agree with the point Ms.
Cochran just made. In that if we over-legislate and make doing
business in the United States, you know, 50 percent margins,
ridiculously low position limits, just simply make it so
uncomfortable for people to conduct commercial activities, I
fully contemplate, and as you know, there are other energy
exchanges, other clearinghouses around the world. There are
other markers that people can use other than the reliable one
that we have had. We can lose that business.
We have been in favor, as stated earlier with regard to the
changes that have been proposed and put into effect on
conditioning the No Action letters, having comparable position
limits, having large trader reporting. We can't control the
margin policies of overseas DCOs. But in terms of keeping a
level playing field for a U.S. commodity, WTI where there is a
look-alike done overseas, we completely support that. If I
could just add one point, if I have heard Mr. White before,
unless I misunderstood him, he made a comment that there are no
limits for commercials in NYMEX or in the U.S. That is not
correct. The expiration limits, the accountability levels, any
1 month and all months are applicable to everyone. We exempt in
the last 3 days if it is demonstrated what we think appropriate
bona fide exposure to parties to prospectively higher levels.
But I want to be clear.
And as Dr. Newsome stated earlier, this is not just a
blanket exemption. You are exempt. Go do what you will. They
ask for finite numbers. We evaluate carefully not only what the
reasonableness of their need is, how appropriate is it, does it
make sense. But also, wouldn't dare give someone just by size
alone the ability to bully the market. I will state to you
that, broadly speaking, if you took the largest exemption
assuming that someone went up to the greatest extent of that in
our markets on the last day, it would be less than 25 percent
of the open interest. And obviously that percentage is smaller
as you go to the second to last day, third to last day because
the open interest is tunneling down.
So we are extremely conservative and mindful of not giving
wide open limits. Thank you.
Mr. Goodlatte. Thank you, Mr. Chairman.
Mr. Etheridge [presiding.] Thank you. I thank the
gentleman. And I yield to the gentleman from Georgia, Mr.
Marshall.
Mr. Marshall. Thank you, Mr. Chairman. I assume our clock
is off at this point. Were you here and did you hear Dr. Irwin
and Dr. Pirrong's testimony, Mr. White, Mr. Nicosia in
particular?
Mr. White. Yes. Yes.
Mr. Nicosia. Yes.
Mr. Marshall. How did they get it so wrong? They have been
at this for what, 30 years, both of them? Could you enlighten
me?
Mr. White. I don't know about enlightening you. But what
they are espousing is the academic and what is taught in the
finance textbooks. I was at University of Chicago when Dr.
Pirrong was a professor there. We met and talked about that. I
think it is a fundamental misconception between financial
futures and commodities futures. So what they teach you in
business school is that the spot price is an anchor, that
futures prices have to convert to spot, that the only thing
that can affect spot prices is supply and demand fundamentals,
and that the only way that the futures price can affect the
spot price is if it somehow affects supply an demand.
But that is just wrong, because there are four ways in
which the futures price can affect the spot price. Beginning in
the 1980s in the energy markets, many energy participants
decided that they were going to price their spot deals off the
futures price. So I call up and I say, ``I would like to buy a
tanker full of crude. What am I going to pay?'' And they say,
``You are going to pay the NYMEX futures price plus or minus a
differential.'' That doesn't have anything to do with the last
3 days. That is just the nearest expiration futures contract.
So when that futures contract goes up, the real world spot
price goes up. That is one. Second of all, there are a lot of
contracts that specify the futures price. Now you might ask
yourself, why do they want to use the futures price? The answer
is because we can hedge the futures price if we specify the
basis in the contract, then we can use the futures to hedge it
and we have eliminated our risk, plus they all agreed back in
the 1980s that the futures price was the best price. It was the
best indication of what was going on.
And it was. Because it was largely determined by supply and
demand because it was just modified physical hedgers in that
market. Then there is arbitrage. That is the third thing. You
can arbitrage the price. Okay. You know which is basically
going to cause convergence. So if you have a giant elephant
buying in the futures price and you are trying to converge, and
then the fourth thing is that it is the benchmark for
everything they do. There is not a guy in the swaps market that
is not aware of where futures prices are and cash prices. There
is nobody in the cash market that is not aware of where futures
prices are. And it is very easy, well, I shouldn't say it is
easy, but there is a strong relationship between futures and
spot that is not part of the academic literature.
Mr. Nicosia. Also I wouldn't say that they necessarily had
it all wrong but I do think that they miss reality. And for
example when Professor Pirrong was talking today about how the
speculator is gone by the time delivery comes, therefore, they
are not affecting delivery price that takes place with real
supply demand when we go into delivery and that is ultimately
what it is. Since they are not in it, that does not affect the
prices, that is absolutely wrong. Because that is not how
commodity markets work. We are the largest handler of taking
delivery, making delivery in the world. And their absence to
being in the delivery market has nothing to do with setting
that price because prices work in relationship to other values.
So, for example, if the nearby futures contract is going to
delivery and the second month, the next month out in frontward
is at a substantial premium, people will take that at any price
because as a relation of the cost of carrying the commodity.
They will own it and the cost of carrying it, paying interest
in storage.
Mr. Marshall. Arbitrage.
Mr. Nicosia. Has nothing to do with the absolute level. It
has to do with the relative level. So if someone is offering
you the promise of a higher price in the future, you will pay
more for it today even though there is no other demand because
you are buying it against his relative promise in the future.
So as these indexes or other speculative positions continue to
roll forward and to move their demand and buy the next month
out, that creates spot demand for anyone who has any money
whatsoever to buy the commodity and hold it against the hope;
against giving it to them into the next month. By the time you
get there, they move forward to the next month again. And all
it does is it creates a chain where you continually link it
month to month and that is where your spot demand comes. Not
from the demand in the cash market of an end consumer and end-
user coming to meet.
Mr. Marshall. You heard me ask the three members of the
last panel, the two doctors. And I can't remember the guy's
name who was in opposition, who took basically the view the two
of you are taking of this matter to get together with the two
doctors to see if they could come to what is the nub of the
disagreement? Are we going to have to agree to disagree?
Mr. Nicosia. I don't think so because I think that there is
some ``generalness'' of agreement, to the idea that you need
convergence at some point in time, that is a reasonable
agreement that all of us would agree to. The difference is that
you can have convergence on an absolute or a relative level.
Mr. Marshall. My sort of understanding of this doesn't come
close to yours. And my sort of basic understanding of this is
that the two doctors were saying this index money didn't have
any effect at all on price. And you differ with that.
Mr. Nicosia. I don't see how anyone can come up with that
conclusion whatsoever.
Mr. Marshall. Are you willing to talk to somebody who did?
Could you talk to the two doctors and see if you, along with
the other fellow, the three of you could get to the nub of what
the two of you or the two sets of views fundamentally differ
with?
Mr. Nicosia. Right. And I do think that is a difference
between today the ag markets and the energy markets that Dr.
Newsome mentioned before. There is a slight difference to it.
But even in the energy markets, I think there is a key
difference between saying that they are responsible for prices
being high as to be a difference for them to be this high.
Because there is no doubt that there is an imbalance in the
energy market. There is no doubt energy prices are going up
with or without the speculation that took place. Whether
today's price would be $125 instead of $145, I think that is
fairly easy to say that the additional piling on of this demand
is taking the place of demand. If you take the 900 million
bushels that is held in speculative position in soybeans today
and that wasn't there, someone else would have to assume that
risk. Prices would be lower before someone else would accept
that risk. It is the same in the energy market.
Mr. Marshall. For certain agricultural commodities, the law
requires that the CFTC itself set position limits which you say
don't work for reasons you have already described. But in any
event, the law does say that corn for example being one, cotton
being another that the CFTC will set position limits. The
position limits are not just the last 3 days. The position
limits apply to given months for yearly positions, for yearly
averages, things like that. I don't know the details.
Mr. LaSala, since Dr. Newsome said there is this very
cooperative relationship between the CFTC and the exchanges
with regard to this position limits matter, what would be the
problem with the CFTC legally being required to set position
limits monthly, yearly? It is the exact same way that the
position limits are set for the ag commodities in energy
markets. And then y'all work well together with the CFTC anyway
so you would obviously be working with them to try to find what
are the appropriate limits to be set. But they wouldn't just be
in the last 3 days and it wouldn't be accountability levels.
There would be position limits.
Mr. LaSala. Again, I think we have a protocol that has
worked. And we have worked cooperatively with the CFTC. I fear
that you start mandating Federal limits and the point that I
raised earlier and where we would be so far out on a limb
insofar as disparate with other regimes FSA, DFSA, you can look
around the world, does not even require large trader reporting.
We are not saying that is right. We think there should be
position limits, position accountability, but I have a sincere
concern that we could prospectively drive business away if we
just simply over-regulate this market. You know to be clear,
gentlemen, it is a process to negotiate exemptions to position
limits. I regularly go through--over the course of the hundreds
of commodities, we have put hard limits on everyone. We have
competitor exchanges that have no limits. When I go and try and
administer even the front month one there are comments that are
made that this is a hassle. I am going to this less transparent
market. And I think that that is absolutely what could happen.
I think it would be detrimental to transparency and the good of
functionality of these markets as they operate today.
Mr. Marshall. Mr. Nicosia.
Mr. Nicosia. Well, again, when we asked the earlier
question, I do agree to the extent that if we were to raise
fees and/or margins to unreasonable levels, that will drive
stuff to overseas marketplaces. But again, I think that as far
as you are looking for legislation or rules or ways to try to
solve other loopholes, it is hard to solve excess speculation
per se. But you have to realize how the real market works. You
don't even have to get a hedge exemption. Every fund, any money
that wants to, just call someone with a hedge exemption and put
the order in with them.
Mr. Marshall. Right.
Mr. Nicosia. They use other people's hedge exemptions to
get around this. So our biggest concern is that in order to get
a handle on it first----
Mr. Marshall. It has got to be market-wide.
Mr. Nicosia. You have to be able to take all the pieces and
put them together. Because otherwise it is like trying to plug
one hole in a net. It just goes out another side of the net.
You can't do it. And until we know the extent of the problem if
there is a problem, we can't fix it because we may be fixing
the wrong thing. So I don't think you can necessarily legislate
against speculation. I think it is very difficult to try and I
would not raise limits. I wouldn't raise limits but I also
would not raise margins or user fees to that extent because I
do think that it would drive business overseas. But we have to
try to get our hand upon all of these circumventing trades to
take place to go around transparency. That is where you must
start before you throw the baby out with the bath water.
Mr. Marshall. We discussed it in an earlier panel and you
might have been there as well, the possibility of having the
over-the-counter market, the swaps market provide reports to
the CFTC to enable the CFTC to see what is going on. But those
reports would not be public information. So presumably one of
the objections that the swaps market might have, and that is
somebody would get ahead of the hedging opportunity.
Mr. Nicosia. I think that was a huge fallacy that you heard
earlier today. I find it very interesting that I have to report
those. So why is it okay that I report my activity? I have to
report my cash activity, my swap activity. I report all of that
activity today. For them to see against me. But they don't have
to report it?
Mr. Marshall. Do they see it?
Mr. Nicosia. Absolutely they see it. They see it in
aggregate.
Mr. Marshall. They see it in aggregate but they don't see
the individual position.
Mr. Nicosia. No, and I don't think anybody has ever asked
to see it individually. I think they want to see it in
aggregate, both aggregates from a general component and then to
aggregate individuals' positions from CFTC's standpoint alone
to see if they are circumventing position limits. But today you
don't get anything. Not only do you not get a reporting of a
swap, you don't get any of the counterparty information either.
So that if an individual had five swaps, with five
counterparties and that in total aggregates to something, there
is no way or no venue today to try to bring that into one
location. That should be CFTC's responsibility.
Mr. Marshall. I know you have been doing this orally and
very much appreciate your testimony both you and Mr. White, all
of you. But with regard to this dispute between the doctors and
you with regard to the impact of this passively long index fund
money, would you be willing to submit something by Monday in
writing that specifically addresses that and points out why the
two academicians just have it wrong?
Mr. Nicosia. Unfortunately I wouldn't won't be able to
because I leave here to join my family for 3 days of vacation
but some time soon thereafter, I would be happy to.
Mr. Marshall. Could you get Neil to do it?
Mr. Nicosia. You get what you ask for.
Mr. Marshall. Mr. White, can you----
Mr. White. Yes.
Mr. Marshall. It is your opportunity to take off after your
old professor there.
Mr. White. Right. I can do that. That is not a problem. I
will just say since we have the time, there is two nubs really.
One is the relationship between futures and spot. And then the
other thing was they talk about where are the inventories if
prices are so much higher than supply and demand would dictate,
why isn't there the inventory? And the answer is is because you
know the problem especially in oil and food is you can't get
any more inelastic than that. It is like basically two vertical
lines in the sense that you know other than air and oxygen and
drinking water, there is nothing more inelastic than food. I
mean that is going to be the last thing that people give up. So
it is really the case where we have to pay at it, whatever the
price is.
Mr. Marshall. I have nothing further. Thank you, Mr.
Chairman.
Mr. Etheridge. I thank the gentleman. Let me thank each of
you. Today has been a very good hearing. The truth is, we have
raised a lot of questions. We have a lot of material to work
with. This Committee will recess until tomorrow morning at 9
a.m. We will be back for another panel. And I think it is the
intent of the Chairman and certainly is my intent as Chairman
of the Subcommittee working with the Members of our
Subcommittee and this full Committee to get all the data we
possibly can. And these 3 days, 2 days thus far have been very
helpful.
Today has been very helpful. And I think tomorrow will be,
as well. And try to come back with some kind of solutions to
the extent we can maybe next week after we have gathered all
this data to move forward. We want to be cautious but we want
to respond to the needs to make sure the market works for the
producers, for the consumers and for the investors. That it
works in a fair manner and that there is enough sunshine
because I happen to believe very strongly that sunshine is a
very purifying source. So with that, we stand adjourned until
tomorrow morning at 9 a.m.
[Whereupon, at 5:42 p.m., the Committee was adjourned.]
[Material submitted for inclusion in the record follows:]
Supplemental Material Submitted By Charles A. Vice, Vice President and
COO, IntercontinentalExchange, Inc., Atlanta, GA
Fact Sheet
About IntercontinentalExchange, Inc. or ``ICE''
IntercontinentalExchange is a leading global exchange operator,
comprising both regulated futures and over-the-counter (OTC) markets
across a variety of product classes, including agricultural and energy
commodities, foreign exchange and equity indexes. ICE owns and operates
three regulated futures exchanges: (1) ICE Futures Europe, a London-
based futures exchange overseen by the U.K. Financial Services
Authority; (2) ICE Futures U.S., an agricultural commodity and
financial futures exchange regulated by the Commodity Futures Trading
Commission (CFTC); (3) ICE Futures Canada, Canada's leading agriculture
exchange, regulated by the Manitoba Securities Commission.
How Energy Futures Markets Operate
Energy derivatives are financial contracts whose value is linked to
changes in the price of an underlying energy product, such as crude oil
or natural gas. Both hedgers and speculators trade energy derivatives
by forecasting price trends for these commodities and taking positions
in the market that reflect their price expectations for the future.
Participants enter into these contracts by taking short or long
positions to hedge their risk against rising commodity prices or to
generate profit. Typically this does not involve the purchase of the
physical commodity, so the supply of the commodity available to
consumers is not reduced by futures transactions. Rather, market
participants buy a futures contract on a commodity; when the contract
is settled, cash payments are made in lieu of taking physical delivery
of the commodity.
In the case of oil, investors in futures markets help to stabilize
the market by providing oil producers with reliable market liquidity,
enabling producers and consumers of energy to lay off risk to those
willing to assume it. By conducting business through transparent and
regulated exchanges like ICE, investors are a necessary part of
establishing efficient, market-driven pricing in the oil markets.
Why Additional Regulation Is Not the Answer
Some in Congress are reacting to higher oil prices--driven by the
rising imbalance between supply and demand--by proposing excessive
regulations on already regulated global commodities markets. These
actions are driven by the misconception that oil prices are being
manipulated by excessive speculation. The U.S. CFTC (which regulates
commodities futures markets) has stated there is no evidence that
excessive speculation or manipulation is occurring in the oil markets.
Paul Krugman, a respected columnist for The New York Times,
recently wrote about the myth that speculators are driving high prices
in the oil market. After expressing doubts over the idea that the
futures market is contributing to rising oil prices, he wrote:
``In any case, one thing is clear: the hyperventilation over
oil-market speculation is distracting us from the real
issues''.
Mr. Krugman suggested the proper role of the government is to
assist the private sector's effort to develop a rational energy policy
that includes real solutions such as alternative-energy technologies,
new methods of conservation, and an expanded public transit.
The sustained rise in crude oil prices is not caused by the
existence of the futures market, but instead by the increasing global
imbalance between supply and demand, geopolitical issues, along with
the depreciation of the U.S. dollar. Placing excessive regulations on
this market would have adverse consequences for the U.S., its energy
markets and its core commercial users without providing meaningful
oversight enhancement or reducing the fundamental pricing pressures
driving world energy prices.
If Congress excessively regulates U.S. exchanges operating
globally, then traders will likely flock to new, less transparent
markets, which are not as regulated and which are outside of the reach
of U.S. regulators. For example, the Dubai Gold and Commodities
Exchange now offers a crude oil futures contract that has no regulatory
obligations to the U.S. regulators. Futures markets in China and India
are searching for ways to develop their own crude oil markets as well--
with no obligation to conduct business under U.S. law.
Driving dollars or investment out of the cash-settled futures
markets by making financial participation costly or illegal is likely
to result in the flow of investment dollars into the physically-
delivered or spot markets. This would amount to financial investors
controlling physical inventories of crude oil, rather than a position
in a ``paper'' or cash-settled futures contract, which puts no pressure
on supply. In such a scenario, hoarding ensues, prices skyrocket, lines
begin to form at gas stations and fuel rationing in the U.S. would be
conceivable.
The ``Enron Loophole'' No Longer Exists
The ``Enron loophole'' referred to the exemptions from CFTC
regulation that existed in the OTC market. While ICE's OTC business
operates as an Exempt Commercial Market, ICE was never granted these
Enron-specific exemptions. Most importantly, ICE's OTC market has a 0%
share of trading in U.S. crude oil, heating oil, jet fuel, and
gasoline, and therefore is not contributing to any price formation in
these markets.
To increase the transparency of energy markets, Congress passed
into law--in a bipartisan fashion--a provision in the 2008 Farm Bill
that unequivocally closes the ``Enron loophole'' by extending CFTC
regulation to all energy contracts deemed to be a price-discovery
contract, rather than just traditional energy futures contracts. This
new legislation has resulted in extending CFTC regulation to all
electronically traded OTC energy contracts, such as those traded on
ICE, requiring futures-style reporting and regulation.
The Chairman of the CFTC has stated for the record that the ``Enron
loophole'' has been fully closed and that the CFTC has sufficient
authority to police the OTC energy markets:
Senator Carl Levin (D&MI): ``Could I ask a quick question of
Mr. Lukken? Have we effectively closed the Enron loophole, in
your judgment?''
Walter Lukken (Chairman, CFTC): ``Absolutely.''
[Senate Committee on Homeland Security and Governmental
Affairs, CQ Transcripts, 6/24/08]
Many leaders in Congress concur that the years of work put into
eliminating this unnecessary loophole have resulted in significant
reform for the previously unregulated OTC markets. Now Congress must
give the Act time to work.
The Existence of a ``London Loophole'' Is a Myth
The mythical ``London Loophole'' is propagated by those who
inaccurately believe that the WTI oil futures contract offered by ICE
Futures Europe (IFE) is subject to substantially less oversight than
its U.S. counterpart NYMEX. Since 1981, IFE has been located in London
and fully regulated by the U.K. Financial Services Authority.
While the Commodity Exchange Act prohibits the CFTC from directly
regulating foreign exchanges, it permits foreign access to U.S.
customers through the ``no-action'' process--today nearly two dozen
foreign exchanges operate in the U.S. pursuant to this process. IFE
originally received its No Action letter from the CFTC to provide
screen access to U.S. traders in 1999. Recently, IFE has agreed to
amend its No Action letter with the CFTC, now ensuring that the WTI oil
futures contract will be subject to equivalent U.S. position limits and
accountability limits.
Proposed Legislative Solutions
ICE stands ready to work with Congress to help ensure that the
commodity futures marketplace is functioning in an appropriately
regulated environment that protects market participants and prevents
market manipulation. We believe there is a clear need to provide more
funding and staffing to the CFTC to carry out expanded responsibilities
in a rapidly growing marketplace. Funding has been cut and staffing is
at all-time lows in a marketplace where commodity trading has been
transformed by global growth and competition. The CFTC warrants
increased resources so it can continue to ensure the integrity of all
markets within its jurisdiction. Furthermore, we believe the exchanges
should provide enhanced quantity and quality of information to the
CFTC, an initiative that ICE is actively participating in today.
News Clips
The Usual Suspects: Are Financial Investors Driving Up the Cost of
Commodities?
Silicon Investor
By Javier Blas and Joanna Chung
7 July 2008
Prices were outrageously volatile. While traders attributed the
sharp market movements to supply and demand, most politicians in
Washington were sure that speculation was the culprit. The U.S. public
became incensed.
The year was 1958, the commodity in question onions. Congress held
long and sometimes tumultuous hearings in which Everette Harris, then
president of the Chicago Mercantile Exchange, tried to convince
lawmakers that the futures market for onions was not the cause of the
volatility. ``We merely furnish the hall for trad
ing . . . we are like a thermometer, which registers temperatures,''
Mr. Harris told a hearing. ``You would not want to pass a law against
thermometers just because we had a short spell of zero weather.'' But
such arguments were ignored and in August of that year the Onion
Futures Act was passed, banning futures trading in the commodity.
Fast-forward 50 years and it seems that little has changed. The
recent surge in commodity prices has sparked an intense and politically
charged debate on whether financial investments--to some, plain
speculation--are affecting the markets. Pension funds and other big
institutions today hold about $250bn in commodities, mostly invested
through indices such as the S&P GSCI, a widely accepted industry
benchmark. This compares with just $10bn in 2000, although part of the
increase represents the rise in prices rather than fresh flows of
money.
Political pressure is also mounting outside the U.S. Italy is
calling on the Group of Eight leading economies to tackle commodities
speculators, while last week a UK Parliamentary Committee said it would
hold its first hearing into regulation of oil markets amid concern over
the possible role of speculators in driving record crude oil prices.
But lawmakers could end up disappointed if they enact restrictions
or outright bans on the trading of commodity futures. Indeed, a number
of governments, regulators, central banks, investors and multilateral
organisations have argued that such moves would be unlikely to either
damp volatility or stem the increase in prices.
The U.S. regulator says there is little evidence to link price
rises to institutional investors. It has maintained its stance that
fundamental supply-and-demand
Some go further. The International Energy Agency, the western
countries' oil watchdog, recently accused politicians of looking for
``an easy solution'' that avoids taking the necessary steps to improve
supply and curtail demand. Michael Lewis, head of commodities research
at Deutsche Bank, says: ``When regulators turn the lights on these
`dark markets', they will find no monsters in the room--rather
underlying fundamentals driving prices higher.''
The Onion Futures Act is a perfect case study. When economists
studied the market, they discovered that volatility and prices were
higher in the period after the ban than they were before. Fre&1de&1ric
Lasserre, head of commodities research at Socie&1te&1 Ge&1ne&1rale in
Paris--who has studied the onion example--says today's context is very
similar. ``The politicians are leading the debate pressured by the
people,'' Mr. Lasserre says.
The onions market is not the only example. India last year banned
financial trading in most agricultural commodities but prices continued
to rise. ``[Banning financial trading] is irrelevant,'' says a senior
Indian official. ``When a commodity is scarce, its price rises, whether
it is traded on an exchange or not.''
That is exactly the argument of those who say that high prices
merely reflect robust demand growth--boosted by the industrialisation
of populous emerging economies such as China, India and Brazil or new
policies such as biofuels--against sluggish supply increases following
years of under-investment.
Moreover, record commodity prices are being seen across the board,
not just in raw materials with developed futures markets but also in
those without significant speculative investments such as iron ore and
rice, up 96.5 percent and 120 percent respectively this year. Research
by Lehman Brothers shows that prices for metals that are not traded in
exchanges, such as chromium, molybdenum or steel, have risen faster
than prices for metals traded in exchanges, such as copper or
aluminium. In addition, some of the commodities markets in which
pension funds hold the largest share of outstanding contracts, such as
hogs, have seen price drops.
Equally important is that price rises across the commodity spectrum
are not in line. This shows that different markets are responding to
their own supply-and-demand fundamentals rather than to financial
investors' money flows, analysts say. The base metals market is a good
example: while aluminium and copper prices have risen by about 30
percent since January, nickel, zinc and lead have fallen between 20 and
40 percent. Tin, the only metal in which pension funds had little
exposure, has jumped almost 40 percent.
In another sign that supply and demand is the main driver,
inventories for most commodities--including crude oil--have fallen
since January. Many analysts echo Mr. Lukken in pointing out that
financial investors in commodities are no longer betting only that
prices would rise, as at the beginning of the boom in 2000&2001. Today,
many funds are betting on lower prices.
The UK Treasury, in a report published last month, suggests that
investors are not driving price increases. ``Although there is
insufficient evidence to conclusively rule out any impact, it is likely
to be only small and transitory relative to fundamental trends in
demand and supply for the physical commodities,'' it says.
Wall Street banks acknowledge that investor flows could influence
day-to-day movements, pushing prices to overshoot or undershoot their
fundamental level for a few days. But they state that investors are
unable to shape the long-term trend.
Such arguments, however, seem to have proved less persuasive for
U.S. lawmakers than those of other experts testifying before Congress.
Michael Masters, a manager of a long-short equities hedge fund with a
large stake in oil-hit airlines shares, told legislators that gasoline
prices could fall as low as $2 a gallon--half today's price--with
legislation barring commodity index funds. Fadel Gheit, an equity
analyst at Oppenheimer, claimed that current record oil prices in
excess of $135 per barrel were inflated. ``I believe, based on supply
and demand fundamentals, crude oil prices should not be above $60 per
barrel,'' he said.
In response, lawmakers are preparing new legislation aimed at
quickly fixing the problem of record high oil and food prices--or, as
one Committee staffer put it, to ``help American families right now''.
The proposals--several backed by political heavyweights--range from a
ban on some kinds of speculation in commodities and energy futures
markets, to higher margin requirements, to effectively extending the
jurisdiction of the CFTC overseas. For instance, the ``Close the London
Loophole Act'' aims to stop traders from manipulating prices and
speculating excessively by routing oil trades through foreign
exchanges. The ``End Oil Speculation Act'' proposes to increase the
money, or margin, that speculators would have to put up to trade oil
futures to 25 percent of the value of the underlying commodity compared
with seven percent now.
Some sceptics dismiss the various proposals as political posturing.
But amid the growing political pressure, the CFTC has already taken the
step of imposing position limits on the crude oil contract traded on
London's ICE Futures Europe exchange and a similar contract to be
traded on the Dubai Mercantile Exchange, bringing limits for crude oil
traders overseas in to line with limits on domestic markets. Congress
recently approved legislation closing the so-called ``Enron loophole''
and giving greater authority to the CFTC to oversee over-the-counter
derivatives markets.
Some observers of Capitol Hill suggest that lawmakers could try to
consolidate the different proposals. But is unclear what laws, if any,
will emanate from Congress, not least given that the White House--which
has the power to veto legislation--has taken the view that supply and
demand are behind the price surges. President George W. Bush recently
threw his support behind proposals--forwarded by John McCain,
Republican Presidential candidate--to lift the ban on fresh oil
drilling off the U.S. coast to help reduce dependence on foreign energy
sources.
A White House veto could be overridden if enough Republicans join
the Democratic majority as they did last month, when the House voted by
a huge margin--402 to 19--to require the CFTC to ``utilise all its
authority, including emergency powers, to take steps to curb excessive
speculation in the energy futures markets''. However, it is unclear
whether the Senate will take up the same bill.
Political pressure is so high that some think that Congressional
action is possible before the summer recess in August. One
Congressional insider says: ``The truth is that it is going to be very
difficult to get anything done before the Presidential election . . .
But this is so much a primary issue facing everyone, there is
momentum.'' One of the bills that could have some traction is the so-
called ``Increasing Transparency and Accountability in Oil Markets
Act'', introduced by Democratic senators Dick Durbin, the Senate
majority whip, and cosponsored by 15 other Senators. The bill would
authorise new resources for the CFTC, including 100 extra employees,
and close the ``London Loophole''.
Some of the more extreme proposals have already been shelved, such
as one idea from Mr. Lieberman's Committee that suggested limiting
certain institutional investors from investing in the commodities
futures market. ``After hearing from experts, the public, and holding
numerous hearings on excessive speculation, our third draft proposal to
limit certain institutional investors from commodity markets does not
appear to be viable at this time. It doesn't look like it would have
the support in the Senate,'' says one Lieberman Committee staffer.
But industry executives, analysts and some lawmakers warn that in a
U.S. election year, there is a danger of over-regulation. ``If we reach
September and gasoline prices or food prices are setting new highs,
noone knows what Congress would do,'' one says. That means there is
also a risk of long-term damage to the commodity futures industry.
Today, the Onion Futures Act remains in effect. But that has not
stopped the price of onions from shooting up an eye-watering 420
percent since 2000.
Lawmakers and Stakeholders Fail To Grasp the Details of the Debate
In 2002, when the U.S. Congress was debating whether to close the
``Enron Loophole''--that is, to require that over-the-counter energy
markets be brought under the full oversight of the U.S. futures
regulator--Republican Trent Lott rose to his feet in the Senate
chamber.
Brandishing a dictionary, the senator looked up a definition of ``a
derivative'', a term referring to the complex futures contracts used in
the energy markets to hedge the risks associated with holding physical
supplies of commodities such as oil and natural gas. The dictionary
told him that it was ``the limit of the ratio of the change in a
function to the corresponding change in its independent variable as the
latter change approaches zero''.
Mr. Lott turned to his colleagues with a warning: ``We don't know
what we are doing here. I have serious doubts how many Senators really
understand [this] and it sounds pretty complicated to me.''
Six years later, it is hard not to conclude that lawmakers are
still not as informed as they could be about the issues. That matters,
as legislation is now floating around Capitol Hill that could end up
forcing significant changes to the mandate of the Commodity Futures
Trading Commission, the U.S. commodities regulator.
Bart Stupak, a Michigan Democrat who has introduced legislation,
said in May that ``excessive speculation'' had ``inflated oil prices to
the point that they are no longer tied to underlying supply and
demand''--a claim most economists would struggle to agree with.
Some of the stakeholders in the debate are not helping. A coalition
of airline and travel industry associations wrote to Harry Reid, the
Senate majority leader, and Nancy Pelosi, the House Speaker, last month
claiming that speculators traded 22 barrels of ``paper oil''--futures
contracts--for every physical barrel of oil consumed. However,
Francisco Blanch, commodity strategist at Merrill Lynch, says:
``Speculators do not add physical demand or take away physical supply
from the market. They do not take away any barrel of oil or bushel of
corn from the economy and the only way they can affect spot prices is
if they reduce the quantity available for final consumers.''
Editorial: The Onion Ringer
The Wall Street Journal
8 July 2008
Congress is back in session and oil prices are still through the
roof, so pointless or destructive energy legislation is all but
guaranteed. Most likely is stiffer regulation of the futures market,
since Democrats and even many Republicans have so much invested in
blaming ``speculators'' for $4 gas.
Congress always needs a political villain, but few are more
undeserving. Futures trading merely allows market participants to
determine the best estimate--based on available information like supply
and demand and the rate of inflation--of what the real price of oil
will be on the delivery date of the contracts. Such a basic price
discovery mechanism lets major energy consumers hedge against
volatility. Still, ``speculators'' always end up tied to the whipping
post when people get upset about price swings.
As it happens, though, there's a useful case--study in the
relationship between futures markets and commodity prices: onions.
Congress might want to brush up on the results of its prior
antispeculation mania before it causes more trouble.
In 1958, Congress officially banned all futures trading in the
fresh onion market. Growers blamed ``moneyed interests'' at the Chicago
Mercantile Exchange for major price movements, which could sink so low
that the sack would be worth more than the onions inside, then drive
back up during other seasons or even month to month. Championed by a
rookie Republican Congressman named Gerald Ford, the Onion Futures Act
was the first (and only) time that futures trading in a specific
commodity was prohibited, and the law is still on the books.
But even after the nefarious middlemen had been curbed, cash onion
prices remained highly volatile. In a classic 1963 paper, Stanford
Economics Professor Roger Gray examined the historical behavior of
onion prices before and after the ban and showed how the futures market
had actually served to stabilize prices.
The fresh onion market is highly seasonal. This leads to natural
and sometimes large adjustments in prices as the harvest draws near and
existing inventories are updated. Speculators became the fall guys for
these market forces. But in reality, the Chicago futures exchange made
it possible to mitigate the effects of the harvest surplus and other
shifts in supply and demand.
To this day, fresh onion prices still cycle through extreme peaks
and troughs. According to the USDA, the hundredweight price stood at
$10.40 in October 2006 and climbed to $55.20 by April, as bad weather
reduced crop yields. Then it crashed due to overproduction, falling to
$4.22 by October 2007. In April of this year, it rebounded to $13.30.
Futures trading can't drive up spot prices because the value of
futures contracts agreed to by sellers expecting prices to fall must
equal the value of contracts agreed to by buyers expecting prices to
rise. Again, it merely offers commodity producers and consumers the
opportunity to lock in the future price of goods, helping to protect
against the risks of future price movements.
Tellingly, the absence of that option for onions now has some
growers asking Congress to lift the ban. But instead of learning from
its onion mistakes, the political class seems eager to repeat them.
Easy Target, But Not the Right One
New York Times
By Joe Nocera
28 June 2008
So now we know: it's all the fault of those damnable speculators.
They're the ones to blame as the price of oil tops $140 a barrel.
It's not our government's fault for failing to come up with a
credible energy policy--that can't be it. Nor is the problem the weak
dollar, or the voracious energy appetite of the Chinese, or those pesky
rebels in Nigeria who are trying to blow up their country's oil
pipelines. And it's certainly not the fault of you and me for driving
gas-guzzling S.U.V.'s. It has to be those speculators. They are the
only villains in sight.
This was ``first let's kill all the speculators'' week on Capitol
Hill, and it was not a pretty sight. On Monday, the House Oversight and
Investigations Subcommittee held an 8 hour hearing (!), the sole
purpose of which was to decry ``excessive speculation.'' ``Have
speculators hijacked trading on the futures exchange?'' asked the
Michigan Democrat Bart Stupak. His answer throughout the day--as he
``grilled'' an array of sympathetic academics and futures market
critics--was a resounding yes.
On Tuesday, the action moved to the Senate, where the Homeland
Security and Governmental Affairs Committee held its hearing.
``Speculation in the food and fuel markets is not illegal,'' Senator
Joe Lieberman of Connecticut conceded, ``but that does not mean it is
not very hurtful.'' He continued: ``They are artificially inflating the
price of food and oil and causing real suffering for millions and
millions of people and businesses.''
There were yet more hearings on Wednesday, and by Thursday evening,
the House had passed, by a wide margin, a bill calling on the Commodity
Futures Trading Commission to curtail ``excessive speculation.''
Indeed, the C.F.T.C. spent the week being raked over the coals for
allowing all this rampant speculation to take place. On Monday
afternoon, for instance, Representative John Dingell of Michigan took
unseemly glee in going after Walter L. Lukken, the agency's Chairman.
Jabbing his pencil at Mr. Lukken, Mr. Dingell described the
founding of the agency as an effort to prevent farmers and consumers
from being ``screwed'' by ``those folks in the futures markets.''
``Now,'' he said, ``we find that those good-hearted folks in the
futures market have figured out how not just to screw the farmers and
the consumers in the city, but they figured out how to screw the
farmers and the consumers in the city on a whole new product--oil.'' As
Mr. Dingell sneered triumphantly, Mr. Lukken seemed to shrivel in his
seat.
Yes, it was wonderful theater, and great blood sport. And it had
absolutely nothing to do with the price of oil.
It's not just Congressmen who are railing about speculators, of
course. As oil prices have doubled in the last year, I've gotten e-mail
messages from readers decrying speculators, who, many believe, are
manipulating the futures market. More than once this week, legislators
used that same word their constituents were using: ``manipulation.''
So let's take a closer look at what the speculators' critics are
saying. First, despite the loose use of the word ``manipulation,'' that
is really not what is being alleged here, at least not in the classic
sense. Remember how the Hunts tried to corner the silver market? They
bought up silver and took it off the market, thereby creating an
artificial shortage. I suppose OPEC could do something like that--one
could even argue that OPEC does that already--but no mere speculator
could.
I can already hear your rejoinder: what about Enron and its famous
manipulation of energy prices in California? But remember, Enron was
manipulating electricity prices, not oil, which was possible mainly
because electricity can't be stored. By getting power plants to shut
down for hours at a time, Enron was able to create artificial shortages
and jack up the price.
Instead, the critics' thesis is that speculators are creating an
energy bubble the same way investors created the Internet bubble. As
speculative bets on energy have grown drastically in recent years, the
sheer amount of money being thrown at energy futures is making those
bets a self-fulfilling prophecy. All that money, in other words, pushes
prices higher than they would go if the market simply consisted of the
actual buyers and sellers of oil.
In addition, because of something called the ``London loophole''
and the ``Enron loophole,'' which allow speculators to use unregulated
exchanges, they can evade the limits of the New York Mercantile
Exchange, as well as C.F.T.C. scrutiny.
The leading proponent of this theory is a portfolio manager based
in the Virgin Islands named Michael W. Masters. When I caught up with
him on Thursday afternoon, after his week of testimony, he said that
the problem was that institutional investors had stopped seeing energy
as a commodity the world relies on and instead saw it as an ``asset
class'' for their portfolios. ``I am opposed to thinking about
commodities as an asset class,'' he said.
Several years ago, he continued, he began to notice that increasing
cash flows were moving into commodities index funds. This was, he said,
``long-only money''--meaning that it was a pure bet that prices would
go up. By now, he told me, there is $240 billion in commodity index
funds, up from $13 billion 5 years ago. As he also noted in his
testimony before Congress, ``the prices of the 25 commodities that
compose these indices have risen by an average of 183 percent in those
5 years!'' He claims that energy prices will fall by 50 percent if the
speculators can only be driven out of the futures market.
There are so many holes in this argument I scarcely know where to
start. The C.F.T.C. says that some $5 trillion worth of futures and
options transaction trades take place every day; can an influx of $240
billion, spread over 5 years, really propel prices upward to the extent
that he and others claim? Then there's the fact that the commodities
markets don't work like equity markets, where a small amount of trading
can lift every share of a company's stock. In commodities trading,
every contract has a buyer and a seller, meaning that for every bet
that prices are going up, somebody else is betting they are going down.
Why doesn't that short interest depress prices?
And what about all those commodities, like coal or barley or
sulfur, that don't trade on any futures market but have risen as fast
as or faster than oil? Or how about the recent decline in cash flows
into many commodity funds--why have prices kept going up if the money
has stopped pouring into those funds? My speculator friends tell me
that in the last 2 weeks, trading volumes have been cut in half.
Indeed, what I hear is that much of the speculative money that remains
in the market is betting against higher oil prices.
As for the London and Enron loopholes, I can pretty much guarantee
they will be closed soon. There are some eight bills aimed at curbing
speculation, and virtually every one of them calls for an end to the
loopholes. That is probably a good thing--but I'd lay odds the price
will not drop as a result. The loopholes are not the reason prices are
going up.
In fact, I'd be willing to go a step further. Even if you
eliminated speculation entirely, the price of oil wouldn't fall.
Thankfully, no one is proposing to go that far (though Senator
Lieberman was toying with the idea), because even Members of Congress
understand that futures markets serve a crucial purpose. They help
companies hedge their oil prices, and they help energy companies manage
their risk, for starters.
The energy speculators I spoke to say that Congress has it exactly
backward: the futures market is actually taking its cues from the
physical market, where the buyers and sellers of oil do their business.
Last week, the Saudis promised to produce an extra 200,000 barrels a
day. But it is pricing that oil so high that oil companies are balking
at paying for it. The Saudis didn't arrive at their price by looking to
the futures market--but if they get that price, it will certainly
affect the futures market.
Both speculators and oilmen say that supply and demand is the real
culprit. ``Our supply is pathetic,'' said Gary Ross, the Chief
Executive of the PIRA Energy Group, and a well-known energy consultant.
``Look at the data,'' he continued. ``The world economy is growing by
3.9 percent a year. World oil demand should grow by 2.3 percent just to
keep pace. That's an extra two million barrels a day. We don't have it!
It's obvious.''
I also think there is something else at play. After years of
ignoring the rather obvious fact that oil is a finite resource, the
world has suddenly become acutely aware of that reality. Everyone in
the oil markets is attuned to every little twitch that has the
potential to damp supply or increase demand. That's why, for instance,
when Libya announced on Thursday that it might cut oil production, oil
jumped more than $5. Meanwhile, when Brazil discovers a huge new oil
field, the market shrugs. That is not speculation at work--it's market
psychology. There's a big difference. If there is indeed a bubble,
that's what is causing it.
``Speculators have always been an easy target,'' said Leo Melamed,
the man who founded the futures markets. As Ron Chernow, the great
business historian put it, ``At times in history when you have vast and
impersonal forces wreaking havoc in markets, there is always a
temptation to villainize someone.'' Centuries ago, it was Shylock; now
it's the speculator and the short-seller.
In his book ``The House of Morgan,'' Mr. Chernow has a description
of Herbert Hoover, ``moody and isolated,'' convinced that short-sellers
were behind the market's horrendous downturn in 1929. ``He came to
believe in a Democratic conspiracy to drive down stocks by selling them
short,'' Mr. Chernow writes, adding that Hoover ``began to compile
lists of people in the bear cabal and even claimed to know they met
every Sunday afternoon to plot the week's destruction!''
I wonder whether Mr. Dingell has heard about them.
Fuels on the Hill
New York Times
By Paul Krugman
Congress has always had a soft spot for ``experts'' who tell
Members what they want to hear, whether it's supply-side economists
declaring that tax cuts increase revenue or climate-change skeptics
insisting that global warming is a myth.
Right now, the welcome mat is out for analysts who claim that out-
of-control speculators are responsible for $4 a gallon gas.
Back in May, Michael Masters, a hedge fund manager, made a big
splash when he told a Senate Committee that speculation is the main
cause of rising prices for oil and other raw materials. He presented
charts showing the growth of the oil futures market, in which investors
buy and sell promises to deliver oil at a later date, and claimed that
``the increase in demand from index speculators''--his term for
institutional investors who buy commodity futures--``is almost equal to
the increase in demand from China.''
Many economists scoffed: Mr. Masters was making the bizarre claim
that betting on a higher price of oil--for that is what it means to buy
a futures contract--is equivalent to actually burning the stuff.
But Members of Congress liked what they heard, and since that
testimony much of Capitol Hill has jumped on the blame-the-speculators
bandwagon.
Somewhat surprisingly, Republicans have been at least as willing as
Democrats to denounce evil speculators. But it turns out that
conservative faith in free markets somehow evaporates when it comes to
oil. For example, National Review has been publishing articles blaming
speculators for high oil prices for years, ever since the price passed
$50 a barrel.
And it was John McCain, not Barack Obama, who recently said this:
``While a few reckless speculators are counting their paper profits,
most Americans are coming up on the short end--using more and more of
their hard-earned paychecks to buy gas.''
Why are politicians so eager to pin the blame for oil prices on
speculators? Because it lets them believe that we don't have to adapt
to a world of expensive gas.
Indeed, this past Monday Mr. Masters assured a House Subcommittee
that a return to the days of cheap oil is more or less there for the
asking. If Congress passed legislation restricting speculation, he
said, gasoline prices would fall almost 50 percent in a matter of
weeks.
O.K., let's talk about the reality.
Is speculation playing a role in high oil prices? It's not out of
the question. Economists were right to scoff at Mr. Masters--buying a
futures contract doesn't directly reduce the supply of oil to
consumers--but under some circumstances, speculation in the oil futures
market can indirectly raise prices, encouraging producers and other
players to hoard oil rather than making it available for use.
Whether that's happening now is a subject of highly technical
dispute. (Readers who want to wonk themselves out can go to my blog,
krugman.blogs.nytimes.com, and follow the links.) Suffice it to say
that some economists, myself included, make much of the fact that the
usual telltale signs of a speculative price boom are missing. But other
economists argue, in effect, that absence of evidence isn't solid
evidence of absence.
What about those who argue that speculative excess is the only way
to explain the speed with which oil prices have risen? Well, I have two
words for them: iron ore.
You see, iron ore isn't traded on a global exchange; its price is
set in direct deals between producers and consumers. So there's no easy
way to speculate on ore prices. Yet the price of iron ore, like that of
oil, has surged over the past year. In particular, the price Chinese
steel makers pay to Australian mines has just jumped 96 percent. This
suggests that growing demand from emerging economies, not speculation,
is the real story behind rising prices of raw materials, oil included.
In any case, one thing is clear: the hyperventilation over oil-
market speculation is distracting us from the real issues.
Regulating futures markets more tightly isn't a bad idea, but it
won't bring back the days of cheap oil. Nothing will. Oil prices will
fluctuate in the coming years--I wouldn't be surprised if they slip for
a while as consumers drive less, switch to more fuel-efficient cars,
and so on--but the long-term trend is surely up.
Most of the adjustment to higher oil prices will take place through
private initiative, but the government can help the private sector in a
variety of ways, such as helping develop alternative-energy
technologies and new methods of conservation and expanding the
availability of public transit.
But we won't have even the beginnings of a rational energy policy
if we listen to people who assure us that we can just wish high oil
prices away.
______
Submitted Letters By Hon. Bob Etheridge, a Representative in Congress
From North Carolina
William H. Prestage, President and CEO, Prestage Farms, Clinton, NC
July 11, 2008
Dear Congressman Etheridge:
Prestage Farms is a producer of swine and poultry in eastern NC. We
have been in business for over 25 years and have experienced many ups
and downs in the industry. However, we have very strong concerns over
various costs currently affecting our business, our customers, and our
employees.
At least 70% of the cost to raise livestock is feed itself. The
costs of commodities such as corn, soybean meal, and fat, which
represent approximately 90% of our feed cost, have been rising at an
alarming rate. The additional cost of these ingredients has had a
tremendous impact on our company financially, as they will ultimately,
the consumer.
The cost for a bushel of corn has increased over 100% since last
year, soybean meal over 80% and fat over 68%. The additional cost of
these three items alone will be over $225,000,000 to Prestage Farms in
2008. As a result of that, our cost to produce a pound of turkey meat
and hog meat will increase by more than 50%.
It is difficult to quantify the impact of rising fuel costs, as
increased fuel costs will affect virtually every aspect of our
business. Vendors from whom we purchase products are experiencing
rising fuel costs and are increasing their product costs to us as a
result. Our employees are also feeling the impact of increased fuel
cost in commuting, child care costs, and food cost. Directly, the
increased cost of fuels increases our cost to haul ingredients and
commodities, to haul our livestock, to provide heat to our livestock,
as well as increasing our cost to operate machinery and equipment
necessary for our production. Our cost of fuel purchases in 2008 alone
will increase by approximately $6,000,000 due to increased prices. This
does not take into account the additional costs passed through to us by
vendors.
Again, the impact of the rising cost of commodities, ingredients,
and fuels, is proving to have extremely negative impacts on our
industry. Employees, consumers, and businesses alike are in dire need
of efforts that will help control some of these issues. I appreciate
your efforts to help control and even possibly reverse some of these
issues, as they are proving to have such negative impacts on our
consumers and businesses.
Sincerely,
William H. Prestage,
President and CEO.
Roger F. Mortenson, President and CEO, House-Autry Mills, Inc., Four
Oaks, NC
Dear Congressman Etheridge:
It was a pleasure seeing you last week in Four Oaks. I certainly
commend you for your visibility with your constituents. You
consistently visit your constituents to learn what their concerns are
as well as reporting to us what is going on in the nation's capital.
Thank you for your excellent representation.
