[Senate Hearing 110-459]
[From the U.S. Government Publishing Office]
S. Hrg. 110-459
NON-COMMERCIAL INSTITUTIONAL INVESTORS ON THE PRICE OF OIL
=======================================================================
HEARING
before the
COMMITTEE ON
ENERGY AND NATURAL RESOURCES
UNITED STATES SENATE
ONE HUNDRED TENTH CONGRESS
SECOND SESSION
TO
EXAMINE THE INFLUENCE OF NON-COMMERCIAL INSTITUTIONAL INVESTORS ON THE
PRICE OF OIL
__________
APRIL 3, 2008
Printed for the use of the
Committee on Energy and Natural Resources
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COMMITTEE ON ENERGY AND NATURAL RESOURCES
JEFF BINGAMAN, New Mexico, Chairman
DANIEL K. AKAKA, Hawaii PETE V. DOMENICI, New Mexico
BYRON L. DORGAN, North Dakota LARRY E. CRAIG, Idaho
RON WYDEN, Oregon LISA MURKOWSKI, Alaska
TIM JOHNSON, South Dakota RICHARD BURR, North Carolina
MARY L. LANDRIEU, Louisiana JIM DeMINT, South Carolina
MARIA CANTWELL, Washington BOB CORKER, Tennessee
KEN SALAZAR, Colorado JOHN BARRASSO, Wyoming
ROBERT MENENDEZ, New Jersey JEFF SESSIONS, Alabama
BLANCHE L. LINCOLN, Arkansas GORDON H. SMITH, Oregon
BERNARD SANDERS, Vermont JIM BUNNING, Kentucky
JON TESTER, Montana MEL MARTINEZ, Florida
Robert M. Simon, Staff Director
Sam E. Fowler, Chief Counsel
Frank Macchiarola, Republican Staff Director
Judith K. Pensabene, Republican Chief Counsel
C O N T E N T S
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STATEMENTS
Page
Barrasso, Hon. John, U.S. Senator From Wyoming................... 6
Bingaman, Hon. Jeff, U.S. Senator From New Mexico................ 1
Book, Kevin, Senior Analyst and Senior Vice President, FBR
Capital Markets Corporation, Arlington, VA..................... 25
Burkhard, James, Managing Director, Cambridge Energy Research
Associates, Cambridge, MA...................................... 33
Cino, Victor J., President, Pyramid Oil Marketing................ 72
Cota, Sean, Co-Owner and President, Cota & Cota, Inc., President,
New England Fuel Institute, Bellows Falls, VT.................. 37
Domenici, Hon. Pete V., U.S. Senator From New Mexico............. 3
Dorgan, Hon. Byron, U.S. Senator From North Dakota............... 5
Eichberger, John, Vice President, Government Relations, National
Association of Convenience Stores, Alexandria, VA.............. 43
Emerson, Sarah A., Managing Director, Energy Security Analysis,
Inc., Wakefield, MA............................................ 18
Harris, Jeffrey, Chief Economist, Commodity Futures Trading
Commission..................................................... 7
Salazar, Hon. Ken, U.S. Senator From Colorado.................... 2
APPENDIX
Responses to additional questions................................ 77
NON-COMMERCIAL INSTITUTIONAL INVESTORS ON THE PRICE OF OIL
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THURSDAY, APRIL 3, 2008
U.S. Senate,
Committee on Energy and Natural Resources,
Washington, DC.
The committee met, pursuant to notice, at 9:35 a.m. in room
SD-366, Dirksen Senate Office Building, Hon. Jeff Bingaman,
chairman, presiding.
OPENING STATEMENT OF HON. JEFF BINGAMAN, U.S. SENATOR FROM NEW
MEXICO
The Chairman. Ok. Why don't we get started here? I think
there will undoubtedly be things that try to interrupt us as we
go forward. I thank the witnesses for joining us.
Today's hearing will be about an issue that we've been
debating in Congress for a number of years. That is how
increased speculation in financial energy markets is
contributing to recent record setting oil prices. Certainly
there's a broad recognition that the fundamentals of supply and
demand explain much of the current oil price.
We see increased oil demand especially in developing
economies such as China and India. We've seen OPEC oil
production policies successfully manage U.S. and global oil
inventory levels keeping global commercial stocks low. This
adds to market tightness and upward price pressure. At the same
time we see frequent small scale oil supply interruptions,
which in the last week included sabotage of energy
infrastructure in Iraq, Ecuador, Nigeria, which are all OPEC
members.
We also have a misguided, in my view, policy with regard to
continued filling of the Strategic Petroleum Reserve. Senator
Dorgan has consistently pointed out this and has been trying to
do something about it, which I support. This removes more oil
from the marketplace than the small-scale disruptions. Clearly
there are fundamental factors that are very important, but as
we heard from Guy Caruso, the Administrator of EIA, these
market fundamentals could explain perhaps as much as $90 of the
current price of a barrel of oil.
In addition to these factors there have been a number of
important developments in financial markets in recent years.
These trends include a dramatic increase in the volume of
trading in oil derivative markets, the participation of new
classes of traders in those markets. These trends are
exacerbated by the historic weakness of the dollar, which
encourages non-commercial investors to seek commodity
investments in order to protect against inflation risk.
According to a GAO report issued last fall, the average
standing contract volume for crude oil traded on the New York
Mercantile Exchange increased by 90 percent between 2001 and
2006. In addition, GAO noted the average daily number of non-
commercial participants in crude oil markets included hedge
funds and large institutional investors more than doubled from
2003 to 2006. So taken together, it seems that just as the
demand for physical barrels of oil has grown with the global
economy there is also an increased demand for oil purely as a
financial asset.
Untangling whether and how these dual sources of demand may
be operating in concert and potentially impacting all prices is
complicated. Certainly, I think, it's accurate to say there's
growing suspicion on the part of many Americans that at the
very least Wall Street's geo-political judgments may be serving
to increase current pricing trends. To my mind, unraveling
these issues is made more difficult to the extent that we're
confronted with the lack of reliable and comprehensive data
across these markets.
There's a notable lack of reliable information with respect
to global oil reserves; a lack of transparency related to
certain corners of financial markets. It seems to me that
markets operate best on the basis of complete and reliable
information. In the absence of such information the probability
increases for prevailing market prices to become untethered
from the fundamental supply and demand consideration. In
addition, I think it's also important for us to better
understand the degree to which energy commodities in a purely
financial sense have become an attractive investment given the
state of the overall U.S. economy.
Today we have a very distinguished panel of witnesses, and
I look forward to hearing from each of them on these
complicated issues. I thank them for being here.
Let me defer to Senator Domenici for any opening statement
he'd like to make.
[The prepared statement of Senator Salazar follows:]
Prepared Statement of Hon. Ken Salazar, U.S. Senator
From Colorado
Thank you Chairman Bingaman and Ranking Member Domenici for holding
today's hearing on the influence of speculators and non-commercial
investors on the price of oil. Today's hearing should shed light on the
economic and market forces that determine the price of oil. Global
demand for this resource grows stronger daily. This demand now comes in
two varieties: demand for the physical product itself, and demand for
oil as an investment commodity--so-called ``paper barrels.'' In an
increasingly uncertain global financial climate, many investors are
seeking to lock their capital into commodities. At the same time,
consumers and businesses are powerless as gasoline prices skyrocket.
We are all aware that the price of oil hit an all-time inflation-
adjusted high last month. Some are projecting that we'll have $4 per
gallon gasoline this summer. Many analysts have suggested that
speculation in the crude oil market has played a determining role in
the price surge. The recent increase in trading volume on energy
commodities markets highlights the rising significance of investors'
and speculators' behavior. It is reasonable to suspect that this
behavior plays a significant role in determining the price of oil, and
therefore the price of gasoline. If this is in fact the case, consumers
are paying the price for investors' priorities.