As a small company, House-Autry Mills is being very negatively
affected by increased costs on every side. Our primary products are
wheat flour, corn and corn based products. With commodity costs rising
seemingly uncontrollably and being influenced by market speculators and
speculation, we find ourselves in the position of having had to raise
prices to our consumers a number of times over the past months, which
only exacerbates the financial stress and strain on the consumer.
So it is with the rising fuel costs, again due in a large part to
the speculators and speculation in the cost of oil. Not only affecting
consumers directly at the pump, the high fuel costs also increase the
cost of food because of the high cost of getting ingredients to our
plant as well as increasing the costs of delivering finished products
to our customers. As we distribute to 25 to 30 states from our Four
Oaks plant, it is becoming almost cost prohibitive to continue at the
same level of business, much less trying to expand our sales volume and
distribution.
I certainly applaud your efforts to reverse and control some of
these issues that are proving so destructive to consumers and companies
alike. I look forward to your positive efforts in securing concrete
ways to limit cost increases in fuel and in food.
Best personal regards,
President and CEO.
______
Supplemental Material Submitted By Paul N. Cicio, President, Industrial
Energy Consumers of America, Washington, D.C.
July 16, 2008
Hon. Bob Etheridge,
Chairman,
Subcommittee on General Farm Commodities and Risk Management,
Committee on Agriculture,
U.S. House of Representatives,
Washington, D.C.
Dear Mr. Chairman:
This letter and its attachments are a response to your request
during the July 10, 2008 hearing on the review of legislation amending
the Commodity Exchange Act and excessive energy speculation. You
requested that I provide additional information relating to a
concerning potential relationship between bank borrowing from the
Federal Reserve and the corresponding rise of energy commodity prices.
As we said in our testimony, we encourage the Congress to ensure
that Federal Reserve monetary policy is not causing higher energy and
food costs by providing low cost money to banks to speculate on
commodities. The attached graphs show an almost linear relationship
between lower Federal Reserve interest rates, increased borrowing by
banks and corresponding higher commodity prices. We are concerned that
the timing is not coincidental.
The attached graphs include:
Graph 1. Federal Reserve Fund Borrowing (February 2007&June
2008)
Graph 2. Federal Reserve Fund Borrowing (August 2007&July 2008)
Graph 3. Federal Reserve Fund Borrowing vs. Light Crude Oil
Graph 4. Federal Reserve Fund Borrowing vs. Natural Gas
Graph 5. Federal Reserve Fund Borrowing vs. NY Harbor RBOB
Gasoline Blendstock
Graph 6. Federal Reserve Fund Borrowing vs. Heating Oil
Thank you for your interest in this matter and we look forward to
hearing from you on the response from the Federal Reserve.
Sincerely,
President.
While a majority of the industry is concentrated in 17 cotton-
producing states, stretching from Virginia to California, the
downstream manufacturers of cotton apparel and home furnishings are
located in virtually every state. The industry and its suppliers,
together with the cotton product manufacturers, account for more than
230,000 jobs in the U.S. The annual economic activity generated by
cotton and its products in the U.S. is estimated to be in excess of
$100 billion.
The NCC would like to thank Chairman Peterson for holding this
series of very important hearings to review possible amendments to the
Commodity Exchange Act (CEA). Since late February, all segments of the
cotton industry have felt the impacts of the disruptive and uncertain
nature of the New York cotton futures markets. Many of the concerns
felt by this industry were conveyed to the Commodity Futures Trading
Commission (CFTC) during their April 22 roundtable. In addition, Mr.
Andy Weil, then President of the American Cotton Shippers Association
(ACSA), presented those concerns during a hearing of Subcommittee on
General Farm Commodities and Risk Management.
The NCC would like to take this opportunity to reiterate a number
of points and recommendations made by the industry and also stress the
importance to of a well-functioning futures market.
Unfortunately, the cotton futures market remains largely
dysfunctional at the current time. The impact of unregulated
investments by index funds and other speculators have resulted in a
significant divergence of cash and futures prices. This scenario is
common to many agricultural markets but appears more severe in cotton
futures trading. As an example, the synthetic value of cotton futures
increased by approximately 31 cents between February 20 and March 4
while the cash price changed by only 4 cents. Furthermore, markets
continue to be highly volatile. Just in the past 2 weeks, December 2008
futures fell from the low 80 cents range to the low 70 cents range with
no significant change in market fundamentals.
The New York Cotton Exchange was founded in 1870 as the first
commodity exchange in this country and has served this industry well
for over 100 years. The frustration shared by members of the cotton
industry stems from a cotton futures market that is now unable to
discover future prices with any historical correspondence to cash
prices and provide a hedging mechanism. Cotton merchants are no longer
offering forward contracts to producers because of extreme price risks.
Likewise, producers are unable to convince their bankers to assume
similar risks for their own price protection. Therefore, as cotton
prices have soared and plunged over the past 4 months--producers, along
with merchants, have been merely bystanders.
Not only have we been on the outside of the market, we are also
deeply troubled about the impact this recent price volatility has had
on the liquidity of buyers. Traditional merchandising relationships
between growers and buyers have ceased because price risks are too
great for short hedging purposes. Growers continue to be concerned
about the financial viability of buyers with whom they have previously
contracted new crop sales. This situation equally applies to growers
who trade with private merchants and those who belong to marketing
cooperatives. The inability of merchandisers to hedge their risks
translates into a weaker basis and lower prices offered to the cotton
producer. Each penny reduction in the price of cotton means that U.S.
cotton farmers lose $85 million in revenue.
Cotton futures markets must be returned to their historical
function of price discovery and risk management relative to real market
conditions. Cotton producers face extreme pressures from escalating
input costs which threaten their viability and yet currently have no
mechanism to forward price their production at reasonable costs.
The NCC urges Congress to provide CFTC with the necessary authority
and resources in order to better protect market participants against
manipulation. All industry segments concur with recommendations from
our merchandising members that call for more transparency in trading
and reporting. In addition, CFTC should regulate swaps and over-the-
counter (OTC) activity by requiring reporting by market participants of
such activity.
Speculative limits and reporting requirements must be consistent
across all market participants. Consideration should also be given to
increasing speculative position margins and disallowing any increase in
speculative position limits. We understand the importance of
speculative participation in a viable futures market. However it is
incumbent upon the CFTC to use its authority to regulate futures
markets so as to provide meaningful risk management and price
discovery.
Many in the cotton industry question what the public policy
position of the CFTC should be regarding futures markets. Should these
markets be regulated so that their primary purpose is to facilitate the
cash market by providing price discovery and risk transfer, which has
been its historic role? Or should they be regulated so that their
primary purpose is to provide an investment vehicle to invest in
commodities without taking title to the physical commodity? Our concern
is that it has become the latter and that is not healthy for cotton or
any commodity markets.
In early June, the CFTC announced several policy initiatives--
including a cotton market investigation--aimed at addressing concerns
in the agricultural futures markets that were raised at its April 22
roundtable. The NCC remains hopeful that the ongoing probe will yield
some definitive outcomes to address the ongoing problems with the
cotton futures market. Restoring confidence in the futures market is of
the utmost importance to this industry.
Thank you for the opportunity to share our views and concerns.
______
Submitted Statement By United Egg Producers
This statement is submitted for the record on behalf of United Egg
Producers (UEP). UEP is a farm cooperative whose members independently
market about 97% of all the shell eggs produced in the United States.
UEP commends the Committee on Agriculture for holding comprehensive
hearings on legislative proposals affecting the energy futures markets.
Like many other farm groups, UEP has been concerned about the recent
performance of both agricultural and energy markets.
UEP members have a strong interest in the legislative proposals
before the Committee:
We are exposed to rising energy costs by the nature of our
business: Henhouse ventilation systems operate by electric
power; trucks that deliver eggs to our customers are diesel-
fueled; heat supplied to pullet houses is generated by natural
gas or propane; and those producers who grow all or a portion
of their own feed require diesel fuel to operate farm
equipment. Therefore, rapidly rising energy costs have a
significant negative impact on our businesses.
The futures markets are also important to us as purchasers
of feed. Smoothly functioning futures markets for corn, soybean
meal and other commodities allow us to hedge our feed costs,
which comprise more than half of our total production costs.
The health of our businesses is threatened not only by
extremely high feed commodity prices, but also by large margin
calls that result from the high prices, as well as the well-
documented deterioration in cash and futures market
convergence.
In the many Congressional hearings that have focused on energy
futures markets during the past few months, one question has been asked
again and again: How much of the recent increase in oil prices can be
attributed to speculation rather than supply-demand fundamentals? The
question may ultimately be unanswerable, at least with precision;
hearing witnesses' answers varied from none to $65 or $70 a barrel.
Two things seem obvious to us. First, market fundamentals have
driven prices upward; one only has to think of growing Chinese and
Indian demand and the volatile politics of the Middle East, to name
only two factors. Second, it is impossible to believe that the huge
inflow of speculative capital, including large amounts of long-only,
passively-managed index fund investment, does not exert upward pressure
on futures prices.
Some observers minimize the role of speculators by saying that for
every long there must be a short. This simplistic statement ignores the
central fact of futures markets. The law of supply and demand still
applies. Yes, there must be a short for every long, but when demand for
long futures positions increases as a result of billions of dollars of
new demand for long positions, the price of those positions--i.e., the
price the long must pay the short--will rise. The well-documented
increase in investment by index funds--nearly all of which by
definition are on the long side of the market--seems certain to account
for some of the rise in energy and agricultural futures prices.
The traditional role of futures markets is being undermined by
excessive speculation by multi-billion dollar funds betting on a price
increase in commodities. Commodity futures markets were created for and
still exist for the purpose of allowing the producers and consumers of
commodities to hedge their risks by fixing their prices in advance. As
these markets became more successful, they have served another
important function, price discovery. This has become an enormously
important function of the markets because even the millions of primary
commodity users and retail consumers have the prices of their purchases
determined on the futures markets.
Nowhere is the importance of price discovery more evident than in
the price of gasoline. Typically, buyers and sellers of the physical
commodity use the price established on the New York Mercantile Exchange
as a reference point and make deals on some differential of this price.
For the average motorist, this comes as no surprise. When there is an
oil price spike in the futures market, it is quickly followed by a
boost in the price at his or her local gas station.
Many legislative proposals center on applying fairly traditional
rules governing speculation in a stricter manner. The proposals seek to
ensure that the Commodity Futures Trading Commission (CFTC) gains
additional information about the positions of various market
participants, including those in various off-exchange and over-the-
counter market venues. Many proposals also seek to apply more
rigorously the traditional exchange requirements for large-trader
reporting and speculative position limits.
In general, we believe that hedging exemptions should be available
only where there is a clear nexus with an entity that is exposed to the
price of the underlying commodity in the normal course of its business.
A grain elevator that uses futures to manage the risk of offering cash
forward contracts to local farmers is undoubtedly hedging. On a much
larger scale, an airline that enters a swap agreement to manage jet-
fuel costs, with the result that a swaps dealer takes an offsetting,
on-exchange position in petroleum futures, is also hedging. A pension
fund that invests in an index fund or an actively managed hedge fund is
not hedging and the associated on-exchange transactions should not be
carried out under a hedging exemption.
We favor legislation that requires the consistent application of
position limits to speculators, and provides guidance to the CFTC in
differentiating between hedgers and speculators. We would recommend
some degree of discretion for the CFTC in applying position limits, to
allow for special or unforeseen circumstances.
With respect to specific legislative proposals, UEP supports
legislation to achieve the following:
The CFTC should be provided sufficient budgetary resources
and personnel to handle its increasingly important
responsibilities. We realize that the actual appropriations
cannot be provided in legislation reported by the Committee on
Agriculture, but we urge the Committee to work with
Congressional colleagues to build support for 'an adequate CFTC
budget. We support the request for an additional $27 million
and 100 full-time equivalents (FTEs) made last month by the
CFTC.
Exempt commercial markets should be subject to large-trader
position reporting and speculative position limits and, if
appropriate, other applicable regulations.
Foreign boards of trade that desire ``no-action'' letters
from the CFTC should be required to maintain large-trader
position reporting, speculative position limits, and other
regulatory provisions deemed appropriate by the Commission.
Granting such ``No Action'' letters should be a function of
CFTC Commissioners, not staff.
Exemptions from speculative position limits should be
available only to legitimate hedgers. If a swap dealer seeks to
manage its swap-based risk by taking an offsetting position in
the futures markets, the CFTC should review the swap
transaction to determine whether it qualifies for a hedging
exemption. The exemption should only be granted where an entity
is managing a risk that it incurs in the normal course of its
business with respect to the underlying commodity being traded
in the futures market.
With respect to index funds, we believe the application of
position limits is the appropriate way for Congress to address
this issue. We believe any restrictions applied to index funds
in energy markets should also be applied in agricultural
markets.
With respect to the last point, we urge Congress to avoid any
unintended consequences of treating one futures market differently from
another. There is some possibility that the application of position
limits to index funds in energy markets--which we believe is
justified--would provide an artificial inducement for large
institutions to shift such investments into agricultural markets if
exemptions from position limits continued to be available in those
markets. Already, the index funds are a major force in agricultural
futures markets and may be exerting upward price pressure there, just
as they are in energy markets. Congress should avoid any artificial
incentives for these funds to shift their investments into agricultural
markets merely for regulatory reasons. As a general matter, we believe
that the rules for index fund and hedge fund investment should be
similar across the markets for physical commodities.
UEP appreciates the Committee's consideration of our views.
HEARING TO REVIEW LEGISLATION AMENDING THE COMMODITY EXCHANGE ACT
----------
FRIDAY, JULY 11, 2008
House of Representatives,
Committee on Agriculture,
Washington, D.C.
The Committee met, pursuant to call, at 9:08 a.m., in Room
1300, Longworth House Office Building, Hon. Collin C. Peterson
[Chairman of the Committee] presiding.
Members present: Representatives Peterson, Holden,
Etheridge, Baca, Cardoza, Scott, Marshall, Herseth Sandlin,
Cuellar, Costa, Salazar, Ellsworth, Boyda, Space, Walz,
Gillibrand, Kagen, Pomeroy, Barrow, Lampson, Donnelly,
Childers, Goodlatte, Moran, Hayes, Graves, King, Neugebauer,
Boustany, Kuhl, Foxx, Conaway, Fortenberry, Smith, and Walberg.
Staff present: Adam Durand, Alejandra Gonzalez-Arias, Scott
Kuschmider, Clark Ogilvie, John Riley, Bryan Dierlam, Kevin
Kramp, and Jamie Weyer.
OPENING STATEMENT OF HON. COLLIN C. PETERSON, A REPRESENTATIVE
IN CONGRESS FROM MINNESOTA
The Chairman. The Committee will come to order. I
appreciate the Members being here on a Friday when we could be
someplace else.
Mr. Conaway. I could be in Texas.
The Chairman. That's right. And we appreciate the witnesses
being here with us today.
This is the third day of hearings that we have been having
regarding all of these issues and bills that we have had
Members of Congress come in and explain their proposals. And we
had a good discussion yesterday with the panels in the various
areas we discussed yesterday. Today we will examine the foreign
boards of trade; the second panel, margins; and the third panel
we will kind of tie everything else up that we couldn't find a
category for.
We have Members that have obligations, and so I am going to
be--as opposed to yesterday, I am going to impose the 5 minute
rule with some strength today.
Mr. Conaway. You have a gavel.
The Chairman. So we would encourage everybody to be mindful
of that, and hopefully we can move through this in an
expeditious fashion.
[The prepared statement of Mr. Peterson follows:]
Prepared Statement of Hon. Collin C. Peterson, a Representative in
Congress From Minnesota
Good morning and welcome to today's hearing.
Today marks the last day of three hearings this week to review
legislative proposals to amend the Commodity Exchange Act.
We have three full panels today and a lot of ground to cover, so I
will keep this very brief and not repeat what I said the last 2 days.
Wednesday we heard from six of our House colleagues who have
introduced bills that would amend regulation of commodity futures
markets. Yesterday and today, we will hear from stakeholder groups
about these and other legislative proposals, as well as the major
issues currently surrounding commodity futures and options markets.
What we intend to do is have each panel examine one of these
subjects in detail. Today's three panels will look at:
Foreign Boards of Trade;
Margins; and
Miscellaneous/General.
Today's witnesses will hopefully shed some light on these topics
and how legislation that has been introduced would affect them. Some
groups, of course, have vested interests in more than just one area,
and that will be reflected in their broader written testimony submitted
for the record. But with so much to get to today, we will try and keep
this as focused as possible.
At this time, I now yield to the Ranking Member of the Committee,
Mr. Goodlatte for an opening statement.
The Chairman. So we welcome the witness to the first panel
on the foreign boards of trade: Mr. Mark Young from the Futures
Industry Association; Mr. David Peniket, President and Chief
Operating Officer of ICE Futures Europe, London, U.K.; Mr.
Gerry Ramm--Ramm is it?
Mr. Ramm. Yes.
The Chairman.--from the Inland Oil Company on behalf of the
Petroleum Marketers Association; and again, Mr. Michael
Greenberger, who was with us yesterday, from the University of
Maryland School of Law. And we welcome the panel.
Your full statements will be made part of the record. We
would encourage you to try to limit your remarks to 5 minutes,
and, if possible, talk to us in terms that we can understand,
which may not be possible.
So, Mr. Young, you are on.
STATEMENT OF MARK D. YOUNG, J.D., PARTNER, KIRKLAND & ELLIS
LLP, WASHINGTON, D.C.; ON BEHALF OF FUTURES
INDUSTRY ASSOCIATION
Mr. Young. We will try.
I am Mark Young. I am actually a Partner in the law firm of
Kirkland & Ellis, and I am appearing today on behalf of our
client, the Futures Industry Association. I am a pinch-hitter
for John Damgard, the President of the Futures Industry
Association, who regrets he is not able to be here. But like
John, I have been involved in every CFTC reauthorization since
1978. I also teach a derivatives course at the Georgetown Law
School and have for many years, even before Mike Greenberger
joined the CFTC. So I am very familiar with the history and law
being discussed in this hearing.
FIA represents the interests of the U.S. futures industry
as a whole. And especially the firms that broker trades for
customers. Our member firms execute and clear orders for
customers worldwide. That business is jeopardized, we believe
inadvertently, by the legislative proposals you are considering
in the foreign board of trade area. FIA asked this Committee in
any legislation you consider to work with us to remove this
threat without harming market surveillance transparency in any
way.
Before discussing what is called the FBOT issue, I want to
make two quick points. First, FIA fully appreciates the serious
economic challenges high energy prices create. These prices are
hurting real people in a real way. Did the futures markets
cause those prices or merely serve as the vehicle delivering
those prices? Were futures the message or the messenger? At
this point we believe futures were the messenger. But it would
be imprudent to reach any firm conclusion before the CFTC
completes its analysis of this question.
For now FIA looks forward to reviewing the CFTC's findings.
We will not, and we believe others should not, prejudge that
verdict one way or the other.
Second, many of you have asked in the last couple of days
about the term ``excessive speculation.'' The recent history of
that term is instructive. From 1922 until the year 2000, the
Commodity Exchange Act stated that preventing excessive
speculation was a major reason futures regulation was
imperative. In 2000, however, Congress repealed that finding.
Instead, the statute now states that futures markets serve the
national public interest, ``by providing a means for managing
and assuming price risks, discovering prices and disseminating
pricing information through trading in liquid, fair and
financially secure trading facilities.''
Congress found that assuming price risks, in a word
speculating, enabled futures markets to serve the public
interest. The importance of that modern finding seems to have
been lost by some in the current debate.
What isn't lost is that every witness before you has
opposed price manipulation. FIA is no exception. Price
manipulation robs the futures markets of their ability to serve
the public interest. Congress wisely granted the CFTC vast
powers to detect and deter price manipulation. The key to those
powers is effective and intensive CFTC market surveillance.
At its core the FBOT issue is all about market
surveillance. Sometimes two exchanges compete to list the same
product. When they do, market surveillance is more difficult,
even with two U.S. exchanges, because it requires seeing
trading activity in two markets, not just one. And when that
trading activity is being conducted on a foreign market with a
foreign regulator, the CFTC must coordinate with those foreign
officials in order to conduct effective market surveillance.
This market surveillance challenge is a two way street.
Again, that is a point I don't believe that we have heard
discussed in these hearings. It applies when a foreign exchange
tries to compete with a dominant U.S. exchange and when a U.S.
exchange tries to compete with a foreign exchange. This
challenge requires cooperation. No exchange, whether in the
U.S. or in a foreign jurisdiction, should be subject to the
dictates of two separate regulators. Coordination by the CFTC
and what the statute calls foreign futures authorities is
therefore essential.
The FIA supports legislation to address both sides of this
street. We want the CFTC to have access to any and all trading
data it needs to make informed market surveillance judgments.
We recognize that foreign regulators have the same legitimate
concerns about trade on U.S. exchanges that compete with
foreign exchanges. In that instance the statute should call for
the CFTC's cooperation with the efforts of its foreign
counterpart. This two way street approach will lessen the
likelihood that legislation in this area will spark trade war-
style retaliation. FIA is extremely concerned about that
prospect because it could cause foreign exchanges to avoid CFTC
regulation by walling out order flow from U.S. firms.
That reaction would threaten our firms' ability to serve
their customers from the United States. The result could be a
shift in brokerage firm business to overseas affiliates and the
loss of jobs. That shift would be even more likely if the U.S.
FCM becomes legally responsible for a foreign exchange's
compliance with CFTC mandates, as some legislation now
proposes.
The FIA thanks you, Mr. Chairman and Members of the
Committee, for your continued interest in these issues. Your
hearings this week have been fair and informative. As your
deliberations continue, FIA will help you in any way we can. We
look forward to answering your questions.
[The prepared statement of Mr. Young follows:]
Prepared Statement of Mark D. Young, J.D., Partner, Kirkland & Ellis
LLP, Washington, D.C.; on Behalf of Futures Industry Association
Mr. Chairman and Members of the Committee, I am Mark Young,
appearing on behalf of the Futures Industry Association. FIA
appreciates the opportunity to present its views to the Committee on
the pending legislation to address futures regulation and energy
prices.
FIA regular member firms are registered with the Commodity Futures
Trading Commission as futures commission merchants (``FCMs''). FIA's
FCM member firms execute customer orders for and provide the financial
guarantees underwriting more than 90% of the futures contracts traded
on U.S. exchanges. FIA member firms also play a substantial role in
executing and clearing orders for customers world-wide in futures
contracts traded on non-U.S. exchanges. As the leading trade
association for the U.S. futures industry, FIA and its member firms
have an acute interest in the many legislative proposals you are
considering.
FIA has a long record with this Committee. We have supported every
legislative reform of futures regulation dating back to the Commodity
Futures Trading Commission Act of 1974 as well as each Reauthorization
of the CFTC since 1978. As in the past, FIA is committed to working
with this Committee on constructive legislation to modernize regulation
and adapt to the ever quickening pace of change in futures trading
around the world.
While I suspect FIA, led by John Damgard, is well known to many
Members of this Committee, I am sure I am not as well known. I am a
Partner in the law firm of Kirkland and Ellis, LLP in the Washington,
D.C. office. In 1977, I joined the CFTC's legal staff when I graduated
from law school. I then moved to Kirkland in 1982. I have represented
clients in every CFTC reauthorization from 1978 to 2008. I now
represent FIA on a variety of legislative, litigation and regulatory
matters. I represent other clients as well on a variety of regulatory
and litigation matters. I do not now represent any U.S. futures
exchanges or foreign futures exchanges. Also, since 1991, I have taught
a course in Derivatives Regulation as an Adjunct Professor at the
Georgetown University Law Center.
FIA and its members have long believed that futures market price
integrity is a paramount concern. FIA does not support higher prices or
lower prices on any market. FIA does support having prices discovered
openly and competitively on what the Commodity Exchange Act calls,
``liquid, fair and financially secure trading facilities.''
In 1974, this Committee described the Commodity Exchange Act as a
``comprehensive regulatory structure to oversee the volatile and
esoteric futures trading complex,'' a description the U.S. Supreme
Court later called an ``apt[] characteriz[ation].''&\1\ Amending this
complex structure, under even the best of circumstances, can be a
difficult challenge. FIA thanks this Committee for your thorough and
thoughtful approach to deliberating on the benefits and costs of the
many different legislative proposals before you.
---------------------------------------------------------------------------
\1\&Merrill Lynch v. Curran, 456 U.S. 353, 355&356 (1982).
---------------------------------------------------------------------------
FIA views each legislative proposal through the lens of seven basic
principles.
1. Futures trading serves the congressionally-endorsed national
public interests in commodity price risk management and
commodity price discovery. Price manipulation robs futures
markets of their ability to serve those public interests.
2. The Commodity Futures Trading Commission now has vast powers to
prevent price manipulation, ranging from position limits and
vigorous enforcement actions to transparent market surveillance
and emergency powers. The CFTC is an effective agency; it needs
additional resources more than it needs additional powers.
3. Speculators are essential for futures markets, as the Supreme
Court and many commentators have found.\2\ Without speculators,
U.S. futures markets would not serve the national public
interest. Speculation is not price manipulation. Those who
claim it is would also equate oxygen with air pollution.
---------------------------------------------------------------------------
\2\&Merrill Lynch v. Curran, 456 U.S. at 390 (speculators play a
``crucial role in an effective and orderly futures market'');
Economist, ``Don't blame the Speculators,'' July 5&11, (at 15&16
(``speculators provide a vital service''); Robert Samuelson, ``Lets
Shoot the Speculators,'' Newsweek, July 7&14, 2008 (``What makes the
futures markets work is the large number of purely financial players--
`speculators' just in it for the money--who often take the other side
of hedgers' trades.''); Richard W. Rahn, ``Greedy Speculators,''
Washington Times, June 25, 2008 at A22 (``There are many . . . market
speculators who provide liquidity to the market and fill the void if
the numbers of short and long hedgers do not match up.''); J. Nocera,
``Easy Target, But Not The Right One,'' New York Times, June 28, 2008
at B1.
4. Congress should not enact legislation that would create
disincentives for futures business to be conducted through U.S.
firms and on U.S. markets, which could cost U.S. jobs. Congress
should also not enact legislation that would hinder the CFTC's
---------------------------------------------------------------------------
market oversight and price transparency.
5. The forces of globalization and technological innovation are
linking economic and financial activities world-wide more every
day. No legislation could repeal that market reality.
6. Loopholes are a misnomer. Congress made many deliberate and
realistic policy choices from 1982 to 2000, many of which
originated in this Committee. Each was intended to serve the
public interest, not any special interest. Those choices have
served the public interest well, resulting in strong growth,
more transparency and less financial risk in U.S. derivatives
markets.
7. The CFTC's legal authority over U.S. futures exchanges, traders
and firms is and must be greater and more direct than its legal
authority over foreign futures exchanges, traders and firms.
International cooperation and coordination is therefore an
essential component of effective market surveillance for global
markets.
Along with other financial services trade associations, FIA has
provided a list of measures Congress should enact to deal with the
current market situation. Those recommendations are included as
Appendix A. For this hearing, the Committee has grouped the issues
presented in the pending legislative proposals into six categories.
FIA's thoughts on each area follow. We emphasize the foreign board of
trade issue because it is the primary area of concern to the clearing
firms that comprise our core membership.
Foreign Boards of Trade
Background
In 1982, Congress determined that futures contracts traded on an
exchange ``located outside the U.S.''--called a ``foreign board of
trade''--would be excused from the requirement that futures contracts
in the U.S. must be traded on a CFTC-approved exchange. That
requirement remains the law today unless a statutory or regulatory
exclusion or exemption is applicable. In 1982, Congress also specified
that the CFTC could not directly regulate foreign boards of trade or
their operations. For well over a decade, this provision was non-
controversial and applied in a legally certain atmosphere: an exchange
was considered to be ``located'' where its trading floor was located
and U.S. customers accessed foreign boards of trade without incident.
In recent years, matching engines, trading terminals, servers and
web access allowed any exchange anywhere in the world to access U.S.
customers directly. Because issues were raised about whether these
developments affected where an exchange was ``located,'' the CFTC and
its staff developed a no-action approach. Through the no-action
process, the CFTC was able to condition the ability of a foreign board
of trade to conduct business with firms and customers in the U.S. One
important condition is the level of cooperation the CFTC could receive
from a foreign board of trade's foreign regulator, what the CEA defines
as a ``foreign futures authority.'' To date, the CFTC's website lists
20 of these No Action letters issued to foreign boards of trade.
As commodity markets have become more international in scope and
electronic trade execution mechanisms have become predominant, U.S. and
foreign exchanges have begun some level of direct competition. U.S.
futures exchanges have attempted to engage in direct competition with
certain foreign futures exchanges and foreign exchanges have attempted
to engage in direct competition with certain U.S. exchanges. For
example, in recent years the Chicago Board of Trade offered replicas of
the German Bund, Bobl and Shatz futures contracts which trade
successfully on EUREX, the German-Swiss Exchange. The New York
Mercantile Exchange also trades a Brent Oil futures contract which is a
cash-settled version of the same contract which first traded on what is
now ICE Futures Europe. Competition is a two way street. ICE Futures
Europe also has listed and trades a cash-settled clone of the
bellwether WTI crude oil futures contract traded at NYMEX.
FIA strongly supports direct competition among trading facilities
both within the U.S. and globally. Competition leads to more liquidity,
lower trading costs, tighter spreads, and more innovation. It does,
however, complicate market surveillance. It is easier to know who is
trading what futures contracts on one exchange, than on multiple
exchanges. It is also easier for a single dominant designated contract
market to discharge its statutory duty to prevent manipulation on its
own market without having to worry about trading in the same commodity
on the market of its competitor, the ``challenger'' exchange. The CFTC
has determined that direct competition is important to promote and that
the agency itself will bridge the gap in market surveillance among
different exchanges trading the same product when these instances of
direct competition arise. FIA has endorsed the CFTC's determination and
actions to promote exchange competition.
Competition does promote innovation. For example, in response to
the ICE Futures Europe decision to list a NYMEX-replica WTI crude oil
futures contract and the immediate success ICE experienced through
electronic trading in a contract that previously could only be traded
on the NYMEX trading floor, NYMEX accelerated its efforts to allow
electronic trading for its WTI contract. In response, the CFTC has
taken a number of proactive steps, with the cooperation of ICE's
regulator, the UK Financial Services Authority, to make sure that the
CFTC's market surveillance picture for both markets is clear and
transparent. Again, FIA endorses the measures the CFTC has implemented
and commends the agency for its leadership and initiative.
Current Proposals
We understand that many want to codify in the CEA the CFTC's market
surveillance protocols where a foreign-based and regulated exchange
attempts to compete with a U.S. exchange for market share in a
particular futures contract. FIA supports that goal. Competition should
not compromise market surveillance. When two exchanges, no matter where
located, compete for trading volume in the same product, the CFTC has
heightened market surveillance responsibilities and its traditional
market surveillance tools need to be adjusted to make sure that the
CFTC has any and all data to prevent price manipulation or other major
market disturbances.
As this Committee understands well, with most CEA proposals it is
particularly important to target the legislative language to address
the specific problem at issue and to avoid triggering legal and
business consequences that would undermine the intended policy goal or
have other unintended repercussions. In this instance, it is essential
that any proposal adopted by the Committee not unintentionally harm the
CFTC's efforts to enhance its surveillance capabilities by pushing more
market activity to less transparent venues where the trading data the
CFTC may need would not be readily available.
FIA has reviewed the pending proposals and our list of concerns
with each proposal is found at Appendix B to this testimony. Overall,
FIA fears that the proposals in the FBOT area that have been introduced
to date would inadvertently harm both the CFTC's ability to prevent
manipulation and the competitiveness of U.S. brokerage firms, while
potentially leading to trade-war type retaliation from foreign
governments against U.S. exchanges. Some of these proposals are drafted
in a circular manner so that only foreign exchanges otherwise excused
from CFTC oversight by statute would be subject to the heightened
surveillance requirements. Other proposals enable FBOTs to evade the
contemplated mandated CFTC regulation of FBOT self-regulatory
operations by simply refusing to deal with U.S. traders and firms,
while welcoming the business of any overseas affiliates of these same
traders and firms. This has happened before in the context of security
futures products and other trading instruments. In fact, some U.S.
clearing firms have moved or may be compelled to move their operational
and processing facilities out of the U.S. for just this reason. The
results? No direct CFTC transparency for these FBOT trades, leading to
increased manipulation risk and increased systemic financial risk on
the clearing side, and a weakened business base for U.S. traders and
firms (which creates a disincentive to even start such a business in
the U.S.).
FIA also believes that any legislation in this area should be
symmetrical because competition is global and U.S. exchanges do try to
wrest market share from foreign boards of trade in various products, a
competitive trend we hope will continue. Foreign futures authorities
have as much interest in preventing price manipulation in their
jurisdictions as the CFTC does here. None of the introduced proposals
addresses this market and regulatory reality.
As mentioned earlier, FIA shares the policy goals of many of the
introduced FBOT proposals: to enhance CFTC surveillance where warranted
to deal with competition among foreign and U.S. exchanges in energy
futures trading and to prevent market manipulation. To achieve those
objectives, FIA recommends that the Committee consider the following
type of provision:
When a foreign board of trade lists for trading an energy
futures contract that is linked to the settlement price of an
energy futures contract trading on a U.S. futures exchange (or
vice versa) and when the CFTC (or its foreign regulatory
counterpart) believes enhanced market surveillance is necessary
or appropriate, then the CFTC and its foreign counterpart
should immediately consult on, develop and implement heightened
surveillance measures to prevent price manipulation and ensure
transparent, coordinated market surveillance.
This approach will not only codify and strengthen the process and
procedures the CFTC already has implemented with respect to ICE Futures
Europe and its coordinated efforts with the FSA, it would build upon
the CFTC leadership in this area to promote international consultation
and coordinated regulatory responses. We would be leading the world in
a common and important mission--the prevention of price manipulation
any time, anywhere. We would not be telling the world how that mission
must be accomplished or that every CFTC or U.S. exchange requirement
must be replicated in every instance. We would be leading, not
dictating.
FIA also is very concerned that some legislative proposals in the
FBOT area would operate to impose prohibitions on U.S. futures
commission merchant firms that accept and execute customer orders on
FBOTs. Unintentionally and inadvertently, these proposals would make
U.S. firms liable if an FBOT fails to comply with U.S. law. They could
also be read to allow customers to sue U.S. firms to void or rescind
foreign futures contracts if the FBOT fails to comply with the CFTC-
imposed regulatory conditions. When executing and clearing orders for
U.S. or foreign customers, U.S. FCMs should not be guaranteeing the
regulatory compliance of FBOTs. Specific statutory safe harbors and
exemptions are needed to prevent CFTC-registered professionals from
bearing the legal risk of FBOT non-compliance. Otherwise investment
banks and other clearing firms will simply and sensibly decide to run
their futures brokerage and clearing businesses through overseas
affiliates to avoid that potential liability.
The foreign board of trade issue is vitally important to the future
commercial viability of the U.S. FCM community which comprises the core
of the FIA's membership. We would be happy to consult with the
Committee and its staff on specific legislative language to achieve the
objectives of much of the FBOT legislation proposed to date without the
adverse consequences outlined above.
Swaps: Treating Energy Commodities Like Agricultural Commodities
Under the Commodity Futures Modernization Act of 2000, Congress
prescribed different levels of CFTC oversight and regulation for
different trading systems, different market participants and different
commodities. Generally, Congress determined that trading on
multilateral trading facilities, where many market participants may
execute trades with other market participants (so-called ``many to
many'' markets), replicated the trading structure of traditional
futures trading pits and should not be excused from CFTC regulation.
Also trading among only Eligible Contract Participants, essentially
well-capitalized, sophisticated or regulated entities, might not
require full CFTC regulation and oversight because each ECP would be
capable of protecting itself. And transactions in financial, energy and
metals commodities did not implicate the same historical CEA regulatory
concerns about market manipulation as did futures on agricultural
commodities, which are the only commodities subject to CFTC-set
speculative limits for futures trading on an exchange. Building on
those concepts, Congress extended legal certainty to non-agricultural
commodity transactions among ECPs by excluding or exempting those
transactions from the CEA when the transactions were not executed on a
trading facility.\3\
---------------------------------------------------------------------------
\3\&This summary oversimplifies the web of CEA exclusions and
exemptions enacted in 2000. But it captures the essence of CEA &2(c),
2(d), 2(e), 2(g) and 2(h). Notably, parties engaged in exempt
transactions in energy commodities under section 2(h) could still be
subject to CFTC prosecution for energy price manipulation.
---------------------------------------------------------------------------
Agricultural options and swaps transactions, however, may still be
exempted from the CEA's exchange-trading requirement, among other
regulatory provisions, under a CFTC exemption found in Part 35 of its
Rulebook and adopted under Section 4(c) of the CEA, as enacted in 1992.
Under the Part 35 rules, non-standardized and non-fungible derivatives
transactions among Eligible Swap Participants (again, well-capitalized,
sophisticated parties) are generally exempt from the CEA unless traded
on a multilateral transaction execution facility or submitted to a
futures-style clearing system. These otherwise exempt agricultural
transactions are still subject to the CEA's anti-fraud and anti-
manipulation prohibitions.
The CFMA exemptions and exclusions in the energy area represented
an attempt statutorily to increase price transparency and remove
systemic financial risk in over-the-counter energy transactions. And
those provisions have worked as intended. ICE and other market
innovators have developed methods of increasing price transparency for
energy swaps in less than fully multilateral electronic trading
systems. It is uncertain whether those swaps would be eligible for
exemption under Part 35. What is certain is that none of those energy
swaps could be subject to a futures-style clearing system unless the
CFTC adopted a new exemption. Treating energy commodity swaps like
agricultural commodity swaps therefore would likely diminish price
transparency and increase financial risk for these transactions.
In the 2008 Farm Bill, Congress addressed the legitimate concern
that exempt energy transactions under Section 2(h) that are traded
electronically and develop into significant price discovery
transactions should be regulated more like futures contracts than
Congress envisioned in 2000. Once full implemented by the CFTC, this
reform will enhance price transparency and market oversight. Its
valuable benefits will be lost, however, if energy commodities are
treated in the same ways as agricultural commodities and removed from
the transactions eligible for exemption under Section 2(h)(3) of the
CEA. Like most quick fixes under the CEA, equating energy commodities
with agricultural commodities will disserve the public interest. FIA
would not recommend its adoption or the approval of any substantive
amendments to CEA &2(g) and 2(h). Instead, the reforms in the farm
bill should be allowed to take full effect and monitored to determine
whether any adjustment is warranted in the near future.
Resources for the CFTC
FIA strongly supports the proposals for additional resources for
the CFTC, including at least 100 new CFTC employees. Those numbers are
commensurate with the CFTC's scope of responsibilities and ever
expanding authority in a global and changing market place. The bulk of
the CFTC's new resources we would expect to be used to hire attorneys
in the Enforcement Division to investigate and root out any alleged
price manipulations the CFTC staff may uncover. Manipulation should not
be tolerated and enforcement actions for past misconduct are the best
means to deter future misconduct.
Pension Funds and Index Trading
FIA strongly opposes banning any collective investment vehicles,
whether they are pension funds, mutual funds, commodity funds or hedge
funds, from participating in futures markets. When the funds'
professional trading managers determine it is in the best interests of
the funds' investors or beneficiaries to diversify their portfolio by
trading in futures markets, that new speculative capital and liquidity
should not be shunned. The CFTC is wisely investigating to determine
whether index traders or any one else has engaged in price
manipulation. FIA has every confidence that the CFTC (along with staff
from other, less directly interested, Federal agencies) will analyze
the right data and will make public its conclusions on or about
September 15, 2008. FIA will be interested to evaluate the Commission's
analysis under that accelerated time table. Until the facts are known
and analyzed, however, FIA would urge all interested parties not to
pre-judge the price effects of index trading, swap dealer net offsets
in futures or pension fund activities.
Speculative Limits
Some observers believe that swap dealers should not be considered
to be hedgers when they enter into futures market transactions to
offset the price risk of their swap transactions with non-physical
commodity counterparties. To the extent the CFTC study will consider
this issue, FIA would withhold final judgment. But it seems to make no
difference from the perspective of the swap dealer whether its futures
position is designed to manage a price risk incurred with a physical
counterparty or a financial counterparty. Price risk is price risk.
Swap dealers in energy commodities use futures to reduce their net
market price risk on transactions with financial and physical
counterparties. If a swap dealer entered into a long swap transaction
in crude oil with a notional amount equal to10 futures contracts with a
financial counterparty and then entered into a short swap transaction
in crude oil with a notional amount equal to five futures contracts
with a physical counterparty, the dealer could then go short five crude
oil futures contracts on NYMEX to manage its net outstanding price
risk. Some proposals would disallow treating the dealer's five short
futures position as a hedge; instead those proposals would insist the
dealer has a five short speculative position in futures, a result which
distorts both the economic reality of the swap dealer's risk and any
CFTC surveillance of that position. That approach also could make it
more costly for the dealer to margin its futures position (a cost the
dealer would likely pass along to its swaps counterparties).
The better way to handle this situation is to allow the CFTC as
well as the NYMEX and other exchanges to establish position
accountability standards and to look behind the positions when
appropriate to see whether the swap dealers or other large traders are
engaged in any transactions that would raise surveillance concerns,
without worrying about the classification of a position as hedge or
speculative. Current law and DCM core principles accomplish that kind
of flexibility. Indeed, under NYMEX rules, the hedge versus speculation
classification only really matters for position limit purposes during
the last three trading days in every contract when speculative position
limits first become applicable.
Margin
U.S. futures exchanges should set margins, not the U.S. Government.
Exchanges and their clearing entities set margins to balance credit
risk considerations against other market interests. It is a delicate
business judgment that goes to the heart of exchange operations and
should be left to the exchanges. In the context of crude oil prices,
there is no evidence that NYMEX has abdicated its authority in any way
in this area. To the contrary, from January 2, 2007 through July 3,
2008, NYMEX has increased its margin for WTI crude oil futures for non-
member speculators by about 270% in absolute terms and about 50% when
compared to the notional amount per contract.
Conclusion
Record high gasoline prices are creating challenges and hardships
in our national and international economy. If FIA believed that some
reform to futures regulatory surveillance practices would reduce those
challenges and hardships, we would not hesitate to recommend those
reforms. But FIA is not aware of any proposed change to the CEA that is
likely to result quickly, automatically and permanently in a decline in
the price of crude oil. We are aware of statutory proposals that would
substantially and adversely affect U.S. futures firms and markets,
price transparency, systemic risk, and competition. These proposals
threaten the viability of many services our member firms now provide to
customers in the U.S. and overseas. Those proposals should not be
adopted by this Committee and Congress.
FIA respectfully requests that the Committee continue to proceed
with caution in considering the pending proposals. We look forward to
working with the Committee and its staff to fashion meaningful,
realistic and targeted legislation to enhance market surveillance for
energy futures markets and to strengthen the CFTC's regulatory muscle
over the ever changing dynamic of futures trading activities.
Appendix A
What Congress Should Do
Congress should call on the President to immediately send a
request for emergency appropriations to allow the CFTC to
increase oversight, improve the Commission's information
technology, and hire at least 100 new full time employees.
Congress should instruct the Commission to add at least 100
new full time employees in order to increase surveillance of
the market, improve enforcement and otherwise carry out the
purposes of the Act.
Congress should require the CFTC to obtain all necessary
market surveillance information to prevent market manipulation.
Congress should require the CFTC to report to Congress
regarding the effectiveness of its expanded information-sharing
arrangement with the FSA, and the results of its review of the
scope of commodity index trading in the futures market, and its
recommendations for any changes to its authority or rules,
including any modifications to the Commitment of Traders
reports as necessary to provide increased transparency in
energy derivative markets.
Congress should instruct the Commission to undertake a
comprehensive report, in conjunction with other futures and
options regulators world-wide, relating to differences in
regulatory regimes worldwide as well as the role of
institutional investors, speculators and other participants in
the markets.
Appendix B
Futures Industry Association--Concerns Relating to Foreign Board of
Trade (``FBOT'') Legislative Proposals
1. H.R. 6284 (Mattheson), H.R. 6334 (Etheridge), S. 2995 (Levin),
S. 3044 (Reid), S. 3129 (Levin), S. 3130 (Durbin)--CFTC may
grant &4(a) relief only for FBOT with comparable regulation
and willing to submit trading data to CFTC.
(a) ``Located outside.'' Applies only to foreign boards of trade
which, by definition, are located outside the U.S. and
therefore do not need &4(a) relief. Because FBOTs need no
&4(a) relief the provision is ineffective and self-
defeating.
(b) ``Cash-settled.'' Applies only to FBOTs ``with respect to an
energy commodity that is physically delivered in the U.S.''
FBOT contracts that are cash-settled would not be covered
by the provision. ICE Futures Europe's WTI futures contract
is cash-settled and does not call for physical delivery of
any energy commodity.\1\
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\1\&H.R. 6349 (Marshall) is substantially similar to the six
enumerated bills except it does not have the physical delivery
limitation. It would apply if an FBOT's energy contract refers to the
price of a physically delivered energy contract traded on a U.S.
exchange and the contract contemplates a ``primary physical delivery
point'' in the U.S. This formulation would allow CFTC regulation to
apply to FBOT contracts that are cash-settled, although the concept of
a primary U.S. delivery point is not well established and may not be
easy to apply in all circumstances. Other than cash-settlement, H.R.
6349 raises all of the same issues as the six other bills listed.
(c) Attempts to impose direct CFTC regulation on FBOTs in a
number of areas. In response and to avoid duplicative
regulatory oversight, FBOTs are likely to close off foreign
markets from U.S. market participants and firms. FBOTs will
simply refuse to take orders from U.S. firms and traders.
FBOT business may not suffer; firms and traders will
continue to trade on the FBOT, but will trade through their
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overseas affiliates.
(d) If FBOTs are made subject to affirmative U.S. statutory
requirements, U.S. FCM firms could be liable under &4(a)
for an FBOT's non-compliance because of the way &4(a) is
structured. FCMs should not be insuring FBOT compliance
with U.S. law.
(e) No coordination role provided for foreign futures authority
with jurisdiction over the FBOT.
2. H.R. 6341 (Van Hollen)--Disqualifies boards of trade from being
considered to be foreign if they have U.S. ties and trade SPDCs
in energy.
(a) Harms CFTC Surveillance Transparency. Any FBOT could avoid
U.S. jurisdiction by not affiliating with an entity in the
U.S. or not having any infrastructure in U.S. FBOTs could
set up matching engines outside the U.S., with servers
outside the U.S. and no direct U.S. presence. FBOTs would
not need any CFTC relief. CFTC would lose all possible
leverage in trying to obtain surveillance information.
(b) If CFTC determines an exchange with U.S. ties trades a
Significant Price Discovery Contract (a new statutory term
designed to serve a very different purpose) in any energy
commodity, then that contract becomes illegal to trade in
the U.S. unless the FBOT becomes a DCM. Making illegal a
contract that others are using for price discovery--
theoretically world-wide--will harm the price discovery
process and may cause serious commercial harm in the energy
markets.
(c) It is unclear how to apply the SPDC criteria from the farm
bill to an international market. The SPDC criteria were
developed to discern price discovery contracts in the U.S.,
not in overseas markets. Is the CFTC supposed to make a
national or international SPDC determination?
(d) Would encourage foreign exchanges to bar U.S. traders and
firms from participating in their markets. Congress may
want U.S. parties to participate in energy price discovery
rather than leave price discovery just to parties in the
Middle East and other parts of the world.
(e) Requires ICE Futures Europe to become a U.S. designated
contract market. Could spark trade-war style retaliation.
3. H.R. 6330 (Stupak)--Makes illegal non-DCM energy futures if
delivery point in U.S. or ``transacted'' on a terminal in U.S.
(a) Would not apply to cash-settled transactions on an FBOT.
(b) Exchanges now rely less on dedicated terminals for trading.
Modern technology and web-access make trading easier to
access from anywhere in the world. FBOT do not need to have
terminals in the U.S. If FBOTs don't have terminals in the
U.S., the CEA doesn't apply to those FBOTs' contracts.
(c) Excuses an energy contract from coverage under the CEA unless
it calls for delivery point in the U.S. or is transacted on
a U.S. terminal. An FBOT could list a cash-settled energy
contract and allow U.S. traders access from websites in the
U.S. and not be subject to the CEA. May actually cut back
on CFTC authority, making transparency and market
surveillance harder to achieve.
(d) Misapprehends that CFTC FBOT no-actions have relied on
Section 4(c) exemptions (which bill seeks to nullify absent
public comment). No-actions are not 4(c) exemptions.
4. H.R. 6130 (Barton)--Requires CFTC within 6 months to determine
whether to adopt a rule regarding how the CFTC determines a
foreign futures authority regulates its exchanges and markets
in a way comparable to the CFTC.
(a) Developing regulatory standards for determining comparability
in different regulatory structures may limit CFTC
discretion. But providing notice to market participants and
FBOTs of the factors the CFTC would take into account in
making a comparability determination may not be
problematic.
(b) May remove CFTC flexibility by requiring FBOTs to have
certain specific regulatory tools to achieve comparability.
Better approach would be to determine whether anti-
manipulation protections are adequate and how well sharing
of surveillance data on competing contracts could work.
5. H.R. 6279 (Chabot)--Same as bills covered under Part I above,
but adds that FBOT margin requirements must be comparable to
U.S. and ``sufficient to reduce excessive speculation.''
(a) DCMs in U.S. have considerable flexibility in imposing
margin, as they should. They operate under core principles
subject to CFTC oversight.
(b) Under U.S. law, margin is not generally designed to curb
excessive speculation. Margin is largely a credit risk
issue. FBOTs should not be held to a different, higher
standard.
6. H.R. 6372 (Hill)--No board of trade may be an FBOT if it has a
U.S. affiliate, trades a commodity other than an exempt
commodity or trades a significant price discovery contract.
(a) No ``U.S. affiliate'' test artificially restricts cross-
border exchange mergers with U.S. entities. Why limit the
commercial maneuverability of U.S. trading facilities when
foreign counterparts are not similarly restricted? Also
allows board of trade a fairly painless way to evade U.S.
law.
(b) Energy and metals are exempt commodities. Trading in those
kinds of commodities would be not be affected by this bill.
Trading in agricultural commodities and financial
commodities (excluded commodities) like interest rates,
currencies and equities would be affected. Not sure that
was intent.
(c) SPDC determination in farm bill was not developed with
foreign or global markets in mind. Not sure how well SPDC
determination can be adapted to this context. Also SPDC is
not self-executing; it requires an affirmative CFTC
determination. Why would Congress want to make it illegal
to trade a contract that businesses are relying on for
significant price discovery.
7. S. 3122 (Cantwell)--Makes into a DCM any trading facility that
(a) ``operates one or more trading terminals'' in U.S.; (b)
trades contracts that serve a price discovery function for a
commodity delivered in the U.S.; and (c) is regulated by a
foreign regulatory agency. Terminates existing exemptions from
DCM registration.
(a) FBOTs today operate under a CFTC-approved no-action process,
not Section 4(c) exemptions.
(b) FBOTs do not need to operate ``trading terminals'' in the
U.S. Web access is world-wide. Also servers that facilitate
the pace of execution of U.S. customer orders on FBOTs are
not considered to be trading terminals. Servers are not
trading terminals.
(c) Price discovery function is an undefined, new term. To the
extent it is different than the ``significant price
discovery contract'' definition from the 2008 Farm Bill, it
is not clear why a new phrase is needed. To the extent it
is the same as the farm bill formulation, it is not self-
executing, adds administrative cost to CFTC regulation, and
may not be applicable to energy markets traded overseas.
Also has the perverse consequence of penalizing a foreign
exchange for developing an energy contract (Brent) which a
U.S. exchange later copies.
The Chairman. Thank you very much.
Mr. Peniket.
STATEMENT OF DAVID J. PENIKET, PRESIDENT AND COO, ICE FUTURES
EUROPE, LONDON, UNITED KINGDOM
Mr. Peniket. Chairman Peterson, Members of the Committee,
it is a privilege to appear before you today in respect to the
issue of regulation of foreign boards of trade.
I am David Peniket, President and Chief Operating Officer
of ICE Futures Europe. ICE Futures Europe is the largest
regulated futures exchange for energy trading in Europe and the
second largest in the world. We trade a number of energy
contracts which are used as pricing benchmarks both in Europe
and internationally. Our Brent crude futures contract is the
leading benchmark for the oil traded outside the United States.
Our gasoil futures contract is the main European middle
distillate benchmark.
Since February of 2006, we have offered financially settled
WTI crude oil futures, giving our customers the ability to
trade the main U.S. and European crude oil futures on a single
platform.
In conjunction with our partners at the Chicago Climate
Exchange, we operate the market for the European Climate
Exchange, which is the largest carbon market in the world.
ICE Futures Europe was founded as the International
Petroleum Exchange in 1980. It was acquired by
IntercontinentalExchange in 2001 and was subsequently renamed.
But ICE Futures Europe remains a U.K.-recognized investment
exchange subject to the regulation of the U.K. Financial
Services Authority. ICE Futures Europe is a U.K. company with
its own board, on which I sit, and which is chaired by Bob
Reid, former Chairman Shell U.K.
The contracts we trade are subject to U.K. law and the
jurisdiction of the English courts. All the contracts are
cleared through a U.K. clearinghouse, currently LCH.Clearnet,
shortly to be ICE Clear Europe.
Our headquarters are an international house near Tower
Bridge, where a team of nearly 70 exchange staff are based. All
our regulation compliance and market supervision staff are
based in London.
Since 1999, we, in common with many other exchanges, have
operated screens in the United States under a No Action letter
from the CFTC. This is the regime that all international
derivatives exchanges use to achieve access to the U.S. market.
The regime has been highly successful in helping to promote the
growth of derivative markets around the world. A framework of
mutual cooperation between derivatives regulates this. This
meant that markets have grown strongly and without the
disruption that has been present in other parts of the
financial services industry.
Since we launched our WTI contract, the CFTC has been
concerned to understand its implications of the WTI market as a
whole. We collect large trader reports to the contract on a
daily basis, and this information has been shared regularly
with the CFTC, at first informally and then subject to a
Memorandum of Understanding between the CFTC and the FSA. That
Memorandum of Understanding was strengthened 2 months ago when
we agreed to provide additional large trader information to the
CFTC and to alert them when certain position accountability
levels were exceeded.
On the 17th of June, 2008, the CFTC amended the No Action
letter under which we operate. This amendment further
formalized the information-sharing arrangements and required
that we impose position limits and position accountability
levels in respect of WTI. We will comply in full with the terms
of this letter subject to the approval of the U.K. Financial
Services Authority.
In the normal course of our operations, we receive
information requests from the CFTC via the FSA from time to
time. We have always cooperated with such requests. In our
view, the CFTC now has all the information it needs to fulfill
its role as overseer of the WTI futures markets. We will
continue to operate closely with them.
Mr. Chairman, it is in our interest and the interest of our
market participants to ensure that the energy markets are fair,
orderly and free of manipulation. The only way in today's
global, interconnected world that we will we be able to ensure
this is through active cooperation between regulators and
exchanges around the world. We respectfully submit that the
effective regulation of today's global commodity markets is
best served by measures that promote and enhance such
regulatory cooperation.
Thank you for your time, Mr. Chairman. I would be happy to
take any questions.
[The prepared statement of Mr. Peniket follows:]
Prepared Statement of David J. Peniket, President and COO, ICE Futures
Europe, London, United Kingdom
Chairman Peterson, Ranking Member Etheridge. I am David Peniket,
President and Chief Operating Officer of ICE Futures Europe.
I very much appreciate the opportunity to appear before your
hearing today to share ICE Futures Europe's views on foreign boards of
trade. The United States' approach to the regulation of foreign boards
of trade is an important issue for the global trading community.
Executive Summary
1. ICE Futures Europe is a 27 year old London-based fully regulated
futures exchange. ICE Futures Europe is one of the largest
European energy markets. It offers a ``cash-settled'' WTI crude
oil contract, meaning positions in the contract do not result
in taking physical barrels of oil off of the market or permit a
price squeeze.
2. 85% of the open positions for the WTI crude futures and options
market are held on the NYMEX, which establishes the price of
WTI crude oil due to the physical nature of the NYMEX market.
ICE Futures Europe prices its contract, which has a 15% market
share, based on the settlement price discovered in the NYMEX
WTI market.
3. ICE Futures Europe, as a fully regulated exchange, monitors
positions daily and has enforcement powers as does the FSA to
detect and punish attempts a manipulation.
4. Pursuant to amended CFTC and FSA agreements in May and June of
2008, the ICE WTI contract will be subject to the same U.S.
regulatory provisions as the NYMEX WTI contract, including
position reporting and position accountability and limits
5. Finally, ICE Futures Europe margin rates have tripled from May
2007, while prices have approximately doubled. The use of
margining as a tool for controlling price movements or market
participation, which is one of the proposed market alterations,
could have extremely negative consequences for market
participants and consumers and could result in excessive
volatility, the hoarding of oil or the departure of regulated
markets from the U.S.
Background
ICE Futures Europe (the ``Exchange''), formerly the International
Petroleum Exchange of London Ltd, is the leading regulated energy
futures exchange outside the United States of America. The Exchange was
formed in 1980 and operated as a mutual exchange until 2001 when it was
acquired by IntercontinentalExchange, Inc. The Exchange's primary mode
of operation was open outcry trading until 2005, when we converted our
markets to fully electronic trading. ICE Futures Europe is the home of
the Brent Crude Futures contract, a North Sea blend of crude oil. The
Brent complex, of which our futures contract is a part, forms the basis
for pricing--directly or indirectly--\2/3\ of world traded crude
oil.\1\ We also offer a Gas Oil futures contract which serves as the
primary pricing benchmark for European middle distillate products, as
well as UK natural gas and electricity contracts. In conjunction with
our partners at the Climate Exchange we operate the futures market for
the European Climate Exchange, which is now the largest carbon futures
market in the world.
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\1\&Source: Brent: A User's guide to the Future of the World Price
Marker (Liz Bossley, CEAG, 2007).
---------------------------------------------------------------------------
The customers of ICE Futures Europe's market, like those of most
major exchanges, are based around the world. Even when ICE Futures
Europe was an open outcry exchange, customers from around the world
used its markets by phoning their orders in to the trading floor in
London. Today the trading floor is a virtual one, with orders being
sent to the market through computer terminals--but the global nature of
our markets has not changed. We have regulatory clearance for our
screens to operate in over fifty jurisdictions globally.
Responding to customer demand, in February 2006, ICE Futures Europe
launched a cash settled futures contract for West Texas Intermediate
(WTI) crude oil to complement our Brent crude oil contract since both
are similar ``light sweet'' grades of crude oil. We chose to offer a
financially settled WTI contract at a time when NYMEX was committed to
retaining and promoting open outcry trading rather than pursuing
electronic trading despite market demand. As the first exchange to
launch a fully electronically-traded WTI contract on an around-the-
clock trading platform, our contract was successful in taking market
share from NYMEX. Since the subsequent launch of electronic trading by
NYMEX in September 2006, NYMEX's WTI contract has grown more rapidly
than the ICE market. Today, ICE has a relatively small 15% share of
total WTI futures and options open interest, while NYMEX retains the
remaining 85%. Nevertheless, the ICE WTI contract is an important
contract for ICE Futures Europe, as it is used by commercial
participants to hedge exposure to small differences in WTI and Brent
prices. Notably, NYMEX similarly offers a cash-settled Brent crude oil
futures contract that settles on ICE Futures Europe's final settlement
price for precisely the same reason.
Regulatory Framework: ICE Futures Europe's Operations
ICE Futures Europe is a Recognized Investment Exchange which
operates under a legislative framework set out in the Financial
Services and Markets Act 2000. This framework gives the exchange an
equivalent regulatory status under UK law to the status that U.S.
Exchanges have under U.S. law. The Exchange is subject to supervision
by the Financial Services Authority, which has a designated team whose
responsibility is to oversee the work of UK exchanges and other
recognized bodies. The financial services regulatory regime in the
United Kingdom is well-established and has been used as a model in the
design of other regulatory systems around the world.
ICE Futures Europe is a UK corporate entity that files that is
registered with Companies House, whose principal place of business is
in the UK and which is subject to UK law. All contracts traded on ICE
Futures Europe are subject to UK law and regulation. For European
market participants, this is important for a variety of reasons,
including the applicability of UK bankruptcy and insolvency laws in the
event of a contract default. All of ICE Futures Europe's contracts are
cleared in London by LCH.Clearnet Limited, which acts as central
counterparty to all trades on the Exchange. Clearing of such contracts
will shortly be transferred to our own new London-based clearing house,
ICE Clear Europe.
At all times since it became a subsidiary of ICE, Inc., ICE Futures
Europe has been headquartered in London and has operated as a
Recognised Investment Exchange. At all times during this period, ICE
Futures Europe has been governed by a separate board of directors which
is accountable to the Financial Services Authority for the operation of
ICE Futures Europe's markets. The board is chaired by Sir Bob Reid, a
former Chairman of Shell UK, and also includes three independent
European-based board members: Lord Fraser of Carmyllie, Robert Mabro
and Peter Nicholls. Jeff Sprecher, Chairman and Chief Executive Officer
of IntercontinentalExchange and Scott Hill, ICE Chief Financial Officer
are also members of the Board. A Subcommittee of the Board, the Risk
Committee, made up of the independent directors, meets separately to
consider financial and operational risk issues, including financial
resources. This separate governance structure and degree of
independence within the ICE, Inc. group is mandated by the Financial
Services Authority in order for ICE Futures Europe to maintain its
status as a Recognised Investment Exchange and a self regulatory
organization. ICE Futures Europe has approximately seventy full-time
employees, all of whom are based in the United Kingdom.
Our Role
Our role as a Recognised Investment Exchange is to provide a fair
and orderly market in which the interaction of market participants is
allowed to determine prices. We strive to be strictly neutral and
independent. Our role is neither to be on the side of the producer nor
the consumer; we are dedicated to ensuring that price formation is
fair.
A Fair and Orderly Market
Being a fair and orderly market means operating within a framework
laid down by law and regulation. The ultimate decision-making body of
the Exchange is its board of directors. The rule-making functions are
fulfilled by the Authorization, Rules and Conduct Committee under
delegation from the board. Changes of significance are brought back to
the board for approval. There is an independent disciplinary framework
which is followed in circumstances where the Exchange pursues
disciplinary action against members.
The ICE electronic trading platform has sophisticated audit
facilities which allow it to record extensive information about every
trade on the platform. Compliance staff monitors trading patterns and
price movements to identify circumstances which warrant further
investigation. They seek to identify improper conduct, and in
particular, any attempt to manipulate the market.
As well as receiving information about transactions, the Exchange
also receives information about any large positions held by members,
including details of the customer(s) responsible for such positions.
While ICE Futures does not presently impose formal position limits (but
recently has agreed to do so with respect to its WTI contract at the
request of the CFTC), the Exchange receives daily reports from all
members who hold large positions in the front 2 months of any contract
detailing who is responsible for holding such positions. The Exchange
has the regulatory authority to require that members reduce positions
in any contract if they judge them to be unduly large, and has the
power to compulsorily close out positions.
There is a particular focus on physically-delivered contracts--in
particular the Gas Oil contract--where it is possible for delivery
squeezes to occur, for example by a single participant obtaining
control of most of the oil due for delivery in a particular month. In
financially-settled contracts such as WTI this risk of a squeeze or a
``corner'' does not exist in the same way because physical delivery
does not occur.
The Exchange has the power to bring disciplinary proceedings
against its members. Where an investigation identifies issues beyond
its direct control, the Exchange will notify the Financial Services
Authority and, if appropriate, relevant overseas regulators such as the
CFTC.
Cooperation With the CFTC
As noted above, the ICE WTI contract is financially-settled, which
narrows the area of risk in comparison with a physically-delivered
contract. Nonetheless it is clearly important that the CFTC has the
opportunity to have an overview of the market to ensure that there is
no activity across NYMEX and ICE that might be construed as price
manipulation or market abuse. In November 2006, ICE Futures Europe,
through the Memorandum of Understanding between the FSA and the CFTC,
began providing trader position data on WTI for the prompt 2 months. On
29 May 2008, we agreed with the CFTC and FSA on an extension of this
information sharing to encompass position information across the entire
expiry horizon, on a daily basis. Portions of this agreement have
already been instituted--the CFTC already receives an analysis of
positions in the WTI contract on a member by member basis for every
contract month. Full implementation of the expanded information sharing
agreement is due in the near term.
Furthermore, on 17 June 2008, the CFTC announced an amendment of
the conditions under which the Exchange is permitted to operate through
direct screen based access in the United States. In addition to
formalizing the information sharing arrangements announced in May, the
amended letter conditions direct screen access on ICE Futures Europe's
adoption of equivalent U.S. position limits and accountability levels
on the ICE WTI Crude Oil futures contract. The Exchange will follow
similar U.S. hedge exemption requirements and will report violations of
any position limits to the CFTC. In addition, ICE Futures Europe will
provide data identifying commercial and noncommercial participants that
will allow the CFTC to incorporate the ICE Futures WTI contract into
the CFTC's Commitments of Traders report, its weekly report on the
level of commercial and speculative activity in a given market.
The revised Commission staff foreign access conditions must be
satisfied by ICE Futures Europe within 120 days. Rule changes to
implement the program are subject to the approval of the UK Financial
Services Authority.
Rising Oil Prices
Oil prices are at historically high levels. The cause of these
price increases are complex and much has been written about them,
particularly in recent weeks. Many commentators have asserted that the
bulk of the recent increase in oil prices is related to depreciation in
the value of the dollar and supply and demand fundamentals.
In a report published earlier this month, the International Energy
Agency said, ``supply growth so far this year has been poor and higher
prices are needed to choke off demand to balance the market.'' It went
on to say that abnormally high prices are largely explained by the
fundamentals.
Jeffrey Harris, the Chief Economist of the CFTC said in a recent
Senate testimony that he did not see any evidence that the growth of
speculation in oil has caused the price to rise. Rising prices might
have stimulated the growing investment rather than the other way round,
Harris noted. In the oil futures market, investment can flow in without
driving up the price because the speculators are not buying actual
crude to be able to hold onto it or keep it off the market. These
contracts are either traded out of prior to expiration or, in the case
of a financially settled contract, held to expiry with an exchange of
cash flows between the buyer and seller in connection with the open
contract. Trading in futures contracts allow market participants to
take a view on future price direction, but the number of views being
expressed through this trading does not affect the amount of oil
available to be consumed in the marketplace.
Some have asserted that the primary cause of recent oil price rises
is speculation. ``Speculation'', however, needs to be distinguished
from manipulation, which is to deceive investors by controlling or
artificially affecting a market. A central role of a regulated
marketplace such as ours is to take steps to prevent and detect such
manipulation.
We prefer the term ``financial participation'' to ``speculation''.
Such participation helps to increase liquidity, which makes it easier
for market participants to get in and out of positions at a given
price, and, in fact, makes it more difficult for any individual
participant to manipulate the market by creating an artificial price.
Financial participants are the counterparties to the commercial
entities who hedge their production or consumption. Such participants
can take either `long' or `short' positions depending on their
expectations of the way in which prices will change.
Recent Oil Price Movements
The increase in oil prices has been particularly marked since
January 2007, when oil prices stood at $58 per barrel. During the
period from 2000 to 2007 we had seen a steady upward movement in oil
prices, but over the past 6 months in particular we have seen a
breakout from those price levels. Importantly, during this time, the
dollar has been significantly devalued, supplies have decreased, and
demand has remained constant or even grown by many accounts.
Some have asserted that the change in WTI prices since the
beginning of 2007 has been driven by speculative traders building large
positions in the ICE WTI contract. The facts, however, indicate
otherwise as ICE Futures Europe's share of global WTI open interest has
declined from about 20% to 15% over that same period. Furthermore, the
total WTI open interest, on both the Nymex and ICE contracts has not
increased materially over the past year, and indeed is significantly
lower than its peak levels.
Margin Levels
One proposal currently under consideration is to require the CFTC
to substantially increase the margin requirement on crude oil futures
trades. It is the responsibility of a futures market to be a neutral
venue for the setting of prices. Margins are required by clearing
houses for the purpose of ensuring that they have adequate security in
the event of the default of a market member. Margins are used by a
clearing house to manage risk and should be set on the basis of the
needs of risk management and of risk management alone. The level of
margin is calculated by clearing houses on the basis of calculations
carried out in accordance with a proven margining methodology such as
SPAN--an approach which was developed by the Chicago Mercantile
Exchange and is also used by Nymex and LCH.Clearnet and will be used by
ICE Clear Europe. Changes in margin levels tend to be driven by changes
in price levels and levels of volatility.
Artificially increasing margin levels on regulated futures markets
would drive business either to futures markets in other jurisdictions
where there are no such constraints, or to off-exchange OTC
marketplaces where clearing is not available. Moving business away from
cleared markets is precisely the opposite of what should be done at a
time of highly volatile prices and systemic financial risk. Clearing
provides a valuable function in the mitigation of financial risk and
has been a tried and tested source of risk mitigation at a difficult
time for financial markets.
Even if margins were to be increased it is not clear that such
increases would reduce price levels. Such steps could actually drive up
prices, particularly in circumstances where commercial participants
found it more difficult to meet higher margins than financial
participants, or where financial participants with short positions were
forced to buy them back.
Margin levels have in fact been increasing over recent months.
Margin levels today are over 3.5 times margin levels at the start of
2007. They have been set at those levels because of the higher
volatility that we have seen in oil markets. We have not seen evidence
that this increase in margins has reduced prices.
recognizing the benefits of regulatory cooperation and mutual
recognition.\2\&CFTC Release: 5252&06 issued October 31, 2006.
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The basis of this approach is that markets, particularly oil
markets, are global. Participants are based all over the world and
cooperation between regulators is crucial in this context. The concept
that each exchange be subject to the jurisdiction of one primary
regulator has avoided duplication and conflicting regulations that
would have made it unduly burdensome and expensive for participants to
conduct their trading activities within the current arrangements. Other
regulators with an interest in the activities of the exchange can
exercise secondary oversight and jurisdiction through consents to
jurisdiction, and through information sharing with the correspondent
regulator.
ICE Futures Europe has cooperated fully with the CFTC and will
continue to do so. As well as supplying position information on a
regular basis ICE has provided extensive transaction information to
CFTC to assist in investigations. We share the CFTC's desire to see
that markets are fair, orderly and free of manipulation.
Conclusion
We recognize the severe impact of high crude oil prices on the U.S.
economy and understand the Congressional desire to ``leave no stone
unturned.'' However, with a 15% share of global WTI futures and options
open interest; we feel it is highly unlikely that our WTI contract is
the primary driver of WTI prices. This ``inconvenient truth'' clearly
contradicts any notion of a ``London loophole''.
Our view, Mr Chairman, is therefore that the current regulatory
regime works well, and that greater regulation is not the answer. The
priority for regulators in our increasingly interconnected world should
be increasing cooperation with their counterparts in other countries.
This is best promoted and developed by the establishment of
international best practices in the context of a framework of
regulatory mutual recognition. This is a framework in which the CFTC
and the FSA take a leading role, and one which they should seek further
to build upon in the future.
The Chairman. Thank you.
Now Mr. Ramm.
STATEMENT OF GERRY RAMM, SENIOR EXECUTIVE, INLAND OIL COMPANY,
EPHRATA, WA; ON BEHALF OF PETROLEUM MARKETERS ASSOCIATION OF
AMERICA; NEW ENGLAND FUEL INSTITUTE
Mr. Ramm. Mr. Chairman and Members of the Committee, I
appreciate the opportunity to provide some insight on this
extreme energy crisis that could well cost human lives this
winter. I am an officer with Petroleum Marketers Association of
America. I represent real businesses delivering gas and diesel
to real people.
PMA has communicated for the past 3 years on the urgency
and has specifically testified before Congress seven times on
the grave need to address this issue. Before I address the
foreign boards of trade issue, PMA recommends that Congress
acts immediately to end excessive speculation in the energy
commodities market, and if strong legislative action cannot be
executed now, that the CFTC needs to exercise its emergency
authority. Specifically CFTC must respond and suspend
speculative long positions for noncommercial traders until this
market returns to functional behavior.
Just yesterday the price of heating oil on the futures
market went up 16 cents. In my home State of Washington, diesel
moved up as much as 17 cents a gallon, with no supply
disruption and no event that should have caused that pricing.
Excessive speculation on the energy trading facilities is
the fuel that is driving the runaway train in crude oil prices,
which has dragged every petroleum refined product up with it.
Recently several Big Oil executives testified before
Congress that oil should be about half the price that it is
today. Our marketers are facing a crisis due to the dramatic
run-up of gasoline, diesel and heating oil, and have lost faith
in the ability to hedge for the benefit of our customers. For
that reason, PMA has implemented a Stop Oil Speculators
Campaign which will be showing up at all the gas stations and
convenience stores throughout this nation.
First and foremost, there must be full market transparency.
Over the last 8 years, energy commodities have been exempt from
Federal oversight due to a series of legal and administrative
loopholes. This has led to excessive speculation being driven
on exchanges that are not fully transparent and accountable to
U.S. rules of law.
Certain boards of trade that are operating here in the
United States are virtually exempts from CFTC regulation.
Because these are unregulated trades, there is no record. These
trades, if they were manipulative in nature, it would increase
the cost of the American consumer, and it would increase the
cost of the commodities sold. Such trading would leave no
public data, and there would be no fingerprints. Why would the
CFTC not want to exercise its authority over the trading
platforms that are operating within the United States and
trading U.S.-delivered commodities?
In response to the comment the traders will simply move
overseas, 20 percent of the world consumption takes place here
in the U.S., and foreign boards of trade need access to U.S.
markets, as evidenced by the fact that they have sought No
Action letters issued by the CFTC.
PMA supports efforts to increase domestic supply. They
support alternative fuels and conservation that will help ease
prices in the long term; however, time is running out. Our
businesses are at risk, and our consumers are hurting. Congress
and the President must rein in excessive speculation which is
driving gasoline and heating oil prices to the levels that
aren't justified by simple fundamentals of supply and demand.
Again, until Congress can get a handle on the commodity
markets, the Petroleum Marketers Association of America
recommends that Congress acts immediately to end excessive
speculation in the energy commodity markets. And if strong
legislative action cannot be executed now, specifically CFTC
should--must suspend speculative long positions for
noncommercial traders until the markets return to functional
behavior.
If Congress does not take immediate action to close all the
loopholes and apply aggregate position limits on controlled
entities set by commercial hedgers and imposed by the CFTC,
some people will not be able to heat their homes this winter
and may freeze to death. Some people will lose their jobs
because they can't afford to drive to their jobs. And Congress
will not be able to say that they were not warned of this
impending problem.
PMA strongly supports the free exchange of commodities on
an open, fair, regulated, transparent market. PMA also supports
consumers' need to fuel their cars, to buy food and heat their
homes. Reliable futures markets are crucial to the entire
petroleum industry and to consumers. Let's make sure that these
markets are competitively driven by supply and demand.
We want to thank you for the opportunity to speak to you
today, and I would answer any questions that you may have.
[The prepared statement of Mr. Ramm follows:]
Prepared Statement of Gerry Ramm, Senior Executive, Inland Oil Company,
Ephrata, WA; on Behalf of Petroleum Marketers Association of America;
New England Fuel Institute
Honorable Chairman Peterson and Ranking Member Goodlatte and
distinguished Members of the Committee, thank you for the invitation to
testify before you today. I appreciate the opportunity to provide some
insight on the extreme volatility and record setting prices seen in
recent months on the energy commodity markets.
I am an officer on the Petroleum Marketers Association of America's
(PMAA) Executive Committee. PMAA is a national federation of 46 state
and regional associations representing over 8,000 independent fuel
marketers that collectively account for approximately half of the
gasoline and nearly all of the distillate fuel consumed by motor
vehicles and heating equipment in the United States. I also work for
Inland Oil Company in Ephrata, Washington. Today we operate seven gas
stations and convenience stores and we also supply fuel to eight
independent dealers. Also, supporting my testimony here today is the
New England Fuel Institute who represents over 1,000 heating fuel
dealers in the New England area.
The Competitiveness of the Retail Motor Fuel and Heating Fuels Industry
The state of the petroleum marketing and the retail gasoline
industries are in their most critical environment ever. Last year,
gasoline and heating oil retailers saw profit margins from fuel sales
fall to their lowest point in decades as oil prices surged. The retail
motor fuels industry is one of the most competitive industries in the
marketplace, which is dominated by small, independent businesses.
Retail station owners offer the lowest price for motor fuels to remain
competitive, so that they generate enough customer traffic inside the
store where station owners can make a modest profit by offering
beverage and snack items. For instance, even as gasoline wholesale
prices rise with each jump in crude oil prices, station operators are
reluctant to be first on their corner to go up a penny because every
station's prices are posted on huge signs. To highlight the
competitiveness of the retail gasoline station industry, one does not
need to look any further than to the recent ExxonMobil Corp.
announcement which said that it plans to sell its remaining company-
owned gas stations due to falling profit margins and significant
competitive growth in the industry.
Because petroleum marketers and station owners must pay for the
inventory they sell, their lines of credit are approaching their limit
due to the high costs of gasoline, heating oil and diesel. Due to high
gas prices, marketers are having a hard time paying invoices before the
due date which causes a significant strain on cash flow. Furthermore,
credit card interchange fees are now the second biggest expense item on
a marketers' profit margin which collect anywhere from 8 cents to
10 cents per gallon. Couple all of this with banks who are less
amenable to lend money, marketers are now wondering how they are going
to stay in business. I have heard from marketers' across the country
that the dealers they supply are having to borrow against equity in
their business to keep operating. If gas prices continue to rise, these
dealers may eventually go out of business.
Below is from a petroleum marketer that shared his story on how
high gas prices are affecting his business.
``Our jobbership (petroleum marketer business) has been around
since 1926. A couple of years ago we had about 25 dealers and
were running 11 convenience stores. The high prices caused our
carrying costs and financial requirements for accounts
receivable and inventory to go up dramatically. The high cost
has also caused our credit card fees to soar. Suppliers are
unwilling to up credit lines with the instability in the
industry. I have had to sell four of my convenience stores just
to try and stay afloat. I am attempting to sell three more and
will let the lease run out on two more. I have cut my staff to
the bones. Three of my dealers have closed operations and I
don't expect them to be the last.''
From a petroleum marketer in Arkansas:
``If we didn't have a Line of Credit at the bank we would be
out of business. The Line of Credit costs my company
approximately $8,000 per month. This also limits the growth of
our company because we don't have the capital for new projects.
Another problem is that our smaller `Mom & Pop' country
convenience stores simply don't have the money to operate under
these conditions. They have charge accounts and when their
customer pays them late then our payment is delayed as well.
Smaller farm deliveries are also taking a toll on our industry.
The farmers and ranchers can't afford the high diesel prices so
instead of filling their 500 gallon tank they only order 200
gallons.''
Stories like these above are very common right now. Something must
be done to curb energy costs. PMAA, along with several other trade
associations, have come to the conclusion that excessive speculation is
behind the recent run-up in prices.
Excessive Speculation Is Driving Energy Costs
Excessive speculation on energy trading facilities is the fuel that
is driving this runaway train in crude oil prices. The rise in crude
oil prices in recent weeks, which reached $145.85 on July 3, 2008, has
dragged with it every single refined petroleum product. According to
the Department of Energy, the cost of crude accounts for roughly 75
percent of the pump price, up from 62 percent in January of 2008.\1\
Wholesale heating oil prices from March 5, 2008&July 1, 2008 have risen
from $2.97 to $3.92.\2\ The spike comes despite it being summer in the
Northeast. The data doesn't add up.
---------------------------------------------------------------------------
\1\&Energy Information Administration, ``Gasoline and Diesel Fuel
Update,'' May 2008.
\2\&Energy Information Administration, ``U.S. No. 2 Heating Oil
Wholesale/Resale Prices,'' March 5&July 1, 2008.
---------------------------------------------------------------------------
According to a 2006 Senate Permanent Subcommittee on Investigations
bipartisan report by Chairman Carl Levin (D&MI) and Ranking Member Norm
Coleman (R&MN) entitled, The Role of Market Speculation in Rising Oil
and Gas Prices: A Need to Put the Cop Back on the Beat, ``Several
analysts have estimated that speculative purchases of oil futures have
added as much as $20&$25 per barrel to the current price of crude oil,
thereby pushing up the price of oil from $50 to approximately $70 per
barrel.'' Who would have thought that crude oil futures would rise to
over $145 a barrel?
Commodity futures exchanges were predominately created for oil
producers and consumers to offset price risk by entering into a futures
contract for future delivery. Over the years, PMAA members have noticed
a disconnect between commodity prices and supply and demand
fundamentals. For instance, Colonial Pipeline had 150,000 barrels of
surplus heating oil available for auction on May 7. On that same day
heating oil futures on the NYMEX settled at another record-high with
its June contract closed with a 9.3ct gain at $3.38/gal with New
England temperatures averaging in the high 70s. PMAA has lost faith in
the ability to hedge for the benefit of their customers.
There Must Be Full Market Transparency and Accountability
U.S. destined crude oil contracts could be trading DAILY at a rate
that is multiple times the rate of annual consumption, and U.S.
destined heating oil contracts could be trading daily multiple times
the rate of annual consumption. Imagine the impact on the housing
market if every single house was bought and sold multiple times every
day. An October 2007 Government Accountability Office report, Trends in
Energy Derivatives Markets Raise Questions about CFTC's Oversight,
determined that futures market speculation could have an upward effect
on prices; however, it was hard to quantify the exact totals due to
lack of transparency and record-keeping by the CFTC.
To be able to accurately ``add up'' all of the numbers, you must
have full market transparency. This is perhaps the biggest barrier to
obtaining an accurate percentage calculation of the per barrel cost of
noncommercial speculative investment in crude oil, natural gas and
other energy products. Much of the noncommercial (i.e., speculators
that have no direct contact with the physical commodity) involvement in
the commodities markets is isolated to the over-the-counter markets and
foreign boards of trade, which, due to a series of legal and
administrative loopholes, are virtually opaque.
PMAA would like to thank Congress for passing the farm bill (H.R.
2419), specifically, Title XIII, which will bring some transparency to
over-the-counter markets. However, the farm bill is only a first step.
Closing the Administrative Foreign Board of Trade Loophole
What the farm bill language does not do is repeal a letter of ``no
action'' issued by the CFTC to the London based International Petroleum
Exchange (IPE) which was subsequently purchased by the
IntercontinentalExchange (ICE). The letter of no action was issued
since the IPE was regulated by the United Kingdom's Financial Services
Authority (FSA), which theoretically exercised comparable oversight of
the IPE as CFTC did to NYMEX. Recently, however, whether or not the FSA
exercises ``comparable oversight'' was brought into question by CFTC
Commissioner Bart Chilton. Congress needs to investigate whether or not
oversight by foreign regulators is ``comparable.'' Currently, FSA
doesn't monitor daily trading to prevent manipulation, publish daily
trading information, or impose and enforce position limits that prevent
excessive speculation.
ICE is the exchange most often utilized by those who exploit the
Enron Loophole. ICE is a publicly traded exchange whose shareholders
are primarily investment funds. In recent years ICE's trading volume
has exploded at the expense of the regulated NYMEX. According to the
Securities and Exchange Commission filings, traders on ICE made bets on
oil with a total paper value of $8 trillion in 2007, up from $1.7
trillion in 2005.\3\ ICE purchased IPE and will continue to claim
exemptions on various contracts whether or not the Farm bill becomes
law since they effectively have a ``get out of jail free card.''
---------------------------------------------------------------------------
\3\&Herbst, Moira; Speculation--but Not Manipulation: Financial
News, Business Week, May 30, 2008.
---------------------------------------------------------------------------
While PMAA applauds the recent CFTC announcement that it will
expand information sharing with the U.K.'s Financial Services Authority
and ICE Futures Europe to obtain large trader positions in the West
Texas Intermediate crude oil contract, more needs to be done to prevent
and deter market excessive speculation and manipulation on all foreign
boards of trade.
PMAA urges Congress to close the administrative Foreign Boards of
Trade Loophole via review or elimination of CFTC ``No Action letters''
to overseas energy trading platforms. PMAA supports any legislative
remedy that would ensure that all off-shore exchanges be subject to the
same level of oversight and regulation as domestic exchanges such as
the NYMEX when those exchanges allow U.S. access to their platforms,
trade U.S. destined commodities, or are owned and operated by U.S.
based companies.
Institutional Investor Influence on Energy Commodity Prices
I also would like to discuss the influence institutional investors
have on commodity markets. Last month, Michael Masters, Managing Member
and Portfolio Manager of Masters Capital Management, LLC, a hedge fund,
argued before the Senate Committee on Homeland Security and Government
Affairs that institutional investors are the cause of the recent run-up
in commodity prices. Institutional investors are buying all the
commodity contracts (going long), especially energy commodities, and
are not selling, thereby causing the demand for contracts to increase
and putting further pressure on commodity prices.
The institutional investment ``buy and hold'' strategy has further
inflated crude oil price because index speculators do not trade based
on the underlying supply and demand fundamentals of the individual
physical commodities. When institutional investors buy an initial
futures contract, that demand drives up the price. This has the same
effect as the additional demand for contracts for delivery of a
physical barrel today which drives up the price for oil on the spot
market. Thus, this ``buy and hold'' strategy distorts the futures
markets price discovery function.
Institutional investors are not traditional speculators who profit
when prices go up or down. Institutional investor's ``buy and hold''
strategy only profit when prices continue to rise which can have
serious consequences. Because the speculation bubble might soon burst,
pension funds and endowment funds will likely suffer the greatest
losses because they are notoriously slow to react to quickly changing
market conditions. When the market corrects, hedge funds will quickly
reduce holdings and cut their losses.
Masters also stated that since commodities futures markets are much
smaller than equity markets, billions invested into commodity markets
will have a far greater impact on commodity prices than billions of
dollars invested in equity markets. Masters testified that while some
economists point to China's demand for crude oil as the cause for the
recent rise in energy costs, he disclaims that assumption. In fact,
Masters' testimony highlights a Department of Energy report that annual
Chinese demand for petroleum has increased over the last 5 years by 920
million barrels. Yet, over the same 5 year period, index speculators'
demand for petroleum futures has increased by 848 million barrels, thus
the increase in demand from institutional investors is almost equal to
the increase in demand from China! Wouldn't this demand by
institutional investors have some effect on prices?
The Weak Dollar Can Not Explain the Recent Run-Up in Energy Costs
Also, many economists and financial analysts report that the weak
dollar has put pressure on crude oil prices. While the weak dollar
explanation is partly true because crude oil is denominated in dollars
which reduces the price of oil exports for producers, leading them to
seek higher prices to make up for the loss, this does not justify crude
oil's move beyond $145 a barrel. On May 1, 2008, the front month NYMEX
WTI crude oil contract closed just under $113 per barrel. Three weeks
later the same front month NYMEX WTI contract was trading at over $132
per barrel. In that same period of time the dollar traded between $1.50
to $1.60 against the Euro. While the Euro strengthened against the
dollar, it doesn't justify that crude oil should have increased $19.
There were no significant supply disruptions during this time period.
While the depreciation of the dollar and geopolitical risk have put
pressure on energy prices, PMAA believes these factors do not justify
the drastic run-up in crude oil prices over the last few months.
Congress and the Administration have a responsibility to ensure that
commodity futures exchanges are fully transparent and accountable to
the rules of law.
PMAA urges both Congress and the President to consider the
following:
1. Closing the Administrative Foreign Boards of Trade Loophole via
review or elimination of CFTC ``No Action letters'' to overseas
energy trading platforms. PMAA supports any legislative remedy
that would ensure that all off-shore exchanges be subject to
the same level of oversight and regulation as domestic
exchanges such as the NYMEX when those exchanges allow U.S.
access to their platforms, trade U.S. destined commodities, or
are owned and operated by U.S. based companies.
2. Raising margin requirements (or necessary collateral) for
noncommercial entities or so-called ``non-physical players,''
i.e., commodities traders and investors that do not have the
ability to take physical possession of the commodity, or
otherwise incurs risk (including price risk) associated with
the commodity either in connection with their business or that
of a client. In other words, anyone who does not meet the
definition of ``eligible commercial entity'' under 7 U.S.C.
&1a(11). Currently, margin requirements in futures trading are
as low as three percent for some contracts. To buy U.S.
equities, margin requirements are a minimum of 50 percent.
3. Requiring noncommercial traders (e.g., financial institutions,
insurance companies, commodity pools) to have the ability to
take physical delivery of at least some of the product. (Rep.
John Larson (D&CT) has introduced legislation H.R. 6264 that
would require anyone trading oil to have the capacity to take
physical delivery of the product).
4. Banning from the market any participant that does not have the
ability to take direct physical possession of a commodity, is
not trading in order to manage risk associated with the
commodity, or is not a risk management or hedging service
(again, anyone that does not meet the statutory definition of
``commercial entity'' under 7 U.S.C. &1a(11).
5. Significantly increase funding for the CFTC. The FY 2009
President's budget recommendation is for $130 million. While
this is an increase from previous years, CFTC staff has
declined by 12 percent since the commission was established in
1976; yet total contract volume has increased over 8,000
percent. Congress should appropriate sufficient funding to keep
up with the ever changing environment of energy derivatives
markets.
We and our customers need our public officials, including those in
Congress and on the CFTC, to take a stand against excessive speculation
that artificially inflates energy prices. PMAA strongly supports the
free exchange of commodity futures on open, well regulated and
transparent exchanges that are subject to the rule of laws and
accountability. Many PMAA members rely on these markets to hedge
product for the benefit of their business planning and their consumers.
Reliable futures markets are crucial to the entire petroleum industry.
Let's make sure that these markets are competitively driven by supply
and demand.
Thank you again for allowing me the opportunity to testify before
you today.
The Chairman. Thank you very much.
Mr. Greenberger, welcome again.
STATEMENT OF MICHAEL GREENBERGER, J.D., PROFESSOR, UNIVERSITY
OF MARYLAND SCHOOL OF LAW, BALTIMORE, MD
Mr. Greenberger. Thank you, Mr. Chairman and Members of the
Committee.
One of the nice things about this hearing is I have run
into people I haven't seen in well over a decade, including Mr.
Young, with whom I had many happy experiences when I was at the
CFTC. I am a little intimidated by the fact that he teaches a
derivatives course at Georgetown because I don't know whether
you realize this, Mr. Young, but I am trying to encourage the
Chairman to attend one at the University of Maryland. I have
even offered to run the course in Washington to make it easy
for him to attend.
Mr. Young. I think the Chairman could be a guest lecturer
in either of our courses.
Mr. Greenberger. Well, another option is for him to take my
position at the University of Maryland, and I would gladly
chair the Agriculture Committee.
It is a pleasure to be back here today to discuss this
issue. The one thing I do want to say with regard to Mr.
Young's references about excessive speculation is I believe
that excessive speculation is still very much a part of this
statute. As the Chairman knows, I have had my little problems
with the Permanent Subcommittee on Investigations on the Senate
side. At one time when we were all happily working together,
they issued a report in June of 2007, and I would reference
pages 44 to 45 where they did an investigation of the Amaranth
collapse, and they outlined the important role that excessive
speculation plays in the Commodity Futures Modernization Act.
The other thing I would like to say is that I was the evil
genius who wrote the template for the No Action letters that
allowed foreign board trades to come into the country. And I
did so--it was a very controversial position. The Commissioners
could not reach a conclusion about how to--we had a proposed
rule, and they couldn't do a final rule. It was decided to
defer to the staff, and there were many issues. Germany had
gotten in before anybody had thought about it, and they became
the biggest exchange in the world by virtue of having trading
terminals in the United States. You can well imagine that every
other major foreign exchange lined up at my door saying, that
is not fair. They are in, we want to be in.
The Commission realized this is an important issue. We
should have standards, et cetera, et cetera. They couldn't
agree on a rule. So I wrote a template for a No Action letter
with their permission, and that we began to allow exchanges in,
like the International Petroleum Exchange, which the
IntercontinentalExchange purchased and now stands in their
place.
Those No Action letters were clearly contemplated to be for
truly foreign exchanges that were in foreign countries selling
foreign commodities. The fact of the matter is if we allowed
them to sell something like the WTI contract, that No Action
letter would never have been issued. The United States
exchanges would not have allowed that kind of competition
without the same kind of regulation. In fact, in June of 2006,
when the IntercontinentalExchange listed the WTI contract, Dr.
Newsome, was very upset about that. And for a year and a half
he urged the Commission to have--I remember correctly most
recently his testimony on June 2007 before this very same joint
Committee, he wanted to have a level playing field. And he, if
I remember his testimony correctly, because it certainly is
acted out in the very effective ways that he has run NYMEX, he
said, if I can't beat them, I will join them. For example, he
now has an application in to have a London NYMEX. And he has
said in his testimony that he will now apply for a No Action
letter to have London NYMEX come to the United States and
operate the same way the IntercontinentalExchange does.
Now, Dr. Newsome has said to me he is not sure what
contracts he is going to list, and they haven't announced that.
It just shows the evil ways within which this system works,
that a U.S. exchange would go to London and come back through a
No Action letter. Of course, you have the Dubai Mercantile
Exchange having done the same thing, and they have announced
they are going to list the WTI contracts.
In closing, I will say the CFTC, by virtue of its June 17th
letter and its letter to the Dubai Mercantile Exchange a few
days ago, has tightened up considerably the conditions it is
imposing on the ICE, on Dubai and presumably on NYMEX when it
comes back as NYMEX London. I applaud that. I think a lot of
what they have done is consistent with Mr. Etheridge's bill,
which now as I read it would codify what the CFTC has done.
My personal view is that when you have trading terminals in
the United States, trading 30 percent--there are arguments over
what, but a lot of the WTI contract--that that operation should
be regulated by the United States Government. If it causes
duplicative regulation, ICE has been very clever in setting up
subsidiaries. They could set up another subsidiary in the
United States that would be for selling WTI, which would be
regulated by the CFTC.
I think when you have a system that allows this kind of
running to London and coming back here--ICE, as you know, is
run in Atlanta, and the ICE Futures Europe is a wholly owned
subsidiary--I really even think that is irrelevant. The
question, I would say, when you have people like Mr. Ramm here
hanging on by their fingernails, it doesn't look good to have
the U.S. trading terminals in the United States, trading our
WTI product, but being regulated by the United Kingdom. It
doesn't allow real-time emergency authority for the CFTC. It
does not allow for the kind of self-surveillance that we insist
on by our exchanges.
My final point would be Dr. Newsome spent $6\1/2\ million
on self-surveillance and has 40 employees. I am told by many,
and maybe I can stand corrected, that ICE has ten people
surveilling their crude oil thing. And they trade Brent, so
they trade more than that. That is about 47.8 percent of
world's crude oil product, as I understand it, ten surveillance
people. I think if we keep the template we are now operating
under, we lose a lot, but I do say that the CFTC has made
dramatic strides in this regard. Thank you.
[The prepared statement for July 10 and 11 of Mr.
Greenberger is located on page 100.]
The Chairman. Thank you very much, and we thank all of the
panel for that outstanding testimony.
I am going to yield now to the Chairman of the General Farm
Commodities and Risk Management Subcommittee, who has done a
lot of work on this, Mr. Etheridge from North Carolina. And I
am going to unfortunately keep you to 5 minutes.
Mr. Etheridge. I will stick to it, Mr. Chairman.
Let me thank each of you for being here. I will be quick,
and I will ask that you be very succinct in your answers if we
can.
Let me get something on the record, if I may. On Wednesday
we had testimony from some Members who were here stating, ``We
know the Enron loophole for the London market, 64 percent of
the WTI of West Texas Intermediate crude has been traded on
that market.''
Now, has ICE Futures Europe ever controlled 64 percent of
the world's market share of WTI contracts?
Mr. Peniket. We have never had a 64 percent market share.
Mr. Etheridge. If not, what is the highest market share
that ICE has achieved in that market?