Many people are also worried that the crude oil derivatives markets
are susceptible to manipulation. We know from the Enron scandal that
without adequate oversight and regulation, market manipulation is
possible--and that the consequences can extend far beyond the bottom-
lines of the investors involved and their share-holders to affect the
lives of individual consumers. The new Energy Independence and Security
Act explicitly prohibits manipulation of crude oil, gasoline and
petroleum distillates wholesale markets. I am particularly interested
to hear our panelists' assessments of whether the regulatory structures
exist to properly enforce this new statute.
In the bigger picture, oil prices are still largely a function of
OPEC's supply-and price-setting whims. The U.S. consumes 25 percent of
the world's oil, but produces only 3 percent. Given our limited
domestic supplies of crude oil, it is wrong to suggest that drilling in
the Arctic or even offshore would have any impact on world prices. At
the end of the day, we are still captive to OPEC's preferred oil price.
Ensuring a rational and open crude oil market is a matter of
national and economic security. Because of strong leadership from this
Congress, our country is on the verge of a clean energy revolution that
will reduce our oil consumption. However, as we continue to rely on
foreign oil in our transportation sector, it is imperative for us to
understand the forces that affect the oil market. We must do everything
we can to shield consumers from oil price shocks. I look forward to
discussing these issues with our witnesses today, and I thank them each
for participating.
Thank you, Mr. Chairman.
STATEMENT OF HON. PETE V. DOMENICI, U.S. SENATOR FROM NEW
MEXICO
Senator Domenici. Thank you very much, Mr. Chairman. Thanks
to all of you for coming.
Mr. Chairman I might say that I listened carefully to your
statement. Rather than deliver a detailed statement I would say
for the record that I agree with everything Senator Bingaman
said except two things that we already know we disagree on. One
is SPR. I think it has an impact but I think the risk we're up
against instead of having an extreme shortage justifies us
having SPR and even perhaps even having it bigger than it is.
Other than that I agree with his comments and observations.
I'm very concerned about whether we can ever find out the
facts. But I hope that today we at least begin to understand
the extent to which oil is becoming a commodity, in that it is
being used to a much larger extent in the market for oil and
what is the impact of that.
Now I think we know a few answers there. Commodity trading
is growing dramatically: the part that is observed and readily
seen is growing dramatically, and so is the over-the-counter
market.
All that means, in my opinion, is that rather than buying
the commodity, oil permits itself to be traded by all kinds of
instruments that can be invented and used by those who trade
for commodities. That oil comes closer and closer to being a
commodity rather than being a good that is sold and bought on
the market.
I concur with the Senator, the chairman, that there are
various reasons that stand right out and indicate why the price
is going up so much. It is obvious that the demand for oil is
incredible. As compared with 10 years ago, the new users in the
market including China and India are having an absolutely
dramatic effect.
In addition the United States, with everything we do, is
still unable to reduce its importation. We are using less, but
at the same time our own production is going down. As a result,
we are importing more.
We are net importers. So we belong in that same category
with China. We have a dramatic impact on the world market. Much
of our capital goes into $100 a barrel oil, even with our
dollar devaluing which the chairman spoke of. All of those are
real impact of our current.
But some people say it is the speculators using these
various commodity instruments, that are influencing high oil
prices. Some say their actions add 10&rcent impact, some say 50
percent. I think we did right on this committee to try and find
out, as best we can, what that percentage is. But I'm not sure
we're going to find out.
We're going to hear opinions. But again, I'm not sure we're
going to find an exact answer. Instead, I think sooner or later
we will get to the point of knowing enough to see if we have to
change the way things are done or not.
Right now I wouldn't know how to change it without having
people claim we're taking a risk that we shouldn't take,
because we don't know enough. But I'm not averse to letting it
be known that this Senate committee is serious about looking at
the commodity trading of crude oil because we are concerned
about whether or not that's having an unreasonable impact, a
speculative impact, on the price of oil.
Thank you to the witnesses. I wish to hear from you. Thank
you, Mr. Chairman.
[The prepared statement of Senator Domenici follows:]
Prepared Statement of Hon. Pete V. Domenici, U.S. Senator From
New Mexico
Welcome. I want to thank our panel of witnesses for taking time out
of their busy schedules to join us today. Your testimony will be
invaluable as we look into the role of non-commercial investors in the
crude oil market.
In previous hearings, and discussions with others, we've heard
everything from ``speculators have little or no independent impact on
the price of oil'' to ``they've driven up the price an additional $50
dollars or more.'' I commend the chairman for convening this hearing to
attempt to shed more light on the true impact of these markets.
This is a useful discussion, and we must pay close attention to
energy trading because of it clearly is a significant component of our
energy markets. I am very concerned that it will deflect us focus from
the factors that we KNOW threaten our energy security. I'm afraid that
some may find that it is easier to blame nameless ``oil speculators''
for all our troubles rather than face the reality of fundamental
problems with how we produce and consume energy in the United States
and the world.
What are the factors that we know are driving up oil prices? First,
higher demand. Despite a dramatic 60% increase in oil prices over the
last year, the Energy Information Administration (EIA) projects that
world oil consumption will continue to increase this year. This strong
increase in demand, despite rising prices, is the result of economic
growth in China, and India. Even despite a slower economy, consumption
in the U.S. is expected to grow, as well.
In addition to an increase in global oil demand and a reduction in
supply, geopolitical instability in Nigeria, Iraq, Iran, and Venezuela,
and the weakening of the dollar have driven oil prices higher.
How has the depreciation of the dollar affected crude oil prices?
Most oil price contracts are denominated in dollars and since 2002 the
dollar has decreased in value by 30% against major currencies. This
means that American consumers are more affected by the price of crude
oil then consumers from other countries who have a stronger currency,
such as the Euro or the Yen, because the prices of imports have gone
up.
With high prices and growing consumption worldwide, we must find
ways to increase domestic supplies. U.S. crude oil production is
projected to decline 10,000 barrels a day in 2008. This, combined with
projected increases in U.S. petroleum consumption, will require this
country to rely even more heavily on foreign oil imports and continue
to ship nearly $400 billion annually overseas to import oil.
Mr. Chairmen, I appreciate your willingness to examine the role of
non-commercial investors in the crude oil market. But we must also
recognize that while non-commercial investors may contribute something
to high oil prices, it is just one piece of a very large puzzle. I look
forward to hearing from today's witnesses, and, going forward, to
working with the members of this Committee to resolve all of the major
obstacles to our Nation's energy security.
The Chairman. Thank you. Senator Dorgan wanted to make a
statement here. Let me call on him.
STATEMENT OF HON. BYRON DORGAN, U.S. SENATOR FROM NORTH DAKOTA
Senator Dorgan. Chairman, thank you. I wanted to make a
comment. I had requested, among others, that this hearing be
held. I think this is very important.
The last 24, 36 hours, 2 airlines have shut down. We see
news reports about truckers deciding that they can't continue
trucking. They're going to slow down. They can't afford to buy
the fuel. These energy prices are having significant
consequences.
I'm not very generous with respect to the notion that it's
just supply and demand that is driving these energy prices. I
don't think pure supply and demand describes why the price of
oil has gone from $50 to $100 in a relatively short period of
time. I think the evidence is pretty substantial.
There's an orgy of speculation in the futures market. We've
got people buying what they'll never get from people who never
had it. I understand these markets and the reason for the
markets and the need for liquidity in markets. But I think
there has been an unbelievable amount of speculation.