Mr. Peniket. Our market share grew from the launch of the
contract in February 2006. I can't remember precisely how high
it was. Last year it was about 30 percent in terms of futures.
Our share now in terms of the open interest on a like-for-like
basis, including futures and options of futures equivalent, is
15 percent, and the market share at the moment is running at
about 25----
Mr. Etheridge. But it is growing?
Mr. Peniket. The market share has declined over the last 3
months because NYMEX has been growing slightly faster than we
have.
Mr. Etheridge. Thank you.
Mr. Ramm, your testimony included several legislative
recommendations. We thank you for that. Many of them weren't
the topic that we are covering today, but I did notice that you
did not advocate elimination of energy over-the-counter
derivatives as Professor Greenberger had talked about or as has
shown up in a couple of the other pieces of legislation. Do
your remember if you used the swap transactions to hedge risk,
or did you use them previously? And does PMA support their
elimination?
Mr. Ramm. We do have members that do hedge in the futures
markets. Whether or not they use the swaps or derivatives, they
usually do that directly through a broker.
Mr. Etheridge. So you do not recommend elimination of
those?
Mr. Ramm. No. What we would recommend is position limits
that are controlled and set by physical hedgers, though.
Mr. Etheridge. Okay. Thank you, sir.
Professor Greenberger, you want ICE Futures Europe to rest
with a designated contract market such as NYMEX. Does it need
to be that everything traded on that exchange, which one of the
bills before us has recommended does, or favor energy
commodities traded on that exchange, which one of the other
bills does, or just every energy commodity delivered to the
United States?
Mr. Greenberger. First of all, I think they would be
eligible to be a designated transaction execution facility.
They wouldn't necessarily, because they don't have retail
customers, as I understand it--they wouldn't have to be a DCM.
They could have a lighter regulation.
I would be happy with bringing their U.S.-delivered or
price-based on U.S.-delivered products under a DTF system. I
know many of the bills want every foreign board of trade to
register whether they trade U.S. or not. Mr. Lukken says there
are 20 of them. I do not go that far. I would just say if you
are a foreign board of trade trading U.S.-delivered products or
based on U.S.-delivered products on U.S. terminals, you should
have some form of registration with the CFTC.
Mr. Etheridge. Through the CFTC.
Mr. Greenberger. Yes. And that would mean, if Mr. Lukken's
figures are right, two out of 18 would have to register for
those products.
Mr. Etheridge. If they don't supply the proper information,
then your recommendation is we talked about that terminal would
be pulled.
Mr. Greenberger. Well, that is what Mr.--it is not Mr.
Lukken, but the staff letters to both ICE and Dubai say if you
don't follow our conditions, we are going to end our No Action
letter and ask--and recommend enforcement to register under our
laws. I mean, they are giving them the option of registering;
they don't necessarily have to pull them.
Mr. Etheridge. Sure.
Let me thank each of you. I will defer other questions. The
one thing that we all are about here, and we want to make good
policy in the end, but it came up to me very starkly several
weeks ago when we had a large operation close that put 800
people out of work. These are real, live bodies. People have
lost their jobs in a tough time. And it wasn't just energy, but
it was a combination of energy tied to a run-up in commodity
prices that were so fast that they could not adjust. And these
are the kinds of things that we want to make good policy.
I think at the same time we want to make sure these markets
are working the way they should work for the producer, for the
consumer and for those who are looking for an opportunity to
invest. I think it is a critical piece.
Thank you, Mr. Chairman. I yield back.
The Chairman. I thank the gentleman.
The gentleman from Texas.
Mr. Conaway. Thank you, Mr. Chairman.
I appreciate the witnesses being here. Don't be discouraged
by the lack of Members. The Agriculture Committee has two CPAs
on it, and we are both here today.
Mr. Peniket, on June 23rd, there was reference in the
London press in reaction to some of the bills that have been
introduced, some retaliation by the London regulators and the
Brits, something referred to as the ``Balls clause'' being
implemented. If you would comment on that as well as being
described as a participant in evil ways; you want to respond to
your regulatory scheme or your self-regulatory scheme that you
have in place? Is it accurate from the description of Mr.
Greenberger?
Mr. Peniket. If I could take the second part of the
question first, we are a recognized investment exchange in the
U.K. We are subject to the Financial Services and Markets Act
and oversight of the FSA. We have our own compliance and market
oversight arrangements.
On a like-for-like basis, in terms of comparison with
NYMEX, I think we would need to do quite a detailed exercise to
work out the exact equivalence in terms of numbers. In terms of
oversight and market supervision staff, we have around 22 or
23. We, of course, have fewer contracts on our market than the
number of contracts traded on the New York Mercantile Exchange.
I think the regulatory regime under the FSA is very similar
to the regime under the CFTC. They are both principle-based
regimes. They both put a lot of emphasis on the responsibility
of the exchange as a regulated body. And the exchange itself
takes power and responsibility as a regulator in terms of
carrying out enforcement actions against its own members and
oversight over its own members. And we have a series of
procedures and oversight mechanisms that are followed on a
regular basis to prevent market manipulation and to detect
market manipulation if it occurs.
In terms of the publicity in the London press over the
Balls clause, the ``Balls clause'' is the Investment Exchanges
and Clearing Houses Act of 2006, which is a piece of
legislation designed to prevent regulatory changes being--
disproportionate regulatory changes being imposed on U.K.
exchanges as a result of regulatory changes overseas. We will
have to notify certain changes in rules that we intend to make
in order to comply with the CFTC's rules to the FSA. We do not
believe that the rule changes that we are going to be notifying
are disproportionate. We think they are entirely reasonable,
and we don't see that that Act should come into play.
Mr. Conaway. The idea of regulating that activity here in
the United States for terminals in the United States, if we
made it so tough mechanically, can all of that trading activity
be moved overseas, conducted somewhere else? Do you have to
have, at the end of the day, a U.S. terminal to actually be
doing what you are doing?
Mr. Peniket. We don't have to have U.S. terminals to do
what we do, but we wish to continue to have terminals in the
U.S.; because the U.S. is an important part of the global crude
oil market. It is not a simple question of establishing a
separate subsidiary or doing something of that kind. We have
open positions on the WTI contracts and our Brent contract
which goes a number of years. They are traded on an U.K.
exchange which has market participants around the world.
It is very important for us to be able to give market
participants certainty in terms of the legal regime and the
contractual regime under which they are trading. It is
therefore very important for us to continue to have the same
regulatory status that we have today tomorrow. And it is not
simply a question of moving contracts from one legal entity to
another.
Mr. Conaway. Mr. Greenberger, in the time that is left, can
Congress go too far with this regulatory reform or change?
Mr. Greenberger. Yes, it can go too far. I would say it
would go too far if it ordered foreign boards of trade
competing with our U.S. product to come under the regulation.
As Mr. Etheridge has said, there seems to be some legislation
to that effect.
My own view is if a foreign board of trade is bringing
terminals in the United States and competing directly with the
U.S. contract markets here, there should be a level playing
field, and they should be regulated the same way.
I believe the IntercontinentalExchange is headquartered in
Atlanta. They have several U.S. subsidiaries, the old New York
Board of Trade, they are over-the-counter markets. I recognize
the problems that Mr. Peniket had said with existing contracts.
I would not object to a grandfather clause or grace period that
would take into account existing contracts.
Mr. Conaway. Thank you, Mr. Chairman.
The Chairman. Thank you.
The gentleman from Pennsylvania.
Mr. Holden. Mr. Young, your written testimony states a
concern that if Congress were to require a foreign board of
trade to register as a U.S. exchange like NYMEX or CME, then
U.S. firms could face liability through customers should the
foreign board of trade fail to comply with the CFTC's
regulations. Could you explain this in a little more detail?
And would this liability exist only if we regulated FBOT, or
does it exist already? And how does this risk compare with the
risk U.S. firms face if the U.S. exchange fails to comply with
the CFTC's regulations?
Mr. Young. That covers a lot of ground. Let me try it this
way. Under the proposals that you are considering, there is a
theme that the foreign boards of trade will have new
obligations to the CFTC. Some of those obligations you just
heard discussed in the context of the No Action letters. Let us
just say there is an obligation on a foreign board of trade to
report daily position information, and instead of reporting
that information daily, the foreign board of trade misses a day
or two, or reports every other day; maybe trading is light, and
that is what they do.
The way some of these proposals work, because the U.S. FCM
executes or is involved in executing or confirming the
execution of a trade on a foreign board of trade, whether it is
for a customer in the United States or sometimes outside the
United States, that FCM can be found to be liable under section
4(a) of the Commodity Exchange Act. We think it would be an
unfair result, and we don't think it is an intended result, to
have the FCM ensure the foreign board of trade's compliance
with the CFTC's requirements. And so we would ask the Committee
to work with us to make sure that there is language crafted to
avoid that result.
Mr. Holden. Thank you, Mr. Chairman.
The Chairman. Thank you.
The gentleman from Georgia.
Mr. Marshall. Thank you, Mr. Chairman.
We have now had hours and hours of testimony concerning the
possible impact of passive law on commodities money in the
futures market. It has been really quite an education for me,
and my thinking has evolved substantially as a result of all of
the testimony that we have received.
I find myself now thinking that it would be appropriate to
suggest possible action that we might take, not that I am able
to compel that by any stretch of the imagination, so that the
industry generally can react and tell us whether or what effect
this will have if we were to do something like that.
These markets, the markets that we regulate, the futures
market, were never intended as devices to permit entities or
individuals to hold commodities. They were originally designed
to assist commercial hedging, and liquidity was added in the
form of speculation in order to assist commercial hedging and
in order to assist price discovery.
It seems to me, based on the testimony we have heard, that
those who say the influx of--possibly long or short really
doesn't matter, I suspect--money that is simply designed to
hold commodity positions is distorting the price discovery
mechanism. Frankly it may well have increased prices in all
commodities, particularly energy recently, in ways that have
hurt all kinds of Americans and damaged the credibility of the
markets.
So if we conclude that that is the case, and we want to
make sure that this money doesn't come into the market in this
form, it seems to me we should do a number of different things.
One, anybody doing business in the United States, whether it is
over-the-counter or unregulated markets, we need to have some
transparency. It doesn't have to be public. The CFTC needs to
have information. We should have reporting and record
maintenance for everybody. And the CFTC's experts can figure
out what kind of reporting is needed in order for the CFTC to
see the markets, not just the regulated markets, but the
unregulated markets as well.
Hedging: Hedge exemptions should only be permitted to hedge
commercial risk, not to lay off any other kind of risk. Laying
off other kinds of risk simply distorts the price discovery
mechanism and lessens the confidence that investors can have in
our markets. Federal position limits should probably be
established for energy markets, for energy commodities, just as
they have been established in ag commodities, and probably
fairly similar. We should be working with industry and experts
trying to figure out what those should be in order to maximize
the likelihood that we have the right kind of liquidity in the
market and the right kind of speculation so that hedging,
commercial hedging, and price discovery works as efficiently as
possible, and there isn't distortion where price discovery is
concerned.
Finally, a number of witnesses have said, ``Yes, that is
great, and that is exactly what you should be doing,'' but it
won't work because people will simply go over-the-counter into
what I refer to as opaque or dark markets and circumvent the
position limits.
It seems to me that we might solve that problem by
providing that it is a felony and violation of Federal law,
punishable up to a certain amount of time in jail, plus fines,
by any device or mechanism to intentionally circumvent position
limits that are established on the exchanges. It seems to me
that we ought to hear from industry and from those who are
advocating that there is a problem here, and we need to fix
this problem before more people are hurt. We need to hear from
both sides whether or not an approach like that would make
sense and what impact it would have.
My sense is that it would diminish, but not eliminate
altogether, the avenues that various investors, pension funds
and others would have in order to take positions in
commodities. It would diminish that. But overall, confidence in
our markets would go up. This would be a healthy move, not an
unhealthy move. And it seems to me, based upon the testimony I
have heard, it is something we should consider.
So we need to have feedback. And if I am way off base in
these suggestions, I need to know it. And obviously my time is
up. You can take this in the form of a question, requesting
comments, but not comments right at the moment.
Mr. Young. Mr. Marshall, would you like a quick response?
Mr. Marshall. No.
The Chairman. Sorry, I was in another discussion.
The gentlelady from South Dakota.
Ms. Herseth Sandlin. Thank you, Mr. Chairman. I don't want
to yield my entire time, but I am very interested in the
witnesses' comments on the very thoughtful suggestions that Mr.
Marshall has put forward in light of the testimony he has heard
over the last couple of days. I have at least one question I
want to pose, so if you could very quickly, those of you who
are interested in commenting on Mr. Marshall's statement.
Mr. Greenberger. Mr. Marshall, I would tell you I think in
10 minutes Senators Lieberman and Collins are introducing
legislation that does much of what you say, would aggregate
speculation limits across all markets. If you are a speculator,
wherever you went, if you are under U.S. jurisdiction or you
are trading in the U.S., you would get a certain amount of
speculation you could do, and you could apply it to any market
you wanted to apply. And I was at a meeting last night on the
Senate side and I think there is a lot of steam behind that,
and I think that bill is very similar to much of what you said.
Mr. Ramm. Congressman Marshall, I think you are spot on on
the fact the commodity markets were not designed for investors.
They were designed for price discovery and risk management for
commercial hedgers, commercial users. And it has completely
gotten blown out of proportion. Speculators have three times
the participants in those markets today. Seven years ago it was
actually just the opposite. So I think you are spot on.
Mr. Peniket. Very quickly, in terms of the CFTC seeing the
market and having an overview of everything that is going on,
absolutely in that the CFTC should have a view of all the
trading that is going on on regulated markets and potentially
beyond that that.
In terms of hedge exemptions to hedge commercial risk, I
think there is a danger around that proposal and also around
too severe position limits of creating circumstances where it
becomes difficult for people to trade on regulated markets, and
trading will move off those markets. And the devil is in the
details of the construction of proposals like that. I feel that
if you have too severe penalties of people circumventing
position limits, that does run a danger that you will
discourage people from trading in the U.S.
Mr. Young. I am a lawyer, not an economist, but I will
venture an opinion, that is a lay opinion, as a result of that.
I am not sure I understand the evidence behind the predicate to
Mr. Marshall's proposals, because what I have heard in the
testimony this week is that at least on NYMEX they have
testified that the so-called passive investors have been net
short this year, which would have tended to drive down the
price if they were moving the price. And as a result, when you
see a price rise in light of that net short activity, I can't
make logical sense out of pointing the finger at them and
saying, that is the problem.
I also think the CME's testimony on this has made some very
good points that should be taken into account, and I find that
important.
Last, I know the CFTC is conducting an investigation and is
looking at more data and more granularity at this point. And
until they finish, I don't really want to speculate about what
the role of speculators has been. I would like to see the data.
Having said that, I think every idea should be considered,
because I know that these are serious times, and I am a little
concerned about one aspect of the proposal, and that is does
this make it harder for hedgers who are looking at a time
horizon of a year or 2 years out to hedge their positions if
you remove some of the liquidity from the market that passive
investors provide?
Ms. Herseth Sandlin. Mr. Ramm, has the PMA endorsed any of
the legislative proposals introduced to date or any specific
provisions in any of those proposals that, based on your
testimony, would help restore the connection between commodity
prices and supply and demand fundamentals?
Mr. Ramm. The portions of the bills presented to us
currently are aggregate position limits set by the commercial
entities that are then enforced by the CFTC. We think that by
the markets getting back to the people that they were designed
for--they talk about liquidity. I don't think a commercial
would want a lack of liquidity. And I think that they would be
able to and be the best people to set those position limits.
So with that, we think that a lot of--by doing that will
take care of a tremendous amount of more of the problems, the
swaps loophole, we think the FBOT loophole. If everybody was
subject to those position limits, then we feel that that would
take care of itself. I think it is time for the commodity
markets to be given back to the people they were designed for.
They weren't designed for Wall Street.
Ms. Herseth Sandlin. Thank you, Mr. Chairman.
The Chairman. Thank you.
The gentlelady from Kansas.
Mrs. Boyda. Thank you very much, Mr. Chairman.
To Mr. Marshall I say, amen. I am glad to hear what you
say. We wake up to news this morning about Fannie and Freddie,
and we have had to have a Bear Stearns bail-out because they
have gotten too big. Fannie and Freddie are so close, it is
frightening the American people.
I will tell you, the American people want us to be very,
very prudent in what we are doing. And I think the reason that
we are having all of these hearings is each one of us
understands that we can overstep. And so I would say to you on
the commodities side, on the market side, that you need to be
working with us, because as--we are representative of the
American people, and the American people are pretty sick and
tired of hearing that the market fundamentals are all intact
and not to worry. So to the extent that you can say, here is
what we can do, you will gain credibility with us, you will
gain credibility with the American people, and, quite honestly,
will come up with a better solution.
I would ask you, again, and to each one of you, Mr.
Greenberger and Mr. Ramm, of the bills that we heard discussed
among the House proposals, which one of those were you most
worried about, came closest to what you all were thinking? Are
you two in agreement by any chance, pretty close?
Mr. Greenberger. I don't know the answer to that. I know I
like Mr. Ramm very much.
Mrs. Boyda. And Mr. Young and Mr.--we all like each other.
Mr. Greenberger. Let me just say there are lots of pieces
of legislation. I would tend to support those that call for the
greatest regulation. And the PUMP Act is one of them, the Van
Hollen-DeLauro bill is another.
But I will say where I am sitting right now, I think there
is a lot of momentum behind the kind of proposals that Mr.
Marshall made, and I think those proposals would have a
tremendous therapeutic effect.
Mrs. Boyda. Help me understand this. Is what Mr. Marshall
saying closest to one of the bills that we heard?
Mr. Greenberger. There are some bills--for example, there
is a bill on the House side that has aggregated speculation
limits, and what that essentially means----
Mrs. Boyda. Which one was that?
Mr. Greenberger. Part of Mr. Stupak's bill. It is a part of
it, it is not the bill. Senator Lieberman and Senator Collins
on the Senate side, this has been a big mission of theirs. They
have held several hearings.
Mr. Marshall. Would the gentlelady yield?
Mrs. Boyda. Sure.
Mr. Marshall. I wasn't talking about aggregate position
limits applying to all markets.
Mr. Greenberger. Okay.
Mr. Marshall. And that consequently--there are two
possibilities here. An aggregate position limits applying to
all markets would be one. Another would be position limits as
it affects the futures markets alone, the regulated markets.
And the advantage of not doing an aggregated position limit
affecting all markets is it leaves the market participants free
to--if people are willing to take the risks, they are big boys,
what have you, in a soft market, that is okay. They just can't
lay that risk that is noncommercial, nonphysical, they can't
lay it off in the futures market, regulated futures market.
Mr. Greenberger. Thank you for the clarification.
Mrs. Boyda. I want to reclaim my time, too. I think we will
come back to it. Are we going to do one round or more?
The Chairman. Well, probably one.
Mrs. Boyda. There were some things that I don't understand.
When you look in 2005, it looked like the annual or the average
world supply daily, these are the figures I have: 84.63 million
barrels a day. That is what we were producing. I think the
actual production capacity is more like 86\1/2\, has been. In
2007, it actually went down a few hundred, so it is not
dramatic. But the fact that it didn't go up is pretty dramatic,
and today it is still right around in that area. And yet we
have seen gas or oil go up from about $37 to close to $150
without any real--the Americans cut back. China, India have
moved forward some, but we haven't seen any big tilt.
One thing we keep saying, this is all about the dollar, and
I definitely am concerned about the weak dollar, don't get my
wrong, but we have seen--in the last 6 months we have seen the
dollar decline by less than eight percent against the Euro, and
yet there is an unexplainable 50 percent increase in the price
of oil.
I am kind of with Mr. Marshall. I was really--if you had
given me a pop quiz and said you had to choose, a few weeks ago
I would have said this is market-driven. The more you look into
it, some of this just doesn't hold. Do you have any comments on
how I can get that straight?
Mr. Young. Well, I don't know that I have a perfect answer,
but I would just suggest the following. If you looked at the
dollar decline over time, so let us say go back 2 years, and
you apply the value of the dollar to the price of crude oil
today, from 2 years ago to today's price, you would have a
lower price by around 20, 25 percent.
Now, Mr. Greenberger--I think, Mike, I have this right--I
think there was some quantification or attempt to quantify what
the so-called speculator premium was in the price today. And I
think you said something like four or five percent yesterday.
Maybe I got that wrong.
Mr. Greenberger. No. What I said yesterday was even if it
was just four or five percent, it shouldn't be----
Mr. Young. That is just to give you an order of magnitude,
it is not that I know these numbers cold. My real point is
unfortunately it is a more complicated issue than it has ever
been before because of the globalization of our marketplace.
Mrs. Boyda. In January we had about $450 million going into
the speculation in a week, and by March it went up to $3.4
billion. That is just in terms of orders of magnitude about
one.
Mr. Young. Did you say in wheat?
Mrs. Boyda. No, no, no. In oil.
Mr. Young. But that speculation was long and short.
Mrs. Boyda. I understand.
Mr. Young. So if it is long and short----
Mrs. Boyda. No, I understand. You have a buyer and a seller
and all of that. I understand.
Mr. Young. It shouldn't have that much of an effect on
price.
Mrs. Boyda. I agree it shouldn't have, but empirical data--
--
Mr. Young. People must think the price is going up, that is
the problem.
Mr. Peniket. I think we are at the stage where the market
is fundamentally readjusting its expectations. I think you had
an interaction between three key things that have happened. We
can all discuss how much the movement in the dollar has had an
impact on the price of oil. Clearly it is a significant factor.
I think there are two other things. First, the supply is
pretty constrained, and demand has not responded to the price
signals that have come to the market in any significant way in
the last 12 months. It may be that that starts to happen now.
The market doesn't expect that to happen.
The other factor is that the market is looking ahead seeing
very strong rates of growth in India and China, extrapolating
that out over the next few years, and expecting the oil prices
are going to move progressively higher. Not as a result of what
is going on in the United States or Europe particularly, but
because of very substantially increasing demand coming out of
Asia. So it does come back to a market view that is being taken
in terms of the expectation about the supply and demand
fundamentals.
Mr. Ramm. One thing, if you lay up the price of the risk of
the dollar off on oil, it distorts the price discovery system
for oil. They are using it as the hedge for the dollar instead
of the oil itself, the commodity itself. That is one of the
problems we have. The currency shouldn't be--the oil commodity
market shouldn't be used as a hedge against the dollar, oil
should be. That wasn't designed to do that.
Mrs. Boyda. I see.
Mr. Ramm. That is what it is being used for.
Mrs. Boyda. I would love to continue, but I yield back.
The Chairman. I thank the gentlelady. Maybe I will jump in
here.
This kind of goes to what I have been wondering about. The
more I hear about this, I think I agree with Mr. Marshall that
there is something going on here. I am not exactly sure what. I
get the sense that a lot of people are trying to have the
futures market regulate something they don't like, which is
these crazy--all these credit swaps and derivatives and all the
other stuff that is been invented out there by all the geniuses
that you guys hire. My question is why aren't we regulating
that stuff? Why did we let these credit swaps destroy the
housing market? Who in the hell was watching the store?
And the more I look into these things, I wonder if we
should even have some of these products. And you know this is
not our jurisdiction. We can't do anything about this if we
wanted to. And like pension money, I don't think it should be
in the commodity market. But we can't control that because we
don't control ERISA.
So people are coming in here wanting us to put all these
parameters on things to try to keep people from doing this
stuff when maybe we ought to be looking at the source of this.
And I think we can have some effect here and maybe we will
have. But I guess I would like any of you that might have any
comments on that, should we be doing some of this stuff? Are we
luring people into things that are going to be a big problem,
blow up in our face and then we get blamed?
Mr. Greenberger. Mr. Chairman, we----
Mr. Young. Mr. Chairman----
Mr. Greenberger. With regard to credit default swaps, I
don't know how that--what the originator of that was. But that
was in the Commodity Futures Modernization Act. Swaps,
financial swaps were deregulated from Federal law and almost
all state law. In fact, the New York Insurance Superintendent
has taken the position, the swap involved is to give the bank a
premium and the bank will guarantee the financial assets. Bear
Stearns never set aside a capital reserve.
The Chairman. Right.
Mr. Greenberger. That was allowed by section 2(g) of the
Commodity Futures----
The Chairman. Well, I understand that. So that created an
opportunity for that market. But there are other Committees,
and there are people in the United States Government that have
the ability to look at these things and decide whether they
make sense or not, right?
Mr. Greenberger. Mr. Chairman, I think a lot of people
think that that is your jurisdiction.
Mr. Young. Mr. Chairman, I would have hated to have been on
The Gong Show with Mr. Greenberger. Let me try to add some
history to this.
Before Congress ever thought about the 2000 Act, there were
swaps. And some of them were called equity swaps. And some of
those swaps, a lot of those swaps were done not in the United
States, they were done overseas because of legal uncertainty in
the United States. And as a result of that, our regulators had
less transparency, less access to information about that
trading activity. The 2000 Act, by creating the very legal
certainty that Mr. Greenberger just attacked, brought those
swaps back to the United States, gave regulators a better
handle on them----
The Chairman. Maybe brought them back but we don't
understand--we don't have enough information to know what is
going on with these things.
Mr. Young. I understand. And that is my second point. And
allowing for well-established time-tested systems like clearing
systems and additional price transparency in those markets that
have made those markets safer. Now, the credit default swap
market is not yet subject to exchange trading. It is not yet
subject to a clearing system. I know that the Chicago
Mercantile Exchange testified this week in favor of doing that.
That seems like a very solid idea based on the history in this
area. But to say that Congress in 2000 somehow allowed the
credit default swap to blossom--market to blossom I think is
just inaccurate.
The Chairman. I understand that. And a lot of people don't
and I agree with you.
Mr. Greenberger. Well, let me just say I don't agree with
that. I am not going to take time.
The Chairman. Well, I know there is a disagreement here.
But my staff tells me that this stuff was going on before 2000.
Mr. Greenberger. In the United States in, the United States
it was going on.
The Chairman. Yes.
Mr. Greenberger. But that was the problem. It wasn't legal
so they deregulated it.
Mr. Young. Well, it was legal. Excuse me. It was legal.
That is not accurate.
The Chairman. Well, bottom line, my concern as Chairman of
this Committee is if this thing blows up, I would rather--I
don't care if it is in a foreign country. They are the ones
that screwed it up, not us. What I want to do is make sure that
whatever we do here, that we don't let something happen on our
watch in this Committee similar to what happened with these
securitized mortgages.
Somebody should have been watching that. There is no way
they should have ever let them sell those things. And the guys
that sold them made a fortune and they are out in the Virgin
Islands having a good time and the government is bailing them
out. And I don't know exactly how much of this is heading for
that kind of a situation. But I don't want it to happen on my
watch. So that is where I am coming from.
Mr. Ramm. Mr. Chairman, I believe that if you apply capital
market fundamentals to the commodity market, you are going to
have trouble. They aren't capital markets.
The Chairman. Well, I understand that. That is what I am
saying. This is not our business. Somebody in the Congress here
should be watching this--in the Energy and Commerce Committee
or the Financial Services Committee that actually have the
jurisdiction over these instruments. We don't. That is my
point, is that this Committee is not--our job is to make sure
that the futures market works properly and that this is not
manipulation. And maybe we do allow some of these things to
develop because of some of these loopholes that we have
allowed, and that is what we are going to look at. But it is
mixed up in more than just what we are doing.
Mr. Ramm. Mr. Chairman, and I hope you would agree that the
commodity markets formed for beginning farmers.
The Chairman. For what?
Mr. Ramm. For farmers.
The Chairman. Yes. I understand.
Mr. Ramm. And for the people that actually touch the
physical commodity.
The Chairman. Right.
Mr. Ramm. And we have to get it back into their hands. Say
if all farmers and all oil producers decide that the markets
are completely gone, these guys don't have a market anymore.
The Chairman. No. And that is the other concern of this
Committee. What is going on in energy, bottom line my biggest
concern is that if we do something here that you know they say,
``Well, we are going to do this with energy, and we are not
going to do it in agriculture, don't worry about it,'' that
this thing is going to morph over to the agriculture market and
screw us up. Because I am not an oil guy. I don't have any oil.
We would love to discover oil in Minnesota, but I don't think
it is going to happen.
Mr. Ramm. You never know.
The Chairman. My concern is that we protect the
agriculture. But I have gone over my time. Who is next? Mr.
Kagen.
Mr. Kagen. Thank you, Mr. Chairman. I appreciate all the
expert testimony here today. And I would like to help everyone
to begin to think a little bit differently. I would like you to
consider that oil might just be, as essential as it is, make
the analogy that it might be the essential medication that
every one of my constituents in northeast Wisconsin requires
just to survive. We do, after all, live in our cars in a rural
area. We live in our cars to go to work, live in our cars to
get to business. The oil distributors need to be able to
purchase the oil at a price they can afford to pay, just as the
consumers, the people I represent, hard-working people in
Wisconsin, have to dig deeper and deeper into their pocket to
pay the $4 plus per gallon for the gasoline just to get to
work.
So if you would begin to think with me that oil is not
really a commodity but an essential pill, it is a medication
that every single person in my district requires. Now who
should be able to buy that pill? If this pill were available
for sale to people that didn't need it, and now somebody in the
ICE Futures or somebody in another country has purchased a
whopping 75 percent of that available medication. Now it is not
available for the people that really need it, what are people
doing buying that medication if they don't have to take it? So
why would we allow people to purchase the oil if they are not
going to use it in their business or use it as a consumer? The
people that are investing and making money or losing money in
these markets are making and losing money on the change in the
price of this product. But at the same time, the people I
represent need it to survive. It gets cold in northern
Wisconsin. People need the energy to put in their car, to fuel
their homes and make sure that they can survive. What are we
going to do when we come to the point where somebody corners
the market for essential heart medication or an asthma
medication like Albuterol? What are the asthmatics going to do
if it is just not available because they cannot afford the
medication they need? It is already happening in health care.
People go to the pharmacy, stand at the counter, see the
medication they need, and they can't afford to buy it. And that
is happening at the gas stations. And it is happening in the
industry of oil delivery of the people I represent.
So I don't know where the solution is going to be on this.
But I do have some questions as to who is messing with the
markets and cornering the market, taking positions in oil,
locking it up in their computer and not making it available at
prices we can afford to pay.
So Mr. Peniket, I have a question for you. What effect
would it have on your business, on the price of oil? And what
effect would it have on the transparency of the markets, the
dynamics of what is going on, if everyone who is purchasing oil
contracts had to take possession of the oil that they buy?
Mr. Peniket. In terms of the business that we do around
crude oil, both of our crude oil contracts, Brent and WTI, are
cash settled contracts. So nobody is buying any oil. They are
transferring risk around the future movements in the price of
oil.
Mr. Kagen. But they are not in the business of buying the
oil for distribution to 1,200 or 1,500 gas stations, are they?
Mr. Peniket. Many of the people who use our marketplace are
in the business of supplying oil or in the business of using
oil and they are hedging price risk as they go forward. People
are coming into the market and taking on some of that risk.
On your point in respect to the hoarding of the commodity,
clearly if there was hoarding of a commodity that would point
to market manipulation. There is no evidence----
Mr. Kagen. Let me interrupt because I only have another
minute and 5 seconds. Why would they be buying a pill if they
didn't intend to take it, if only to mark up the price and they
could profit by acquiring it?
Mr. Peniket. People speculate around future price movements
in order to make a profit.
Mr. Kagen. Well, at some point don't you think it is the
role of government to step in and say, ``Look, you need this
medication and you don't, you don't have the right to keep that
medication from the very patients that require it. You don't
have the right to own the oil that people need to heat their
homes.''
Mr. Peniket. But going back to the role of the futures
market, the role of the futures market is for participants in
the market to manage their price risk. If people are unable to
manage that price risk, then there is going to be no benefits
to the consumer around that. If somebody is hoarding oil, that
is a different question, and that is away from the role of the
oil futures market.
Mr. Kagen. Mr. Ramm, do you have another opinion on this?
Mr. Ramm. Well, I would say that today that the futures
market dictates price and that price--and I think there was an
example of it yesterday. Heating oil went up 16 cents--around
the United States it went up from 15 cents to 16 cents to
17 cents a gallon. That futures price was influenced by
investors' money. It wasn't influenced on that day by any
supply disruption. Maybe something in the news that happened in
Iran, that might happen. But it affected the American consumer
today.
Approximately, 924 trucking companies went out of business
in the first quarter of this year. There is going to be over
that in the second quarter. Our trucking industry is getting
destroyed. People are not going to be able to heat their homes
in northern Wisconsin because they won't be able to afford it.
They are going to have to pick between food and fuel. That is a
terrible thing that is starting to happen.
The price of fuel, the price of crude today does not need
to be at $140 a barrel. It doesn't need to be that high. The
thing that is forcing it to be that high is the price discovery
system that is happening in a dysfunctional futures market. We
need to get something done about this now.
Mr. Kagen. I see my time has elapsed, and I will yield
back.
The Chairman. We thank the panel for their testimony and
call on panel two.
We have Mr. Terrence Duffy, Executive Chairman, CME Group,
Chicago. Mr. Kendell Keith, President of the National Grain and
Feed Association, Washington, D.C. And Mr. John Johnston,
independent trader from Morristown, New Jersey.
Mr. Duffy, when you are ready, you may proceed.
STATEMENT OF TERRENCE A. DUFFY, EXECUTIVE CHAIRMAN, CME GROUP
INC., CHICAGO, IL
Mr. Duffy. Thank you. I am Terrence Duffy, the Executive
Chairman of the Chicago Mercantile Exchange. I want to thank
the Committee for giving this opportunity to present our views.
The CME Group exchanges are a neutral marketplace. They
serve the global risk management needs of our customers,
producers, and processors who rely on price discovery provided
by our competitive markets to make important economic
decisions. We do not profit from higher food or energy prices.
Our Congressionally mandated role is to operate fair markets
that foster price discovery and the hedging of economic risks
in a transparent self-regulated environment overseen by the
CFTC.
My theme today is direct and indisputable. Even if every
economist and every Member of Congress had genuine evidence
that excessive speculation was distorting prices, it would be a
monumental mistake to try to cure that problem by mandating an
arbitrary increase in performance bond, commonly called margin,
above prudent levels.
First, the impact would be more likely to drive prices in
favor of the speculators and counter to the desired outcome.
Second, arbitrarily high performance bond is the equivalent of
a toll or a tax on the use of regulated markets. Its effect
would be to drive trading offshore or into unregulated venues
in clear contravention of the purpose of having well-regulated
markets in this country.
For the record, it is essential to report that we see no
evidence whatsoever that excessive speculation in futures
markets is distorting prices. We renewed our research on this
topic earlier this year when we were inundated with unverified
claims that driving speculators from futures markets will bring
commodity prices, in particular oil, back to some correct lower
level. Fortunately, in addition to our own research findings,
enough time has passed to permit a strong counter from
economists and editorial writers, debunking these false claims.
Nonetheless, legislation has been proposed to mandate
margin increases which would require hedgers and speculators to
increase the level of performance bond required to guarantee
performance of their contractual obligations to the clearing
house.
One bill attempts to limit the increase to speculators who
are not the counterparties to hedgers. The questionable theory
behind this legislation is that the increased cost will drive
speculators out of the futures markets. That prices will
retrench to more comfortable levels because speculators with
long positions are assumed to have caused price escalation in
the first place.
This idea is seriously flawed and reflects a lack of
understanding on the role of margin in futures markets. Given
the critical juncture of policy deliberations, it is imperative
that Congress recognize the falsities behind the demand to use
margin increases to control commodity prices.
First, advocates of arbitrarily raising margins assume that
speculators are all on the wrong side of the market, and this
herd approach to trading has driven prices above their
legitimate equilibrium level. All of the leading academic work
in the field as well as our extensive studies support the
opposite view; namely, that speculators are about equally
divided on both sides of the market.
Second, increasing margins to artificially high levels will
most likely cause a price spike rather than systemically lessen
commodity prices. Moreover, mandated price by direct price
control or by indirect actions distort future production and
cause costly misallocation of resources of production.
Third, the imposition of an artificially high performance
bond is a tax on trading as it raises traders' costs. This has
been repeatedly demonstrated and even more so as markets have
become electronic and available from anywhere around the globe.
Indeed, excessive performance bond levels drives users away
from transparent, regulated U.S. futures markets into opaque,
unregulated over-the-counter markets. And remember, OTC markets
have less liquidity, less price transparency and no public
accounting for traders' positions. This is a net loss to the
Congressionally defined purpose of creating fair, efficient and
well-functioning energy and commodity markets.
Raising the margin to drive speculators on the wrong side
of the market out of the market in a time in upward trending
prices does not work. The speculators who have been wrong have
been collecting the profits on their positions. They are in an
especially strong position to meet any additional margin calls.
Moreover, they are well aware that commercial hedgers on the
short side of the market have been losing money and probably
have been forced to borrow to support their short hedges.
Therefore, they will be pressed to meet increasing margin calls
and forced out of the markets. Furthermore, there is no
evidence that artificially increased performance bonds will
drive well-capitalized index funds or other passive long only
investors to sell, nor is there any evidence that the impact of
any such selling would be beneficial and positive for hedgers
and commercials using the futures market.
Long index traders will not be driven from the market
because they already have a fully collateralized account that
is held on behalf of their clients. By increasing the amount of
those funds that are required to be posted for margin, the
index trader just transfers Treasury bills from one account to
an account accessible to the clearinghouse. There is no cost to
this class of trader.
One of the pending bills attempts to deal with the adverse
impact on hedgers by giving relief to the speculator on the
opposite side of the hedger. There is no such person. Every
hedge transaction invites a chain of speculators as
counterparties over its lifetime. In fact, the counterparty to
every futures contract is a clearinghouse, not any identifiable
speculator. Therefore, this approach will not work.
While the suggestion that margin increases can cure
inflation and reduce the cost of oil by 30 to 40 percent is
understandably seductive on a political level, Congress can ill
afford to make a misstep in this regard. The downside risk of
arbitrarily mandating increased margin for futures is enormous.
Congress' credibility is at risk in adopting simplistic, ill-
conceived responses that are destructive to U.S. futures
markets and those legitimately relying on those markets.
I thank you for your time this morning.
[The prepared statement of Mr. Duffy follows:]
Prepared Statement of Terrence A. Duffy, Executive Chairman, CME Group
Inc., Chicago, IL
I am Terrence Duffy, Executive Chairman of Chicago Mercantile
Exchange Group (``CME Group'' or ``CME'') Thank you, Chairman Peterson
and Ranking Member Goodlatte, for this opportunity to present our
views.
CME Group was formed by the 2007 merger of Chicago Mercantile
Exchange Holdings and CBOT Holdings. CME Group is the parent of CME
Inc. and The Board of Trade of the City of Chicago (the ``CME Group
exchanges''). The CME Group exchanges are neutral market places. They
serve the global risk management needs of our customers, producers and
processors who rely on price discovery provided by our competitive
markets to make important economic decisions. We do not profit from
higher food or energy prices. Our Congressionally mandated role is to
operate fair markets that foster price discovery and the hedging of
economic risks in a transparent, self-regulated environment, overseen
by the CFTC.
The CME Group exchanges offer a comprehensive selection of
benchmark products across all major asset classes, including futures
and options based on interest rates, equity indexes, foreign exchange,
agricultural commodities, energy, and alternative investment products
such as weather and real estate. We also offer order routing, execution
and clearing services to other exchanges.
I. Increased transparency through imposition of reporting requirements
for foreign boards of trade and other platforms is appropriate.
We unequivocally support your efforts to materially improve the
enforcement capabilities and machinery of the CFTC and to do so in a
manner that does not increase the costs of trading on fully regulated
U.S. contract markets. We also are enthusiastic supporters of broadly
expanding the mandatory reporting of energy trading and position
information to the Commission. We share the view of regulators and
legislators most famously expressed by Justice Louis Brandeis:
``Publicity is justly commended as a remedy for social and
industrial diseases. Sunlight is said to be the best of
disinfectants; electric light the most efficient policeman.''
--Justice Louis Brandeis, Other People's Money, and How the
Bankers Use It, 1933.
We believe that disclosure of trading and position information to a
regulator with sufficient resources to analyze and act on unusual or
suspicious activities will deter most potential manipulators and assure
punishment of those foolish enough to attempt a manipulation when all
of their actions are visible to the regulator. This is the philosophy
upon which our internal market regulation has been based and why it has
been so successful.
We also clearly understand that the recent surge in the prices of
many commodities, particularly energy, has inspired Congress to look
for assurance that the only price drivers are legitimate supply and
demand factors. Some who claim expertise or special knowledge have
asserted that the entire price inflation can be laid at the door of
speculators and/or passive index funds that have invested billions in
commodity contracts. The more cautious critics have suggested that
there may be a froth of inflation caused by speculation. Our careful,
up-to-date evaluation of market participants and trading patterns in
the commodities traded at CME and CBOT are to the contrary. We have
placed relevant information on our website, which will permit others to
review our findings to date respecting the impact of speculation on our
markets.
Our economists make convincing arguments that neither speculators
nor index funds are distorting commodity prices. Previous studies have
concluded that speculation has not been responsible for any
significant, persistent volatility in futures markets. Nonetheless, we
are strong proponents of securing all of the relevant information from
all sources and fairly testing the hypothesis and reconfirming previous
academic studies. While we expect that the evidence respecting the
impact of speculation and index trading in energy markets will parallel
the results we have found in our own markets, we agree that there is no
reason to rely entirely on economic theory when the data is or can be
made available. We support the efforts of the CFTC and Congress to
secure this data and to assure that a thorough analysis informs any
subsequent legislative or administrative efforts to deal with
uneconomic price inflation.
Increased reporting on swaps transactions would provide much needed
transparency to these unregulated markets. The CFTC should have access
to this data so that it can make an informed decision that speculation
is not leading to a premium in the price of energy commodities. We
recommend that the reporting requirement not be linked to exchange-
traded transactions so as not to drive business off fully-regulated
exchanges.
II. Position limits on foreign boards of trade listing clones of U.S.
DCM listed contracts.
Position limits are a device to promote liquidation and orderly
delivery in physical contracts. If two markets share the same physical
delivery contract it is consistent to apply a single limit across both
markets. However, we are not aware of a foreign board of trade that
lists a physically deliverable futures contract that is a clone of a
U.S. designated contract market's (DCM) listed contract.
The ICE U.K. market lists a WTI crude oil contract that is traded
and settled based on the settlement prices of the NYMEX WTI contract.
The ordinary reasons for imposing position limits on futures markets do
not apply in such a case. It is possible to imagine a trader who is
long a limit position at NYMEX and double that position at ICE U.K.
That trader might expect to profit, if not caught, by driving up the
settlement price on the final day of trading on NYMEX by standing for
delivery, even though he would be required to store and then sell the
oil back at a loss, in the hope to profit from the settlement on ICE.
Of course, such behavior will be obvious to the regulators and the
markets and the manipulator would neither enjoy the profits nor much
additional freedom. Moreover, the impact on the price of oil would be
transitory.
Setting aside theoretical understanding, we support a temporary
imposition of position limits on the ICE Futures U.K. WTI contract
until the CFTC is able to secure and analyze a more complete data set
respecting the impact of speculation and/or indexed commodity trading
on price inflation. We do not imagine that any harm will be done and
this action will allay concerns.
III. The exemption for commercial markets in energy products, even as
limited by the recent amendment of the CEA, is unnecessary and
creates information gaps.
In the aftermath of the Amaranth controversy, Congress provided
CFTC new authorities in the recently enacted farm bill to regulate
``significant price discovery contracts'' on platforms like ICE by
requiring those platforms to meet certain core principles drawn from
the longer list applicable to fully regulated exchanges. It is clear
that when Congress wants to ensure fair dealing and regulatory
propriety, it uses as its comparative yardstick the regulatory regime
imposed on America's fully regulated exchanges.
Trading that is conducted on fully regulated exchanges is an open
book to which you already have complete access and accountability.
Indeed, CFTC monitors that exchange trading daily and has repeatedly
opined that speculation on those fully regulated exchanges does not
raise regulatory concerns. But that is not the case with the other
forms of energy commodity trading, which lie outside the reach of CFTC
regulation and are far larger in size in terms of trading volume.
Section 5(b) of the Commodity Exchange Act charges the Commission
with a duty to oversee ``a system of effective self-regulation of
trading facilities, clearing systems, market participants and market
professionals'' and ``to deter and prevent price manipulation or any
other disruptions to market integrity; to ensure the financial
integrity of all transactions subject to this chapter and the avoidance
of systemic risk; to protect all market participants from fraudulent or
other abusive sales practices.''
These ``purposes'' and the statutory exemption for Commercial
Markets found in Section 2(h)(3) are in conflict. The key purposes
mandated by Congress in Section 5(b) are jeopardized if trading
facilities for contracts in exempt commodities are permitted to coexist
with regulated futures exchanges that list those same commodities.
Exempt Commercial Markets (ECMs) do not have any system of ``effective
self regulation'' of their facilities or of their market participants.
Their contracts are traded based on the prices of commodities that have
limited supplies and that have often been the subject of manipulative
activity and disruptive market behavior. There is no mechanism in place
``to deter and prevent price manipulation or any other disruptions to
market integrity.'' The Commission cannot track the build up of
dominant positions. At best, the Commission has power to punish such
conduct after the fact. We find this to be a serious problem that is at
odds with Congress' intent behind the CFMA, which, if left unaddressed,
jeopardizes the public's confidence in the CFTC's ability to do its
job.
The Section 2(h)(3) exemption for unregulated commercial markets
should be eliminated. You cannot fix the problem by merely changing
reporting requirements. In order to secure accurate reports, a market
needs an effective surveillance and compliance system. This requires
that an effective system of self regulation must be put in place. The
logical conclusion is you must implement at least the core principles
required of a derivatives transaction execution facility (DTEF) to get
a useful result.
IV. Mandating an arbitrary increase in margin for futures above
prudential levels is counterproductive and potentially
destructive to U.S. futures markets and Congress should reject
calls to do so.
Beginning several weeks ago, there was a strong suggestion that
driving speculators from the markets will bring commodity prices, in
particular oil, back to some ``correct'' level below what exists today.
Worse still, these critics argue for driving speculators from the
market by government-mandated increases in margins. The most prominent
witness before Congressional Committees was a large speculator in
airline and automobile stocks that may have benefited from the
precipitous actions he advocated. Fortunately, enough time has passed
to permit a strong counter-current from economists and editorial
writers debunking those claims.\1\
---------------------------------------------------------------------------
\1\&Attached to our testimony are four noteworthy pieces published
in recent days. (1) ``Oil Speculation.'' Financial Times. Retrieved
July 3, 2008 from www.FT.com.; (2) ``For Love of Speculators.'' Chicago
Tribune. Retrieved July 2, 2008 from www.chicagotribune.com., this
document is copyrighted and available for a fee from The Chicago
Tribune; (3) Nocera, Joe. (June 28, 2008) ``Easy Target, but Not the
Right One.'' New York Times.; (4) Samuelson, Robert J. (July 1, 2008)
``Who's Behind High Prices.'' Washington Post, A11.
---------------------------------------------------------------------------
Nonetheless, legislation has been proposed to mandate margin
increases, which would require hedgers and speculators to increase the
level of performance bonds required to guarantee performance of their
contractual obligations to the clearing house. The theory behind the
legislation is this: increased costs will drive speculators out of the
futures markets and prices will retrench to more comfortable levels,
because speculators with long positions are assumed to have caused
price escalation in the first place. This idea is seriously flawed and
reflects a lack of understanding of the role of margin in futures
markets.
The discussion of margin increases during recent congressional
hearings makes it abundantly clear that many legislators wrongly assume
the concept of margin in futures markets is similar to that in equity
markets. In other words, they think of it as an extension of credit or
a down payment on the cost of a security. However, the notion of
``credit'' has nothing to do with the concept of margin as used in
futures markets. In futures markets, margin is not an extension of
credit. Rather, margin is the equivalent of a performance bond designed
to ensure that contractual obligations are met and that clearing houses
can fulfill their responsibilities. Margins are not intended to create
incentives or disincentives for trading decisions.