We've not sat in this room before when hedge funds were
neck deep in the oil and commodities futures markets. We've not
sat in these rooms before when investment banks were actually
buying oil storage so they could speculate and actually take
oil off the market and put it in storage away before the price
of oil goes up. There's an unbelievable amount of speculation,
in my judgment.
Twenty times more oil is sold every single day in these
markets than exists. Think of that. Now we've had testimony
before this committee, Mr. Chairman, by some pretty respected
analysts, top analysts for Oppenheimer and Company says there's
no justification for the price of oil to be where it is.
It's about $20 to $30 above where it ought to be because
this is a 24/7 casino with unbelievable speculation. I believe
it's our job, and not to simply say well it's supply and
demand. It's our job to ask tough questions.
We have a margin requirement here of what, 5 to 7 percent.
You can control $100,000 worth of oil with a $5,000 or $7,000
investment. You can't do that on the stock market. We ought to
increase the margin requirements in this country and get the
speculators out of this system.
So, I feel very strongly about this. The consequences of
what's happening with the price of oil are all around us. I
understand the Indians are going to drive more cars. I
understand the Chinese are going to drive more cars. I
understand the future fundamental issues. I don't understand
the current price, relative to the fundamentals, that exist
today in these markets. I think there's an orgy of speculation
that we ought to be deciding to do something about.
The Chairman. Let me ask if any other Senator wishes to
make a statement.
Senator Barrasso.
STATEMENT OF HON. JOHN BARRASSO, U.S. SENATOR
FROM WYOMING
Senator Barrasso. Yes. Mr. Chairman, thank you very much.
Mr. Chairman, the message that I heard loud and clear
during the most recent recess was that record prices at the
pump are hurting the wallets of Wyoming families and American
families. High oil prices hit consumers in States like Wyoming
particularly hard, but it's just not Wyoming. It's Colorado.
It's North Dakota. It's New Mexico. This committee is well
represented with folks who are from States where people travel
long distances to go to work, to run errands, and to see
friends and family.
Mr. Chairman, I understand that the Research Director with
Greenpeace was quoted earlier this week as saying that his
organization wasn't inherently against high gas prices. I want
to be very clear, Mr. Chairman, I'm very concerned about the
prices at the pump. I'm pleased that this committee is holding
this hearing.
There are multiple contributors to today's price of oil.
Some relate to the fundamentals of demand and supply and
growing world economies. Others relate to the geopolitical
tensions, the weakness in the dollar, environmental regulations
and the like. But in markets with very little available excess
supply, marginal contributions to supply and demand seem
particularly influential.
I don't believe that the American oil producers and
refiners and distributors or the corner service stations are
solely responsible for today's high gasoline prices. In that
context the world economy, America's producers are generally
price takers, not price makers. Free markets and competition
serve to keep prices in check, but at a minimum I strongly
believe government policies should not drive oil prices higher.
This is true when it comes, in my mind, to deposits into the
Strategic Petroleum Reserve, any calls for higher taxes at the
pump or government mandates.
There are some short and long term policy proposals, which
I believe warrant congressional attention. I am compelled by
the GAO's recommendations that we begin dollar cost averaging
in purchasing heavy oil for the Strategic Petroleum Reserve.
These steps are simply sound, financially responsible measures.
I think Senator Dorgan's call for a temporary suspension of
deposits into the Strategic Petroleum Reserve until the price
is below a certain level have merit and should be debated. I
believe high prices at the pump will ultimately encourage
consumers to seek out individual ways to conserve and to invest
in more efficient transportation. But these responses may not
provide the immediate relief that the consumers need.
Congress has more tools that can and should be on the
table. Part of a comprehensive solution must incorporate a
vision for the future and expanded domestic production. There
are areas throughout America that have vast potential for oil
development and serious consideration must be given in how we
manage these lands and deep seas.
Another component is technology. America must capitalize on
existing opportunities and continue to invest in emerging
energy technologies. One technology to me that is especially
interesting is in the terms of domestic transportation fuel:
coal to liquids. With respect to market excessive speculation,
Congress needs to explore the extent to which price
manipulation is occurring and to what extent the impacts can be
minimized.
I appreciate the chairman's efforts in calling this
hearing. In this global economy will more regulation result in
America losing its leadership in financial markets? Or can
stepped up efforts, to root out excessive speculation and
manipulation, ultimately help American consumers?
I'm also increasingly compelled by concerns over our trade
deficit. As America expends more and more of our hard earned
money to purchase foreign oil of particular interest to the
activities of the sovereign wealth funds. These funds, often
supported national oil profits, can serve as a self-reinforcing
mechanism pushing oil future prices up higher than they
otherwise would have been.
So with that, Mr. Chairman, I look forward to today's
informative discussion. Thank you for holding these hearings.
The Chairman. Thank you very much. Unless other members
have just some burning need to speak at this point, I would
prefer to go ahead and hear from our witnesses. Why don't we do
that?
Let me introduce the six distinguished witnesses we have,
and just have them testify in this order if they would. Jeffrey
Harris is here from the Commodity Futures Trading Commission.
Thank you for being here.
Sarah Emerson from Energy Security Analysis. Thank you for
being here.
Kevin Book is here with Friedman Billings Ramsey and
Company in Arlington, Virginia.
Jim Burkhard is here from Cambridge Energy Research
Associates. Thank you for being here.
Sean Cota is here representing the Petroleum Marketers
Association of America.
John Eichberger is here representing the National
Association of Convenience Stores.
So thank you all for being here. If each of you could take
about 6 minutes or something like that and make the main points
that you think we need to understand from your testimony. We
will include your entire testimony in the hearing transcript.
Mr. Harris.
STATEMENT OF JEFFREY HARRIS, CHIEF ECONOMIST, COMMODITY FUTURES
TRADING COMMISSION
Mr. Harris. Thank you, Mr. Chairman and members of the
committee. I am Jeffrey Harris, Chief Economist of the
Commodity Futures Trading Commission or the CFTC. I appreciate
the opportunity to discuss the CFTC's role with respect to
crude oil futures markets and the Office of Chief Economist's
view of current trends in the marketplace as part of the
government regulator charged with overseeing them.
Congress created the CFTC in 1974 as an independent agency
with a mandate to regulate commodity futures markets in the
United States. Broadly stated CFTC's mission is two-fold. To
protect the public and market users from manipulation, fraud
and abusive practices and to assure that open, competitive and
financially sound markets for commodity futures and options.
Commodity commission's oversight of future trading is
focused on the New York Mercantile Exchange, West Texas
intermediate crude oil contract. That's it. Designated contract
market. Secondarily on the intercontinental exchanges in
Europe, ICE futures of Europe contract because one of its
contracts cash settles on the NYMEX settlement price.
The CFTC receives millions of data points everyday about
trading activity in our markets. The agency's large trader data
base system is the cornerstone of our surveillance system and
is used to analyze data. Large trader positions reported to
CFTC consistently represent more than 90 percent of all trading
interest in NYMEX's WTI contract with the remainder being
allocated to small traders who don't meet reporting
requirements.
The CFTC closely tracks the developments in the crude oil
markets. Crude oil prices have risen significantly in the last
few years. Are currently above $100 a barrel. Concurrently open
interest in WTI contracts has expanded dramatically from about
one million contracts in 2004 to more than 2.8 million
contracts in the most recent week.
The Office of the Chief Economist has studied these markets
to better understand the compliments of this rapid growth. Our
studies find three major things.
First, we find similar rates of growth for both commercial
and non-commercial trading interest. Where non-commercial
interest is commonly considered speculative.
Second, most of the growth in trading interest is
concentrated in futures contracts that expire after 12 months
suggesting that an increase in ability for hedging at longer
horizons now exists in our markets.
Figures 1-A and 1-B* in my presentation here demonstrate
these two points.
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* Figures have been retained in committee files.
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The Chairman. Are these also in the testimony?
Mr. Harris. These are also in the written testimony, yes.
The Chairman. Ok.
Mr. Harris. We've highlighted here 2000 verses 2007. As you
can see the 2007 bars are much larger for commercial traders in
2007 than they were in 2000. Figure 1-B highlights the
positions of non-commercial traders or speculators in these
markets, which also exhibit significantly larger trading
volume.
The second component is that you can see the bars are much
larger as we move to the right on these graphs indicating the
greater propensity or the opportunity to hedge in the futures
markets at longer horizons.
Figures 1-A and 1-B also highlight the fact that commercial
trading in short positions, hedging in the market, rely
intimately on the ability of the speculators to take the
opposite sides of trades.
The Chairman. Let me just ask on this. The second, the
columns there, do I understand it correctly that that indicates
the----
Mr. Harris. The bars above the zero mark are long
positions.
The Chairman. Right. So there's----
Mr. Harris. Bars below are short.
The Chairman. So there's been well over a tenfold increase
in the number of non-commercial traders involved in these 3 to
6 month futures contracts. Is that accurate?
Mr. Harris. Yes.
The Chairman. Ok. Go right ahead.
Mr. Harris. The point being with commercial traders being
short and non-commercials being long, the supply and demand for
hedging services intimately ties hedgers and speculators
together in futures markets.
The third major trend during the past few years is that
crude oil markets have witnessed a rapid growth in swap dealer
trading. Swap dealers now hold significantly larger positions
in crude oil. These dealers, who take the short sides of over
the counter swap trades lay off their risk with long positions
in the crude oil futures markets.
This development has altered the traditional role of
commercial traders. Previously commercial traders predominately
hedged using long positions in the stock market and went short
in the crude oil futures markets. Recent development has swap
dealers, those also classified as commercial dealers, hedging
their short, swap positions with long positions in our futures
markets.
Figures 2-A here and 2-B show the difference between the
two different types of commercial traders. 2-A shows that
traditional commercial traders are typically net short in the
near term futures contract. Swap dealers also considered
commercial traders are net long in these same contracts. So
commercial traders, depending on the type, trade very
differently in our markets.
Figure 2-B also demonstrates the growth in swap dealer
market in the near term futures contracts. Partially represents
this flow from commodity index trading. Even the substantial
increase in open interest in crude oil futures, the Office of
the Chief Economist utilizes the Commission's extensive data to
examine the role of all market participants. How their
positions might affect prices.
Although longer term studies show a slight increase in the
number of non-commercial market share in crude oil market, OCE
analysis shows that more recent increases in oil prices to
levels above $100 has not been accompanied by significant
changes to participants in the market. Figure 3 here shows that
the number of commercial and non-commercial traders has
remained nearly constant over the last 22 months with about 120
commercial and 310 non-commercial traders in the market.
OCE has also studied the impact of speculators as a group
in the oil markets during the most recent price run up.
Specifically we have closely examined the relationship between
futures prices and the positions of speculators in the crude
oil markets. Our studies have consistently found that when new
information comes to the market it is commercial traders such
as oil companies, utilities and airlines who react first by
adjusting their futures positions. When these commercial
traders adjust their futures positions it is speculators who
are most often taking the other side of their trade.
Price changes that prompt hedgers to alter their futures
positions attract speculators who've changed their positions in
response. Simply stated there is little evidence that position
changes by speculators precede price changes in the crude oil
futures contracts. Instead, changes in commercial traders
significantly precede oil price changes.
To highlight this effect a bit more clearly, Figure 4 plots
the prices in the market share one group of highly active
speculators, managed money traders, over the past 22 months.
Notably, while the WTI contract prices have doubled in the last
14 months managed money positions, as a fraction of their
overall market have changed very little. Speculative positions
do not generally amplify crude oil price changes.
More specifically, the recent crude oil price increases
have occurred with no significant change in the net speculative
positions. The OCE has also studied position changes of
commercial and non-commercial traders by category finding
similar results. We find little evidence that net positions
changes of any category of non- commercial traders is affecting
or preceding price changes in crude oil futures prices.
Figure 5 highlights the fact that commercial and non-
commercial open interest has grown during the most recent 22
months. But generally this growth remains balanced between long
and short positions for each trader group. Looking at the
trends in the marketplace combined with studies on the impact
of speculators in the market there is little evidence that
changes the speculative positions are systematically driving up
crude oil prices.
Given the relatively stable make up of participants and
their positions in the markets and the absence of evidence of
speculation causing oil price changes, it appears that
fundamentals provide the best explanation for crude oil price
increases. These fundamentals can be either broad factors
affecting many markets like the dollar or general inflation
fears or factors particular to this market such as strong
demand from China or India. In addition geopolitical events,
tensions in Venezuela, Nigeria and other countries have
affected crude oil markets.
Concerns about the high price of oil are not unique to the
United States. I recently presented some of these findings to
the International Energy Agency in Paris, which representatives
attended from 40 different countries, OPEC, industry economists
and traders. Our findings were supported by many of the
conference presenters and attendees who've conducted their own
research on these topics.
Given the widespread interest in crude oil in particular,
is something I'm certain we will continue to monitor closely as
will my counterparts around the world. This concludes my
remarks. I'd be happy to answer any questions if you'd like.
[The prepared statement of Mr. Harris follows:]
Prepared Statement of Jeffrey Harris, Chief Economist, Commodity
Futures Trading Commission
Thank you, Mr. Chairman and members of the Committee. I am Jeffrey
Harris, Chief Economist of the Commodity Futures Trading Commission
(CFTC or Commission). I appreciate the opportunity to discuss the
CFTC's role with respect to the crude oil futures markets and our view
of current trends in the markets as the government regulator charged
with overseeing them.
cftc mission
Congress created the CFTC in 1974 as an independent agency with the
mandate to regulate commodity futures and option markets in the United
States. Broadly stated, the CFTC's mission is two-fold: to protect the
public and market users from manipulation, fraud, and abusive
practices; and to ensure open, competitive and financially sound
markets for commodity futures and options. To do this, the Commission
employs a highly-skilled staff who work to oversee the markets and
address any suspicious or illegal market activity.
The Commodity Exchange Act (CEA or Act) grants the Commission
exclusive jurisdiction with respect to, among other things, accounts,
agreements, and transactions involving commodity futures and options
contracts that are required to be traded or executed on an exchange or
a designated contract market, also known as a DCM. DCMs are regulated
futures exchanges that are self-regulatory organizations (SROs) subject
to comprehensive oversight by the CFTC. DCMs can list for trading any
type of contract, they can permit intermediation, and all types of
traders (including retail traders) are permitted to participate in
their markets.
The CFTC has been overseeing the U.S. futures industry under
principles-based regulation since the passage of the Commodity Futures
Modernization Act (CFMA) in 2000. A principles-based system requires
markets to meet certain public outcomes in conducting their business
operations. For example, DCMs must continuously meet 18 core
principles--ranging from maintaining adequate financial safeguards to
conducting market surveillance--in order to uphold their good standing
as a regulated contract market.
market oversight
The CFTC's Division of Market Oversight (DMO) is responsible for
monitoring and evaluating a DCM's operations. DMO conducts market
surveillance of all activity on DCMs. While operational, DCMs must
establish and devote resources toward an effective oversight program,
which includes surveillance of all activity on their markets to detect
and deter manipulation and trading abuses. The CFTC routinely assesses
the regulatory and oversight activities of DCMs through regularly
scheduled examinations of DCMs' self-regulatory programs. The
Commission currently regulates DCMs located in New York, Chicago,
Kansas City, and Minneapolis.