In futures markets, margin--aka performance bond--is set at a level
to cover, with a high degree of confidence, any change in the
underlying value of a futures contract during a single day of trading.
It has nothing to do with the notional or face amount of the contract.
For example, performance bond on a $36,700 CBOT corn contract is
currently set at $2,025, while performance bond on a $100,000 thirty
year bond contract is set at $3,510. In each case, the holder of the
contract must make good on his losses and conversely gets credit for
his gains on a daily basis. Our clearing system continuously holds 100
percent collateral for a near worst case loss scenario. The cost of
depositing collateral or cash with the clearing house is considered a
cost of trading.\2\
---------------------------------------------------------------------------
\2\&We have attached hereto an article titled ``SPAN: The First 20
Years'' that succinctly describes CME's Standard Portfolio Analysis
risk methodology for determining margin based on actual volatility
risk, which revolutionized the management of futures and options risk
world-wide and is the industry standard around the world today. Futures
Industry Magazine, pages 32&35 (March/April 2008).
---------------------------------------------------------------------------
Based on our strong track record of zero credit defaults in the 100
plus year history of CME Clearing, we believe our current system for
calculating margin is the most prudent and sound approach to margining.
So do the rest of the world's futures markets, a majority of which
utilize the same concept of margin created by CME Group. Mandating
arbitrary margin levels would not improve the functioning of energy and
commodity futures markets and would interfere with the prudential risk
management practices of central counterparty clearing houses. To urge
Congress to arbitrarily interfere with this well-functioning system of
margin invites substantial risk to the proper functioning of futures
markets. Given the critical juncture of policy deliberations, it is
imperative that Congress recognize the fallacies and misunderstandings
that are prompting calls to meddle artificially with this time-tested
margin concept.
First, advocates of arbitrarily raising margin assume that
speculators are all on the long side of the market and that this herd
approach to trading has driven prices above their legitimate
equilibrium level. All of the leading academic work in the field, as
well as our extensive internal studies, support the opposite view--
namely, that speculators are about equally divided on both sides of the
market.
Second, the imposition of artificially high performance bonds is a
tax on trading as it raises a trader's cost. This has been repeatedly
demonstrated, and ever more so as markets have become electronic and
available from anywhere around the globe. Indeed, excessive performance
bond levels drive users away from transparent, regulated U.S. futures
markets and into opaque, unregulated OTC markets. And remember, the OTC
markets have less liquidity, less price transparency and no public
accounting for traders' positions. This is a net loss to the
Congressionally defined purpose of creating fair, efficient and well-
functioning energy and commodity markets.
Our extensive market regulation experience--and our experience with
previous efforts to control commodity prices by means of adjusting the
level of performance bond--have established the fact that artificially
increasing margins is not effective. Raising margins to drive
speculators on the long side of the market out of the market in a time
of upward trending prices does not work. The speculators who have been
long have been collecting the profits on their positions. They are in
an especially strong position to meet any additional margin call.
Moreover, they are well aware that traders on the short side of the
market have been losing money and probably have been forced to borrow
to support their short hedges. Therefore, they will be pressed to meet
increased margin calls and forced out of the markets.
A North Dakota farmer who sold corn futures at a new high of $5 a
bushel and locked in a $2 per bushel profit needs to be able to carry
his hedge until his crop is harvested. A single contract is 5,000
bushels and margin is now set at $1,000 per contract. Assume the farmer
had sold 100 contracts. Corn was $7 this morning and the farmer has
been forced to go to his bank to borrow $2 \ 5,000 \ 100=$1,000,000 to
continue to carry the position. If margins are artificially raised to
some arbitrary level, the long speculator will be in a very favorable
position knowing that the short hedger is going to have to go to the
bank and borrow millions more to hold his hedge position until his crop
is harvested. The cost to hedgers can be even more drastic when the
country is in the midst of a severe credit crunch.
Moreover, there is no evidence that artificially increasing
performance bonds will drive well-capitalized index funds or other
passive long-only investors to sell. Nor is there evidence that the
impact of any such selling would be beneficial or positive for hedgers
and commercial users of futures markets. Generally, these investors are
not leveraged and are in the best position to margin up to 100 percent.
Long index traders will not be driven from the market, because they
already have a fully collateralized account that is held on behalf of
their clients. By increasing the amount of those funds that are
required to be posted for margin, the index trader just transfers
treasury bills from one account to an account accessible to the
clearing house. There is no cost to this class of trader.
One of the pending bills attempts to deal with the adverse impact
on hedgers by giving relief to the speculator on the opposite side of
the hedger. There is no such person. Every hedge transaction invites a
chain of speculators as counterparties over its lifetime. In fact, the
counterparty to every futures contract is the clearing house, not any
identifiable speculator. This approach will not work.
Though it is tempting to view the current commodity market
situation as unique historically, Congress may find it valuable to
recognize the lessons arising from a period not so long ago when
speculation in agricultural markets raised similar concerns as we are
experiencing today. In a study published in June 2008,\3\ University of
Illinois Professors Sanders, Irwin and Merrin examined the agricultural
markets of 1972 through 1975, the last period with comparable episodes
of structural change marked by all-time high commodity price increases.
The researchers indicated that the commodity environment was influenced
by structural shifts such as oil embargoes, Russian grain imports, and
the collapse of the Bretton Woods fixed exchange rate system. Their
findings have particular relevance to the current situation facing our
nation. Indeed, in the troubled context of the agricultural commodity
markets of 1972&1975, commodity price increases were often blamed on
speculative behavior associated with the tremendous expansion of
futures trading in a wide range of commodities.
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\3\& Sanders, D.R., S.H. Irwin, and R.P. Merrin. ``The Adequacy of
Speculation in Agricultural Futures Markets: Too Much of a Good
Thing?'' Marketing and Outlook Research Report 2008&02, Department of
Agricultural and Consumer Economics, University of Illinois at Urbana--
Champaign, June 2008. [http://www.farmdoc.uiuc.edu/marketing/reports]
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We find the conclusions reached by Sanders et al. to be very useful
with regard to today's hearing:
The complex interplay between these factors and how they impact
price expectations is often difficult to grasp in real-time.
So, much like the mid-1970's, the scapegoat for commodity price
increases seems to have become the speculator. The present
research suggests that current levels of speculation--given
hedging needs--are at historically normal levels. Indeed,
Working's T [an objective index of speculative activity] in
many agricultural futures markets is at levels associated with
`inadequate' speculation in the past. If this is the case, then
policy decisions aimed at curbing speculation may well be
counter-productive in terms of price levels and market
volatility. In particular, these policy initiatives could
severely compromise the ability of futures markets to
accommodate hedgers and facilitate the transfer of risk.
As in the 1972&1975 period, we can certainly understand how
appealing it would be for Members of Congress to believe that
increasing margin is a sure-fire, fast-track way to lower commodity
speculation and in turn lower commodity prices--by perhaps 50 percent
in 30 days. While the allure of this suggestion is understandably
seductive on a political level, Congress can ill afford to make a
misstep in this regard. The downside risk of arbitrarily mandating
increased margin for futures is enormous. Congress's credibility is at
risk in adopting simplistic, ill-conceived responses that are
destructive to U.S. futures markets and those who legitimately rely on
those markets.
V. Speculation is essential to efficient, liquid markets. Congress
should do everything in its power to avoid responses that
threaten the vitality of futures markets.
Current fuel and food prices are shocking and painful to consumers
and the economy. Unfortunately, the pressure to reverse rising prices
has led some to look for a simple, causal agent that can be neutralized
with the stroke of a pen. The favored culprit is the traditional
villain--speculators. But speculators sell when they think prices are
too high and buy when they think prices are too low. They are not a
unified voting block and are on both sides of every market. Speculative
selling and buying send signals to producers and processors that help
keep our economy on an even keel. High futures prices for corn induce
farmers to bring new acreage to market. High forward energy prices
encourage exploration and new technology to capture existing untapped
reserves and foster conservation and other behavioral changes to adjust
demand.
Futures markets perform two essential functions--they create a
venue for price discovery and they permit low-cost hedging of risk.
Futures markets depend on short- and long-term speculators to make
markets and provide liquidity for hedgers. Futures markets could not
operate effectively without speculators, and speculators will not use
futures markets if artificial barriers or tolls impede their access.
Most important, blaming speculators for high prices diverts attention
from the real causes of rising prices and does not contribute to a
solution.
The weight of the evidence and informed opinion confirms that the
high prices are a consequence of normal supply and demand factors. The
Wall Street Journal surveyed a significant cross-section of economists
who agreed that: ``The global surge in food and energy prices is being
driven primarily by fundamental market conditions, rather than an
investment bubble . . . .''&\4\
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\4\&``Bubble Isn't Big Factor in Inflation,'' By Phil Izzo (May 9,
2008; Page A2).
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The traditional production/consumption cycle that has governed
prices in commodity markets is stressed by the confluence of a number
of factors. David Hightower, author of The Hightower Report, summed up
the supply/demand situation in corn last year as follows: ``We have
experienced 3 consecutive years of record corn production and 3
consecutive years of declining ending reserves. Supply has put its best
team on the field and demand keeps winning.''
The headlines that are grabbing the greatest attention these days
derive from the cost of energy commodities primarily traded elsewhere
than CME Group's markets. Nevertheless, a review of our experience in
the agricultural future markets that we do operate illustrates the
predominant roles that non-speculative forces, and particularly the
fundamentals of supply and demand, play in the economic challenges
Americans face today. Based on our expertise in agricultural markets,
we have identified five significant factors that are influencing the
supply and demand for grains and oilseeds:
1. Weather/disease/pestilence.
2. Increasing per capita consumption in the emerging markets.
3. The dramatic impact of the demand for grain and oil seeds as
feed stock for biofuel.
4. Reactionary governmental trade policies.
5. Financial Market turmoil, including a weakened dollar.
These factors combine to create volatile markets and increased
prices.
1. Weather/Disease/Pestilence: This is of course a traditional
factor in the grain markets. Wheat recently attained all-time record
prices, coincident with 60 year lows in world stockpiles. In the past 2
years there have been production shortfalls in Australia, Argentina,
Europe, North America, and the Ukraine due to a combination of drought
in some places, untimely rains in others, and even infestation by the
Eurygaster beetle.
2. Per Capita Consumption in Emerging Markets: Despite that some
projections imply a slowing population growth during this century,
global population is still growing, and from an ever increasing base.
In the short-run, GNP and personal income levels in the large,
emerging-market countries such as India, China, Russia and Brazil are
creating unprecedented per capita demand growth for animal protein.
Commonly in human history, as a society grows richer, its diet expands
to include additional animal protein in the form of meat and dairy.
According to a report on Bloomberg.com, worldwide meat consumption is
forecast to increase by more than half by 2020. Most of the new demand
will come from China. The implications for grain demand will be
staggering. Already in just the past 12 years, China has gone from a
net exporter of soybeans to the world's largest importer of soybeans,
with soybean imports exceeding 30 million tons in 2007. Never before in
history have we witnessed the impact of two billion people asking for a
higher standard of living at the same time.
3. Growth in Biofuels: The mandate to produce biofuels created
additional market stress. The expectation is for continued growth in
biofuel use/demand; politics rather than logic is at work--resulting in
continued demand growth for feed grains and vegetable oils. To
illustrate this point, the 2005 Energy Bill in the United States
spurred the rush to plant approximately 93 million acres of corn in
2007, the highest level since World War II. The USDA recently reported
that corn-based ethanol production will continue to rise, placing
additional demands on the crop: ``driven by continued expansion in
ethanol production capacity, corn use for ethanol is projected at 4.1
billion bushels 2008&2009, up 28 percent from the current year
projection. Ethanol corn will now account for 31 percent of total corn
use, up from a projected 25 percent for 2007&2008.'' The amount of corn
used in ethanol production just 5 years ago was approximately ten
percent. In addition to the U.S. initiative, the EU enacted legislation
that will require significantly increased use of biofuel fuel by 2010.
The problem is that there simply is not enough land to set aside in the
entire EU to meet these ambitious requirements. They will need to
import significantly higher levels of either finished product or higher
levels of oilseeds in order to produce the needed biofuel.
4. Reactionary Government Trade Policies: During the last 3 months,
there has been an ever expanding pattern of increasing export tariffs
and decreasing import tariffs on grains and oilseeds by foreign
governments. Russia extended a grain export tariff from April 30 to
July 1. In addition, Russia has placed an export ban upon its grain to
the four CIS (Commonwealth of Independent States) members designed to
prevent re-export of Russian grain to third countries. Argentina
extended its wheat export closure through April 8, and announced a new,
higher soy export tax that will rise by 7&9 percentage points based
upon current prices. India increased its grain export tariffs while
lowering import tariffs on edible oils. China has announced a further
increase in edible oil imports in 2007&2008 with projections currently
up an additional 14 percent. South Korea announced the emergency
lifting of import tariffs on 70 price-sensitive products, including
wheat and corn in an effort to confront rising inflation. The pattern
we are witnessing is one of keeping domestic production off the global
market while lowering barriers for the acquisition of grains and oils
from the global market. This trend results in increased demand for U.S.
grain and oil seed products.
5. Financial Market Turmoil: The events that began in the subprime
sector of the financial markets are now spreading out with very serious
and negative consequences throughout the nation's banking sector.
Restrictive lending policies are having deleterious effects within our
marketplace. High volatility leads to higher margins, large directional
price moves require significant continuing variation deposits, and all
of this comes at a time when money is difficult to obtain.
The non-speculative factors summarized above all have a material
impact on supply and demand in energy and agricultural commodity
markets. Given these factors, it would be wise for Congress to examine
rigorously any assertions that speculation is driving up prices in food
or energy markets--before enacting any legislation in response.
Policies that are based on factually invalid assumptions of
speculation's role could be disastrous and impose additional, perhaps
even greater, economic dislocation than the current impact of high food
and energy prices themselves.
VI. Participation in commodity markets by index funds, hedge funds and
pension funds.
We strongly oppose any effort to eliminate index funds from
participating in the commodities markets. Index funds may rely on no-
action risk-management exemptions to exceed position limits or they may
enter into OTC transactions with a swaps dealer to gain exposure to
commodities by benchmarking their OTC transaction to a broad-based
commodity index. For index funds that obtain market access through a
swaps dealer, the swaps dealer is often granted a hedge exemption as
described above. For index funds that agree to track an index (as
opposed to holding a swaps position directly linked to the price of an
index), CFTC has determined that these index-based positions differ
enough that a hedge exemption is not appropriate. Instead, the fund is
granted no-action relief from speculative position limits for this
otherwise legitimate investment strategy (subject to conditions to
protect the markets).
Others have suggested excluding pension funds and index funds from
participating in commodity futures markets. These funds are using
commodity exposure to decrease volatility in their portfolios. Barring
them from regulated U.S. futures markets will only push them offshore
or into over-the-counter trading. These funds will continue to need
commodities as an asset class and will need to find ways to invest on
behalf of their clients. Certainly a number of foreign commodity
futures exchanges offer comparable and liquid ag product alternatives
in particular and could easily become the benchmark in these
commodities should unreasonable barriers be placed on the U.S. markets.
We believe it would be prudent public policy to ensure this investment
occurs on a domestic regulated market instead of driving this capital
overseas or into opaque markets.
CME Group has conducted a thorough review of the impact of index
trading and speculative trading on its primary agricultural markets. We
have found a negative correlation between price increases and index
fund buying.
While we favor a broader study of the impact of index fund trading,
we do not think it is appropriate to cast those funds as a villain in
price inflation until the study is completed, especially since in
theory it is not likely that the index funds are having a detrimental
impact. Index funds buy and hold. They may have some small impact on
days when new money enters the market and they create additional net
long positions, but those changes are transitory. The important
statistic in this regard is new net positions, not overall positions.
After the flow of new money into the market from the index funds,
the price will, in the absence of other factors, revert to the
equilibrium dictated by current supply and demand factors because the
index traders simply sit and hold the positions until they roll to the
next delivery month. Traders making informed trades should be expected
to drive the market to equilibrium.
All price changes take place at the margin as those traders with
information, meaning that they are hedging or expressing an opinion
based on knowledge, buy and sell. Even if 20 percent of the open
interest in a particular contract month of a commodity is held by index
funds, buying and selling by a few traders based on need and knowledge
drive the market to its fair equilibrium price. The open positions of
the index traders have no impact on prices driven by informed trading
activity.
Beyond being subjected to the criticisms leveled at speculators in
general, there have been more specific suggestions that money managers
and hedge funds that operate under defined strategies may have impaired
the price discovery process. The CFTC's staff responded to questions
implying that managed money traders, particularly hedge funds, ``may
exert undue collective influence on markets and thus move prices in
ways that hinder the market's price discovery role, reduce the
effectiveness of hedges constructed with contracts from those markets
and raise trading costs.'' CFTC's professional staff conducted an
analysis in 2005 which came to the following conclusions:&\5\
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\5\&http://www.cftc.gov/opa/press05/opa5074-05.htm.
Using a unique set of data from the Commodity Futures Trading
Commission (CFTC), the staff studied the relationship between
futures prices and the positions of managed money traders
(MMTs), commonly known as hedge funds, for the natural gas and
crude oil futures markets. The staff also examined the
relationship between the positions of MMTs and positions of
other categories of traders (e.g., floor traders, merchants,
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manufacturers, commercial banks, dealers) for the same markets.
The results suggest that on average, MMT participants do not
change their positions as frequently as other participants,
primarily those who are hedgers. The staff found that there is
a significant correlation (negative) between MMT positions and
other participant's positions (including the largest hedgers),
and results suggest that it is the MMT traders who are
providing liquidity to the large hedgers and not the other way
around.
The staff also found that most of the MMT position changes in
the very short run are triggered by hedging participants
changing their positions. That is, the price changes that
prompt large hedgers to alter their positions in the very short
run eventually ripple through to MMT participants who will
change their positions in response. The staff also found no
evidence of a link between price changes and MMT positions
(conditional on other participants trading) in the natural gas
market, and find a significantly negative relationship between
MMT position changes and price changes (conditional on other
participants trading) in the crude oil market.
In recent Congressional testimony, the CFTC has reaffirmed the
validity of this 2005 analysis.\6\ It is instructive that CFTC's
analysis parallels the conclusions of many other economists who have
also studied the issue of causation in the context of speculators and
commodity futures prices.\7\
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\6\&During his appearance before the Senate Appropriations
Committee on May 7, 2008, CFTC Acting Chairman Walt Lukken stated that
the CFTC's recent revisitation of the 2005 study using more current
data for energy market trading affirmed the conclusions reached in the
2005 study. This conclusion mirrors the views of the majority of 53
economists surveyed by The Wall Street Journal in May 2008 which
indicated that the global surge in food and energy prices is being
driven primarily by fundamental market conditions, rather than an
investment bubble. Wall Street Journal, May 9, 2008, page A&2.
Similarly, the U.S. Department of Energy's Energy Information Agency's
most recent ``Short Term Energy Outlook'' published May 6, 2008,
evidenced the tightness in world oil markets, with growth in world oil
consumption outstripping growth in production in non-OPEC nations by
over 1 million bbls/day, and dramatically increased demand coming from
China, India and other parts of the developing world.
\7\&See, for example, Antoshin and Samiei's analysis of the IMF
research on the direction of the ``causal arrow'' between speculation
and commodity prices in ``Has Speculation Contributed to Higher
Commodity Prices?'' in World Economic Outlook (September 2006):
On the other hand, the simultaneous increase in prices and in
investor interest, especially
by speculators and index traders, in commodity futures markets in
recent years can poten-
tially magnify the impact of supply-demand imbalances on prices. Some
have argued that high
investor activity has increased price volatility and pushed prices
above levels justified by fun
damentals, thus increasing the potential for instability in the
commodity and energy markets.
What does the empirical evidence suggest? A formal assessment is
hampered by data and
methodological problems, including the difficulty of identifying
speculative and hedging-re-
lated trades. Despite such problems, however, a number of recent
studies seem to suggest that
speculation has not systematically contributed to higher commodity
prices or increased price
volatility. For example, recent IMF staff analysis (September 2006
World Economic Outlook,
Box 5.1) shows that speculative activity tends to respond to price
movements (rather than the
other way around), suggesting that the causality runs from prices to
changes in speculative
positions. In addition, the Commodity Futures trading Commission has
argued that specula-
tion may have reduced price volatility by increasing market
liquidity, which allowed market
participants to adjust their portfolios, thereby encouraging entry by
new participants.
Similarly, James Burkhard, managing director of Cambridge Energy
Research Associates testified to the Senate Energy Committee on April
3, 2008 that: ``In a sufficiently liquid market, the number and value
of trades is too large for speculators to unilaterally create and
sustain a price trend, either up or down. The growing role of
noncommercial investors can accentuate a given price trend, but the
primary reasons for rising oil prices in recent years are rooted in the
fundamentals of demand and supply, geopolitical risks, and rising
industry costs. The decline in the value of the dollar has also played
a role, particularly since the credit crisis first erupted last summer,
when energy and other commodities became caught up in the upheaval in
the global economy. To be sure, the balance between oil demand and
supply is integral to oil price formation and will remain so. But `new
fundamentals'-- new cost structures and global financial dynamics--are
behind the momentum that pushed oil prices to record highs around $110
a barrel, ahead of the previous inflation-adjusted high of $103.59 set
in April 1980.''
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Regulated futures markets and the CFTC have the means and the will
to limit speculation that might distort prices or distort the movement
of commodities in interstate commerce. Acting Chairman Lukken's recent
testimony before the Subcommittee on Oversight and Investigations of
the Committee on Energy and Commerce United States House of
Representatives (December 12, 2007)&\8\ offers a clear description of
these powers and how they are used:
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\8\&http://www.cftc.gov/stellent/groups/public/@newsroom/documents/
speechandtestimony/opalukken-32.pdf.
CEA Section 5(d)(5) requires that an exchange, ``[t]o reduce
the potential threat of market manipulation or congestion,
especially during trading in the delivery month . . . shall
adopt position limitations or position accountability for
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speculators, where necessary and appropriate.''
All agricultural and natural resource futures and options
contracts are subject to either Commission or exchange spot
month speculative position limits--and many financial futures
and options are as well. With respect to such exchange spot
month speculative position limits, the Commission's guidance
specifies that DCMs should adopt a spot month limit of no more
than \1/4\ of the estimated spot month deliverable supply,
calculated separately for each contract month. For cash settled
contracts, the spot month limit should be no greater than
necessary to minimize the potential for manipulation or
distortion of the contract's or underlying commodity's price.
For the primary agricultural contracts (corn, wheat, oats,
soybeans, soybean meal, and soybean oil), speculative limits
are established in the Commodity Exchange Act and changes must
be approved via a petition and public rulemaking process.
With respect to trading outside the spot month, the Commission
typically does not require speculative position limits. Under
the Commission's guidance, an exchange may replace position
limits with position accountability for contracts on financial
instruments, intangible commodities, or certain tangible
commodities. If a market has accountability rules, a trader--
whether speculating or hedging--is not subject to a specific
limit. Once a trader reaches a preset accountability level,
however, the trader must provide information about his position
upon request by the exchange. In addition, position
accountability rules provide an exchange with authority to
restrict a trader from increasing his or her position.
Finally, in order to achieve the purposes of the speculative
position limits, the Commission and the DCMs treat multiple
positions held on a DCM's market that are subject to common
ownership or control as if they were held by a single trader.
Accounts are considered to be under common ownership if there
is a ten percent or greater financial interest. The rules are
applied in a manner calculated to aggregate related accounts.
Violations of exchange-set or Commission-set limits are subject
to disciplinary action, and the Commission, or a DCM, may
institute enforcement action against violations of exchange
speculative limit rules that have been approved by the
Commission. To this end, the Commission approves all position
limit rules, including those for contracts that have been self-
certified by a DCM.
It is clear that speculation is an important component of the
futures markets, but there is a point when excessive
speculation can be damaging to the markets. As a result, the
CFTC closely monitors the markets and the large players in the
markets, in addition to position and accountability limits, to
detect potentially damaging excessive speculation and potential
manipulative behavior.
On June 26, 2008, the House passed overwhelmingly H.R. 6377,
directing the CFTC to utilize fully its authority, including its
emergency powers, to investigate the potential role of excessive
speculation in any CFTC regulated market. The CFTC was also directed to
take appropriate action to curb any excessive speculation that may be
found to exist that results in prices diverging from those reflecting
the forces of supply and demand. In our view, H.R. 6377 is an
understandable and appropriate response given the circumstances facing
the markets. The bill respects the need to have dispassionate expert
analysis of this highly technical matter before action is taken.
Congress is not well-equipped to make these technical assessments and
the public interest will be advanced and better protected by CFTC's
careful and meticulous analysis. Moreover, our sense is that the CFTC
well understands the urgency that underlined passage of H.R. 6377. We
are confident that the CFTC is the right agency with the expertise to
analyze the relevant derivatives markets in an expeditious and
thoughtful manner and to take appropriate action commensurate with what
the facts may dictate.
VII. The CFTC's exclusive jurisdiction over trading on CFTC regulated
markets must be preserved.
CME Group recently joined with other leading participants in the
financial services industry to respond to the Federal Trade
Commission's (FTC) request for comments regarding its proposed rule
respecting false reporting and manipulative activities in the wholesale
oil market. We are concerned that the FTC's jurisdictional reach could
come into conflict with the CFTC's exclusive jurisdiction respecting
futures trading. While the statute very clearly limits the FTC's
jurisdiction to conduct in connection with ``the purchase or sale of
crude oil, gasoline or petroleum distillates at wholesale,'' the
Federal Energy Regulatory Commission (FERC), which has similar
authority, has read ``in connection with'' to give it authority over
conduct that took place entirely on a futures exchange. This latest
opportunity for incursion into CFTC's exclusive jurisdiction should be
of high concern to the Agriculture Committee.
In 1974, Congress recognized the overriding importance of
entrusting to the expertise of the CFTC the exclusive regulatory
authority over the nation's futures markets. Congress preempted other
Federal and state rules that would either assert parallel jurisdiction
over the futures markets or produce conflicts with the CFTC regulatory
regime. This system has produced the best regulated, most innovative
and efficient futures market in the world.
As markets evolve and become more interrelated, such agency
``boundary disputes'' can be expected and, for the most part, the
agencies usually take pains to accommodate one another and allow each
to accomplish the mission Congress mandated for it. We are concerned by
the FERC's claim of jurisdiction in the Amaranth case, where the
alleged manipulative trading took place on a futures exchange. FERC has
refused to recognize and yield to the CFTC's exclusive jurisdiction.
The result is that participants in the natural gas futures markets no
longer have legal certainty as to the legal standard governing their
transactions.
By the same token, we have been concerned by recent calls to have
other Federal agencies--the Department of Energy and the FTC in
particular--take leading roles in investigating commodity markets that
fall primarily within the exclusive jurisdiction of the CFTC. We
strongly urge the Agriculture Committee to take special care in
articulating the public policy wisdom of the exclusive jurisdiction
bestowed long ago on the CFTC and the invaluable contribution that the
CFTC's expertise can play in sifting fact from fiction amid the
turbulence of the current market situation.
The recently enacted farm bill demonstrates the continued vitality
of the CFTC's exclusive jurisdiction. Congress reauthorized the CFTC
for another 5 years and granted the CFTC new authority to regulate
certain exempt commercial markets that are active enough to constitute
price discovery markets.
VIII. Congress should increase the CFTC's resources.
The spate of recent congressional hearings has established that the
CFTC is working at staffing and resource levels that could inhibit
attainment of the agency's Congressionally mandated statutory mission.
Given that the CFTC is now expected to be even more aggressive in its
oversight and enforcement, Congress should provide CFTC with additional
funding to hire more personnel, acquire more technology, and do
everything necessary to police the derivatives markets effectively. The
enormous value that accrues to the public from effective CFTC activity
warrants the investment of additional financial resources from general
revenues.
Conclusion
CFTC regulated futures markets have demonstrated their importance
to the economy, the nation's competitive strength, and America's
international financial leadership. Imposing arbitrary increases in
margins in these markets, as has been suggested as a way to control
prices, will result in the exportation of these markets to overseas
competitors and to unregulated and non-transparent over-the-counter
markets. We have the means and the power to protect markets against
speculative excesses on our markets and are committed to doing so.
Attachments
Oil Speculation
Financial Times
Published: July 3 2008 12:40
Last updated: July 3 2008 12:42
What would you do if you were a senator? Explain to Americans that
reducing the oil price will involve trading in that truck for a Mini?
Or blame it all on ``speculators'' and promise a quick regulatory fix?
No prizes for guessing which way sentiment is leaning in
Washington. Those blaming speculators for high crude prices reason that
the marginal cost of producing a barrel is about $75. The current oil
price is almost double that figure. Clearly, much money has gone into
commodities recently. Therefore, speculation explains the ``excess''
and clamping down on it should push prices down.
It's not our government's fault for failing to come up with a
credible energy policy--that can't be it. Nor is the problem the weak
dollar, or the voracious energy appetite of the Chinese, or those pesky
rebels in Nigeria who are trying to blow up their country's oil
pipelines. And it's certainly not the fault of you and me for driving
gas-guzzling S.U.V.'s. It has to be those speculators. They are the
only villains in sight.
This was ``first let's kill all the speculators'' week on Capitol
Hill, and it was not a pretty sight. On Monday, the House Oversight and
Investigations Subcommittee held an 8 hour hearing (!), the sole
purpose of which was to decry ``excessive speculation.'' ``Have
speculators hijacked trading on the futures exchange?'' asked the
Michigan Democrat Bart Stupak. His answer throughout the day--as he
``grilled'' an array of sympathetic academics and futures market
critics--was a resounding yes.
On Tuesday, the action moved to the Senate, where the Homeland
Security and Governmental Affairs Committee held its hearing.
``Speculation in the food and fuel markets is not illegal,'' Senator
Joe Lieberman of Connecticut conceded, ``but that does not mean it is
not very hurtful.'' He continued: ``They are artificially inflating the
price of food and oil and causing real suffering for millions and
millions of people and businesses.''
There were yet more hearings on Wednesday, and by Thursday evening,
the House had passed, by a wide margin, a bill calling on the Commodity
Futures Trading Commission to curtail ``excessive speculation.''
Indeed, the C.F.T.C. spent the week being raked over the coals for
allowing all this rampant speculation to take place. On Monday
afternoon, for instance, Representative John Dingell of Michigan took
unseemly glee in going after Walter L. Lukken, the agency's Chairman.
Jabbing his pencil at Mr. Lukken, Mr. Dingell described the
founding of the agency as an effort to prevent farmers and consumers
from being ``screwed'' by ``those folks in the futures markets.''
``Now,'' he said, ``we find that those good-hearted folks in the
futures market have figured out how not just to screw the farmers and
the consumers in the city, but they figured out how to screw the
farmers and the consumers in the city on a whole new product--oil.'' As
Mr. Dingell sneered triumphantly, Mr. Lukken seemed to shrivel in his
seat.
Yes, it was wonderful theater, and great blood sport. And it had
absolutely nothing to do with the price of oil.
It's not just Congressmen who are railing about speculators, of
course. As oil prices have doubled in the last year, I've gotten e-mail
messages from readers decrying speculators, who, many believe, are
manipulating the futures market. More than once this week, legislators
used that same word their constituents were using: ``manipulation.''
So let's take a closer look at what the speculators' critics are
saying. First, despite the loose use of the word ``manipulation,'' that
is really not what is being alleged here, at least not in the classic
sense. Remember how the Hunts tried to corner the silver market? They
bought up silver and took it off the market, thereby creating an
artificial shortage. I suppose OPEC could do something like that--one
could even argue that OPEC does that already--but no mere speculator
could.
I can already hear your rejoinder: what about Enron and its famous
manipulation of energy prices in California? But remember, Enron was
manipulating electricity prices, not oil, which was possible mainly
because electricity can't be stored. By getting power plants to shut
down for hours at a time, Enron was able to create artificial shortages
and jack up the price.
Instead, the critics' thesis is that speculators are creating an
energy bubble the same way investors created the Internet bubble. As
speculative bets on energy have grown drastically in recent years, the
sheer amount of money being thrown at energy futures is making those
bets a self-fulfilling prophecy. All that money, in other words, pushes
prices higher than they would go if the market simply consisted of the
actual buyers and sellers of oil.
In addition, because of something called the ``London loophole''
and the ``Enron loophole,'' which allow speculators to use unregulated
exchanges, they can evade the limits of the New York Mercantile
Exchange, as well as C.F.T.C. scrutiny.
The leading proponent of this theory is a portfolio manager based
in the Virgin Islands named Michael W. Masters. When I caught up with
him on Thursday afternoon, after his week of testimony, he said that
the problem was that institutional investors had stopped seeing energy
as a commodity the world relies on and instead saw it as an ``asset
class'' for their portfolios. ``I am opposed to thinking about
commodities as an asset class,'' he said.
Several years ago, he continued, he began to notice that increasing
cash flows were moving into commodities index funds. This was, he said,
``long-only money''--meaning that it was a pure bet that prices would
go up. By now, he told me, there is $240 billion in commodity index
funds, up from $13 billion 5 years ago. As he also noted in his
testimony before Congress, ``the prices of the 25 commodities that
compose these indices have risen by an average of 183 percent in those
5 years!'' He claims that energy prices will fall by 50 percent if the
speculators can only be driven out of the futures market.
There are so many holes in this argument I scarcely know where to
start. The C.F.T.C. says that some $5 trillion worth of futures and
options transaction trades take place every day; can an influx of $240
billion, spread over 5 years, really propel prices upward to the extent
that he and others claim? Then there's the fact that the commodities
markets don't work like equity markets, where a small amount of trading
can lift every share of a company's stock. In commodities trading,
every contract has a buyer and a seller, meaning that for every bet
that prices are going up, somebody else is betting they are going down.
Why doesn't that short interest depress prices?
And what about all those commodities, like coal or barley or
sulfur, that don't trade on any futures market but have risen as fast
as or faster than oil? Or how about the recent decline in cash flows
into many commodity funds--why have prices kept going up if the money
has stopped pouring into those funds? My speculator friends tell me
that in the last 2 weeks, trading volumes have been cut in half.
Indeed, what I hear is that much of the speculative money that remains
in the market is betting against higher oil prices.
As for the London and Enron loopholes, I can pretty much guarantee
they will be closed soon. There are some eight bills aimed at curbing
speculation, and virtually every one of them calls for an end to the
loopholes. That is probably a good thing--but I'd lay odds the price
will not drop as a result. The loopholes are not the reason prices are
going up.
In fact, I'd be willing to go a step further. Even if you
eliminated speculation entirely, the price of oil wouldn't fall.
Thankfully, no one is proposing to go that far (though Senator
Lieberman was toying with the idea), because even Members of Congress
understand that futures markets serve a crucial purpose. They help
companies hedge their oil prices, and they help energy companies manage
their risk, for starters.
The energy speculators I spoke to say that Congress has it exactly
backward: the futures market is actually taking its cues from the
physical market, where the buyers and sellers of oil do their business.
Last week, the Saudis promised to produce an extra 200,000 barrels a
day. But it is pricing that oil so high that oil companies are balking
at paying for it. The Saudis didn't arrive at their price by looking to
the futures market--but if they get that price, it will certainly
affect the futures market.
Both speculators and oilmen say that supply and demand is the real
culprit. ``Our supply is pathetic,'' said Gary Ross, the chief
executive of the PIRA Energy Group, and a well-known energy consultant.
``Look at the data,'' he continued. ``The world economy is growing by
3.9 percent a year. World oil demand should grow by 2.3 percent just to
keep pace. That's an extra two million barrels a day. We don't have it!
It's obvious.''
I also think there is something else at play. After years of
ignoring the rather obvious fact that oil is a finite resource, the
world has suddenly become acutely aware of that reality. Everyone in
the oil markets is attuned to every little twitch that has the
potential to damp supply or increase demand. That's why, for instance,
when Libya announced on Thursday that it might cut oil production, oil
jumped more than $5. Meanwhile, when Brazil discovers a huge new oil
field, the market shrugs. That is not speculation at work--it's market
psychology. There's a big difference. If there is indeed a bubble,
that's what is causing it.
``Speculators have always been an easy target,'' said Leo Melamed,
the man who founded the futures markets. As Ron Chernow, the great
business historian put it, ``At times in history when you have vast and
impersonal forces wreaking havoc in markets, there is always a
temptation to villainize someone.'' Centuries ago, it was Shylock; now
it's the speculator and the short-seller.
In his book ``The House of Morgan,'' Mr. Chernow has a description
of Herbert Hoover, ``moody and isolated,'' convinced that short-sellers
were behind the market's horrendous downturn in 1929. ``He came to
believe in a Democratic conspiracy to drive down stocks by selling them
short,'' Mr. Chernow writes, adding that Hoover ``began to compile
lists of people in the bear cabal and even claimed to know they met
every Sunday afternoon to plot the week's destruction!''
I wonder whether Mr. Dingell has heard about them.
Who's Behind High Prices
The Washington Post
By Robert J. Samuelson
Tuesday, July 1, 2008; Page A11
Tired of high gasoline prices and rising food costs? Well, here's a
solution. Let's shoot the speculators. A chorus of politicians,
including John McCain and Barack Obama, blames these financial
slimeballs for piling into commodities markets and pushing prices to
artificial and unconscionable levels. Gosh, if only it were that
simple. Speculator-bashing is another exercise in scapegoating and
grandstanding. Leading politicians either don't understand what's
happening or don't want to acknowledge their own complicity.
Granted, raw materials prices have exploded across the board. From
2002 to 2007, oil rose 177 percent, corn 70 percent, copper 360 percent
and aluminum 95 percent. But that's just the point. Did ``speculators''
really cause all those increases? If so, why did some prices go up more
than others? And what about steel? It rose 117 percent--and has
increased further in 2008--even though it isn't traded on commodities
futures markets.
A better explanation is basic supply and demand. Despite the U.S.
slowdown, the world economy has boomed. Since 2002, annual growth has
averaged 4.6 percent, the highest sustained rate since the 1960s, says
economist Michael Mussa of the Peterson Institute. By their nature, raw
materials (food, energy, minerals) sustain the broader economy. They're
not just frills. When unexpectedly high demand strains existing
production, prices rise sharply as buyers scramble for scarce supplies.
That's what happened.
``No one foresaw that China would grow at a ten percent annual rate
for over a decade. Commodity producers just didn't invest enough,''
says analyst Joel Crane of Deutsche Bank. In industry after industry,
global buying has bumped up against production limits. In 1999, surplus
world oil capacity totaled five million barrels a day (mbd) on global
consumption of 76 mbd, reckons the U.S. Energy Information
Administration. Now, the surplus is about two million barrels per day--
and much of that is high-sulfur oil not prized by refiners--on
consumption of 86 mbd.
Or take nonferrous metals, such as copper and aluminum. ``You had a
long period of under-investment in these industries,'' says economist
John Mothersole of Global Insight. For some metals, the collapse of the
Soviet Union threw added production--previously destined for tanks,
planes and ships--onto world markets. Prices plunged as surpluses grew.
But Mothersole says ``the accelerating growth in India and China
eliminated the overhang.'' China now accounts for up to 80 percent of
the world's annual increased use of some metals.
Commodity price increases vary because markets vary. Rice isn't
zinc. No surprise. But ``speculators'' played little role in these
price run-ups. Who are these offensive souls? Well, they often don't
fit the stereotype of sleazy high rollers: Many manage pension funds or
university and foundation endowments.
Their trading might drive up prices if they were investing in
stocks or real estate. But commodity investing is different. Investors
generally don't buy the physical goods, whether oil or corn. Instead,
they trade ``futures contracts,'' which are bets on what prices will be
in, say, 6 months. For every trader betting on higher prices, another
is betting on lower prices. These trades are matched. In the stock
market, all investors (buyers and sellers) can profit in a rising
market, and all can lose in a falling market. In futures markets, one
trader's gain is another's loss.
Futures contracts enable commercial consumers and producers of
commodities to hedge. Airlines can lock in fuel prices by buying oil
futures; farmers can lock in selling prices for their grain by selling
grain futures. The markets work because numerous financial players--
``speculators'' in it for the money--can take the other side of
hedgers' trades. But the frantic trading doesn't directly affect the
physical supplies of raw materials. In theory, high futures prices
might reduce physical supplies by inspiring hoarding. But that's not
happening now. Inventories are modest. World wheat stocks, compared
with consumption, are near historic lows.
Recently, the giant mining company Rio Tinto disclosed an average
85 percent price increase in iron ore for its Chinese customers. That
affirmed that physical supply and demand--not financial shenanigans--is
setting prices: Iron ore isn't traded on futures markets. The crucial
question is whether these price increases will continue or ease as
demand abates and investments in new capacity expand supply. Prices for
some commodities (lead, nickel) have receded. Could oil be next?
Politicians promise to tighten regulation of futures markets, but
futures markets aren't the main problem. Scarcities are. Government
subsidies for corn-based ethanol have increased food prices by
diverting more grain into biofuels. A third of this year's U.S. corn
crop could go to ethanol. Restrictions on oil drilling in the United
States have limited global production and put upward pressure on
prices. If politicians wish to point fingers of blame, they should
start with themselves.
Thank you, Mr. Duffy.Mr. Keith.
STATEMENT OF KENDELL KEITH, PRESIDENT, NATIONAL GRAIN AND FEED
ASSOCIATION, WASHINGTON, D.C.
Mr. Keith. Good morning, Mr. Chairman and Members of the Committee.
I am Kendell Keith of the National Grain and Feed Association. We
appreciate the opportunity to participate here today.
First, I would like to comment on financial liquidity in our
industry. The very rapidly rising commodity prices have created an
unprecedented financial squeeze in our industry. While the banking
industry has been very supportive, banks do have limits on long
capacity and in some cases have restricted ownership positions for our
companies out of necessity. This changing capital need has led to a
major pullback in our industry on offering forward grain contracting,
which is very unfortunate both for our industry, companies, and the
farmers that we serve.
We are at work on solutions to this issue. One idea that has
emerged that could help is one that has been developed by the Merchants
Exchange of St. Louis. It would permit a financial swap to be sold by a
party holding a long position to a short hedger that in essence would
fund the margin calls as the market goes up. This has yet to be proven,
but in the next few weeks there is going to be a pilot for that project
and we think that it does hold some promise.
Next, I would like to comment on market performance. There is no
question that there has been less consistent convergence in cash and
futures and the commodity markets that we participate in than we have
experienced in the past. This has led to more of a disconnect between
cash and futures, and the futures price is a less reliable measure of
the true underlying value of commodities in our business. The situation
has led to much more volatility in basis levels and partially
contributes to a substantial widening in basis in particular for wheat.
How can we improve market performance? Well, we are working with
the CME Group and others on evaluating storage rate levels that might
enhance the market's ability to converge at expiration and other
concepts, such as index markets, making more delivery points available
and compelling the taker of delivery to load out. All of these issues
are being reviewed.
While we are concerned about market performance, I want to assure
this Committee that NGFA continues to receive outstanding cooperation
from both exchanges and the CFTC in working as quickly as possible
toward possible solutions.
Regarding the setting of margins, we hold the philosophy that the
exchanges and the clearing corporations are still in the best position
to establish and assess risk and establish margins in volatile
conditions. As markets change daily, adjustments in margins are always
necessary, and the exchanges remain in the best position to evaluate
those needed changes.
Finally, we have some comments and recommendations regarding
futures market transparency that we would like this Committee to
consider.
First, we recommend that swaps dealers, index and pension funds,
exchange traded funds, and issuers of exchange traded notes and other
similar nontraditional participants be required to report to CFTC to
justify their futures market positions. In essence, we think this would
level the playing field. It would cause these traders that are not
considered to be speculators and therefore not restricted by speculator
limits to have the same reporting requirements as large commercial
hedgers in our industry who have to report cash positions on a monthly
basis. Though nontraditional participants don't have cash positions per
se, we would like to see them report their analogous positions
regarding which ag futures serve as a financial hedge.
Our second recommendation would increase the usefulness of the
CFTC's weekly Commitment of Traders report which our industry relies on
to assess who is participating in the markets. We would like to see the
CFTC require the large nontraditional participants to disaggregate data
so it clearly shows activity that should be reported in the index
category of the COT report. Currently CFTC is unable to report some
index activity because positions are being netted out prior to being
reported to the Commission. We would also like to urge that the CFTC
make another review of its breakout of various categories of the
Commitment of Traders report to ensure the definitions of categories
are clear and stated in ways that prevent large nontraditional hedgers
or investors from reclassifying themselves or self-selecting categories
within the reported framework. Making such reporting regular and
permanent by the nontraditional hedgers we think would shed more light
on speculative investment capitals, participation in ag futures and
related OTC activity, and also help the CFTC basically to do its job.
Thank you for the opportunity to participate today.
[The prepared statement of Mr. Keith follows:]
Prepared Statement of Kendell Keith, President, National Grain and Feed
Association, Washington, D.C.
Thank you, Mr. Chairman, and Mr. Goodlatte, for calling today's
hearing to examine activity in agricultural futures markets. The
National Grain and Feed Association (NGFA) appreciates the opportunity
to testify.
I am Kendell Keith, President of the NGFA. Our members include over
900 companies, including grain elevators, feed manufacturers, oilseed
processors, flour mills, biofuels producers and marketers and many
other related commercial businesses. We estimate that these member
firms operate more than 6,000 facilities nationwide. The NGFA's member
firms have relied for years on U.S. agricultural futures markets to
hedge their price and inventory risk, and to aid them in assisting
producers to market their commodities and manage risk. As first-
purchasers of grains and oilseeds from producers, these firms rely on
efficient and well-functioning futures markets for price discovery and
risk management, and to help them provide marketing options for their
producer customers.
Financial Liquidity Crisis
On May 15, the NGFA testified before the Subcommittee on General
Farm Commodities and Risk Management that grain elevators were feeling
financial stresses due to historically large borrowing to finance grain
inventory and margins necessary to maintain hedges. Today, spiraling
commodity futures prices have brought additional challenges to our
industry. If grain and oilseed prices continue to advance, we will
experience a further crunch on liquidity among grain hedgers that could
force companies to reduce cash grain-buying activities and could
ultimately cause additional company consolidation.
Typically, when producers want to market their crops, one of the
primary tools they utilize is forward cash contracts written with their
local elevator. When the elevator contracts with the producer to
purchase cash grain--often for delivery many months later--the elevator
hedges its cash position by selling futures on an exchange like the
Chicago Board of Trade, the Kansas City Board of Trade, or the
Minneapolis Grain Exchange. The elevator performs a valuable service
for the producer by assuming price risk on his behalf.
The problem this year is that futures prices for agricultural
commodities have reached record levels, spurred upward by historically
tight supplies, flooding in the Midwest, and an influx of speculative
investment capital. An elevator that forward contracted with a producer
last year and sold futures on-exchange--a tried-and-true, prudent risk
management strategy--now has seen futures prices advance to record
levels. As the gap between the elevator's short futures position and
the current futures price has grown, the elevator has been obligated to
meet ever-growing margin requirements established by a futures
exchange--margin requirements that we recognize as legitimately needed
to protect the financial well-being of the exchange and its clearing
corporation. Add to this the increasingly expensive financing of grain
and oilseed inventories and the elevator's borrowing needs have become
immense.
To illustrate the heightened harvest borrowing needs of a typical
country elevator today, the following simulation is derived from an
aggregate of the customer base of an NGFA-member firm that provides
futures and option brokerage services to the agricultural industry,
along with offering hedging education and merchandising risk-management
services. It arrives at an ``average'' case that is illustrative of
conditions faced by a ``typical'' commercial grain hedger today to
purchase inventory--increased borrowing needs in the range of 250&300%.
To help further understand the financial stresses a ``typical''
elevator might face when hedging forward purchases, a separate but
related exercise looked at a selected group of elevators for whom the
actual weighted average per bushel ``loss'' on open 2008 crop, 2009
crop and 2010 crop hedges were $1.46 for corn, $4.47 for soybeans and
$3.51 for wheat, for a total weighted average hedging loss of $2.49 per
bushel (Figure 2). Applying those averages to several real-world
elevators who buy grain from producers and hedge on-exchange shows that
a ``typical'' country elevator's hedges could be ``under water'' in
amounts ranging from just less than $1 million to almost $8 million, as
a consequence of forward contracting with its producer-customers.