The CFTC's market surveillance mission regarding DCM activity is to
ensure market integrity and customer protection in the futures markets.
Traders establishing positions on DCMs are subject to reporting
requirements so that CFTC staff and the DCM can evaluate position sizes
to detect and prevent manipulation. In addition, trade practice
surveillance involves compilation and monitoring of transactional-level
data by the Commission and the DCM to protect market participants from
abusive trading such as wash sales, money laundering and trading ahead
of customers.
A key market surveillance mission is to identify situations that
could pose a threat of manipulation and to initiate appropriate
preventive actions. Each day, for the estimated 1,400 active futures
and option contracts in the U.S., the CFTC market surveillance staff
monitors the activities of large traders, key price relationships, and
relevant supply and demand factors to ensure market integrity.
Surveillance economists routinely examine trading in futures and
options contracts that are approaching their expiration periods for any
unusual trading patterns or anomalies. Regional surveillance
supervisors immediately review unusual trading or anomalies to
determine whether further action is warranted. Surveillance staff
advise the Commissioners and senior staff of significant market
developments as they occur and also conduct weekly surveillance
meetings (non-public, closed meetings) so that the Commission will be
prepared to take action if necessary. In addition to the transparency
provided to the CFTC by position reporting by large traders, the
Commission provides a degree of transparency to the public by
publishing aggregate information in the CFTC's weekly Commitment of
Traders Report.
As noted, surveillance of DCM trading is not conducted exclusively
by the Commission. As SROs, DCMs have significant statutory
surveillance responsibilities. Typically, however, surveillance issues
are handled jointly by Commission staff and the relevant DCM. The
Commission, while continuing to monitor market events, typically
permits the DCM, as the front-line regulator, to utilize its self-
regulatory authorities to resolve issues arising in its markets. If a
DCM fails to take actions that the Commission deems appropriate,
however, the Commission has broad emergency powers under the CEA to
order the DCM to take specific actions. The Commission has exercised
its emergency authority four times in its history.
financial oversight
The Commission's Division of Clearing and Intermediary Oversight
(DCIO) is responsible for and plays an integral role in ensuring the
financial integrity of all transactions on CFTC-regulated markets.
DCIO's most important function is to prevent systemic risk and ensure
the safety of customer funds. DCIO meets these responsibilities through
an oversight program that includes the following elements: (1)
conducting risk-based oversight and examinations of industry SROs
responsible for overseeing Futures Commission Merchants (FCMs),
commodity trading advisors, commodity pool operators, and introducing
brokers, to evaluate their compliance programs with respect to
requirements concerning fitness, net capital, segregation of customer
funds, disclosure, sales practices, and related reporting and
recordkeeping; (2) conducting risk-based oversight and examinations of
all Commission-registered derivatives clearing organizations (DCOs) to
evaluate their compliance with core principles, including their
financial resources, risk management, default procedures, protections
for customer funds, and system safeguards; (3) conducting financial and
risk surveillance oversight of market intermediaries to monitor
compliance with the provisions of the CEA and Commission regulations;
(4) monitoring market events and conditions to evaluate their potential
impact on DCOs and the clearing and settlement system and to follow-up
on indications of financial instability; and (5) developing
regulations, orders, guidelines, and other regulatory approaches
applicable to DCOs, market intermediaries, and their SROs.
Collectively, these functions serve to protect market users, the
general public and producers; to govern the activities of market
participants; and to enhance the efficiency and effectiveness of the
futures markets as risk management mechanisms.
The DCOs that the Commission currently regulates are located in New
York, Chicago, Kansas City, Minneapolis and London, England. The
intermediaries overseen by the Commission are located throughout the
United States and in various other countries.
enforcement
In Section 3 of the CEA, Congress provided that transactions
subject to the Act ``are affected with a national public interest''
because they constitute ``a means for managing and assuming price
risks, discovering prices, or disseminating pricing information through
trading in liquid, fair and financially secure trading facilities.''
The Commission's Division of Enforcement (Enforcement) is responsible
for prosecuting fraudulent, abusive and manipulative trading practices.
Enforcement has a substantial role over maintenance and protection of
principles of fairness and integrity in commodity markets. At any one
time, Enforcement's investigations (which are non-public) and pending
litigation involve, on average, approximately 750 individuals and
corporations.
In protecting the national public interest associated with
transactions subject to the Act, the Commission has broad authority to
investigate and prosecute misconduct occurring in both the futures and
cash markets. Included in this broad authority is Section 9(a)(2) of
the CEA which prohibits manipulating or attempting to manipulate the
price of any commodity in interstate commerce or for future delivery,
cornering or attempting to corner any such commodity, and knowingly
delivering or causing to be delivered false or misleading or knowingly
inaccurate reports of crop or market information that affects or tends
to affect the price of any commodity in interstate commerce.
During the last five years, Enforcement has maintained a record
level of investigations and prosecutions in nearly all market areas,
including attempted manipulation, manipulation, squeezes and corners,
false reporting, hedge fund fraud, off-exchange foreign currency fraud,
brokerage compliance and supervisory violations, wash trading, trade
practice misconduct, and registration issues. Working closely with the
President's Corporate Fraud Task Force, Enforcement is staffed with
skilled professionals who prosecute cases involving on-exchange
transactions and, to the extent of the Commission's jurisdiction,
complex over-the-counter (OTC) transactions as well. Enforcement also
routinely assists in related criminal prosecutions by domestic and
international law enforcement bodies. Through those efforts, during the
past five years (April 2003--March 2008), the CFTC has obtained more
than 2 billion dollars in monetary sanctions, which include civil
monetary penalties and orders to pay restitution and disgorgement.
In the energy sector, from December 2001 through the present,
Enforcement investigated or prosecuted Enron and BP, dozens of other
energy companies, and more than one hundred energy traders (including a
pending action against Amaranth). With respect to crude oil in
particular, Enforcement staff in August 2007 announced a settlement for
a charge of attempted manipulation in OTC crude oil markets against
Marathon Petroleum Company, a subsidiary of Marathon Oil Corporation
(Marathon Petroleum). In that action, which imposed a $1 million civil
monetary penalty, the Commission entered an Order finding that Marathon
Petroleum attempted to manipulate a price of spot cash West Texas
Intermediate (WTI) crude oil by attempting to influence downward the
Platts market assessment for spot cash WTI on November 26, 2003. The
Platts market assessment for WTI is used as the price of crude oil in
certain domestic and foreign transactions. At the time in question,
Marathon Petroleum priced approximately 7.3 million barrels of physical
crude per month off the Platts market assessment for WTI.
crude oil trading on futures markets and other markets
The Commission's oversight of oil futures trading focuses on the
New York Mercantile Exchange or (NYMEX) and secondarily on the
Intercontinental Exchange Europe (ICE Futures Europe)--the latter
because one of its contracts cash settles on the price of the NYMEX WTI
Light Sweet Crude futures contract. (Notably, crude oil futures
products are also traded on some Exempt Commercial Markets, but those
contracts are fairly low in trading volume.)
NYMEX is a DCM with self-regulatory responsibilities and operates
under the Commission's oversight as provided by the CEA. NYMEX lists
several crude oil futures contracts. The exchange's highest volume
crude oil contract is the WTI Light Sweet Crude Oil futures contract,
which provides for physical delivery of oil in Cushing, OK. NYMEX's
Light Sweet Crude contract traded a volume of 122 million futures
contracts in 2007. NYMEX also lists several cash settled futures
contracts based on the Light Sweet Crude Oil futures contract price.
NYMEX also lists futures contracts based on Brent blend crude oil,
which settle on the price of the ICE Futures Europe Brent contract, as
well as a Dubai crude oil calendar swap contract. In addition, NYMEX
offers several financially-settled, cleared contracts, including
differential and spread contracts involving prices of the WTI, Brent
and Dubai crude oil futures contracts.
ICE Futures Europe lists a Brent Crude Oil futures contract, a WTI
Crude Oil futures contract that settles on the price of the NYMEX light
sweet crude oil contract, and a Middle Eastern Sour Crude futures
contract. The Brent and WTI contracts are very actively traded, while
the Middle Eastern Sour Crude contract trades much less frequently.
ICE Futures Europe is a UK Registered Investment Exchange and is
regulated by the UK's Financial Services Authority (FSA). The U.S.-
based members of ICE Futures Europe were granted permission by
Commission staff to directly access the Exchange's trading system from
the U.S. pursuant to a Commission no-action letter issued to ICE
Futures Europe's predecessor, the International Petroleum Exchange
Limited, on November 12, 1999, as amended.
Pursuant to the no-action letter's terms and conditions and
information--sharing arrangements, CFTC surveillance staff knows, among
other things, when ICE Futures Europe proposes to list new contracts to
be made available from the U.S., the volume of trading originating from
the U.S., the identities of members who have direct access to the
trading system in the U.S., and when there are material changes to any
aspect of the information provided that resulted in the issuance of the
no-action letter. Pursuant to CFTC-FSA information--sharing
arrangements, CFTC surveillance staff also receives ICE Futures
Europe's member position reports for its WTI Crude Oil futures contract
on a weekly basis (daily during the week prior to contract expiration).
Thus, CFTC surveillance staff knows the positions and identities of
members/customers who meet or exceed position-reporting requirement
levels in the ICE Futures Europe WTI contract, and can consider that
data along with the large trader reporting information that it receives
from NYMEX for its counterpart contract.
foreign boards of trade
The CFTC employs a ``no-action'' process when foreign boards of
trade (FBOTs) seek to provide electronic screen access to the U.S., but
without registering as a DCM. With the advent of the ICE Futures Europe
WTI contract in 2006, the CFTC undertook a thorough review of its FBOT
policy. The Commission concluded that the best way to handle the issue
was to continue its no-action approach, a response that reflects the
internationally accepted ``mutual recognition'' approach used by
regulators in many developed market jurisdictions to govern access to
foreign electronic exchanges by persons located in their jurisdictions.
This approach generally is based upon a review of, and ongoing reliance
upon, the foreign market's ``home'' regulatory regime, and is designed
to maintain a threshold level of regulatory protections while avoiding
the imposition of duplicative regulation.
The CFTC has followed the no-action approach since 1996 and it has
never experienced any market integrity or customer protection problems.
The no-action procedure provides the CFTC with flexibility in dealing
with the particular foreign exchanges and different CFTC practices. The
Commission held an FBOT hearing in June 2006, including a related open
public comment opportunity, during which market users, foreign
exchanges and even competitive domestic exchanges that compete with
FBOTs overwhelmingly confirmed the success of the CFTC's approach in
terms of market and customer protection and access to additional
products. Subsequently, the CFTC issued a Statement of Policy re-
affirming the use of the FBOT no-action process, but also enhancing it
through the imposition of information-sharing conditions where no-
action relief is sought for FBOT contracts that could adversely affect
the pricing of contracts traded either on a DCM or on any cash market
for commodities subject to the CEA.
On November 17, 2006, the CFTC and the UK FSA signed a Memorandum
of Understanding (MOU) concerning consultation, cooperation and the
exchange of information related to market oversight. The MOU
established a framework for the CFTC and FSA to share information that
the respective authorities need to detect potential abusive or
manipulative trading practices that involve trading in related
contracts on U.S. and UK derivative exchanges. Since the adoption of
the MOU, the CFTC and FSA have been holding monthly conference calls to
discuss matters of mutual interest including trading on ICE Futures
Europe. Commission staff has found that the 6 MOU has strengthened
information-sharing on an ongoing basis between the two regulatory
authorities.
exempt commercial markets
In the Commodity Futures Modernization Act of 2000 (CFMA), Congress
enacted special provisions in the CEA to govern Exempt Commercial
Markets (ECMs), which are electronic marketplaces for commercial
participants to trade contracts in energy and certain other
commodities. ECMs have been evolving over time since then, such that
today, certain ECM contract settlement prices link to DCM futures
contract settlement prices. Linkage of contract settlement prices was
not something that was contemplated at the time of the CFMA.
Last September, the CFTC conducted an extensive public hearing on
ECMs, and found that certain energy futures contracts traded on ECMs
may be serving a significant price discovery function. This raised the
question of whether the CFTC has the necessary authority to police the
ECM markets for manipulation and abuse. The Commission concluded that
changes to the CEA would be appropriate as a result and, to that end,
in October 2007 the Commission recommended legislative changes in a
Report delivered to Congress. Specifically, the Commission recommended
that significant price discovery contracts on ECMs be subject to the
same position limit and position accountability core principle that
applies to contracts traded on DCMs. In addition, its recommendations
would further require: 1) large trader position reporting on
significant price discovery contracts on ECMs; 2) self-regulatory
responsibilities for the ECM; and 3) CFTC emergency authority over
these contracts.
We are pleased that the Commission's recommendations were endorsed
by the President's Working Group on Financial Markets, and have been
well received in Congress. In December, these recommendations were
included in legislation that moved forward in both the House of
Representatives and the Senate. Both bills largely adopt the CFTC's
recommendations on the need for enhanced oversight over significant
price discovery contracts traded on ECMs, including position limits and
position accountability. The modest differences between the bills are
being worked out as part of the Conference on the Farm Bill, and we are
hopeful that Congress will take final action on these proposals soon to
give the CFTC these additional and necessary authorities.
bilateral over-the-counter trading
Much crude oil trading also takes place by what is known as ``over-
the-counter'' (OTC) trading. This trading is typically non-standardized
and between two sophisticated participants. The CFTC does not regulate
privately-negotiated OTC contracts, nor does it regulate cash markets
or forward markets. However, we have the tools to adequately police the
markets falling under CFTC jurisdiction. The typical OTC market
transaction involves a sophisticated market participant's request to a
swap dealer to structure an OTC transaction. The dealer facilitates the
customer by taking the opposite side of the customer's position. The
dealer then turns to the futures markets to offset the risk that it has
taken on. (We see the actions of OTC dealers in our Large Trader
Reporting System as explained below.)
The first thing to recognize about OTC contracts is that they are
typically benchmarked to NYMEX futures prices or to cash market
indexes. In terms of administering the anti-manipulation provisions of
the CEA, our current authority and our current surveillance program are
sufficient to detect an attempted manipulation of the NYMEX futures
price to benefit an off-exchange OTC position.
Our current authority also gives us the ability to ask what we call
``reportable traders'' in the futures markets to reveal their OTC
positions, as well as their cash market and forward market positions.
If required, we also have subpoena authority. We have used this
authority to help bring 50 enforcement actions in energy markets in
recent years.