(Note: these figures are not specific to any one elevator; they are
illustrative in nature but believed to be indicative of actual hedging
results.)
Figure 3):
Looking at these numbers, it is not difficult to understand that
one consequence of this financial liquidity squeeze is that many
elevators have been forced to restrict or even eliminate forward
contracting with producers. This is a very unfortunate situation given
that many producers rely exclusively on cash forward contracts to
manage price risks. Many elevators are unable to access enough funding
to finance hedges on new-crop forward purchases, and many view the
risks of forward purchases in an increasingly volatile marketplace as
being unmanageable. This is a significant shift in the way our industry
does business, and has frustrated producers who would like to lock in
attractive prices for this fall's harvest.
We believe the lenders who do business with our industry have done
a good job to date in responding to borrowing needs that are several
multiples of normal, expected levels. However, we are hearing from our
member companies that some lenders are at or near their lending limits,
while other lenders may have access to sufficient funds but are
reaching the upper bounds of the business risk they are willing to
assume. In our current tight stocks situation, additional price
advances likely would result in elevators being unable to access
sufficient funds for operations and for margining. In a worst case
situation, another weather event or other supply disruption this summer
could drastically deepen the financial difficulties for our industry,
cause further consolidation, and further reduce cash grain bids
available to farmers.
The NGFA is not requesting any specific action by this Committee or
by Congress at this time to respond to the financial liquidity crisis
our industry is facing. However, we do want the Committee to be aware
of the situation, and we would like to keep you apprised as we move
into the critically important summer growing season.
I would add one final observation regarding our industry's
financial liquidity crisis and escalating commodity and food prices. At
its core, the problem goes back to supply and demand fundamentals.
Today, U.S. grain and oilseed production is having trouble keeping up
with growing demand driven by increasing consumption in developing
countries like China and India; the continuing growth of the U.S.
biofuels sector; and other factors. Grain stocks have declined in 6 of
the last 7 years. We have seen market disruptions this year due to
weather problems in the Midwest. The current very tight supply/demand
situation is bound to result in higher commodity prices that will be
attractive to non-traditional market participants. One much-needed
response, for which the NGFA has called for many months, is for
Secretary of Agriculture Ed Schafer to announce a penalty-free early-
out from Conservation Reserve Program contracts on cropland that can be
farmed in an environmentally sustainable way.
Futures Market Transparency
The NGFA's legislative priority with regard to futures markets is
to enhance transparency. Knowing who is participating in agricultural
futures markets and being able to gauge the impact of participants is
critically important to grain hedgers. The CFTC made an important
advance in this respect early last year when it implemented a new
``Index'' category in the weekly Commitments of Traders report.
However, with the continuing influx of speculative investment capital
into agricultural futures markets, and the advent of new market
participants like exchange-traded funds (ETFs) and exchange-traded
notes (ETNs) we believe additional reporting and transparency is
needed.
The challenge is identifying all market participants that should be
subject to enhanced reporting and, in turn, that should be reported on
by CFTC. Index funds, pension funds, swaps dealers, ETFs, and ETNs all
participate primarily on the long side of futures markets, and we
believe they should be required to report to CFTC on their exchange-
traded positions. However, there may be other new and developing
participants who should be subject to reporting too; the challenge is
how best to describe all the players correctly.
We would advise Congress against overly prescriptive approaches, as
it is difficult to anticipate outcomes and reactions of market
participants. It is not sufficient simply to require reporting from
``passive, long-only'' participants. Some of the above players may
currently have short positions in futures markets; and some of them
might ``go short'' in a few small positions just to avoid reporting
requirements. In addition, as the market adjusts and likely goes into a
downward price trend at some point in the future, these participants
may adopt investing strategies that call for greater percentages of
commodity assets in short positions. We need to look to the future and
try to craft legislation that foresees these possibilities, and we look
forward to working with Congress in this effort.
We also would caution against Congress attempting to legislate
things like margin requirements or the share of futures positions that
certain types of participants can hold in agricultural futures markets.
These kinds of proposals have been made by various Members of Congress
with regard to energy markets. For agricultural markets in particular,
we believe the establishment of appropriate margins for various market
circumstances is best left to the exchanges and their clearing
corporations, which are in the optimal position to make determinations
about what is needed to safeguard their financial integrity. We would
also fear the ``law of unintended consequences'' might apply in this
case, and that attempts to regulate ``speculators'' could overreach and
affect participants who are very important to providing liquidity in
agricultural futures markets.
Futures Market Performance Issues
The NGFA's final major concern revolves around the performance of
U.S. agricultural futures markets. It is of paramount importance that
futures exchanges continue to serve their long-established roles of
price discovery and risk management for traditional users like grain
hedgers. We are deeply concerned that agricultural futures markets are
not satisfactorily performing those functions today.
In our May 15 testimony to the Subcommittee, we submitted evidence
that cash and futures convergence in grain and oilseed contracts, a
bedrock principle for the hedging efficiency of futures markets, has
been compromised in recent months. That remains true today. Genuine
convergence occurs less often and only for short periods of time. The
band, or range, of convergence has widened due to several factors,
including: (1) higher and more volatile transportation costs, including
higher fuel costs; (2) demand for storage created by biofuels growth;
and (3) the futures market running ahead of cash values due to the
infusion of speculative investment capital.
This lack of convergence--or ``divergence'' as some are calling
it--is evident in wider basis levels between cash and futures. Cash
bids to producers at any given location and time still reflect the true
value of physical commodities, but rapid advances in futures price
levels have widened basis to levels not historically expected.
As mentioned above, many factors are at work to influence price
levels and basis: transportation and fuel costs; changes in supply/
demand fundamentals; carry-over inventory levels; farmer selling;
storage rates; and more. Changes in any of these factors can result in
significant changes to basis levels, and today we are seeing many
changes occurring simultaneously. However, we believe that the
participation of large amounts of speculative investment capital like
index and pension funds into agricultural futures markets is causing
disruption in markets and resulting in futures prices that no longer
reflect true supply/demand fundamentals.
In today's marketplace, it is critically important that all market
participants--including farmers and grain elevators--be able to see and
understand the impacts of non-traditional participants like index funds
and others mentioned above. With supplies tight, demand high and
volatility increasing, proper identification and reporting of
speculative investment capital in agricultural futures markets should
be a priority.
Thank you again for the opportunity to participate in today's
hearing. I would be happy to respond to any questions, and to assist
this Committee in development of any legislation that may move forward.
The Chairman. Thank you, Mr. Keith.
Mr. Johnston.
STATEMENT OF JOHN L. JOHNSTON, INDEPENDENT TRADER, IB AND
PRECIOUS METALS AND ENERGY CONSULTANT, MORRISTOWN, NJ
Mr. Johnston. Good morning. I am John Johnston. I am a
trader. I would say there are very few days in the last 20
years where I haven't had a crude position. And I am going to
speak like a trader.
I believe the passive long investor through the use of
commodity index derivatives has unwittingly cornered the WTI
light sweet crude oil market.
The NYMEX futures are not oil. They are a 17th century
financial creation whose use has been, until recently, to help
a small community of producers, consumers, trading brokers or
exchange locals and speculators manage their price risks. All
futures have historically been limited by their own supply and
demand rules. If a trader is short in NYMEX, there is no
substitute. He either buys or covers the futures contracts or
the trader must deliver the physical material. Since the
passive investor never liquidates his position, the short must
find another seller or the physical commodity to make a
conforming delivery.
Note, the passive long investor does roll a transitory and
equal amount periodically as the futures contract expire. But
the sale is a linked part of a calendar spread. For all intents
and purposes, the passive long never contributes liquidity to
the futures markets.
Here is the rub. The passive long position, as reported by
credible sources, is estimated to be a weighted AIG/GSCI
equivalent of 1.4 million contracts of crude oil, heating oil,
gasoline and gasoil of NYMEX and/or NYMEX/ICE futures.
Combined, NYMEX and ICE, crude oil, heating oil, gasoil and
gasoline open interest is equal to approximately 3.5 million
contracts. Therefore, the passive long-only index position is
equal to 40 percent of the combined long NYMEX and ICE open
interests. Otherwise stated, 40 percent of the long open
interest has effectively ceased to exist from the liquidity
pool. Therefore, there are only .6 longs available for every
one short.
Think of it like six girls and ten guys at a dance. This
imbalance is dynamic. As the market goes down, the active
number of longs gets smaller. They sell. And the number of
passive longs gets larger. They buy. The relative ratio of
shorts to passive longs goes up and creates a supply void.
Traditional supply and demand fundamentals are subordinate to
this elementary math. One contract wanted, .6 offered. As long
as this architecture is in place, the market for paper barrels
of WTI light sweet crude oil on the NYMEX or ICE cannot go
down. The buyer is facing a chronic deficit in the daily
auction supply of futures, and the resulting outcome in terms
of price is certain.
What is happening in energy markets is not much different
in result than an old-fashioned commodity squeeze. The passive
longs own a critical percentage of the stock or supply of daily
liquidity. But the cast of players and the motives driving
prices are as different as the definition of each found in my
opening paragraphs. It is not important why or if the motives
are legal or moral. It only matters that the opposing shorts
must auction and exit from their losses by paying a premium to
another seller who will risk, take the former's place. But the
passive long never sells. And the new short faces the same
structural imbalance as the price spirals higher and higher,
ever replacing one group of short sellers with another. The
auction resets over and over again at higher prices, but the
architecture does not change.
The remedy in my opinion; the most effective way to deal
with a problem is to raise the cost of being long and
derivative exposure to all commodities on all venues, futures,
OTCs, ETFs and options. If the cost of being long changes,
investment committees will recognize the change and adjust
their allocations.
I am certain if margins and credit requirements were raised
on long positions only, except consumer hedges, crude oil would
fall immediately and precipitously. I do not suggest inhibiting
normal daily use of futures by bona fide hedgers who need
protection from unforeseen negative events and prices. I do
suggest a deliberate clear message: The party is over.
Let's see, I only have 40 seconds left. There is no such
thing as a free market. Any intervention is designed to produce
a specific result whether it is the Fed lowering the funds rate
or the BOJ buying Yen in the open market.
Thank you.
[The prepared statement of Mr. Johnston follows:]
Prepared Statement of John L. Johnston, Independent Trader, IB and
Precious Metals and Energy Consultant, Morristown, NJ
Many years ago, when I first became a member of the NYMEX, I read a
quote by Mark Twain that described a gold mine as ``a hole in the
ground with a liar standing next to it.'' I have always remembered that
wise adage and whenever there is some question about money in the
commodity markets I tend to keep an eye out for the hole and the liar.
There is a lot of murky information in this debate about index length
and there are billions of dollars at stake, so I am careful to remind
myself that those things which I am not allowed to see are probably
hidden for a reason. Transparency is the key to unlocking the mystery
of rising energy prices, and the sooner we can see who has what
position and how big it is, the sooner this episode will be a part of
history.
I have been working in the commodity futures industry for 33 years
and I have been a member of the COMEX and/or NYMEX for 31 years. The
opinions I intend to offer on the challenges of the commodities markets
are not unlike the views of a sailor discussing the challenges of the
sea: there are great natural forces at work and a good deal of
intuition is needed to chart a safe course.
Pundits and journalists have recently demonized `the speculator' as
the root cause of high oil prices. I would like to be clear at the
outset that I do not believe speculators deserve to be blamed for the
current situation. Rather, I propose the root cause of high oil prices
is the Commodity Index Investor or the ``Passive Long'' investor. I
believe the passive long investor, through the use of commodity index
derivatives, has unwittingly cornered the WTI light sweet crude oil
futures market. The following discussion will make a case for
understanding this blameless, yet extremely dangerous condition on
futures exchanges and in leveraged derivative markets.
The market activities of the passive long investor and the
speculator are polar opposites. The speculator has an investment
strategy that relies on responding to market conditions. He manages and
assesses his risk by evaluating changing market conditions and
information. He will be either long or short, without bias. Conversely,
a passive long investor invests a set allocation of assets as directed
by a risk Committee, following a long only investment model. It is
important to note that although the portfolio may be rebalanced, or the
percentage of total assets increased or decreased, this investment
model is always long. In the case of the passive long investor, the
commodity index investment is used to stabilize total returns to the
portfolio and not to achieve them. Thus the position remains completely
passive; the investor is not seeking returns or managing risk and the
index length will remain in the portfolio until the entire fund is
liquidated. The long-only commodity index position merely exists and
requires no measure of active management or maintenance other than
periodic rollovers.
There are a lot of estimates as to the size of the commodity index
position held by these passive long investors. The numbers most
commonly accepted are about $250 billion dollars, of which a weighted
AIG/GSCI energy allocation of 48% equals about 1.4 billion barrels of
crude oil, heating oil, gasoline and gas oil. If the current estimated
passive long energy position were to be sold at the rate it has taken
to acquire, it would add in the neighborhood of one million barrels to
daily supply for ^4 years. It should be noted that during the period of
liquidation, the net effect of a loss of one million barrels in demand
(they stop buying) and an addition of one million barrels in supply
(they start selling) would mean an increase of two million daily
barrels to the supply and demand equation. It does not take much
imagination to estimate the effect such liquidation would have on
prices. Personally, I believe the positions of the passive long
investors are much larger than estimated above.
Because crude oil and crude oil products require tremendous
physical resources to transport and store, the supply/demand equation
is tightly balanced. Elasticity in the physical system is limited to
storage, shipping, and tankage. If total world consumption is 85
million barrels per day, then the system must produce at least 85
million barrels or the marginal excess demand will become apparent in
market prices spontaneously. Conversely, because the economics of the
infrastructure supporting physical crude oil impose limitations on
excess commercial supplies, any surfeit will become equally apparent in
the board price at the futures exchanges. This is the primary function
for which futures exchanges were created: to buffer price volatility
caused by short term gaps in the production/consumption chain. They
were never intended to provide a long term leveraged liquidity venue
for an investment community abstractly allocating of hundreds of
billions of dollars.
The Problem
Oil futures are not oil.
The core problem is in the daily auction of futures. If you have 50
futures offered and 50 futures wanted, you have a balanced auction. If
you have 48 futures offered and 52 futures wanted and you have an
imbalance. The discovery of a price for the futures contract in
question is not found in the transaction of the 48 which are balanced;
rather it is the four demanded that have yet to be satisfied by a
seller that set the price. In sum, it is the marginal excess of supply
or demand which defines the benchmark price in the daily auction.
NYMEX futures are not oil. They are a 17th century financial
creation whose use has been, until recently, to help a small community
of producers, consumers, trading brokers (or exchange locals) and
speculators (as defined above) manage their price risks. All futures
have historically been limited by their own supply and demand rules. If
a trader is short NYMEX futures there is no substitute: either he buys
or covers the futures contracts or the trader must deliver the physical
material. Since the passive investor never liquidates his position, the
short must find another seller or the physical commodity to make a
conforming delivery. Note: the passive long investor does roll a
transitory and equal amount periodically as the futures contracts
expire but the sale is a linked part of a calendar spread. For all
intents and purposes, the passive long never contributes liquidity to
the futures markets.
Here is the rub:
(1) The passive long position, as reported by credible sources, is
estimated to be a weighted AIG/GSCI equivalent of 1.4 billion
barrels of WTI light sweet crude heating oil, gasoline and gas
oil or equal to 1.4 million contracts of crude oil, heating
oil, gasoline and gas oil of NYMEX and/or ICE futures.
(2) Combined NYMEX and ICE crude oil, heating oil, gasoil, and
gasoline open interest is equal to approximately 3.5 billion
barrels or 3.5 million contracts.
(3) Therefore: the passive long only index position is equal to 40%
of the total combined long NYMEX and ICE open interest.
Otherwise stated 40% of the open interest has effectively
ceased to exist from the liquidity pool.
(4) Therefore: there are only .60 longs are available for every 1
short.
Think of it like six girls and ten guys at a dance.
This imbalance is dynamic: as the market goes down the active
number of longs gets smaller (they sell) and the number of
passive longs gets larger (they buy). The relative ratio of
shorts to passive longs goes up and creates a supply void.
Traditional supply and demand fundamentals are subordinate to
this elementary math: one contract wanted, .60 offered. As long
as this architecture is in place the market for paper barrels
or for WTI light sweet crude on NYMEX or ICE cannot go down.
The buyer is facing a chronic deficit in the daily auction
supply of futures and the resulting outcome in terms of price
is certain.
(5) What is happening in energy markets is not much different in
result than an old fashioned commodity squeeze. The [passive]
longs own a critical percentage of the stock or supply of daily
liquidity, but the cast of players and the motives driving
prices are as different as the definition of each found in my
opening paragraphs. It is not important why, or if the motives
are legal or moral. It only matters that the opposing shorts
must auction an exit from their losses by paying a premium to
another seller who will [risk] take the former's place. But the
passive long never sells. And the new short faces the same
structural imbalance as price spirals higher and higher ever
replacing one group of short sellers with another. The auction
resets over and over again at higher prices but the
architecture does not change.
(6) There has been a. 99% positive correlation between the NYMEX
crude contract and the Goldman Sachs commodity index over the
last 2 years. This means that the market prices the entire
Goldman Sachs Commodity Index at nearly at par with the NYMEX
crude oil contract every day It begs one to ask if the
estimates of 48% of the index being allocated to energy are
perhaps low.
(7) It is ironic, but there are no criminals violating laws or
rules. And . . . there are no winners: the overall portfolio
that the commodity index was intended to defend suffers at an
exponentially greater rate with each uptick in crude prices.
Higher energy prices mean lower prices for stocks and bonds.
The Remedy
In my opinion, the most effective way to deal with the problem is
to raise the cost of being LONG in derivative exposure to commodities
on all venues: futures, OTC, ETFs, and options.
If the cost of being LONG changes, investment committees will
recognize the change and adjust their allocations. This can be done by
raising margins on LONGS, demanding and enforcing greater transparency
of OTC swap positions and reporting the same to the market.
I am certain if margins and credit requirements were raised on all
LONG POSITIONS ONLY except consumer hedges, crude oil would fall
immediately and precipitously. I do not suggest inhibiting the normal
daily use of futures by bona fide hedgers who need protection from
unforeseen negative events and prices. I do suggest a deliberate clear
message that the party is over.
Asking to raise margins on longs only may seem prejudicial, but if
margins are raised on longs and shorts equally, prices will explode. In
an up market rising margins put increasing pressure on the short.
Margins have traditionally been increased in rising markets to assure
performance rather than influence behavior, but the crude market is a
moving target and American citizens are getting hurt. I suggest the
first order of business is to inhibit buyers through tighter credit and
higher margins on longs. Investment Banks, passive investors, and
producers don't need to be coddled and any complaints of encroachment
on free and fair markets would be disingenuous to say the least. There
is no such thing as a ``free market''. Any intervention is designed to
produce a specific result, whether it is the FED lowering the funds
rate or the BOJ buying Yen in the open market.
In my opinion, the slightest hint that the Congress might be moving
to deleverage energy derivatives would have a chilling effect on
prices.
Finally, so much information is hidden it is impossible to be
accurate unless changes are made to allow greater transparency. I would
ask the banks who have been a part of the debate to stop making a case
for right or wrong. I don't think anyone has a perfect answer but
stubbornly insisting that only one side of the debate is correct is not
the beginning of a solution. It seems reasonable that institutions who
have relied on the American people for solvency in recent months might
be willing to oblige the government in its efforts to understand and
deal with the effects of rising energy prices rather than arguing the
truth lies only with them. I would also suggest the congress and its
Committees contact passive investors directly and inform them that it's
possible some of their investment objectives might be doing serious
damage to the nation and its citizens. I think an effort like that
might be well received. Maybe we just need a time out to get a better
look at things. Handicapping margins on LONGS and I mean a hard sharp
increase on all long positions (including Wall Street trading desks,
day traders, and producers) will create that pause and oil prices will
go down and stay down for quite a while.
Allow me to thank you for the opportunity to discuss these issues
and offer my opinions.
The Chairman. Thank you, Mr. Johnston.
Mr. Duffy, you are right. Several of our colleagues have
put forth legislation to increase margins. So can you tell us a
little bit about the process of what is their purpose? How are
they determined? And do all players play by the same rules in
the marketplace when it comes to margins?
Mr. Duffy. Absolutely. When it comes to margin, just so the
Committee understands, in the futures industry it is a
performance-based margin unlike that in an equity market where
you are buying an asset. So if you were to be buying CME stock,
you would need to put up 50 percent of the margin. If you are
buying a Euro, dollar, or a corn contract on a CME exchange,
you are not buying anything except for price for a later date.
So what the margin is put in place for is to protect the
integrity of the clearinghouse on any 1 single day's loss. So
from one participant to the other can be paid in cash, which we
do settle twice daily. We hold several billion dollars each day
and we move $6 billion back and forth from market participants.
So performance-based bond margin and futures are completely
different than the equity markets of margin, if that answers
your question, sir.
Mr. Holden [presiding.] Thank you. Mr. Keith, as Chairman
Peterson mentioned to the previous panel, we are very much
concerned on this Committee about stability in the futures
market for agriculture commodities. If we were to increase
margins primarily because we are looking at speculation in the
oil market, what would that do to the ag commodity futures
market? How would that affect the players and the producers,
and so forth?
Mr. Keith. Well, I think from our perspective, if the
approach is only in the energy markets, we would just be
concerned about precedent. We just think it is--the margin
setting authority has traditionally been with the commercial
marketplace, and it is not intended to curb any types of
activity necessarily. There has been a difference in
speculative margins and hedge margins, and that is
understandable. But it is really up to the exchange and the
people that have the money at risk, as Mr. Duffy said, it is to
ensure a performance on the contract. It is not a credit
transaction.
Mr. Holden. I guess what I was trying to say, Mr. Keith, we
understand that if--we don't want to do something just on the
energy side because if there is speculation, it will move over
to the commodity side. But if we did something universally----
Mr. Keith. Yes.
Mr. Holden.--would the small guy be able to have the
security in the market and would he be able to play if margins
were increased? The ability?
Mr. Keith. Well, if the hedgers from our industry, in
effect, are faced by artificially higher margin requirements
than what the exchange thinks is necessary, then yes, it would.
And this would be the worst time ever to increase margins
artificially in our industry. We are having a difficult time as
it is to meet margin calls set by the exchange on the basis of
market risk.
Mr. Holden. Thank you.
Mr. Conaway.
Mr. Conaway. Thank you, Mr. Chairman. Mr. Keith, just to
flush that out, I am told by ag participants that given these
higher prices which drive higher margin calls, that just the
mere function of the price going up makes it difficult for them
to be able to use the markets in ways to meet their price risk.
Is that sort of the mechanics of what happens? The price goes
up, the margin requirement goes up?
Mr. Keith. For the most part, our industry is long on cash
and short on the board and the board of trade. And yes, when
the prices go up, you have to set up margins to cover.
Mr. Conaway. Thank you. We are hearing an awful lot about
excess speculation in the oil markets driving the prices up.
But we have seen dramatic increases in grain and other ag
commodities. Where is the hue and cry to eliminate the excess
speculation there?
Mr. Keith. Well, we think that--based on my testimony, we
think that we have to measure the participants in the
marketplace better than what we have to date to understand what
is going on.
Mr. Conaway. You are talking about the ag markets?
Mr. Keith. Yes. Until we do that, we don't really think we
can make a lot of judgments. But if you ask the majority of my
membership, they would probably agree that the new players in
the marketplace have had some effect on prices. In essence,
though, we think if we solve our convergence issues in those
markets, then ultimately cash and futures have to go back to
tracking each other better than they are today. And that would
solve--if there is excess speculation, that is a solution to
it.
Mr. Conaway. But don't we see that convergence in the oil
markets now? There is not a divergence in the oil market,
right?
Mr. Keith. I am not an expert on oil markets. But we are
having difficulty in terms of consistency in convergence today.
We get it occasionally, but it is not like it used to be. With
the volatility that we have in ag markets and oil markets
today, you can't expect the kind of convergence that we had
when corn was $2 and varied within 25 cents for the whole
season. It is just not going to happen.
Mr. Conaway. Thank you, sir.
Mr. Duffy, Mr. Johnston laid out some specifics and
fortunately warned us that he was going to talk like a trader,
so much of what he was saying I think I understood. And it is
not a debate but could you give us your sense of, have these
passive long folks actually cornered the market in paper
barrels?
Mr. Duffy. I guess I could put my 25 year trader hat on
myself, too. I spent a lot of time on the exchange before I got
into the management of the business. The passive long investor,
what the gentleman was referring to, that they don't sell is
absolutely erroneously wrong. They do sell. They come to
expiration each and every quarterly or whenever the contract is
at maturity and they sell. It is indisputable: they sell. And
they then move forward with the next contract.
Now I believe Dr. Pirrong gave very strong testimony
yesterday citing how futures markets work. When they come to
maturity, if the commercials don't believe that that price is
appropriate, they will either act on that by either making or
taking delivery or liquidating their position and going on to
the next month. And that is exactly what we are seeing. And I
am not speaking just to the energy markets but to the ag
markets also.
So I disagree with what the gentleman said. It is just
wrong. In futures contracts, sir, as you all know, there is an
unlimited supply for futures contract. For every new long there
is a new short. So you can constantly create new participants
in the marketplace. And if you have 60 percent that are not
even participating, they are not affecting the market up or
down. So if the market was to go down, they are not selling
either. So I think they provide a very vital role to the
liquidity of the marketplace. So I disagree with most of the
statements.
Mr. Conaway. Mr. Johnston, you want to kind of flush out
what your comments were?
Mr. Johnston. They don't sell. They roll. That means they
affect a simultaneous purchase and sale on a calendar spread.
Once they entered the long, that is it. They are long. They are
long forever. And that long position never goes away. When you
are trading----
Mr. Conaway. Well, technically that contract has an
expiration.
Mr. Johnston. Well, it expires. But it is simultaneously
translated into the next month, as everybody else is. So you
have a summary amount of length and shorts, whatever the open
interest is. Let's just say it is a million longs. You have a
million longs, a million shorts.
Mr. Conaway. Sure.
Mr. Johnston. The passive long is constantly acquiring a
greater and greater percentage of the long side of that market.
And passive means passive. It means he is unresponsive to
price. It means he doesn't care if you are starving, it means
he doesn't care if you are freezing. He has a mandate set by a
risk committee. A year ago----
Mr. Conaway. Excuse me. He does not care about the price?
So if the price went down, he doesn't care?
Mr. Johnston. He is going to acquire the length required in
order to fill his investment mandate, and he will maintain it.
Mr. Conaway. So he cannot lose money on those contracts?
Mr. Johnston. It doesn't mean that he can't lose money. It
means that he doesn't care because his investment----
Mr. Conaway. He doesn't care if he loses----
Mr. Johnston. Not at all. The whole idea, the paradigm of
passive investing is to stabilize returns, not to achieve
returns. It is a noncorrelating asset class. So if stocks and
bonds are going up, usually commodities are going down. That is
the theory. Right now stocks and bonds are going down.
Commodities are going up. So from that point of view, the
paradigm is performing. But where it mixes things up in
commodities is the passive long is virtually indifferent to
price discovery, liquidity. He makes no contribution to that.
What he does is he owns a huge stock of the daily liquidity
supply and he does not contribute that ever.
Mr. Conaway. So squeezing additional liquidity out of the
market would be helpful?
Mr. Johnston. He doesn't even know he is squeezing
anything. What he has done is he has made a decision in
Committee. Here is a good example. Last February a lady came on
TV from CalPERS and said, ``We had $500 million in commodities
for the last few years. It has been great. We are going to
raise it sixteen-fold this year and go to $7 billion.'' You do
the math on that. GSCI website says it is 77.5 percent energy.
That meant that they were going to pick a window of liquidity
this year and buy 55,000 lots of energy. I know everybody is
kind of grappling with, is a million big, is this small? Take
it from me, a 55,000 lot buy order going into energy is
massive. It is huge. And you can pick the dates. You can call
CalPERS. I suggest you do that and say, hey, when did you make
this announcement? And look what happened to crude oil. There
was a frantic tormented demand for liquidity in crude following
in the next 4 weeks.
Mr. Conaway. So if CalPERS had said, we are going to buy--
--
Mr. Johnston. We are going to buy $7 billion worth of
commodities.
Mr. Conaway. But if CalPERS had said we are going to buy
that much in stocks, wouldn't that have been the same thing?
Mr. Johnston. Stock is different.
Mr. Duffy. With all due respect, sir, if I could just
clarify--55,000 contracts is the number I think you stated. The
volume on the New York Mercantile Exchange on any given day is
about two million contracts. So you are talking about a very
small percentage of an order going into the marketplace. We are
not ever saying that one large buy order or one large sell
order cannot have a short-term effect on a market. But it
always goes back to equilibrium.
So I think that it is very misleading when he is trying to
tell the Committee 55,000 is a lot of contracts. It is not. CME
Group trades 15 million contracts a day.
Mr. Johnston. Okay.
Mr. Conaway. Thank you, Mr. Chairman.
The Chairman [presiding.] The gentleman from North
Carolina.
Mr. Etheridge. Thank you, Mr. Chairman. Let me thank each
of you for being here.
For those who are watching this today who are probably not
familiar with this, they all think they are short if they are
consumers. I guarantee you, my folks at home, the farmers, the
merchants, everyone really believes they are being short, and
so they are trying to get to this so we get some balance back
in this thing.
Mr. Johnston, let me ask you a question. Mr. Duffy
described the purpose of margins as a performance bond designed
to ensure that contractual obligations are met and that the
clearinghouses can fulfill their responsibilities. My question
to you, do you agree with this description, or do you think
margins serve another purpose?
Mr. Johnston. I think they serve another purpose.
Mr. Etheridge. And would you explain.
Mr. Johnston. Well, if we were in the 19th century, I would
say that is true, it was a true statement. But since the 1980s,
when we had managed futures and there was a great concentration
of capital in and around futures and it has morphed into this
marketplace that it is now, margins can and should mean more.
And right now we need some form of intervention rate in order
to stop what is happening to energy.
And when I suggest saying, just raise margins on the longs,
I guarantee you, that will have an impact. It will soften what
is going on in terms of the up move. It will actually make it
go down. Because you are taking a situation where there is
tremendous asymmetry of resources, where you have this
community of people who have trillions of dollars to allocate.
And they are not really thinking that well. They are saying,
``Okay, well, let's throw a few billion here, and we will put a
few billion there and we will see what the returns are.'' Well,
in the little world where people are actually working and
buying this stuff, it is having tremendous impact. So I am
saying, let's have an ascending rate of margins. If you have
10,000, you pay a minimum margin. If you have 20,000, well, you
pay 50 percent. So you think, gee, do I really want 20,000? And
if you are going to go to the area where you are carrying
30,000&50,000 contracts of futures, I think you should be
putting up the full amount cash. If they have the bills, let's
see 'em. Bring 'em in. Let's see 'em. Put them up.
Mr. Etheridge. Let me follow that with the following
question, and I will let the others comment if we have time
left. You advocate, as you just said, margin requirements for
over-the-counter transactions as well, given the over-the-
counter participants separately negotiating the credit risks
associated with the swap and the swaps often are, as you well
know, unique tailored estimates and agreements that differ from
each other. I guess my question would be, how would the CFTC
impose the appropriate margins on each over-the-counter
transaction? And if they do, do you think the CFTC has the
resources to perform these functions? Or what should we do to
deal with that?
Mr. Johnston. I don't know. And I don't know.
Mr. Etheridge. I guess that is an answer. Do either one of
you want to comment on the previous two questions?
Mr. Keith. I would like to comment on the concept of having
higher margins on the longs.
Mr. Etheridge. Longs. Thank you.
Mr. Keith. We don't think that is the right approach. We
think we are going to run into situations where we have funds
that are net short. And some people are going to accuse the
funds then of forcing prices lower more quickly than they would
be otherwise. And what are we going to do? We are going to
switch on the downside and penalize the people that are going
short with higher margins? I think that that is just not good
Federal policy.
Mr. Duffy. I would like to echo those comments. Margins, as
in my testimony, is no way to effectuate price whatsoever. We
have seen prices increase in crude oil, we have seen price goes
up in grain products. And the margin goes up but the price
doesn't come down. It is strictly there based on volatility to
protect the integrity of the clearinghouse. It has nothing to
do to affect the price and I completely agree with Mr. Keith.
You have people on both sides of this market. You are going to
create yourself an issue. I guarantee you, if corn starts to go
down, and these funds are big shorts and start to add onto
positions, you will be sitting in this room trying to figure
out how to get rid of $1.50 corn then. Now what are we going to
do? We are going to raise the margin for the shorts again. Then
we will get back to the gentleman on the left to fix his
problem again. It is just ludicrous to think that margins have
anything to do with price.
Mr. Johnston. Can I respond to that?
Mr. Etheridge. We have about 20 seconds.
Mr. Johnston. I think it is essential you weigh out the
effect of what is happening to people in energy right now. Like
you say, they are losing their jobs, they are losing their
businesses and we need to deal with this. We need to get this
price to stop doing what it is doing, and through margins we
will do that cheaply and quickly.
Mr. Etheridge. Thank you. Mr. Johnston, just a final point.
You are making proposals dealing with margins, and you didn't
know on the other one. I would suggest you go back and research
that. We would appreciate having a response on that in writing
because you made some pretty broad proposals here, and then you
don't know what those proposals do.
Mr. Johnston. I don't have any experience in OTC.
Mr. Etheridge. Well, I would appreciate you taking a look
at that and getting back because that would have an impact just
like it did on the other markets.
I yield.
The Chairman. The gentleman from Georgia.
Mr. Marshall. Thank you, Mr. Chairman. I find myself in
agreement with Mr. Duffy's remarks concerning the purpose of
margins and the likely effect of different proposals that have
been made. It just seemed to me that risk management models
that have been developed by CME and others are truly models for
the industry generally. Frankly I think the SEC and that entire
side of the financial services industry is well behind the
times in appropriate management of risk.
I don't, however, agree, Mr. Duffy, with your assessment of
the impact of this passive money. I think Mr. Johnston has a
better case there based on what I have been hearing for several
days now. It is not that I feel like I have a complete handle
on this. I don't think anybody really does have a complete
handle on this. I think that in a sort of abstract theoretical
world somebody like Dr. Pirrong could feel like he has got an
abstract--a perfect handle on this. But I don't think we live
in that abstract theoretical world. I think Mr. Johnston's
description is consistent with the description we are getting
from any number of other people, the impact of this, and it
makes common sense. It just seems to me the burden is on others
to suggest that money like this wouldn't have an impact. It is
the burden on them to prove it. Because just common sense and
the way markets typically work, money like this does have
impacts like that. So I just don't think that, Mr. Johnston,
this is the solution, that it would have all the negative
impacts that Mr. Duffy suggests it would have, and frankly Mr.
Keith agrees.
Mr. Keith, I find most of your suggestions to be quite
reasonable, things we ought to be doing. I think we ought to be
considering those things.
Mr. Johnston, let's assume that you are right and that
there is the problem present that you described, and many
others described, and that we need to make some action quickly
to deal with it. I think you were here earlier. You heard me
suggest that perhaps the way to do this is to have federally
set position limits that apply to all the players and then to
provide that it will be a Federal criminal penalty, a felony
subject to jail time by any device or mechanism to attempt to
circumvent those federally set limits; with the idea that
anybody is welcome to come and play in the futures market for
whatever reasons but only to a certain extent.
Would that have the same beneficial effect that you are
looking for?
Mr. Johnston. If I had known you were going to say that, I
would not have gotten up at 2 this morning to drive all the way
down here to talk to you.
Mr. Marshall. Wait a minute. I am just one voice here.
I think I was a voice all along who--and I still think that
the long-term fundamentals where supply and demand on oil,
where price is concerned, are absolutely heading toward higher
prices. There is just no doubt about it. We have to take some
action. The dollar's a big problem. I mean, there are a lot of
things that are causing this. But part of it, I am persuaded,
is what you are describing. How much, I don't know. But these
markets were never intended as a place to park your money and
just have a position in.
The price discovery function is disserved by that. The
confidence that people have in the market is disserved by that,
which is bad generally for American markets, for all of our
financial markets. I think that a simple solution might be what
I described. That is what we did years ago with ag commodities
once we started having these same problems where the ag
commodities are concerned. And the reason for Federal criminal
penalties, frankly, there are all kinds of devices to
circumvent this if you want to. But if it is a criminal problem
to circumvent it, then maybe you won't. What do you think?
Mr. Johnston. I think it is a great idea. My concern is how
long will it take to put it in place? And the risk of the
market right now is not unlike sugar in the 1970s or silver in
early 1980. I mean, there is an inadequate amount of liquidity
for whatever reason to satisfy the buyers. And the slightest
thing, whatever it could be crude could go up $20 in 1 day and
go up another $20 the next day. I think it is up $10 in the
last 24 hours.
Mr. Marshall. Well, it seems to me the market is very
savvy, much savvier than we are about its business. And if it
sees Congress heading in the direction I described, don't you
think it is that savvy? It seems to me people are going to
start thinking about liquidating their positions.
Mr. Johnston. It is not going to change the architecture in
the market right now. This setup that we have doesn't happen
all the time. It used to happen when some guys would get
together in plaid pants and foot-long cigars and say, hey,
let's squeeze orange juice. This is an accident. It was a great
idea; 15 years ago some smart guys got together and said, ``If
we do this, it will be good for the overall portfolios.'' But
it has morphed. It has turned into this massive growing
monster. And the liquidity that is available facing the market
now, I mean it is in the background of a very of positive
supply-demand fundamental anyway. There is growth. There is use
of energy. You add this kind of turbo-charging absence of
liquidity to the market, and you are risking something that
only commodity markets can do.
If I sat here last November and said we would be trading
$150, would you believe that? Would you have said, that guy is
crazy. We are not going to $150. Well, here we are at $150.
There is no sign that this is going to change at all. Not any
amount of, like, down the road we are going to do something
with limits. That is not going to stop it. That is not going to
stop it. You have to be able to do something now. Otherwise
what we are hearing from these people is that there are going
to be people that are starving and freezing and dying and all
that other stuff. And that is not what it is about. That is not
what the market, the free market is for.
Mr. Marshall. Mr. Johnston, thank you, sir. I yield back.
The Chairman. I thank you the gentleman. The gentlelady
from South Dakota.
Ms. Herseth Sandlin. Before the hearing today, I had been
persuaded by conversations I had been having that higher
margins were not the answer, and I still find fairly persuasive
Mr. Duffy's explanation for why that would cause some problems.
But Mr. Johnston, you are putting forward some interesting
analysis, and I think my colleagues on the Committee have done
a good job of exploring some of this with you. Rather than the
back-and-forth that we have had here, though in terms of where
we need to go with further evaluating this particular issue, I
do want to go back to a more general question for all of you. I
think that Mr. Keith, you may have answered it in a comment
that you had made with regard to transparency for
nontraditional participants. But what are each of your thoughts
on how important it is to examine and redefine who is in the
markets? I guess that will include both on and off-exchange and
the decision of whether an update of these definitions and
players is needed. And if you think that it is needed, how do
we best accomplish that goal? And if you don't think it is
needed, why not?
Mr. Duffy. I would be happy to take that, Congresswoman.
You know, we as the largest regulated futures exchange not only
in the U.S. but in the world, we agree with that. We agree with
transparency. It has been something we have been on the record
for many years here in Congress calling for more transparency.
We have called for the elimination of the exempt commercial
market over the years. We have been doing all that.
I think the CFTC has done a terrific job. You heard Mr.
Greenberger make some comments earlier where he thought the
steps that they have taken have addressed a lot of the issues.
And that is the first time I have agreed with Mr. Greenberger,
but there are a lot of things that have gone on lately that are
the right things. But we have been abiding by this all the
along, and that is what a regulated futures exchange does.
So the makeup of the participants, we have commercials
versus noncommercials; on the hedge fund stuff, the exemptions.
I just wanted to make one other comment about that because it
is a class of traders that I think is important from the CME
Group's perspective. As we have seen the price of wheat, corn
and soybeans go to $18, $16 and houses floating down streets,
we can understand why these products are doing what they are
doing. But we have seen a decrease in the participants of these
so-called passive long onlys and these products in face of
grain products doing what they are doing.
So the arguments to my left just don't make any sense. So I
am sorry to get off topic a little bit, but I think that the
makeup of the participants is being watched carefully and
effectively on regulated exchanges.
Ms. Herseth Sandlin. I am glad you went off topic a little
bit because as you did, it sort of raises the issue that we are
trying to get at and that is the immediacy of this issue. I
agree the CFTC has taken some important steps. But I also
believe strongly they wouldn't have, absent the Congressional
pressure to do so, because for weeks they claimed that there
was no problem. The fundamentals were solid. They didn't need
any additional authorities; resources maybe but authorities,
no.
Well, again, as I mentioned, I am persuaded by a lot of
what you say about the potential effect of higher margins. What
is the best solution? Because we can't sit back--I think there
has to be some Congressional action here.
Mr. Duffy. We are not disputing what you are saying,
Congresswoman. I am not going to defend the CFTC on what their
actions were. We were on the record going back as far as 2002
calling for some of the exemptions that were put into place. So
there is no disagreement from CME Group.
Ms. Herseth Sandlin. So in addition to agreeing that
greater transparency about all the players in the market but
disagreeing that higher margins, whether it is higher rate of--
--
Mr. Duffy. Absolutely.
Ms. Herseth Sandlin. What else do you think based on the
legislative proposals that have been introduced to date? Do you
agree with any of the other provisions in addition to enhanced
transparency or authorities for CFTC? What else do you think
might be a good tool to use to address this issue and the
problems for our constituents that were best articulated so far
today by Mr. Kagen?
Mr. Duffy. Again, I will go to the one single word which I
think makes the most amount of sense, and that is transparency
and reportability and accountability. That is what a regulated
futures market does, that is what the New York Mercantile
Exchange does, that is what the CME Group does. So those are
the only exchanges I can speak to as the regulated exchanges. I
think we are doing exactly what Congress has mandated us to do
through the 2000 Act.
Ms. Herseth Sandlin. So on the accountability issue, what
are your thoughts on Mr. Marshall's suggestion about criminal
penalties?
Mr. Duffy. Mr. Marshall very well knows as the rest of the
Agriculture Committee knows, position limits in agricultural
products at the CME Group are set by the United States
Government, not by any particular entity. So we agree with him
on the limits as it relates to our grain products. As it
relates to energy products, there are accountability limits
until the last 3 days, and then they go into hard limits. Pre-
2000, I believe those were all hard limits going into that. So
I am assuming that is where Congress is going to take a look. I
am assuming that is what Mr. Marshall is referring to.
Ms. Herseth Sandlin. Thank you.
The Chairman. I thank the gentlelady. The gentlelady from
Kansas.
Mrs. Boyda. Thank you very much. I am going back to the
same kind of question that I had earlier. If you think this is
mainly market-driven, then why has the price of a barrel of oil
tripled in a year and a half?
Mr. Duffy. Why has the cost of corn tripled in a year?
Mrs. Boyda. You could say because oil has tripled.
Mr. Duffy. We can see why these are happening in
agricultural products. I don't think there is anybody denying
in this room or anywhere else why we are seeing the price of
agriculture doing what it is doing. We have every foreign
government putting tariffs on the United States on exports----
Mrs. Boyda. Excuse me. I have just a little bit of time
here. Let me go back to oil. We have seen oil basically triple.
Demand hasn't really substantially changed. The price of the
dollar, cost of the dollar, the valuation of the dollar hasn't
changed that much. What would you say is causing oil to
basically triple?
Mr. Duffy. I think the market in all honesty is
anticipating higher prices down the road and that is what it
does. If you look at a futures market----
Mrs. Boyda. This is mainly psychological?
Mr. Duffy. On WTI, the market is anticipating both
commercials and processors and users. In 2012, for delivery on
the NYMEX, they are looking at the crude oil at $140 a barrel.
So in turn, the spot goes there. If you could fix problems
today, that may take us several years and take the deferred
price down, I am assuming that would affect the spot price
also. So it is just anticipation of what the future looks like.
Mrs. Boyda. But there isn't anything that is really----
Mr. Duffy. I don't know. I am hearing that there is a
finite amount of this supply and there is an appetite for more
of it. I am not an oil expert, ma'am. So I will be somewhat
careful. I just understand how futures markets work and what
people are telling you what they think.
Mrs. Boyda. Do you think----
Mr. Duffy. Those aren't just speculative----
Mrs. Boyda. Do you think when the oil companies say, ``By
the way, we don't have one piece of equipment to drill
anymore,'' what do you think that does to the price of a barrel
of oil? Is that the sort of thing you are talking about?
Mr. Duffy. I find that hard to believe actually, but----
Mrs. Boyda. What?
Mr. Duffy. That they don't have any money to buy one piece
of oil to drill----
Mrs. Boyda. Well, they have the money. They have a lot of
money. Obviously we know that. No. There is not a rig around.
The American Petroleum Institute said here a couple of weeks
ago that, ``No, we don't have any drilling equipment. We have
leases out the Ying Yang, but we don't have any drilling
equipment.''
Mr. Duffy. What was their answer?
Mrs. Boyda. There wasn't an answer. That was just stated as
a given. What you are saying is if this is market driven, then
basically what you have done--we all know now we have 68
million acres of land on shore, as well as millions of acres of
land on the Outer Continental Shelf as well as in Alaska, apart
from ANWR, that are drillable today with larger resources than
any of this ANWR stuff that people are trying to--so what you
are saying is that ultimately panic is driving the marketplace.
I know you are not an expert; but what you are really
saying is that this is driven by some fear. So, when the oil
companies say, ``Gee, we don't have any more equipment,'' then
that is what you would say would be driving the market. Mr.
Johnston would say it is actually more boys at the party than
girls at the party. But you are saying that it is this fear
that we are not going to have a supply.
Mr. Duffy. It is anticipation of price. And it is no
different if it is up or down. That is what the futures markets
do. They give people an opportunity to manage the risk into the
future and that is what the WTI market is telling us today,
that they believe----
Mrs. Boyda. You think it is the oil companies--I am just
speculating here myself. And I am just having a kind of
conversation and I know you are not the oil company. But if you
think they said, ``Oh, my gosh, we just took ownership of ten
new rigs and we are going to start drilling,'' do you think the
market, in fact, would come down? So this is just in
anticipation?
Mr. Duffy. I do not know if that is something----
Mrs. Boyda. But what you are telling me is that that is why
the market has gone up.
Mr. Duffy. No. What I read from the President of Gulf Oil
in his op-ed yesterday in The Wall Street Journal is saying
that if they were to do certain things, they believe the market
would come down. But right now they are not doing it. Certain
things mean drilling.
Mrs. Boyda. They don't have any drills. They don't have any
rigs. They said that.
Mr. Duffy. I don't know if that is what Gulf Oil is saying.
I am just telling you what I read yesterday in The Wall Street
Journal, and he is talking about the deferred futures price of
oil being at $140 a barrel. He is saying it is because of the
supply equation that we know we have today. He says if you
start to do things that could affect the price 5 years out, he
believes that will affect the spot price of today's market. And
that's reporting from him.
Mrs. Boyda. I will yield back in a minute. But what you are
saying again is if I were an oil company and I wanted to drive
supply down and constantly be out there in the market talking
about that, that that would be enough then to drive the prices
of oil up--because, in fact, you are limiting supply. They can
drill until the cows come home. I am from Kansas, I can state
that. I think it is a very compelling argument, but what you
are ultimately saying is that the supply and demand hasn't
changed very much, the dollar hasn't changed.
Mr. Duffy. I did not say that.
Mrs. Boyda. I am saying that. It hasn't changed enough to
warrant a threefold increase. But if you have somebody out
there beating the drum, saying this is all supply driven, then
you are saying it is that fear of it that is going up because
you haven't yet given me anything that I can really bite my
teeth into and say this is the supply and demand future that I
can now take home. It is all basically this fear of what is
going to happen.
Mr. Duffy. I think you stated the fact earlier there were
88 million barrels a day----
Mrs. Boyda. Sixty-eight.
Mr. Duffy. Whatever the number was.