The enactment of the CFMA brought about multilateral clearing of
OTC positions at futures clearinghouses. As a result, OTC trades become
transparent to the CFTC through the clearing process. For 2007,
approximately 224 million OTC contracts cleared through NYMEX and the
InterContinental Exchange (ICE). In fact, as traders in the OTC markets
have become more aware of credit considerations and the benefits of
transparency, they have been moving their positions onto exchanges
where the exchange clearinghouse enhances credit worthiness and the
market is transparent.
using data to oversee the markets
The CFTC receives millions of data points every day about trading
activity in the markets. The agency's Large Trader Reporting System is
the cornerstone of our surveillance system and is used to look at data.
Clearing members, FCMs, foreign brokers and other traders file
confidential electronic reports with the CFTC each day, reporting
positions of each large trader on each DCM. In the NYMEX WTI contract,
for instance, a trader with a position exceeding 350 contracts in any
single expiration is ``reportable.'' Large trader positions reported to
the CFTC consistently represent more than 90% of total open interest in
the NYMEX WTI contract, with the remainder being smaller traders who do
not meet reporting thresholds.
When a reportable trader is identified to the CFTC, the trader is
classified either as a ``commercial'' or ``non-commercial'' trader. A
trader's reported futures position is determined to be commercial if
the trader uses futures contracts for the purposes of hedging as
defined by CFTC regulations. Specifically, a reportable trader gets
classified as commercial by filing a statement with the CFTC (using the
CFTC Form 40) that it is commercially `` . . . engaged in business
activities hedged by the use of the futures and option markets.''
However, to ensure that traders are classified consistently and with
utmost accuracy, CFTC market surveillance staff checks the forms and
re-classifies the trader if they have further information about the
trader's involvement with the markets.
In fact, a reportable participant may be classified at the CFTC as
non-commercial in one market and commercial in another market, but is
never classified as both in the same market. For instance, a financial
institution trading Treasury Notes might have a money management unit
whose trading positions are classified as non-commercial but a banking
unit that is classified as commercial. Reporting firms must file Form
102 to identify each account, and this information allows the CFTC to
relate separate traders to a single higher level of ownership.
In addition to the breakdown between commercial and non-commercial
categories, the large trader data can be filtered by type of trading
activity. For example, on the commercial side, the CFTC can sort the
data by more than 20 types of institutions, ranging from agricultural
merchants and livestock feeders to mortgage originators. Traders that
are non-commercial include commodity trading advisors, commodity pool
operators (managed money traders), and floor brokers and traders.
Using data from the Large Trader Reporting System, the CFTC also
publishes a weekly breakdown of reporting positions of each Tuesday's
open interest known as the Commitments of Traders (COT) report. COT
reports are published for markets in which 20 or more traders hold
positions above CFTC-established reporting levels.
COT reports are available on the CFTC's public website every Friday
at 3:30 PM in both a short and long format. The short report shows open
interest separately by reportable and non-reportable positions. The
long report, in addition to the information in the short report, shows
the concentration of positions held by the largest four and eight
traders and groups the data by crop year, where appropriate. For
reportable positions, additional data is provided for commercial and
non-commercial holdings, spreading, changes from the previous report,
percentage of open interest by category, and numbers of traders.
speculation in the commodities markets
The current market environment has brought questions about the role
that speculators play in affecting prices in the futures markets. The
proper and efficient functioning of the futures markets requires both
speculators and hedgers. While certain targeted controls on speculation
are appropriate, speculators, as a class, provide the market liquidity
to allow hedgers to manage various commercial risks. Unnecessary
limitations on the amount of speculation that an individual or entity
may engage in could limit the amount of liquidity in the marketplace,
the ability of hedgers to manage risks, and the information flow into
the marketplace, which could in turn negatively affect the price
discovery process and the hedging function of the marketplace.
While speculation is critical to well-functioning markets,
excessive speculation can be detrimental to the markets. Under Section
4a of the CEA, the concept of ``excessive speculation'' is based on
trading that results in ``sudden or unreasonable fluctuations or
unwarranted changes in the price'' of commodities underlying futures
transactions. The CEA specifically makes it a violation of the Act to
manipulate the price of a commodity in interstate commerce or for
future delivery. The CEA does not make excessive speculation a per se
violation of the Act, but rather, requires the Commission to enact
regulations to address such trading (for example, through speculative
position limits).
The Commission has utilized its authority to set limits on the
amount of speculative trading that may occur or speculative positions
that may be held in contracts for future delivery. The speculative
position limit is the maximum position, either net long or net short,
in one commodity future (or option), or in all futures (or options) of
one commodity combined, that may be held or controlled by one person
(other than a person eligible for a hedge exemption) as prescribed by a
DCM and/or by the Commission. Moreover, CEA Section 5(d)(5) requires
that a DCM, ``[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
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 one-fourth 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.
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 10 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.
office of the chief economist study of trends in the crude oil market
The CFTC's Office of the Chief Economist (OCE) closely tracks
developments in the crude oil markets. Crude oil prices have risen
significantly during the past few years and are currently above $100/
barrel. Concurrently, open interest in WTI crude oil futures has
expanded dramatically, growing from about 1 million contracts in 2004
to more than 2.8 million contracts during the most recent week.
OCE has studied these markets to better understand the components
of this rapid growth. Our studies find three major trends in crude oil
markets. First, we see similar rates of growth for both commercial and
non-commercial interests. Non-commercial participants are commonly
considered speculators. Non-commercial share of total open interest has
increased marginally from 31% to about 37% over the past three years.
It is important to understand that the majority of non-commercial
positions are in spreads; that is, taking a long position in one
contract month and a short position in another.
Second, much of the growth in open interest is concentrated in
futures contracts that expire after 12 months. Whereas contracts beyond
one year were rare in 2000, we are now seeing significant open interest
in contracts with expires out to five years. In fact, contracts beyond
six years are now available at NYMEX. Figures 1a and 1b below highlight
these two trends.
Figures 1a and 1b also highlight the fact that commercial traders
taking short positions to hedge rely on non-commercial traders to take
the opposite side of their trades. Were fewer non-commercial positions
opened, hedging costs would likely increase. In this light, commercial
traders demand hedging services that are supplied by non-commercial
traders. The supply and demand for hedging services intimately ties
hedgers and speculators together in futures markets.
The third major trend during the past few years in crude oil
markets is that swap dealers now hold significantly larger positions in
crude oil. These dealers, who take the short sides of over-the-counter
swaps against commodity index traders, hedge this exposure with long
futures positions in crude oil. This development has altered the
traditional role of commercial traders. Previously, commercial traders
predominately hedged long cash positions using short futures contracts.
The recent development has swap dealers (also classified as commercial
traders) hedging their short swap positions with long futures. Figures
2a and 2b below depict these differences.
Figure 2b also demonstrates the growth in swap dealer trading in
the near-term futures contract, which largely represents flows from
commodity index trading.
Given the substantial increase in open interest in crude oil
futures markets, OCE utilizes the Commission's extensive data to
examine the role of all market participants and how their positions
might affect prices. Although longer-term studies show a slight
increase in non-commercial market share in the crude oil market, OCE
analysis shows that the more recent increase in oil prices to levels
above $100/barrel has not been accompanied by significant changes to
the participants in this market. Figure 3 below shows that the number
of commercial and non-commercial traders has remained nearly constant
over the past 22 months, with about 120 commercial and 310 non-
commercial participants in the market.
OCE has also studied the impact of speculators as a group in oil
markets during the most recent price run-up. Specifically, we have
closely examined the relation between futures prices and positions of
speculators in crude oil. Our studies have consistently found that when
new information comes to the market and prices respond, it is the
commercial traders (such as oil companies, utilities, airlines) who
react first by adjusting futures positions. When these commercial
traders adjust their futures positions, it is speculators who are most
often on the other side of the trade. Price changes that prompt hedgers
to alter their futures positions attract speculators who change their
positions in response. Simply stated, there is no evidence that
position changes by speculators precede price changes for crude oil
futures contracts. Instead, changes in commercial positions
significantly precede crude oil futures price changes.