Mrs. Boyda. Sixty-eight million acres of land that are----
Mr. Duffy. I am sure you are also aware that we planted 94
million acres of corn in 2007 and according to the government
mandate for ethanol program, by 2017 a third of those acres
will go away just for the ethanol program. So we want to go to
talking about how we are going to feed our people. We have
other issues associated with it. So there are a lot of issues
in this energy and I don't think I can solve them in this
hearing right now for you.
Mrs. Boyda. All right. Mr. Johnston, I don't understand the
six girls and four boys. I think I am beginning to understand
some other things. Thank you.
The Chairman. I thank the gentlelady. The gentleman from
Wisconsin.
Mr. Kagen. Thank you, Mr. Chairman. Mr. Duffy, thank you
for complying with all the Federal guidelines. I know how
difficult it is. We don't mean to make your job any more
difficult or challenging. And I appreciate the services that
you offer. One of the essential elements in my colleague Mr.
Etheridge's bill has to do with transparency. So can you tell
me what percent of the contracts in the CME are being purchased
and sold by pension funds?
Mr. Duffy. I don't have an exact number. Pension funds have
a limit of a percentage of how much they can invest and
diversify into our marketplace. I think it is roughly four to
five percent. So that would be in several different products.
We have asset classes from everything from interest rates, to
foreign exchange, to equities, to agricultural products and
alternative investments such as real estate and weather.
Mr. Kagen. From the information that you are aware of, are
the pension funds a major investor in oil commodities?
Mr. Duffy. I would not have that information, sir.
Mr. Kagen. So we don't have that information?
Mr. Duffy. I would not have it. We don't run the oil
business.
Mr. Kagen. So you don't keep that information. Your friend
and colleague, Mr. Johnston, has suggested that perhaps
increasing the margins, the limits--let us call it the limits--
on longs and passive longs is a meaningful way to control this
herd mentality. What do you think about that?
Mr. Duffy. Well, I respectfully disagree and I agree with
what Mr. Keith said. I think if we have a problem to the down
side of the market, are we going to impose higher margin
requirements for the short side of the market because they are
taking the price too low.
So I just completely disagree with it. I don't believe in
two-tier markets. I don't believe they are effective and I
don't think they suit the needs of what everybody has said in
this room. They are intended to be there for the commercial use
and now they are going to have a lopsided approach to it. So
you could hurt the liquidity. In all honesty, sir, that will
hurt the processor, the producer and everybody else involved
with their product.
Mr. Kagen. Do you have an opinion as to whether or not
pension funds should be allowed to invest in commodities?
Mr. Duffy. They do today, sir. I think that diversification
is critically important for anyone's portfolio. I am a member
of the Federal Retirement Thrift Savings Plan. I am a fiduciary
for the government in that respect. And when you are sitting
there with just long haul equities and the market is going
down, I mean, it is a very painful event. I think people should
have the opportunity to diversify into asset classes such as
commodities to offset some of the inflationary needs. And that
is what exactly what they are doing.
Mr. Kagen. Earlier today there were references made to the
CFTC extending a letter on July 3rd to apply some additional
rules and regulations to ICE and Dubai markets. Do you feel
that that letter that I am holding here, that this letter
would, in action, be effective at all in reducing the oil
prices?
Mr. Duffy. To give them increased--I am sorry, sir. What
was that for?
Mr. Kagen. Would the recent action of CFTC have any
implication to bringing down oil prices?
Mr. Duffy. The CFTC requiring ICE to comply with the same
rules that the NYMEX has?
Mr. Kagen. Yes.
Mr. Duffy. I don't believe that affects the price one bit,
sir, no.
Mr. Kagen. Does it help with transparency?
Mr. Duffy. I think it does help with transparency.
Mr. Kagen. Okay. Mr. Johnston, do you care to comment on
any of the questions I've asked?
Mr. Johnston. Yes. First of all, when Bear Stearns was in
trouble and it looked like there was going to be a big problem
on Wall Street, there was an intervention policy to deal with
the crisis. And I think crude is in the same type of crisis. So
when I say we should raise margins on longs, I am not trying to
just inhibit pension fund behavior. I say pension fund behavior
is essentially a part of the cast of players causing the
problem. We need to understand that and I have tried to give
you a new look or a new point of view on what is happening
there. But when I say raise margins on longs, I want you to
consider doing something that will be effective immediately,
now. And I want you to hand them a weight, a handicap. The
asymmetry which is now occurring and it occurs occasionally, it
doesn't always happen in crude. It happened with beans in the
1970s. Every now and then, things get out of hand.
Mrs. Boyda. Will the gentleman yield?
Mr. Kagen. Not right now. You are looking for immediate
action as everyone is. I have asked the President as has the
leadership of this Congress to immediately release 500,000 or
so barrels a day of our SPR to put more onto the market.
Wouldn't that immediately drive prices down?
Mr. Johnston. Let me think. In the past the long position
was equal to about two billion barrels right now. So yes, that
would add up. It would take time, but it would add up.
Mr. Kagen. It is a temporary measure.
Mr. Johnston. It is temporary. Two things would happen. If
you could persuade the pension funds either through moral
persuasion or otherwise that what they are doing is self-
immolating, that every time they buy another barrel of crude
oil, they are destroying the stock portfolio they are trying to
defend. So maybe they would say that makes sense. We have
enough, we will stop. That has happened before.
Mr. Kagen. Wouldn't it also be a wise move to have a
national energy policy?
Mr. Johnston. I agree with that 100 percent. I think
anything you can do now--maybe I am wrong on margins. It is not
something that I was trained to do. I trade. And I am only
talking about that from the point of view as a trader. If I
heard you were raising margins on longs from four percent to 50
percent, I would say that is it, I am not trading crude
anymore. I just wouldn't do it. I don't know of a single trader
that I know--and I know hundreds--that would say, okay, I am
going to trade crude today. They would just stop. That is it.
If a guy was going to sit down at Morgan Stanley or JPM, and he
was planning on buying a million barrels of crude today and he
had to put up a million barrels of crude, $150 million--he had
to put up $70 million, his trading manager would probably say
``No, you are not doing that.''
Mr. Kagen. Thank you very much for your response. I see my
time has expired and I will yield back.
Mrs. Boyda. Mr. Chairman, could I ask one more quick
question?
The Chairman. If you are quick.
Mrs. Boyda. What would a temporary--would there be any
temporary margin increase that----
Mr. Johnston. How does it start and how does it stop?
Mrs. Boyda. Right. And how long--if you made it temporary,
what would be the shortest time that you could do this in order
to--and what would the effect of that be?
Mr. Johnston. This is guessing. I have seen the effect of
raising margins. Ultimately, if you raise them equally as Mr.
Duffy said, it would be toxic. It would just cause crude to
explode because it would put tremendous pressure on the short.
And since we have asymmetry in the auction as it is, where it
is really the long side that is the problem, coming from the
passive long----
Mrs. Boyda. If we went with your proposal for what you are
talking about, what is the shortest amount of time and what
would be the effect be of a short drive?
Mr. Johnston. Depending on how high you are willing to
raise the margins, I think it would go below $100 almost
immediately.
Mr. Duffy. No.
Mr. Johnston. I think it would go straight down.
Mr. Duffy. Mr. Chairman, could I respond real quickly, sir?
One second. Two things. First of all, there are business plans
in this country that have long hedges on energy that you would
be distorting their whole business plan that they put into
place many months or years in advance. One being Southwest
Airlines. I don't know if they are still technically long
hedged crude oil to protect their business model, but you would
be distorting an American business model, changing the rules of
the game after they did it and they are in a very fragile
situation also.
That is irresponsible for someone to testify on that and to
say that is a good business plan. Second of all, we have no
evidence that margins on long investors would affect the market
whatsoever. We have clearly shown in our testimony that these
passive long onlys already put up the full value of this
contract today, it is just held in a separate account. So they
would shift that money over right to the other account, you
would not affect the price one bit. You would affect business
models that are based on long hedging already.
The Chairman. I just want to weigh in and let people know
that I am totally against this idea because it is going to be a
negative for my farmers and they already have enough problems
out there with the margin situation. Mr. Keith, I would guess
you agree with that.
Mr. Keith. Yes.
The Chairman. I have farmers that can't get a forward
contract right now because the elevator can't afford the margin
calls. So the last thing we need to do is raise these margins.
I agree. I don't think it is going to affect the price one way
or the other. Now, my question is, can't you accomplish the
same thing by putting position limits, getting rid of the hedge
exemption and putting position limits on these vehicles?
Couldn't you do the same thing?
Mr. Johnston. Me?
The Chairman. Yes.
Mr. Johnston. Yes, you could if you could do it now.
The Chairman. Pardon?
Mr. Johnston. Can you do it now?
The Chairman. Sure. We can pass a bill that says--well, we
can set them ourselves, which I think would be a dumb idea
because we don't--I guess we could get together and figure out
amongst ourselves what the position limit of oil should be.
That would be an interesting experiment. But, more likely we
would give the CFTC a short period of time to develop position
limits. We have them in agriculture; they work. As I understand
it, people get together, the folks that are involved in this,
and give advice to the CFTC and they set these limits, right?
Mr. Duffy. The government does, yes.
The Chairman. Or we could do that with oil. We would do it
short order. We could give them 90 days and tell them to look
at this and do it. We are going to have information back that
is finally being collected by the CFTC right now. By the first
part of September, we are going to know this information about
these swaps and what all is going on here with all of this
stuff that is now in the dark market. We are going to know that
information in September. So I think there are other ways to
get at this. I think what you are proposing would work, but one
of my bottom-lines of this whole situation is I am still not
totally convinced how much effect the speculators are having on
this price. I understand people don't like to pay this price
for gas and they are looking for somebody to blame and the
speculators might be part of it. They probably are some part of
it.
But the bottom-line for me is that in agriculture, we are
the people that started this whole thing in the first place. We
depend on this. The last thing I want to do is to do something
here in response to some political pressure in gasoline that is
going to screw up the agriculture markets. And bottom-line,
that is where I am coming from. I think these margin ideas will
screw up the ag market eventually--potentially.
Mr. Marshall. Mr. Chairman, over here. May I just add on to
one thing?
The Chairman. Sure. Briefly.
Mr. Marshall. Mr. Johnston, I wouldn't expect you to know
this, but our laws currently provide for criminal penalties for
fraud or market manipulation. Basically we don't want somebody
going out there and intentionally skewing things in order to
affect prices. In a sense, if we did something as odd as step
in and target longs in some specific way, we the government--of
course, we can get away with it, because we are the ones that
make the laws and they don't apply to us--but we the government
would be guilty of going in there and doing exactly what we
provide criminal penalties for others doing.
So I just don't think we are going to head in the direction
of fooling with frankly a great risk management model that has
been developed here. The direct way to deal with this, to me at
least, is with position limits that work. The testimony is they
don't work because people just go off-exchange and circumvent
them and so we just make criminal penalties for circumvention.
I just don't think the industry is going to be interested in
subjecting itself to criminal penalties. Going back to price
discovery, market confidence and people who want whole
commodities, there are other mechanisms for doing that. This
never was intended for that purpose.
The Chairman. I thank the gentleman. I thank this panel.
You did an excellent job. We appreciate your making your
expertise and time available to us. We will call the next
panel, which is called the miscellaneous and general panel. We
have Mr. Tim Lynch, the Senior Vice President of the American
Trucking Association; Mr. Daniel Roth, President and CEO of the
National Futures Association; Mr. Tyson Slocum, the Director of
Public Citizen's Energy Program; and Captain John Prater,
President of the Air Line Pilots Association.
Welcome to the Committee. Mr. Lynch, all your statements
will be made part of the record. And any Members that have
statements will also be made part of the record. We would ask
you to summarize and try to limit to 5 minutes and I appreciate
your being with the Committee. Mr. Lynch.
STATEMENT OF TIMOTHY P. LYNCH, SENIOR VICE PRESIDENT, AMERICAN
TRUCKING ASSOCIATION, ARLINGTON, VA
Mr. Lynch. Thank you, Mr. Chairman and Members of the
Agriculture Committee for giving us this opportunity to present
our views on the impact of escalating prices on our industry
and our suggestions for addressing the problem, including those
related to the Commodity Exchange Act. The trucking industry is
the backbone of the nation's economy, accounting for more than
80 percent of the nation's freight bill. The U.S. trucking
industry is comprised of over 211,000 for hire carriers and
more than 277,000 private carriers. Over 80 percent of all
communities in the United States are served exclusively by the
trucking industry. Diesel fuel is the lifeblood of the trucking
industry. We will consume some 39 billion gallons of diesel
fuel this year. The national average price of diesel is now
over $4.70 per gallon, which is nearly $2 more than just 1 year
ago. While most of us feel the pain of higher fuel prices when
the gas pump reads $60 or $70, it costs a trucker approximately
$1,400 to fill up and he or she gets to do that twice a week.
In fact, fuel has now surpassed labor as the single largest
operating expense for most truck companies. These costs have a
dramatic impact. In the first quarter of 2008, 935 trucking
companies with at least five trucks closed their doors. It is
very likely that an even greater number of single truck
operators have also turned in their keys. This is the largest
number of trucking closures since the third quarter of 2001.
According to the Department of Labor, over 10,000 individuals
employed in the trucking industry have lost their jobs since
the first of the year. Beyond the trucking industry, these
costs will have a ripple effect throughout the economy. Trucks
transport virtually 100 percent of groceries, medicine,
clothing, appliances and even the fuel that is pumped at the
local service station. We believe that the dramatic run-up in
petroleum product prices is the result of a confluence of
factors, including increases in worldwide demand, failure to
have a supply to keep pace with demand, the risks associated
with geopolitical instability and weather, and certainly the
dramatic decline in the value of the dollar.
But taking all those factors into account, we find
ourselves still asking the question, why now? All of the items
I just mentioned have been in play for an extended period of
time, and certainly did not begin on January 1 of this year.
Yet on January 1, petroleum was selling for under $100 a
barrel. Today it is selling for over $140 a barrel or roughly
40 percent higher in just 6 months. During the past 5 years,
the assets allocated to commodity index trading strategies have
risen from $13 billion to $260 billion. We have been told that
this figure represents only a fraction of assets, primarily
from pension funds, but certainly other large institutional
investors that could come into the commodities markets. Perhaps
as much as $1 trillion.
So here is a very simple concern. If $260 billion can move
the price of petroleum, even by the lowest of percentage
estimates, then what will $1 trillion do and at what cost to
the economy, to American businesses and certainly to thousands
of truck companies large and small that simply cannot take that
risk. Mr. Chairman, Members of the Committee, we cannot
quantify the extent to which speculation is responsible for the
recent dramatic increase in the price of crude oil. But we do
believe that excessive speculation is part of the problem. For
this reason, we believe that Congress should take steps to
increase the transparency of the petroleum exchanges and
establish reasonable position limits to prevent excessive
speculation. Balancing the need for an efficient petroleum
market with a desire to limit petroleum speculation could help
burst any speculative bubble that has formed in the petroleum
markets.
In conclusion, Mr. Chairman, we in the trucking industry
generally talk in terms of equipment and tools. We view this as
a tool in the toolbox. And we believe there are three of those.
One is a saw to help us reduce demand. One is a hammer to help
try and control some of these markets, and the third is the
drill for more domestic supply. Thank you for giving me the
opportunity to appear. We look forward to working with the
Committee and we would be happy to answer any questions you may
have.
[The prepared statement of Mr. Lynch follows:]
Thank you, Mr. Lynch.Mr. Roth.
STATEMENT OF DANIEL J. ROTH, PRESIDENT AND CEO, NATIONAL
FUTURES ASSOCIATION, CHICAGO, IL
Mr. Roth. Thank you, Mr. Chairman. My name is Dan Roth, and
I am the President of National Futures Association. Over the
years, I have testified at hearings before this Committee a
number of times; and I have sat through a whole bunch more. And
I know from sitting through those hearings that it is always
sort of a tradition for every Member of the Committee and the
witnesses to thank the Chairman for holding these hearings.
Today that is a lot more than just a perfunctory gesture. The
issues before this Committee today are profound, they are
difficult, they are complex and they are very, very important
to all of us.
I am glad that this Committee is taking such a leadership
role because this Committee by far has the most experience with
these markets, has, by far, the best understanding of how
futures markets operate and how important they are to our
industry. So again, thank you for the tremendous commitment of
time and energy over the last couple of days from both the
Committee Members and their staff. NFA is a self-regulatory
organization for the futures industry. We regulate
intermediaries, not markets themselves. We don't regulate the
markets. We regulate the intermediaries that bring customers to
the markets; the brokerage houses; the trading advisors; any
category of registration under the Act that does business with
the public, we regulate them.
A real cornerstone of the regulatory approach to these
intermediaries is full disclosure. We require them to make full
disclosure of risks to all their customers. The reason we
wanted to be heard here today is, the issues you are discussing
aren't directly NFA issues, but we became concerned over the
last couple of weeks that maybe Congress wasn't receiving full
disclosure of some of the risks of some of the proposals that
were being described and discussed over the last couple of
weeks. In our written testimony, we try to describe what some
of those risks might be.
I thank you for letting us incorporate that written
testimony into the record. Today, I have been asked to talk
about CFTC resources. I am happy to do that. I am happy to do
that because as a regulator, I have some firsthand experience
of just how difficult it is for a regulatory body to keep up
with changes in an industry that changes as quickly and
dramatically as the futures industry. I know it is difficult
and I know it is even more difficult for the CFTC because they
don't just oversee the intermediaries like we do. They oversee
the markets as well. It is a difficult proposition.
It is even more difficult--and I think the most telling
statistic I have seen over the last couple of weeks on this
issue, is the fact that since the Commission opened its doors
in 1974, trading volume on the exchanges has increased by 8,000
percent and during that same period of time, Commission staff
has dropped by 12 percent. There is something about that
picture that just isn't right. Now, regulators are like
everybody else on God's green Earth. We are supposed to be able
to do more with less because of technology and I know that is
true.
But still at some point, there is just no substitute for
people. I know that at NFA, for example, we are certainly a
technology driven organization. But in the last 2 years alone,
we have increased the size of our compliance department by 25
percent because of problems we were having in our neck of the
woods. I know for a fact that over the last 5 years, the CFTC
has been getting appropriations of about 80 percent of what it
has been asking for. So it is a difficult situation to keep up
with the industry under the best of circumstances. It is a
whole lot harder when you can't get the resources that you
need. I know Chairman Lukken has testified they could use an
additional 100 people. I know, Congressman Etheridge, your bill
calls for an emergency appropriation for the CFTC. What I am
here to tell you is that NFA as a regulatory body is fully
sympathetic with their situation and strongly supportive of any
legislation that would get them the additional resources they
need.
Mr. Chairman, I have mentioned that I have been here a
number of times before. This is the first time I think I
finished my testimony and the red light hasn't gone off. I have
watched enough C&SPAN to say if I could, I yield back the
balance of my time.
[The prepared statement of Mr. Roth follows:]
Prepared Statement of Daniel J. Roth, President and CEO, National
Futures Association, Chicago, IL
My name is Daniel Roth, and I am President and Chief Executive
Officer of National Futures Association. Thank you Chairman Peterson
and Members of the Committee for this opportunity to appear here today
to present our views on some of the proposals that have been introduced
in recent weeks. NFA is the industry-wide self-regulatory organization
for the U.S. futures industry. NFA is a not for profit organization, we
do not operate any markets, we are not a trade association. Regulation
and customer protection is all that we do. I should also point out that
NFA does not regulate markets--we regulate the intermediaries that
bring customers to those markets.
Our customer protection rules are all designed to ensure that
customers have enough information to make fully informed investment
decisions. That's why we prohibit our members from making wildly
exaggerated claims of performance and why we require members to provide
customers with full disclosure of all of the risks. I think full
disclosure of risks is a good idea in Congress too, but as I have
followed the debate here in recent weeks about how to deal with energy
prices, I've seen a lot more wild claims than I have seen disclosure of
risks.
I have seen a number of witnesses testify that Congress can reduce
the price of energy by 50% within 30 days just by cracking down on
futures markets. I have not heard even a shred of data or empirical
information to support that claim, but it's interesting that once a
third witness agrees with that proposition it moves from testimony to
conventional wisdom to a God given truth with the speed of light. Other
witnesses, including a Pulitzer Prize winning author and economic
researcher, have cited extensive economic and geopolitical factors to
caution against the fallacy of a quick fix. My point is that it is a
lot easier to make wild claims than it is to back them up, and I
appreciate this Committee's efforts to explore these issues in a
careful, thoughtful manner. This is especially important since various
proposals under consideration could have dire unintended consequences.
I should also point out that I usually view the ``unintended
consequences'' argument with a fair degree of skepticism. It seems like
every time we propose a new customer protection rule at NFA or propose
customer protection legislation before this Committee, someone throws
the ``unintended consequences'' argument at us. Usually, people are
pretty vague about what those unintended consequences might be or why
they might happen or why they would be so bad. That's not the case
here. Various supposed quick fix solutions under consideration could
have unintended consequences that are specific, foreseeable and very
likely to do much more harm than good.
Risky Business--Areas Where Congress Must Be Careful
Increasing Margins
Take margins, for example. As I mentioned above, some have
suggested that margins for energy futures contracts be raised to as
high as 50%, with the prediction that with this simple stroke energy
prices will fall by 50% within 30 days. Not so fast, please. First, we
should recognize that in the futures industry margin is a performance
bond designed to ensure that traders meet their financial obligations.
Clearing organizations set margin levels with great care to cover the
potential movement in the value of the futures contract in 1 day's
trading. Used for its intended purpose, the margin setting process has
been a huge success over the last 150 years in preventing defaults and
insolvencies. Using margins to try to artificially lower the price of a
futures contract is another thing altogether and could have the
directly opposite result.
The apparent theory of these proposals is that index funds, pension
funds and other institutional investors have predominantly long
positions in the futures market that are driving energy prices up.
These are precisely the investors, though, that have the deepest
pockets and could easily meet any increased margin requirements. A
dramatic increase in margins could be much more likely to drive more
short positions from the market than longs. Fewer sellers with the same
number of buyers means prices go higher, not lower. I do not know for
sure that prices would go higher, but neither do you and neither do
those that promise that energy prices will drop by 50%. That's the
point. No one knows for sure and that's why there is risk. It is
imperative that you recognize that risk, know that it is real, that it
is substantial and know that you are being asked to roll the dice with
the American economy.
We may not know for sure whether raising margins will cause energy
prices to go up, but we do know for sure that it will not reduce
trading activity--it will simply move it to off-shore or over-the-
counter markets. The energy market is global and complex. Participants
that seek to speculate can do so in centralized markets around the
world or through over-the-counter transactions. Those investment
decisions are based on numbers. If the cost of executing trades on
regulated futures markets soars because of increased margins, those
trades will simply move to a different market. And it's not just
speculators that will be moving. Hedgers need liquid markets to manage
their risks and they will go where the liquidity is, whether it's off-
shore or off-exchange. The trading will still take place and the impact
on prices will not diminish. The risk here is not a loss of profit for
U.S. markets, it's a loss of transparency, of information, of
regulatory authority. The notion that you can build a fence around this
country to keep institutional, sophisticated market participants from
trading the way they want to is simply detached from reality.
Finally, Congress should be aware that raising margins could
increase systemic risk. No one knows with certainty whether increasing
margins would cause a temporary drop in oil prices or drive prices
higher. What we do know is that governmental actions would dramatically
increase market volatility during a time when credit is tight,
particularly in the U.S. No one can predict with certainty the
consequences of such actions, but they would certainly subject the
financial markets to turmoil and stress and a much greater risk of
financial failures.
Limiting Access to the Futures Markets
Other proposals have been discussed that would either limit or
completely block access to the futures markets for certain classes of
investors. Completely apart from the question of whether Congress
should, in effect, be making investment decisions for these market
participants, hasty congressional action could again produce some very
unattractive results. Many swaps dealers, including some of the most
important banking institutions in the country, use futures markets to
hedge the risk of their net exposure to their customers. Those
customers may be speculating or may be commercial users that are
hedging their own risks. When these swap dealers use futures markets to
cover their exposure to their customers, they are generally not subject
to speculative position limits and accountability levels because those
firms are managing their risk. Some have suggested that these
exemptions for swaps dealers should be eliminated, supposedly to reduce
energy prices.
The CFTC has issued a special call for information to the largest
swap dealers in the country to better understand the extent to which
the customers of the swap dealers are engaging in speculative trading
or commercial hedging transactions. Congress should not take any action
regarding the swap dealers exemption until the CFTC has carefully and
thoughtfully analyzed that information and reported its findings. Rash
action at this time could limit the ability of both swap dealers and
their commercial user clients to manage their risk at a time when risk
management is more critical than ever. All too often in the recent past
we have seen what happens when major firms fail to effectively manage
their risk, with significant repercussions for the whole economy.
Others have proposed barring large pension funds from diversifying
their portfolios by investing in agricultural and energy commodities.
The health of their pension funds is critically important to literally
millions of retirees. The health of their pension funds, in turn,
depends on the ability of the fund managers to effectively diversify
their portfolios. Barring pension funds from doing so by locking them
out of certain markets makes no sense at all when retirees have to rely
more and more on their pensions and less and less on Social Security.
Things That Congress Should Do
Obviously, the proposals discussed above each carry the substantial
risk of making a very difficult situation much, much worse. Doing
nothing, however, carries risks of its own. NFA strongly supports a
number of proposals that would be constructive, positive steps.
CFTC Resources
CFTC staffing levels are at historical lows while trading volume is
at historical highs. Something here is not right. It is always a
struggle for a regulator to keep up with an ever changing market place,
but that becomes harder and harder to do when you have fewer people on
hand to do more work. NFA strongly supports proposals for emergency
appropriations to the CFTC to hire more people and upgrade its
technology.
As an aside, I know that regulators make convenient punching bags
when bad things happen. That just comes with the territory. But the
CFTC is an independent Federal agency, independent so that it can
withstand external pressure from any source and try to do what is
right. That's precisely what the CFTC has been doing throughout this
process. In enhancing its information sharing agreements with FSA,
working with Congress to close the Enron loophole in the farm bill,
issuing its special call for information to major swaps dealers,
forming an interagency task force to evaluate changes in commodity
markets and undertaking revisions to its commitment of traders reports
to improve transparency, the CFTC has worked tirelessly to do the right
thing. The Commission has been hard at work in the enforcement area as
well, bringing 39 actions involving energy markets alone and working
with the Department of Justice on 35 criminal prosecutions involving
energy market misconduct. I would like to recognize and applaud the
CFTC's continuing efforts in this area.
Foreign Boards of Trade
The CFTC's recent agreement with ICE ensures that any exchange
located in another jurisdiction that trades energy contracts with U.S.
delivery points or that are linked to U.S. exchanges will provide the
CFTC with the same type of information it gets from U.S. contract
markets for surveillance purposes. We support proposals to codify that
agreement. Drafting such legislation, though, can be a tricky business.
The stroke of a bureaucrat's pen could change a foreign board of trade
authorized to offer trading screens in the U.S. into an unregistered
contract market. That could, in turn, make the positions held on that
exchange illegal futures contracts, voidable at the customer's choice.
Customers with losing positions could simply walk away, leaving an FCM
holding the bag, and a very expensive bag at that. I know that others,
including the FIA, are working on language to avoid that result and NFA
supports those efforts.
Commitment of Traders Report
Transparency is everything in futures regulation. Congress should
require the CFTC to enhance transparency in our markets by revising its
monthly Commitment of Traders reports to ensure that trading by
commercial users of the underlying commodity is listed separately from
trading by index funds and hedge funds. The CFTC has indicated its
intention to do so, but legislation to support that initiative would be
helpful.
Concluding Remarks
In sum, Mr. Chairman, at NFA we constantly advise customers to
beware of anyone that is selling a trading program guaranteed to
produce dramatic profits with little or no risk. We offer the same
advice to this Committee. The quick fix solutions currently being
pitched to Congress carry with them substantial risks of unintended
consequences that are real, that are foreseeable and that are
potentially devastating. To enact these proposals would be to roll the
dice on the American economy and would make the Congress of the United
States the biggest speculator in our futures markets.
As always, we look forward to working with the Committee and would
be happy to answer any questions.
The Chairman. Mr. Roth, we appreciate that very much. I
want you to know that.
Mr. Slocum.
STATEMENT OF TYSON SLOCUM, DIRECTOR, ENERGY PROGRAM, PUBLIC
CITIZEN
Mr. Slocum. Hi, my name is Tyson Slocum. I am Director of
the Energy Program at Public Citizen. We are one of America's
largest public interest consumer advocacy groups. I am speaking
today on behalf of the 100,000 households who are dues paying
members of my organization. Members of the Committee, thank you
so much for the opportunity to testify today. I am going to be
talking about an issue that has not unfortunately been touched
on by a number of the other panelists and that is concerns that
my organization has raised about potential anti-competitive
relationships that exist between affiliates that own or control
physical energy assets, like pipelines, storage facilities and
energy trading affiliates.
Now, we all know that the number one issue in markets is
access to information. If you have access to information,
particularly important information before anyone else, whether
that is hours before, minutes or even seconds before, you can
parlay that access to information into huge gains, whether you
are investing in the stock market or whether you are investing
in commodities. We have noticed a trend of investment banks,
hedge funds snapping up ownership over America's and North
America's energy infrastructure assets; Goldman Sachs now owns
an oil refinery. In 2006, Goldman Sachs completed the
acquisition of over 40,000 miles of petroleum products and
natural gas pipelines in North America.
We have all read about hedge funds and investment banks
snapping up leasing rights over storage facilities. Now, why on
Earth would investment banks and hedge funds invest money in
relatively low return infrastructure assets like pipelines and
storage facilities? It is because control over those assets
provides them with enormous information advantages about
products that are moving through that system or moving into
storage. As we have discovered, there are little to no code of
conduct rules governing communications between crude oil and
petroleum product facilities and energy trading. This presents,
in our opinion, a serious problem. I served as an expert
witness in the State of California before the Public Utilities
Commission challenging certain aspects of Goldman Sachs'
acquisition of two petroleum product pipelines in the State of
California. We raised the issue of wanting to erect firewalls,
prohibiting communications between the California pipeline
affiliates and Goldman's energy trading affiliates. It is
important to note that Goldman at no time challenged our
assertions by saying Public Citizen's proposal is redundant
because we already have effective controls at the Federal level
prohibiting this. That is because no effective controls exist.
There are extensive code of conduct rules prohibiting such
communications in the natural gas infrastructure industry, as
headed by the Federal Energy Regulatory Commission. But they do
not exist at the same level for crude oil and petroleum
products.
There is unfortunately precedent for abuses within these
types of relationships as last year's over $300 million
settlement against the oil giant, BP, where BP was forced to
pay over $300 million to settle allegations that it single
handedly manipulated the United States propane markets by
having its propane, pipeline and storage affiliates communicate
with its energy traders. Those energy traders embarked on a
strategy to corner the propane market. This strategy was not
discovered because of the due diligence of America's regulatory
environment. It was because an internal whistle-blower
discussed the practice of the company, exposed the scheme and
took it to regulators who were able to force BP into the
settlement.
And so, in addition to many of the other things about
increasing transparency over markets, I urge the Committee to
examine this fairly recent trend of large energy traders and
speculators obtaining ownership control or effective control
through temporary leasing rights over oil and petroleum product
infrastructure. Thank you so much.
[The prepared statement of Mr. Slocum follows:]
Prepared Statement of Tyson Slocum, Director, Energy Program, Public
Citizen, Washington, D.C.
Thank you, Mr. Chairman and Members of Committee on Agriculture for
the opportunity to testify on the issue of energy futures regulation.
My name is Tyson Slocum and I am Director of Public Citizen's Energy
Program. Public Citizen is a 37 year old public interest organization
with over 100,000 members nationwide. We represent the needs of
households through research, public education and grassroots
organizing.
American families are reeling under the weight of sustained high
energy prices. Congress can take two broad actions to provide relief:
providing incentives to households to give them better access to
alternatives to our dependence on oil, and restoring transparency to
the futures markets where energy prices are set. The former option is
of course the best long-term investment, as providing incentives to
help families afford the purchase of super fuel efficient hybrid or
alternative fuel vehicles, solar panel installation, energy efficient
improvements to the home and greater access to mass transit would all
empower households to avoid the brunt of high energy prices.
But the second option--restoring transparency to the futures
markets where energy prices are actually set--is also important.
Stronger regulations over energy trading markets would reduce the level
of speculation and limit the ability of commodity traders to engage in
anti-competitive behavior that is contributing the record high prices
Americans face.
Of course, supply and demand has played the primary role in the
recent rise in oil prices. Although gasoline demand in America is down
one percent from a year ago, global demand--particularly in emerging
economies like China, India and oil exporting nations in the Middle
East--has skyrocketed at a time when the mature, productive and easily-
accessible oil fields are in decline. Claims of Saudi spare capacity
are questioned due to the Kingdom's refusal to allow independent
verification of the country's oil reserve claims. Simply put, oil is a
finite resource with which the world has embarked on unprecedented
increased demand.
But there is no question that speculators and unregulated energy
traders have pushed prices far beyond the supply-demand fundamentals
and into an era of a speculative bubble in oil markets. While some
speculation plays a legitimate function for hedging and providing
liquidity to the market, the exponential rise in market participants
who have no physical delivery commitments has skyrocketed, from 37
percent of the open interest on the NYMEX West Texas Intermediate (WTI)
contract in January 2000 to 71 percent in April 2008.\1\
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\1\&http://energycommerce.house.gov/Investigations/
EnergySpeculationBinder_062308/15.pdf.
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Rather than demonize speculation generally, the goal is to address
problems associated with recent Congressional and regulatory actions
that deregulated energy trading markets that has opened the door to
these harmful levels of speculation. Removing regulations has opened
the door too wide for speculators and powerful financial interests to
engage in anti-competitive or harmful speculative behavior that results
in prices being higher than they would otherwise be (at least $30 of
the current $140 of a barrel of oil--or about 70 cents of a gallon of
gasoline--is pure speculation, unrelated to supply and demand.
While the Commodity Futures Trading Commission (CFTC) has taken
recent small steps in the right direction--such as asking the United
Kingdom to set limits on speculative trading of WTI contracts,
proposing stronger disclosure for index traders and swap dealers, and
proposing an interagency task force to more closely monitor energy
markets--Congress must do more to protect consumers.
Public Citizen recommends four broad reforms to reign in
speculators and help ensure that energy traders do not engage in anti-
competitive behavior:
1. Increase the level of disclosure that market participants must
submit to Federal regulators. Requiring investment banks, hedge
funds and other market participants to provide more information
to the government will provide regulators and policymakers with
the data necessary to quickly determine the exact cause of
price swings. Subjecting all energy traders to submit Large
Trader Reports that discloses key information of a trader's
activities is critical to ensure that a market is adequately
transparent.
2. Raise margin requirements so market participants will have to
put up more of their own capital in order to trade energy
contracts. Currently, margin requirements are too low, which
encourages speculators to more easily enter the market by
borrowing, or leveraging, against their positions.
3. Require foreign-based exchanges that trade U.S. energy products
to be subjected to full U.S. regulatory oversight.
4. Impose legally-binding firewalls to limit energy traders from
speculating on information gleaned from the company's energy
infrastructure affiliates or other such insider information,
while at the same time allowing legitimate hedging operations.
Congress must authorize the FTC and DOJ to place greater
emphasis on evaluating anti-competitive practices that arise
out of the nexus between control over hard assets like energy
infrastructure and a firm's energy trading operations.
Energy Trading Abuses Require Stronger Oversight
Two regulatory lapses are enabling anti-competitive practices in
energy trading markets where prices of energy are set. First, oil
companies, investment banks and hedge funds are exploiting recently
deregulated energy trading markets to manipulate energy prices. Second,
energy traders are speculating on information gleaned from their own
company's energy infrastructure affiliates, a type of legal ``insider
trading.'' These regulatory loopholes were born of inappropriate
contacts between public officials and powerful energy companies and
have resulted in more volatile and higher prices for consumers.
Contrary to some public opinion, oil prices are not set by the
Organization of Petroleum Exporting Countries (OPEC); rather, they are
determined by the actions of energy traders in markets. Historically,
most crude oil has been purchased through either fixed-term contracts
or on the ``spot'' market. There have been long-standing futures
markets for crude oil, led by the New York Mercantile Exchange (NYMEX)
and London's International Petroleum Exchange (which was acquired in
2001 by an Atlanta-based unregulated electronic exchange, ICE). NYMEX
is a floor exchange regulated by the U.S. Commodity Futures Trading
Commission (CFTC). The futures market has historically served to hedge
risks against price volatility and for price discovery. Only a tiny
fraction of futures trades result in the physical delivery of crude
oil.
The CFTC enforces the Commodity Exchange Act, which gives the
Commission authority to investigate and prosecute market
manipulation.\2\ But after a series of deregulation moves by the CFTC
and Congress, the futures markets have been increasingly driven by the
unregulated over-the-counter (OTC) market over the last few years.
These electronic OTC markets have been serving more as pure speculative
markets, rather than traditional volatility hedging or price discovery.
And, importantly, this new speculative activity is occurring outside
the regulatory jurisdiction of the CFTC.
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\2\&7 U.S.C. &9, 13b and 13(a)(2).
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Energy trading markets were deregulated in two steps. First, in
response to a petition by nine energy and financial companies, led by
Enron,\3\ on November 16, 1992, then-CFTC Chairwoman Wendy Gramm
supported a rule change--later known as Rule 35--exempting certain
energy trading contracts from the requirement that they be traded on a
regulated exchange like NYMEX, thereby allowing companies like Enron
and Goldman Sachs to begin trading energy futures between themselves
outside regulated exchanges. Importantly, the new rule also exempted
energy contracts from the anti-fraud provisions of the Commodity
Exchange Act.\4\ At the same time, Gramm initiated a proposed order
granting a similar exemption to large commercial participants in
various energy contracts that was later approved in April 2003.\5\
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\3\&The other eight companies were: BP, Coastal Corp (now El Paso
Corp.) Conoco and Phillips (now ConocoPhillips), Goldman Sachs' J. Aron
& Co, Koch Industries, Mobil (now ExxonMobil) and Phibro Energy (now a
subsidiary of CitiGroup).
\4\&17 CFR Ch. 1, available at www.access.gpo.gov/nara/cfr/
waisidx_06/17cfr35_06.html.
\5\&``Exemption for Certain Contracts Involving Energy Products,''
58 Fed. Reg. 6250 (1993).
---------------------------------------------------------------------------
Enron had close ties to Wendy Gramm's husband, then-Texas Senator
Phil Gramm. Of the nine companies writing letters of support for the
rule change, Enron made by far the largest contributions to Phil
Gramm's campaign fund at that time, giving $34,100.\6\
---------------------------------------------------------------------------
\6\&Charles Lewis, ``The Buying of the President 1996,'' p. 153.
The Center for Public Integrity.
---------------------------------------------------------------------------
Wendy Gramm's decision was controversial. Then-Chairman of a House
Agriculture Subcommittee with jurisdiction over the CFTC, Rep. Glen
English, protested that Wendy Gramm's action prevented the CFTC from
intervening in basic energy futures contracts disputes, even in cases
of fraud, noting that that ``in my 18 years in Congress [Gramm's motion
to deregulate] is the most irresponsible decision I have come across.''
Sheila Bair, the CFTC Commissioner casting the lone dissenting vote,
argued that deregulation of energy futures contracts ``sets a dangerous
precedent.''&\7\ A U.S. General Accounting Office report issued a year
later urged Congress to increase regulatory oversight over derivative
contracts,\8\ and a Congressional inquiry found that CFTC staff
analysts and economists believed Gramm's hasty move prevented adequate
policy review.\9\
---------------------------------------------------------------------------
\7\&``Derivatives Trading Forward-Contract Fraud Exemption May be
Reversed,'' Inside FERC's Gas Market Report, May 7, 1993.
\8\&``Financial Derivatives: Actions Needed to Protect the
Financial System,'' GGD&94&133, May 18, 1994, available at http://
archive.gao.gov/t2pbat3/151647.pdf.
\9\&Brent Walth and Jim Barnett, ``A Web of Influence,'' Portland
Oregonian, December 8, 1996.
---------------------------------------------------------------------------
Five weeks after pushing through the ``Enron loophole,'' Wendy
Gramm was asked by Kenneth Lay to serve on Enron's Board of Directors.
When asked to comment about Gramm's nearly immediate retention by
Enron, Lay called it ``convoluted'' to question the propriety of naming
her to the Board.\10\
---------------------------------------------------------------------------
\10\& Jerry Knight, ``Energy Firm Finds Ally, Director, in CFTC Ex-
Chief,'' Washington Post, April 17, 1993.
---------------------------------------------------------------------------
Congress followed Wendy Gramm's lead in deregulating energy trading
contracts and moved to deregulate energy trading exchanges by exempting
electronic exchanges, like those quickly set up by Enron, from
regulatory oversight (as opposed to a traditional trading floor like
NYMEX that remained regulated). Congress took this action during last-
minute legislative maneuvering on behalf of Enron by former Texas GOP
Senator Phil Gramm in the lame-duck Congress 2 days after the Supreme
Court ruled in Bush v. Gore, buried in 712 pages of unrelated
legislation.\11\ As Public Citizen pointed out back in 2001,\12\ this
law deregulated OTC derivatives energy trading by ``exempting'' them
from the Commodity Exchange Act, removing anti-fraud and anti-
manipulation regulation over these derivatives markets and exempting
``electronic'' exchanges from CFTC regulatory oversight.
---------------------------------------------------------------------------
\11\&H.R. 5660, an amendment to H.R. 4577, which became Appendix E
of P.L. 106&554 available at http://frwebgate.access.gpo.gov/cgi-bin/
getdoc.cgi?dbname=106_cong_public_laws&docid=f:publ554.106.pdf.
\12\&Blind Faith: How Deregulation and Enron's Influence Over
Government Looted Billions from Americans, available at
www.citizen.org/documents/Blind_Faith.pdf.
---------------------------------------------------------------------------
This deregulation law was passed against the explicit
recommendations of a multi-agency review of derivatives markets. The
November 1999 release of a report by the President's Working Group on
Financial Markets--a multi-agency policy group with permanent standing
composed at the time of Lawrence Summers, Secretary of the Treasury;
Alan Greenspan, Chairman of the Federal Reserve; Arthur Levitt,
Chairman of the Securities and Exchange Commission; and William Rainer,
Chairman of the CFTC--concluded that energy trading must not be
deregulated. The Group reasoned that ``due to the characteristics of
markets for nonfinancial commodities with finite supplies . . . the
Working Group is unanimously recommending that the [regulatory]
exclusion not be extended to agreements involving such
commodities.''&\13\ In its 1999 lobbying disclosure form, Enron
indicated that the ``President's Working Group'' was among its lobbying
targets.\14\
---------------------------------------------------------------------------
\13\&``Over-the-Counter Derivatives Markets and the Commodity
Exchange Act,'' Report of The President's Working Group on Financial
Markets, p. 16. www.ustreas.gov/press/releases/docs/otcact.pdf.
\14\&Senate Office of Public Records Lobbying Disclosure Database,
available at http://sopr.senate.gov/cgi-win/opr_gifviewer.exe?/1999/01/
000/309/00030933130, page 7.
---------------------------------------------------------------------------
As a result of the Commodity Futures Modernization Act, trading in
lightly-regulated exchanges like NYMEX is declining as more capital
flees to the completely unregulated OTC markets, such as those run by
the IntercontinentalExchange (ICE). Trading on the ICE has skyrocketed,
with the 138 million contracts traded in 2007 representing a 230
percent increase from 2005.\15\ This explosion in unregulated trading
volume means that more trading is done behind closed doors out of reach
of Federal regulators, increasing the chances of oil companies and
financial firms to engage in anti-competitive practices. The founding
members of ICE include Goldman Sachs, BP, Shell and Totalfina Elf. In
November 2005, ICE became a publicly traded corporation.
---------------------------------------------------------------------------
\15\&Available at www.theice.com/exchange_volumes_2005.jhtml.
---------------------------------------------------------------------------
Goldman Sachs' trading unit, J. Aron, is one of the largest and
most powerful energy traders in the United States, and commodities
trading represents a significant source of revenue and profits for the
company. Goldman Sachs' most recent 10&k filed with the U.S. Securities
and Exchange Commission show that Fixed Income, Currency and
Commodities (which includes energy trading) generated 35 percent of
Goldman's $46 billion in revenue for 2007.\16\ In 2005, Goldman Sachs
and Morgan Stanley--the two companies are widely regarded as the
largest energy traders in America--each reportedly earned about $1.5
billion in net revenue from energy trading. One of Goldman's star
energy traders, John Bertuzzi, made as much as $20 million in 2005.\17\
---------------------------------------------------------------------------
\16\&www.sec.gov/Archives/edgar/data/886982/000095012308000857/
y46519e10vk.htm.
\17\&http://frwebgate.access.gpo.gov/cgi-bin/
getdoc.cgi?dbname=109_cong_senate_committee_prints&docid=f:28640.pdf,
pages 24 and 26.
---------------------------------------------------------------------------
In the summer of 2006, Goldman Sachs, which at the time operated
the largest commodity index, GSCI, announced it was radically changing
the index's weighting of gasoline futures, selling about $6 billion
worth. As a direct result of this weighting change, Goldman Sachs
unilaterally caused gasoline futures prices to fall nearly 10
percent.\18\
---------------------------------------------------------------------------
\18\&Heather Timmons, ``Change in Goldman Index Played Role in
Gasoline Price Drop,'' The New York Times, September 30, 2006.
---------------------------------------------------------------------------
A recent bipartisan U.S. Senate investigation summed up the
negative impacts on oil prices with this shift towards unregulated
energy trading speculation:
Over the last few years, large financial institutions, hedge
funds, pension funds, and other investment funds have been
pouring billions of dollars into the energy commodity markets--
perhaps as much as $60 billion in the regulated U.S. oil
futures market alone . . . The large purchases of crude oil
futures contracts by speculators have, in effect, created an
additional demand for oil, driving up the price of oil to be
delivered in the future in the same manner that additional
demand for the immediate delivery of a physical barrel of oil
drives up the price on the spot market . . . Several analysts
have estimated that speculative purchases of oil futures have
added as much as $20&$25 per barrel to the current price of
crude oil . . . large speculative buying or selling of futures
contracts can distort the market signals regarding supply and
demand in the physical market or lead to excessive price
volatility, either of which can cause a cascade of consequences
detrimental to the overall economy . . . At the same time that
there has been a huge influx of speculative dollars in energy
commodities, the CFTC's ability to monitor the nature, extent,
and effect of this speculation has been diminishing. Most
significantly, there has been an explosion of trading of U.S.
energy commodities on exchanges that are not regulated by the
CFTC . . . in contrast to trades conducted on the NYMEX,
traders on unregulated OTC electronic exchanges are not
required to keep records or file Large Trader Reports with the
CFTC, and these trades are exempt from routine CFTC oversights.
In contrast to trades conducted on regulated futures exchanges,
there is no limit on the number of contracts a speculator may
hold on an unregulated OTC electronic exchange, no monitoring
of trading by the exchange itself, and no reporting of the
amount of outstanding contracts (``open interest'') at the end
of each day.\19\
---------------------------------------------------------------------------
\19\&The Role Of Market Speculation In Rising Oil And Gas Prices: A
Need To Put The Cop Back On The Beat, Staff Report prepared by the
Permanent Subcommittee on Investigations of the Committee on Homeland
Security and Governmental Affairs of the U.S. Senate, June 27, 2006,
available at http://frwebgate.access.gpo.gov/cgi-bin/
getdoc.cgi?dbname=109_cong_senate_committee_prints&docid=f:28640.pdf.
Thanks to the Commodity Futures Modernization Act, participants in
these newly-deregulated energy trading markets are not required to file
so-called Large Trader Reports, the records of all trades that NYMEX
traders are required to report to the CFTC, along with daily price and
volume information. These Large Trader Reports, together with the price
and volume data, are the primary tools of the CFTC's regulatory regime:
``The Commission's Large Trader information system is one of the
cornerstones of our surveillance program and enables detection of
concentrated and coordinated positions that might be used by one or
more traders to attempt manipulation.''&\20\ So the deregulation of OTC
markets, by allowing traders to escape such basic information
reporting, leave Federal regulators with no tools to routinely
determine whether market manipulation is occurring in energy trading
markets.
---------------------------------------------------------------------------
\20\&Letter from Reuben Jeffrey III, Chairman, CFTC, to Michigan
Governor Jennifer Granholm, August 22, 2005.
---------------------------------------------------------------------------
One result of the lack of transparency is the fact that even some
traders don't know what's going on. A recent article described how:
Oil markets were rocked by a massive, almost instant surge in
after-hours electronic trading 1 day last month, when prices
for closely watched futures contracts jumped 8% . . . this
spike stands out because it was unclear at the time what drove
it. Two weeks later, it is still unclear. What is clear is that
a rapid shift in the bulk of crude trading from the raucous
trading floor of the New York Mercantile Exchange to anonymous
computer screens is making it harder to nail down the cause of
price moves . . . The initial jump ``triggered more orders
already set into the system, and with prices rising, people
thought somebody must know something,'' Tom Bentz, an analyst
and broker at BNP Paribas Futures in New York who was watching
the screen at the time, said the day after the spike. ``The
more prices rose, the more it seemed somebody knew
something.''&\21\
---------------------------------------------------------------------------
\21\&Matt Chambers, ``Rise in Electronic Trading Adds Uncertainty
to Oil,'' The Wall Street Journal, April 10, 2007.
Oil companies, investment banks and hedge funds are exploiting the
lack of government oversight to price-gouge consumers and make billions
of dollars in profits. These energy traders boast how they're price-
gouging Americans, as a recent Dow Jones article makes clear: energy
``traders who profited enormously on the supply crunch following
Hurricane Katrina cashed out of the market ahead of the long weekend.
`There are traders who made so much money this week, they won't have to
punch another ticket for the rest of this year,' said Addison
Armstrong, manager of exchange-traded markets for TFS Energy
Futures.''&\22\
---------------------------------------------------------------------------
\22\&Leah McGrath Goodman, ``Oil Futures, Gasoline In NY End
Sharply Lower,'' September 2, 2005.
---------------------------------------------------------------------------
The ability of Federal regulators to investigate market
manipulation allegations even on the lightly-regulated exchanges like
NYMEX is difficult, let alone the unregulated OTC market. For example,
as of August 2006, the Department of Justice is still investigating
allegations of gasoline futures manipulation that occurred on a single
day in 2002.\23\ If it takes the DOJ 4 years to investigate a single
day's worth of market manipulation, clearly energy traders intent on
price-gouging the public don't have much to fear.
---------------------------------------------------------------------------
\23\&John R. Wilke, Ann Davis and Chip Cummins, ``BP Woes Deepen
with New Probe,'' The Wall Street Journal, August 29, 2006.
---------------------------------------------------------------------------
That said, there have been some settlements for manipulation by
large oil companies. In January 2006, the CFTC issued a civil penalty
against Shell Oil for ``non-competitive transactions'' in U.S. crude
oil futures markets.\24\ In March 2005, a Shell subsidiary agreed to
pay $4 million to settle allegations it provided false information
during a Federal investigation into market manipulation.\25\ In August
2004, a Shell Oil subsidiary agreed to pay $7.8 million to settle
allegations of energy market manipulation.\26\ In July 2004, Shell
agreed to pay $30 million to settle allegations it manipulated natural
gas prices.\27\ In October 2007, BP agreed to pay $303 million to
settle allegations the company manipulated the propane market.\28\ In
September 2003, BP agreed to pay NYMEX $2.5 million to settle
allegations the company engaged in improper crude oil trading, and in
July 2003, BP agreed to pay $3 million to settle allegations it
manipulated energy markets.\29\
---------------------------------------------------------------------------
\24\&``U.S. Commodity Futures Trading Commission Assesses Penalties
of $300,000 Against Shell-Related Companies and Trader in Settling
Charges of Prearranging Crude Oil Trades'' available at www.cftc.gov/
newsroom/enforcementpressreleases/2006/pr5150-06.html.
\25\&``Commission Accepts Settlement Resolving Investigation Of
Coral Energy Resources,'' available at www.ferc.gov/news/news-releases/
2005/2005-1/03-03-05.asp.
\26\&``Order Approving Contested Settlement,'' available at
www.ferc.gov/whats-new/comm-meet/072804/E-60.pdf.
\27\&``Coral Energy Pays $30 Million to Settle U.S. Commodity
Futures Trading Commission Charges of Attempted Manipulation and False
Reporting,'' available at www.cftc.gov/opa/enf04/opa4964-04.htm
\28\&www.cftc.gov/newsroom/enforcementpressreleases/2007/pr5405-
07.html.
\29\& ``Order Approving Stipulation and Consent Agreement,'' 104
FERC &61,089, available at http://elibrary.ferc.gov/idmws/common/
opennat.asp?fileID=10414789.
---------------------------------------------------------------------------
In August 2007, Oil giant BP admitted in a filing to the Securities
and Exchange Commission that ``The U.S. Commodity Futures Trading
Commission and the U.S. Department of Justice are currently
investigating various aspects of BP's commodity trading activities,
including crude oil trading and storage activities, in the U.S. since
1999, and have made various formal and informal requests for
information.''&\30\
---------------------------------------------------------------------------
\30\&www.sec.gov/Archives/edgar/data/313807/000115697307001223/
u53342-6k.htm
---------------------------------------------------------------------------
In August 2007, Marathon Oil agreed to pay $1 million to settle
allegations the company manipulated the price of West Texas
Intermediate crude oil.\31\
---------------------------------------------------------------------------
\31\&www.cftc.gov/newsroom/enforcementpressreleases/2007/pr5366-
07.html.
---------------------------------------------------------------------------
There is near-unanimous agreement among industry analysts that
speculation is driving up oil and natural gas prices. Representative of
these analyses is a May 2006 Citigroup report on the monthly average
value of speculative positions in American commodity markets, which
found that the value of speculative positions in oil and natural gas
stood at $60 billion, forcing Citigroup to conclude that ``we believe
the hike in speculative positions has been a key driver for the latest
surge in commodity prices.''&\32\
---------------------------------------------------------------------------
\32\&The Role Of Market Speculation In Rising Oil And Gas Prices: A
Need To Put The Cop Back On The Beat, Staff Report prepared by the
Permanent Subcommittee on Investigations of the Committee on Homeland
Security and Governmental Affairs of the U.S. Senate, June 27, 2006,
available at http://frwebgate.access.gpo.gov/cgi-bin/
getdoc.cgi?dbname=109_cong_senate_committee_prints&docid=f:28640.pdf.
---------------------------------------------------------------------------
Natural gas markets are also victimized by these unregulated
trading markets. Public Citizen has testified before Congress on this
issue,\33\ and a March 2006 report by four state attorneys general
concludes that ``natural gas commodity markets have exhibited erratic
behavior and a massive increase in trading that contributes to both
volatility and the upward trend in prices.''&\34\
---------------------------------------------------------------------------
\33\&``The Need for Stronger Regulation of U.S. Natural Gas
Markets,'' available at www.citizen.org/documents/
Natural%20Gas%20Testimony.pdf.
\34\&The Role of Supply, Demand and Financial Commodity Markets in
the Natural Gas Price Spiral, available at www.ago.mo.gov/pdf/
NaturalGasReport.pdf.
---------------------------------------------------------------------------
While most industry analysts agree that the rise in speculation is
fueling higher prices, there is one notable outlier: the Federal
Government. In a widely dismissed report, the CFTC recently concluded
that there was ``no evidence of a link between price changes and MMT
[managed money trader] positions'' in the natural gas markets and ``a
significantly negative relationship between MMT positions and prices
changes in the crude oil market.''&\35\
---------------------------------------------------------------------------
\35\&Michael S. Haigh, Jana Hranaiova and James A. Overdahl,
``Price Dynamics, Price Discovery and Large Futures Trader Interactions
in the Energy Complex,'' available at www.cftc.gov/files/opa/press05/
opacftc-managed-money-trader-study.pdf.
---------------------------------------------------------------------------
The CFTC study (and similar one performed by NYMEX) is flawed for
numerous reasons, including the fact that the role of hedge funds and
other speculators on long-term trading was not included in the
analysis. The New York Times reported that ``many traders have scoffed
at the studies, saying that they focused only on certain months,
missing price run-ups.''&\36\
---------------------------------------------------------------------------
\36\&Alexei Barrionuevo and Simon Romero, ``Energy Trading, Without
a Certain `E','' January 15, 2006.
---------------------------------------------------------------------------
The CFTC has a troublesome streak of ``revolving door''
appointments and hiring which may further hamper the ability of the
agency to effectively regulate the energy trading industry. In August
2004, CFTC Chairman James Newsome left the Commission to accept a $1
million yearly salary as President of NYMEX, the world's largest energy
futures marketplace. Just weeks later, Scott Parsons, the CFTC's Chief
Operating Officer, resigned to become Executive Vice President for
Government Affairs at the Managed Funds Association. Former CFTC Lead
Prosecutor Tony Mansfi left the Commission to join the D.C. firm Heller
Ehrman, where he will work for Geoff Aronow--his old boss at CFTC. Such
prominent defections hamper the CFTC's ability to protect consumers. As
a result, a revolving door moratorium must be established to limit CFTC
decision makers from leaving the agency to go to entities under its
regulatory jurisdiction for at least 2 years.
Latest Trading Trick: Energy Infrastructure Affiliate Abuses
Energy traders like Goldman Sachs are investing and acquiring
energy infrastructure assets because controlling pipelines and storage
facilities affords their energy trading affiliates an ``insider's
peek'' into the physical movements of energy products unavailable to
other energy traders. Armed with this non-public data, a company like
Goldman Sachs most certainly will open lines of communication between
the affiliates operating pipelines and the affiliates making large bets
on energy futures markets. Without strong firewalls prohibiting such
communications, consumers would be susceptible to price-gouging by
energy trading affiliates.
For example, In January 2007, Highbridge Capital Management, a
hedge fund controlled by JP Morgan Chase, bought a stake in an energy
unit of Louis Dreyfus Group to expand its oil and natural gas trading.
Glenn Dubin, Co-Founder of Highbridge, said that owning physical energy
assets like pipelines and storage facilities was crucial to investing
in the business: ``That gives you a very important information
advantage. You're not just screen-trading financial products.''&\37\
---------------------------------------------------------------------------
\37\&Saijel Kishan and Jenny Strasburg, ``Highbridge Capital Buys
Stake in Louis Dreyfus Unit,'' Bloomberg, January 8, 2007,
www.bloomberg.com/apps/news?pid=20601014&sid=aBnQy1botdFo.
---------------------------------------------------------------------------
Indeed, such an ``information advantage'' played a key role in
allowing BP's energy traders to manipulate the entire U.S. propane
market. In October 2007, the company paid $303 million to settle
allegations that the company's energy trading affiliate used the
company's huge control over transportation and storage to allow the
energy trading affiliate to exploit information about energy moving
through BP's infrastructure to manipulate the market.
BP's energy trading division, North America Gas & Power (NAGP), was
actively communicating with the company's Natural Gas Liquids Business
Unit (NGLBU), which handled the physical production, pipeline
transportation and retail sales of propane. A PowerPoint exhibit to the
civil complaint against BP details how the two divisions coordinated
their manipulation strategy, which includes ``assurance that [the]
trading team has access to all information and optionality within [all
of
BP] . . . that can be used to increase chance of success [of market
manipula
tion] . . . Implement weekly meetings with Marketing & Logistics to
review trading positions and share opportunities.''&\38\
---------------------------------------------------------------------------
\38\&www.cftc.gov/files/enf/06orders/opa-bp-lessons-learned.pdf.
---------------------------------------------------------------------------
And in August 2007, BP acknowledged that the Federal Government was
investigating similar gaming techniques in the crude oil markets.
BP is not alone. A Morgan Stanley energy trader, Olav Refvik, ``a
key part of one of the most profitable energy-trading operations in the
world . . . helped the bank dominate the heating oil market by locking
up New Jersey storage tank farms adjacent to New York Harbor.''&\39\
Again, control over physical infrastructure assets plays a key role in
helping energy traders game the market.
---------------------------------------------------------------------------
\39\&http://frwebgate.access.gpo.gov/cgi-bin/
getdoc.cgi?dbname=109_cong_senate_committee_prints&docid=f:28640.pdf,
page 26.
---------------------------------------------------------------------------
This shows that the energy traders were actively engaging the
physical infrastructure affiliates in an effort to glean information
helpful for market manipulation strategies. And it is important to note
that BP's market manipulation strategy was extremely aggressive and
blatant, and regulators were tipped off to it by an internal whistle-
blower. A more subtle manipulation effort could easily evade detection
by Federal regulators, making it all the more important to establish
firewalls between energy assets affiliates and energy trading
affiliates to prevent any undue communication between the units.
Financial firms like hedge funds and investment banks that normally
wouldn't bother purchasing low-profit investments like oil and gasoline
storage have been snapping up ownership and/or leasing rights to these
facilities mainly for the wealth of information that controlling energy
infrastructure assets provides to help one's energy traders manipulate
trading markets. The Wall Street Journal reported that financial
speculators were snapping up leasing rights in Cushing, OK.\40\
---------------------------------------------------------------------------
\40\&Ann Davis, ``Where Has All The Oil Gone?'' October 6, 2007,
Page A1.
---------------------------------------------------------------------------
In August 2006, Goldman Sachs, AIG and Carlyle/Riverstone announced
the $22 billion acquisition of Kinder Morgan, Inc., which controls
43,000 miles of crude oil, refined products and natural gas pipelines,
in addition to 150 storage terminals.
Prior to this huge purchase, Goldman Sachs had already assembled a
long list of oil and gas investments. In 2005, Goldman Sachs and
private equity firm Kelso & Co. bought a 112,000 barrels/day oil
refinery in Kansas. In May 2004, Goldman spent $413 million to acquire
royalty rights to more than 1,600 natural gas wells in Pennsylvania,
West Virginia, Texas, Oklahoma and offshore Louisiana from Dominion
Resources. Goldman Sachs owns a six percent stake in the 375 mile
Iroquois natural gas pipeline, which runs from Northern New York
through Connecticut to Long Island. In December 2005, Goldman and
Carlyle/Riverstone together are investing $500 million in Cobalt
International Energy, a new oil exploration firm run by former Unocal
executives.
In 2003, Morgan Stanley teamed up with Apache Corp to buy 26 oil
and gas fields from Shell for $500 million, of which Morgan Stanley put
up $300 million in exchange for a portion of the production over the
next 4 years, which it used to supplement its energy trading desk.\41\
---------------------------------------------------------------------------
\41\&Paul Merolli, ``Two Morgan Stanley M&A deals show bullish
stance on gas,'' Natural Gas Week, Volume 19; Issue 28, July 14, 2003.
---------------------------------------------------------------------------
Conclusion
This era of high energy prices isn't a simple case of supply and
demand, as the evidence suggests that weak or non-existent regulatory
oversight of energy trading markets provides opportunity for energy
companies and financial institutions to price-gouge Americans. Forcing
consumers suffering from inelastic demand to continue to pay high
prices--in part fueled by uncompetitive actions--not only hurts
consumers economically, but environmentally as well, as the oil
companies and energy traders enjoying record profits are not investing
those earnings into sustainable energy or alternatives to our addiction
to oil. Reforms to strengthen regulatory oversight over America's
energy trading markets are needed to restore true competition to
America's oil and gas markets.
Solutions
Re-regulate energy trading markets by subjecting OTC
exchanges--including foreign-based exchanges trading U.S.
energy products--to full compliance under the Commodity
Exchange Act and mandate that all OTC energy trades adhere to
the CFTC's Large Trader reporting requirements. In addition,
regulations must be strengthened over existing lightly-
regulated exchanges like NYMEX.
Impose legally-binding firewalls to limit energy traders
from speculating on information gleaned from the company's
energy infrastructure affiliates or other such insider
information, while at the same time allowing legitimate hedging
operations. Congress must authorize the FTC and DOJ to place
greater emphasis on evaluating anti-competitive practices that
arise out of the nexus between control over hard assets like
energy infrastructure and a firm's energy trading operations.
Incorporating energy trading operations into anti-trust
analysis must become standard practice for Federal regulatory
and enforcement agencies to force more divestiture of assets in
order to protect consumers from abuses.
The Chairman. Thank you, Mr. Slocum. And I would just share
with you some of the issues that you have covered may be beyond
the jurisdiction of this Committee. But that doesn't mean they
shouldn't be looked at. Captain Prater.
STATEMENT OF CAPT. JOHN PRATER, PRESIDENT, AIR LINE PILOTS
ASSOCIATION, INTERNATIONAL, WASHINGTON, D.C.
Mr. Prater. Good morning, Mr. Chairman, and Members of the
Committee. As President of the Air Line Pilots Association, the
largest airline pilot union in the world, I would like to thank
you for the opportunity on behalf of our 55,000 members who fly
for 40 airlines in the United States and Canada.
ALPA pilots do not declare Mayday at the first sign of a
storm. We do not divert from our destination at the first sign
of a snowflake. ALPA pilots, working with other industry
workers, safely deliver passengers and cargo around our country
and around the world every hour of every day. We help keep the
economy running. In fact, the aviation industry alone generates
$690 billion for America's bottom line and airline pilots play
a pivotal role in that economic engine.
That said, our community is once again in an economic
crisis that rivals the events that followed 9/11. Many airlines
are in no position to handle the excessive jet fuel expenses
that now cost more than anything else, exceeding labor and
taxes by a wide margin. As a result of this burden, eight
airlines have ceased operations this year. Two others have
filed for Chapter 11 and several more are on the brink.
Approximately 29,000 airline workers have lost their jobs this
year and more will come this fall.
This hits pilots especially hard because they have already
taken several economic blows to help save their airlines from
the brink of extinction following 9/11. In the last 7 years,
pilots have sacrificed pay, work rules, benefits and pensions
to keep their airlines flying. Many of our members are still
working under those concessions. They did this with the hope
for the future that they would see their lost wages and their
pensions returned. But with the rising cost of fuel, pilots are
now more concerned than ever that their chosen profession is
not one which will provide them with the compensation and
retirement benefits that they need for their families.
Analysts forecast that airlines will lose as much as $10
billion this year. Continental, Delta, United, and Northwest
have already announced further cuts in capacity and reductions
in the workplace. Meanwhile, several other airlines are ready
to announce. Nearly 30 small cities across our nation have
already lost scheduled airline service and numerous larger
cities are experiencing the cutbacks already. We will lose more
transportation in this country.
Unlike other industries, which may have a choice of
whatever type of energy to power its operations, the airliners
that we fly have just one energy option, petroleum-based jet
fuel. The FAA, the industry is working on alternatives to jet
fuel, but it is going to take several years at best before a
viable, renewable alternative meets the exacting specifications
required to operate our jet engines safely.
We believe that rampant speculation in the oil commodities
market is a serious situation that is negatively impacting the
price of aviation fuel. ALPA, as part of a broad coalition with
industry and business partners, has urged Congress for
immediate reforms in the wildly speculative energy commodity
futures markets. We fully support Representative Bart Stupak's
PUMP Act, which would apply a much needed break on the surging
oil prices that are crippling our industry and our economy. We
would encourage any legislation that brings rationality to the
oil markets.
The CFTC needs a nightstick if it helps to police
speculators' trades in U.S. energy commodity markets.
Unregulated swap trades and the so-called Enron loophole, among
other weaknesses in the system, encourage speculators to trade
U.S. energy supplies up to 20 times for each barrel of oil that
is actually consumed. But with strong provisions that will
bring over-the-counter energy commodities within CFTC's
oversight, speculators will at long last be held accountable
for their swaps.
The U.S. pilots who stand to lose their jobs due to the
airlines going out of business are taking their skills abroad.
We are starting to work for airlines overseas because the jobs
aren't back home anymore. Many other young and old experienced
pilots are leaving the industry altogether.
Simply put, in order for our industry to survive and
continue to provide the world's safest transportation system,
we must address this problem now. It is time to rein in rampant
oil speculation.
In conclusion, a long-term, rational energy policy,
including increased domestic supply and energy independence, is
our ultimate goal, but bipartisan, near-term solutions to the
market frenzy are critical now. We urge Congress to pass
legislation before the August recess that will help rein in
these rampant costs.
Thank you.
[The prepared statement of Capt. Prater follows:]
Prepared Statement of Capt. John Prater, President, Air Line Pilots
Association, International, Washington, D.C.
Good morning, Mr. Chairman, Ranking Member Goodlatte, and Members
of the Committee. I am Captain John Prater, President of the Air Line
Pilots Association, International (ALPA). ALPA represents nearly 55,000
professional pilots who fly for 40 passenger and all-cargo airlines in
the United States and Canada. On behalf of our members, I want to thank
you for the opportunity to testify today about the urgent need to
address speculation in the fuel commodities market which we believe has
contributed to the sharp jump in fuel prices that is greatly impacting
our industry.
The rising cost of oil is of concern to everyone in this country
today. Many are worried that they will be forced to choose between
filling their automobile gas tanks and purchasing groceries, and we are
already seeing the negative impact that the escalating price of oil is
having on the economy. Our members--the working men and women safely
flying our nation's airliners--have another, more dire concern: will
they lose their jobs--again--because their airline is forced to park
airplanes or even go out of business?
After the horrific terrorist attacks of 9/11, pilots and other
employees in the airline business suffered through thousands of job
furloughs and pay cuts. In fact, between 2002 and 2011, workers at the
seven largest U.S. airlines have given back $75 billion in concessions.
Almost $30 billion has come from pilots in the form of reduced wages,
revised work rules, and reduced or eliminated benefits. Terminated
pensions totaled another $5+ billion. A brief period of airline profits
in 2007 promised some hope that these massive concessions which helped
save the industry could be returned to workers and their families.
Instead, the recent rise in energy costs has caused a flood of red
ink and analysts now forecast an industry operating loss of as much as
$7 billion or more in 2008, one of the largest losses in the industry's
history and rivaling that experienced shortly after the events of 9/11.
The magnitude of this impact can already be seen in the recent
bankruptcies and/or discontinued operations of ATA, Aloha, Champion,
Skybus, Eos, Frontier, Skyway and Air Midwest. Other airlines have
parked airplanes and either furloughed employees, or plan to do so in
the near future.\1\ This industry contraction is leading to the loss of
thousands of skilled jobs and puts U.S. carriers at a disadvantage in
the world marketplace. Ironically, the current industry fuel crisis
also stifles progress to reduce fuel burn and emissions--at this time
an unstable airline industry cannot afford to invest in new more fuel
efficient aircraft&\2\ or invest in alternative fuel research.
---------------------------------------------------------------------------
\1\&American Airlines is reducing 4th qtr. 2008 mainline domestic
capacity by 11&12% year-over-year. Continental is cutting 4th qtr. 2008
domestic capacity by 11.4% and reducing its workforce by 3,000. Delta
is reducing its workforce by 3,000 and cutting 4th qtr. 2008 domestic
capacity by 11%. United is cutting 4th qtr. 2008 domestic capacity by
14% and reducing the number of salaried employees by 1,400 to 1,600.
Nearly 30 cities have lost scheduled airline service in the past year
and more service cuts are on the horizon. USAirways is reducing
mainline capacity 6&8% and reducing its workforce approximately 1,700.
Air Tran cut employee salaries by 10% and many airlines are delaying
starting new service because of fuel prices. This week, Northwest
announced 2,500 job cuts.
\2\&There are currently no major aircraft manufacturer plans to
produce a next generation narrow body aircraft. We are at least a
decade away from aircraft capable of significantly less fuel burn than
our current fleet.
---------------------------------------------------------------------------
A few salient facts about the current state of jet fuel expense,
and industry reactions to that expense, help explain the airlines'
predicament. Unlike many other industries which have a choice of
electricity, natural gas, coal, heating oil or other sources of
requisite energy, airlines have just one energy option for aircraft
operations--petroleum-based jet fuel which must meet an exacting
specification. Despite great technology-driven reductions in jet engine
fuel consumption and airline pilot fuel conservation practices, jet
fuel expenses have recently become the airlines' largest operating
cost, now consuming as much as 40% of every airline revenue dollar, up
from 15% in 2000. Jet fuel prices are expected to remain at extremely
high levels; already increasing 67% from approximately $90.90 per
barrel in 2007 to $151.72 per barrel in 2008. Every $1 increase in
crude oil prices increases the industry's fuel expense by approximately
$465 million, before considering the impact of any hedging. Because our
carriers compete globally and fuel is priced in the weak U.S. dollar,
our European counterparts have not experienced as dramatic of an
increase in fuel costs, giving them a competitive advantage over the
U.S. industry.
Airline pilots are working every day to conserve precious fuel
during both ground and flight operations. Within the constraints of
safety and hamstrung by an antiquated air traffic control system,
pilots routinely shut down engines while taxiing and select optimal
fuel-conservation altitudes and speeds. Further, pilots are working
with the industry to help develop the NextGen air traffic management
system that will further increase fuel efficiency. But all of those
fuel-saving measures combined are incapable of compensating for the
exorbitant fuel prices that we have experienced over the past year. No
airline business plan can be successful with fuel topping $145 per
barrel, and many will not survive in their present form at
significantly less per barrel. Every day brings news of more airline
worker layoffs, airplanes being grounded and air service to communities
being cut. The U.S. aviation industry is a critical part of our
national economy generating approximately 11% of Gross Domestic Product
through airline travel and all related industries. Absent decisive and
effective leadership on this issue, the airline industry's fortunes
will continue to plummet and harm the national economy, in general, and
airline workers, in particular, in the process.
Experts agree that today's surging oil prices are beyond those
warranted by supply-demand fundamentals. In fact, just yesterday the
International Energy Agency announced that annual demand is projected
to increase at an annual rate of only 1.6% and that demand will be
actually lower this year, growing only 1%, given declining economic
conditions. Instead, surging oil prices are due, in some measure, to
rampant investor speculation. In early June, speculators traded more
than 1.9 billion barrels of crude oil--22 times the size of the
physical oil market, including $150 billion traded on the New York
Mercantile Exchange alone. Sophisticated ``paper'' speculators,
including large pension fund managers, who never intend to use oil are
driving up costs for consumers and making huge profits. This high
amount of activity by ``paper'' speculators is having a grossly
perverse impact on oil prices. Recently, ALPA and a broad coalition of
consumer, labor, and business organizations joined to advocate
immediate reforms in the widely-speculative energy commodity futures
markets. While a long-term, rational energy policy including increased
domestic supply and energy independence is our ultimate goal,
bipartisan, near-term solutions to the market frenzy are absolutely
critical.
With your leadership, we see an end to the current unwarranted
escalation in oil prices which market speculation is helping to drive.
ALPA has endorsed and pledged our support for the prompt enactment of
Congressman Stupak's H.R. 6330, the ``Prevent Unfair Manipulation of
Prices Act of 2008.'' The PUMP Act will apply a much needed brake on
rampant energy commodity speculation to help drive down unprecedented,
surging oil prices that are crippling the economy. We are aware of
several other proposed bills in both the House and Senate that share
the same goal and we believe that they all have merit as a means of
reducing the fuel speculation that is harming our industry.
The heart of the PUMP Act is Section 2 that extends CFTC
jurisdiction over energy commodities that now enjoy a host of trading
loopholes. The bill will open up the market to greater transparency and
fairness to level the playing field for all traders by:
bringing over-the-counter energy commodities within CFTC's
oversight responsibilities;
closing the ``swaps loophole'' by extending CFTC regulatory
authority to swaps involving energy transactions, another
important step towards needed transparency;
extending CFTC regulatory authority to energy transactions
on foreign boards of trade that provide for delivery points in
the United States, a common sense measure as other products
delivered in the United States are subject to the full panoply
of United States regulation, save energy commodities; and
requiring CFTC to set aggregate position limits on energy
contracts for a trader over all markets, ensuring that traders
do not corner markets by amassing huge positions and playing
one exchange off another.
Unregulated swaps trades and the so-called ``Enron loophole,''
among other weaknesses in the system, allow our most important energy
supplies to be traded up to 20 times for each barrel of oil consumed.
Why should oil future traders not have oversight similar to that of
other security markets? Can we, as a nation, continue to stand idly by
while speculators wreak havoc on our economy with the potential to
destroy the air transportation links to many of our small and medium
sized communities?
We strongly urge Congress to pass legislation to address the mostly
unregulated futures trading of fuel before the August recess.
I thank you for the opportunity to testify today and look forward
to your questions.
Mr. Etheridge [presiding.] I thank the gentleman. I yield 5
minutes to the gentleman from Georgia, Mr. Marshall.
Mr. Marshall. Thank you, Mr. Chairman. Thank you all for
being here.
Mr. Slocum, that is the first time I have heard of what you
described. Do your concerns go so far as to worry that the
financial incentives could conceivably be so large, that
someone holding the kind of interests in the actual underlying
assets that control or produce the commodity could
intentionally fool with those underlying assets in order to
create a move in the market that could give it an awful lot of
profit?
Mr. Slocum. Absolutely. And it is not just Public Citizen
making that assertion. As part of the 2006 Senate Subcommittee
on Permanent Investigations report, they provided information
about how a single trader at Morgan Stanley was able to make
huge successful bets in the futures markets based upon his
company's acquisition of leasing rights over nearly all of the
home heating oil storage facilities in New York Harbor, which
obviously is a major import area. And this is something that
the CFTC does have jurisdiction over.
BP admitted in a Securities and Exchange Commission filing
in the summer of 2007 that the CFTC was looking into market
manipulation related to BP's crude oil infrastructure assets
and its energy trading division.
But the issue here is whether or not there is improper
sharing of information that would not be captured under
standard definitions of market manipulation.
Mr. Marshall. As a matter of fact, we have intentionally
permitted individuals to trade on inside information in our
futures markets because they serve such an important price
discovery function for us. So not only do we not have a
prohibition, it almost looks as if we encourage that kind of
sharing.
Mr. Slocum. And there are absolutely legitimate reasons for
owners of infrastructure assets, particularly large refiners
that have to acquire crude oil. And they need to go out and
hedge and participate in these markets. So there are legitimate
functions for entities involved in energy infrastructure to be
involved in the markets. The question, and this is where it is
going to be tricky, is defining what is a legitimate hedging
function and what is a speculative function and what decreases
the level of competitiveness.
Mr. Marshall. Thank you, sir. In the limited amount of time
I have, I want to move to a different subject. Mr. Roth, if we
headed in the direction of providing at least in ag
commodities, no hedge exemption unless it is intended to cover
a legitimate commercial--it is a legitimate commercial hedge
and it is laying off risk from an actual physical market hedge
that has occurred in the over-the-counter markets. We do that,
we put in position limits and we direct the CFTC to put in
position limits for energy that is similar to the position
limits that exist for ag. And then with regard to all position
limits, we say buy, buy these; if you don't and you are guilty
of, directly or indirectly, intentionally circumventing these,
you are liable for criminal penalties. Would that have any
effect and----
Mr. Roth. I think those are all viable options. They are
serious ideas that I wouldn't rule out of hand at all. I would
offer just the following quick observations.
With respect to position limits and again bearing in mind
that I don't regulate markets, with respect to position limits,
I understand how position limits work in a centralized
marketplace because you can see everything. The imposition and
implementation of position limits in a decentralized, bilateral
sort of market like swaps are, would be a much more difficult
thing to implement and monitor. It is not to say it can't be
done, but I think you would have to think that through.
Mr. Marshall. You were here earlier, I noted. There is one
possibility and it is the Lieberman aggregate position limits
across all markets. There is another position limit simply in
the futures markets that are regulated. Information provided
across all markets to the regulator, to enable the regulator to
see what people are doing and to see whether or not there is
any circumvention of the position limits----
Mr. Roth. I am just telling you monitoring compliance in a
centralized market is one thing. Monitoring compliance in a
decentralized, bilateral sort of series of agreements is a much
more complex undertaking.
Mr. Marshall. Very challenging.
Mr. Roth. The second point with respect to the swaps
exemption, if I could. I think that is another idea that really
needs to be explored, and that is why I was glad that the CFTC
has made the special call for information, to really understand
better what the underlying book of the swaps dealers is and
what business they are turning to the futures market to hedge.
The only danger that I see there is if we act now before we
have the facts, before we have the results of that study, I
think you want to be leery of doing anything that could limit
the ability of either major financial institutions or their
commercial users to manage their risk. So by all means, let us
get the CFTC's data. Let us get it as quickly as we can and let
us see if your option is warranted.
Mr. Etheridge. I thank the gentleman very much. The
gentleman from Texas, 5 minutes.
Mr. Conaway. Thank you, Mr. Chairman. Mr. Lynch and Captain
Prater, you both paint some very stark pictures about the
industries you represent and participate in. And speaking for
somebody who is going to get on an airplane this afternoon and
fly with a couple of your members, I am hoping they continue to
do their job really well, at least until we get to the other
end.
We have heard strong, committed, bright people on both
sides of the issue in terms of what impact speculators are
having. Our role is to try to figure out how that is happening.
You did mention that your pilots are going overseas because
there are jobs overseas. Is that because jet fuel is cheaper in
Europe or Asia than it is here?
Mr. Prater. Sir, the amount of concessions that we took
following the 9/11 period has driven many people away from the
job here in the U.S. The fact is a lot of people speak about
prices and what goes into an airline ticket. We all know the
major component is oil. If you fly on a flight this evening,
maybe a 70 passenger jet and you are one of 70 passengers and
you fly an hour, out of that ticket, about $1 will go to the
captain and about 50 cents will go to the first officer. If you
got on my airplane to fly to London, you would spend less than
75 cents an hour for my services, less than 50 cents an hour.
So the jobs are better overseas.
Mr. Conaway. And that is because the airlines there charge
more? I mean, the jet fuel prices are about the same there that
they are here.
Mr. Prater. Different economic systems possibly. Certainly
we have a----
Mr. Conaway. But you are not aware that jet fuel is cheaper
in Europe?
Mr. Prater. No, I think that--while we know that the value
of the dollar has played a part in this, I don't think that is
the reason we are losing pilots here. The fact is pilots are
getting out of the business because it just doesn't pay well.
Mr. Conaway. Sure. And that is kind of all of our
opportunities as Americans. I do want to just briefly comment
about Mr. Roth's plea to get the facts on the table first. We
in Congress have a wonderful history of ready, fire, aim and
the Chairman of this Committee, though, has attempted with
these hearings to not let us run off that ledge. I want to also
thank him for taking the time extensively. Other than the farm
bill, these are the most extensive hearings we have had on a
particular issue, and I appreciate his willingness to do that.
So I don't have any other questions, and I yield back.
The Chairman [presiding.] I thank the gentleman. The
gentlelady from South Dakota.
Ms. Herseth Sandlin. Thank you, Mr. Chairman. Mr. Roth, I
appreciated your response to Mr. Marshall's question about your
thoughts on position limits and how they are easier or more
difficult to administer in a certain context. I would be
interested in your thoughts on the discussion of the prior
panel on margin requirements. There are a number of us on this
Committee that are concerned about unintended consequences with
higher margin requirements, versus dealing with transparency,
accountability and position limits as perhaps a different
alternative to approach the issue.
Mr. Roth. That is a real concern of ours, the margin issue.
Because as I pointed out in my written testimony, that in our
view, increasing the margins dramatically on energy products
could have the effect of making prices higher rather than lower
for the reasons that Mr. Duffy said that you could end up
pushing more longs out of the market than shorts. And that will
cause prices to go up. Mr. Johnston's idea of increasing
margins on the long only is essentially a market manipulation
on the part of the Congress which is going to have a
potentially disastrous effect on people that have taken margin
positions.
In addition--I will just make two other points, one of
which you have heard plenty of. If you increase margins on
these U.S. markets, the business can go elsewhere. They can go
OTC and they can go overseas and you really won't increase
transparency or lower prices at all.
And then the final point that I would make is that a
dramatic increase in margins is going to result in a lot of
margin calls and it is going to result in defaults. It is going
to put a certain amount of stress on futures commission
merchants and clearing organizations. It is going to increase
market volatility and therefore increase financial stress
during a time of tight credit. Now we are talking about
systemic risk, and no one knows where that might take you.
So the margin issue is a scary one for us because I think
it has tremendous potential to do much greater harm than good.
Ms. Herseth Sandlin. I appreciate your comments there and
the concerns about a systemic risk. I understand that you
regulate the intermediaries, but certainly your familiarity
with the issues with futures trading that the Committee has
grappled with and dealt with for years, primarily in
agricultural commodities. We have talked to folks in all of our
districts who are individual producers, who have used grain
merchandisers, elevator operators who are having problems with
not being able to use the exchanges to hedge their risk in the
manner that they used to be able to. How comfortable are you
with a proposal like Mr. Etheridge's--and I appreciate your
comments about the CFTC needing more resources and more staff.
I couldn't agree with you more. Do you think that transparency,
reporting, accountability and perhaps addressing position
limits for institutional investors and those that were exempt,
is that going to help alleviate the problems that individual
producers or our grain elevator operators or petroleum
marketers are facing?
Mr. Roth. Any time you increase transparency, you give
people more information and they can govern their conduct
accordingly. You make it less likely that there can be a market
manipulation, less likely that there will be a distortion of
free market forces. I can't sit here and tell you that an
increase in transparency--I think one of the claims is it would
reduce the price of energy by 50 percent in 30 days. If a
member of ours made a claim like that, we would expel him. I
can't sit here and tell you that increase in transparency and
all those things are going to drive down the price of energy
dramatically. I can tell you that they would provide greater
assurances of at least certain instances of market integrity.
Ms. Herseth Sandlin. Could you comment just briefly on Mr.
Johnston's point in the last panel about how some of the
passive longs have--there has sort of been an unwitting
cornering of the market. I mean, what are your thoughts there?
Mr. Roth. Again, recognizing that this is the deep end of
the pool for me, too, and it is not what we regulate, the role
of passive longs is a really interesting question. I would note
that there are certain commodities where there is a great deal
of index participation where you have relatively flat prices.
There are other commodities where there is virtually no index
participation and you have huge fluctuations in prices. I know
Mr. Johnston says they stay flat. I think Mr. Duffy is right.
They roll over--they are always selling in the near month. And
I would expect that if they are having a significant impact on
prices, that you would see it in the near month as well as in
the far month. I can't sit here and tell you I know what the
impact of those index funds are, but what I can tell you,
though, is this--and I am sorry. I will wrap this up as quickly
as I can. In the time that I have been around, the only
financial products that succeed--and I don't care if they are
new futures contract, I don't care if they are some sort of
exotic swaps contract that someone comes up with or an index
fund, the only way any of these things ever succeed is if they
are filling a market need. These index funds exist because
people want exposure, they want that investment to those
commodity prices, they want that exposure.
I can't conceive of a way to prevent them from doing that.
If we try to foreclose their access to futures markets, that
money will find another way to gain the exposure that they are
looking for. I think transparency again, as I mentioned, always
helps. It always helps ensure market integrity. But trying to
put a jail offense around money and prohibiting money from
being invested in a way that people want to invest it, I find
that difficult.
Ms. Herseth Sandlin. Thank you. I thank the panel. Thank
you, Mr. Chairman.
The Chairman. I thank the gentlelady. The gentlelady from
Kansas.
Mrs. Boyda. Thank you very much, Mr. Chairman. I direct my
comments to the truckers and to the airline association here,
too, and just say again thank you for coming. Both industries
are very, very important to Kansas, as you can well imagine.
And the people who support you are people who you know, the
good working people of Kansas. I feel your pain, let me just
say that, and I hear about your pain on a regular basis. I
appreciate your coming to Congress and asking for help.
What I would come back and ask you is what have you guys
done? What I have heard in the last day--really 2 weeks--is for
some reason the price of oil has tripled in the last year and a
half, even though supply and demand really haven't changed,
even though the dollar has gone down, but not anything that
would affect a three-fold increase. What I have heard since the
beginning of the spring was this drum beat that Democrats won't
allow drilling. Have you ever recommended that you call your
employees, your members and ask them to call oil companies, and
I am truly asking you to do this. Were you in here during the
earlier ones? Were you listening? There isn't a piece of
equipment around. They have drilling capacity out the--they can
drill and drill and drill. Could they be driving up the price
of this? By just dealing with a constant fear in the
marketplace and driving that? Why aren't they drilling? Call
your Member of Congress for sure. Have you ever tried calling
the oil companies and saying why don't you have any equipment,
why aren't you drilling. As I said, there is more oil in the
Alaskan oil preserve, National Petroleum Reserve than there is
in the ANWR, and they have the ability to drill on it today.
What is going on? It is accessible oil. I said over and over
again, ``Public policy follows public opinion.'' And public
opinion, I think people are beginning to understand now that
the Governors of Florida happen to be Republicans for years and
years and years and said, ``Over my dead body am I going to let
you drill off of here,'' and the same in California. Is it
possible that your lives are being wrecked--the lives of your
members are being wrecked for political gain here?
Now, we have one of two things going on. We have
inexplicable change in the marketplace that just started to
happen this spring. Or we have speculation and what we are left
trying to figure out is which one of those it is that.
Mr. Lynch. I will take a stab at that. There is a very good
reason why I am on the miscellaneous panel. There are things
that we know and there are things that we don't know. When the
crisis really started to build, we were directed by our board
to come up and look at a very comprehensive set of solutions,
what can we do. Some of those involved supply, some of them
quite frankly involved demand. I would suggest it is not a
healthy thing to go to the Kansas Motor Truck Association and
recommend that they adopt a 65 mile per hour speed limit in the
State of Kansas, nor in a lot of other places. But yet we are
doing that. I mean, we are trying to encourage our membership
to do the kinds of things----
Mrs. Boyda. And I saw the position that you took on that. I
do not support it one way or the other. I think we should have
a national debate about it. Why it is not even being discussed
is bizarre. But you all took a strong position on that, and
that is gutsy.
Mr. Lynch. We are learning an awful lot about the ins and
outs of the petroleum markets. We have had meetings with API.
We have had meetings with the CFTC. Frankly, 2 years ago, I
couldn't have told you where the CFTC's building was and yet we
have gone down there to learn so that we don't step out too
far.
Mrs. Boyda. Let me reclaim my time with just about half a
minute left. I would ask you to ask your members or to do your
own homework and come up with why all of a sudden this is going
on. Is somebody trying to manipulate a market that is
ultimately really, really hurting you. I would ask the same
thing of you, too, and say call your Member of Congress. But
let us find out. Let us get to the bottom of why the supply--
there isn't anyone on either side of the aisle that says we
shouldn't increase supply. So let us increase supply, let us go
back and I think if API began to understand that at the
grassroots level, people are going to be calling them and
saying, what the heck are you doing, you will start to see some
things change and then we will start to see if this is
speculation or if another message gets out that the American
people are going to demand. You have the capacity right now to
drill. Why the heck aren't you using it? Maybe that will take
the edge off of this kind of irrational exuberance that is
going on in that market and start to mediate it.
I apologize for interrupting you. I yield back.
The Chairman. I thank the gentlelady. The gentleman from
Wisconsin.
Mr. Kagen. Thank you, Mr. Chairman. Mr. Slocum, on page 7
of your prepared statement, I want to read a sentence and see
if you still agree with it. ``Oil companies, investment banks
and hedge funds are exploiting the lack of government oversight
to price gouge consumers and make billions of dollars in
profits.''
You go on to identify that Shell Oil, British Petroleum,
and Marathon Oil have paid millions of dollars in fines for
violations of marketplace rules that the CFTC had brought them
to some form of justice. You then also quote that in 2006
Citicorp concluded, ``we believe the hike in speculative
positions has been a key driver for the latest surge in
commodity prices.''
Then you identify several individuals who went through a
revolving door between the oil industry and the CFTC itself. So
I guess my question comes, you are questioning, really aren't
you, whether there is a cop on the beat and whether or not
there is anyone minding the store. Could you please amplify in
that regard?
Mr. Slocum. That is correct, we have long held a position
that we do not have adequate disclosure requirements or
transparency over these key markets. I began my statement by
talking about how information is the key driver in markets. I
think that it is bad policy for government regulators who are
in charge of protecting households, my constituents as a
representative of one of America's largest consumer groups, the
government lacks access to the key data to understand what is
driving these fluctuations in the marketplace.
We always hear about the supply and demand, and everyone
has acknowledged that a large segment of the energy trading
goes on outside of the jurisdiction of Federal regulators. We
have seen that in the cases where the government does have
regulatory jurisdiction that they have caught very large, very
sophisticated oil companies in market manipulation strategies.
If market manipulation strategies are even occurring on
regulated exchanges, we can only imagine what is going on on
exchanges that are free from regulatory oversight.
Mr. Kagen. Well, if you haven't had time, the opportunity
to review some of the bills that are moving through this House
and this Committee, I would appreciate if you would do so. Bart
Stupak has a bill on the Energy Commerce side on the PUMP Act
or PUMP Act II, as he sometimes refers to it. Mr. Etheridge has
a bill that is moving forward. Do you think any of these
measures will put a cop back on the beat and make certain that
consumers have someone on their side of the equation?
Mr. Slocum. Yes, absolutely. I testified before
Representative Stupak's Committee last year where we talked
about Public Citizen's concerns with regulation of markets. I
believe that Representative Stupak's bill will be a great step
in restoring some transparency.
I do not believe some of the, to put it mildly, hysterical
language that is coming out of some of the large energy
traders, like Goldman Sachs. I just read today in The Wall
Street Journal that Goldman Sachs is running around Congress
trying to warn Congress not to tighten regulations over these
markets. Well, of course Goldman Sachs is going to say that
because they have massive financial interest in continuing to
earn record profits off of under-regulated and nontransparent
markets. That it might be great for the bottom line of Goldman
Sachs and its shareholders and its top executives, but as folks
on this panel have testified and others, and I am sure your
constituents are saying, it is wrecking the American economy
and causing great harm.
And are oil prices high because of supply and demand? Yes.
But I believe that speculation is adding insult to injury to
these high prices and that there clearly is a disconnect
between the supply/demand fundamentals and the current record
high prices and a lot of that is due to the door being wide
open to the ability of speculators. Whether that is----
Mr. Kagen. I don't mean to cut you off, but Mr. Roth, do
you have some comments about this, you have some history here.
Mr. Roth. Just a point of clarification, the CFTC has and
has exercised authority to prevent manipulation on commodities
traded on futures exchanges. Even when the manipulative conduct
occurred off-exchange. There have been any number of cases
where the Commission has brought manipulation cases, where the
activity involved occurred off-exchange but had an effect on-
exchange. So to suggest that there is no cop on the beat to
guard against that type of manipulation of those futures
exchanges is just incorrect.
Mr. Kagen. Would it be more correct to say there is a slow
cop on the beat because that litigation may take years to take
effect and they have not been put in jail?
Mr. Roth. I would suggest that those cases are, by their
nature, incredibly complex. You don't bring a market
manipulation case over a weekend. There are, in fact, intensive
investigations. And as long as we have due process, it will
take a while.
Mr. Kagen. The same question to you, Mr. Roth, begging the
Chairman's indulgence. Do you have an opinion as to the Stupak
bill, the Etheridge bill or any other bill that is before the
House that might help to remedy this situation?
Mr. Roth. We are strongly supportive of this, Congressman.
In Mr. Etheridge's bill there are provisions with respect to
the codification of the CFTC's action to close the so-called
London loophole that needs drafting work. I am sensitive to
some concerns on that.
With respect to Congressman Stupak's bill, I believe there
are positions in his bill that have to do with margins. And I
would be against any sort of precipitous action with respect to
the swaps exemption until we get further information.
Mr. Kagen. I appreciate your input and yield back my time.
The Chairman. I thank the panel for sharing their expertise
and time with us; we appreciate it. With that, we have
concluded the hearing. Everybody, I appreciate you being here.
Do you have anything to say before we adjourn?
Mr. Conway. Thank you for having the hearings, they are
productive and there are great people on both sides of the
issue.
The Chairman. Thank you. Under the rules of Committee, the
record of today's hearing will remain open for 10 days to
receive additional material and supplementary written
responses; this will also apply to the two previous days'
hearings as well, written responses from the witnesses to any
question posed by a Member to the panel. This hearing of the
Committee on agriculture is hereby adjourned.
[Whereupon, at 12:15 p.m., the Committee was adjourned.]