To highlight this fact more clearly, Figure 4 below plots the
prices and the market share of one group of active speculators (managed
money traders) over the past 22 months. Notably, while WTI contract
prices have more than doubled during the past 14 months, managed money
positions, as a fraction of the overall market, have changed very
little. Speculative position changes do not amplify crude oil futures
price changes. More specifically, the recent crude oil price increases
have occurred with no significant change in net speculative positions.
OCE has also studied position changes of commercial and non-
commercial traders by category, finding similar results. In no case do
we find net position changes of any category of non-commercial traders
significantly preceding changes in crude oil futures prices. Figure 5
below highlights the fact that commercial and non-commercial open
interest has grown during the most recent 22 months, but generally
remains balanced between long and short positions for each trader
group.
OCE staff has also studied the propensity of various market
participants to be trading on the same side of the market
concurrently--a phenomenon commonly known as ``herding.'' Although many
rules govern the behavior of individual traders, the Commission
recognizes that concurrent trading by groups of traders--``herds''--can
detrimentally affect markets. Herding behavior can represent an
impediment to the efficient functioning of markets if market
participants follow the herd blindly, causing prices to over-adjust to
new information. The OCE study found little evidence of significant
herding in crude oil futures markets. In fact, when herding was found,
it appeared to be beneficial, and not destabilizing for prices--buy
herding appeared only when prices were falling and price increases were
unrelated to herding activity.
conclusion
Looking at the trends in the marketplace, combined with studies on
herding behavior and the impact of speculators in the markets, there is
little evidence that changes in speculative positions are
systematically driving up crude oil prices. Given the relative
stability of the makeup of participants and their positions in the
markets and the absence of evidence that speculation has caused oil
price changes, it appears that fundamentals provide the best
explanation for crude oil price increases. These fundamentals can be
either broad factors that affect many markets--like the value of the
dollar or general inflation fears--or factors particular to a market--
such as strong demand from China and India for crude oil and other
commodities. In addition, geopolitical events, such as tensions
involving Venezuela, Nigeria, Iran, Iraq, Turkey and the Kurds have
affected commodity markets, especially the energy and precious metals
markets.
Concerns about the high price of oil are not unique to the United
States. I recently presented these findings to the International Energy
Agency conference in Paris which included representatives from 40
different countries, OPEC, industry economists and traders. Our
findings were supported by many of the conference presenters and
attendees who have conducted their own research on the topic. Given the
widespread interest in crude oil in particular, it is something I am
certain we will continue to monitor closely, as will my counterparts
around the world.
This is a dynamic time in the futures markets, given the growth in
trading volume, product innovation and complexity, and globalization--
in all commodities, including energy. The Commission will continue to
work to promote competition and innovation, while at the same time,
fulfilling our mandate under the CEA to protect the public interest and
to enhance the integrity of U.S. futures markets.
The Chairman. Alright. Thank you very much for your
testimony. Ms. Emerson, why don't you go right ahead?
STATEMENT OF SARAH A. EMERSON, MANAGING DIRECTOR, ENERGY
SECURITY ANALYSIS, INC., WAKEFIELD, MA
Ms. Emerson. Good morning, Mr. Chairman, distinguished
committee members. I'm the Managing Director of Energy Security
Analysis, an Energy Research Firm. I oversee all petroleum
market analysis for my firm. I have been asked today to provide
a physical market context for the increased oil prices to over
$100 and the role of the institutional investors in the oil
markets.
We are witnessing striking developments in global markets.
The price of crude oil has doubled since the beginning of 2007
and is at or above $100 today. The dollar has fallen and is now
worth only about two-thirds of a Euro. Oil exporting countries
are pumping petrodollars into the global economy. Some
estimates put that amount at $4 trillion as of the end of 2007.
This is the status quo.
As shocking as it seems it appears to be relatively stable
because these developments reinforce each other. The weak
dollar cushions the impact of high oil prices on consumers
outside of the United States. The petrodollars provide
liquidity of investment which helps grow the global economy,
especially outside of the United States.
These two factors support oil demand growth, again outside
the United States, in spite of the higher price. Excuse me.
Meanwhile the weak dollar and the high oil price encourage
institutional investors to buy commodities especially oil as a
hedge against inflation. Now as we witness these developments
in global markets it's important to keep in mind that we have
reached this status quo in large part because of what is taking
place in the underlying physical market for oil.
During the 1980s and 1990s as you know, the global oil
markets was characterized by over supply. The capacity to
produce oil significantly exceeded demand. Nominal prices were
flat. Real prices fell. These low oil prices supported oil
demand not only in the transportation sectors of the
industrialized countries, but also in the power generation,
industrial and now chemical transportation sectors of the
developing world.
As a result global oil demand caught up with the capacity
to produce oil. Spare crude production capacity has been
reduced to a bare minimum. To illustrate, in the 1980s there
was as much as 15 percent spare crude oil production capacity
in the global market. By the 1990s that number had fallen to 7
percent. Now we are down to 2 to 3 percent.
In the meantime with low consumer prices for much of the
last two decades, refining has been a fairly low margin
business discouraging capacity investment. Except in countries
where refiners are at least partially protected by government
policies such as price subsidies or import controls. In sum,
today both crude oil production and global oil refining have
very limited spare capacity when compared to the previous two
decades.
In addition to these structural factors, there have also
been more transient factors that have contributed to crude oil
march from $30 to $100. Some have been geopolitical events
already referenced this morning, such as interruptions to oil
flows in Iraq and Nigeria or just the threat to an interruption
of oil from Venezuela or Iran. There have also been supply
chain mishaps, like pipeline explosions and of course, the
hurricanes hitting our own refining facilities in the Gulf
coast.
In the past, these surprise events might have had a limited
or short-lived price impact as alternative supplies flowed into
the market. But today, regardless of the severity of the threat
they pose to the supply of crude or products, the impact of
these events on prices is tremendous because again of the
absence of spare capacity, no alternative suppliers. We are
still living in a world with little margin for error.
These factors have helped lift crude oil prices from $30 to
at least $50 or $60. So this brings us to 2007 and 2008 and the
current run up in oil prices. At the end of 2006, oil prices
were sliding and OPEC decided to cut production by about 1.7
million barrels per day. This decision had a significant impact
on the global balance for oil in 2007.
Let me explain. In a typical year, on a global basis, oil
demand exceeds oil supply in the first and fourth quarters of
the year and inventories typically climb. In the second and
third quarters, oil supply typically exceeds oil demand and
inventories typically rise.
In 2007 oil demand exceeded oil supply in the first, third
and fourth quarters and was essentially balanced in the second
quarter. In short the global market did not build supplies last
summer to use this winter. On average in 2007, global oil
demand exceeded global oil supply by somewhere between 500,000
barrels per day and one million barrels per day. A rally in oil
prices was a forgone conclusion at the end of 2007 or at least
in the second half of 2007.
There were of course, other factors that affected the oil
price in 2007. But this basic story of demand outstripping
supply has been the physical market backdrop for the recent run
up in prices. Now we get to the critical question. Can it
account for the entire move to $110?
I personally do not think so. As I said at the beginning of
these comments, institutional investors have identified oil as
an attractive investment. This is in part, in large part,
because the physical market had not discouraged the community
investors who want to buy and hold oil as a portfolio
investment.
Let me conclude by saying some relief is on its way in the
physical market. Hope OPEC has increased production
significantly since late 2007, although perhaps not as much as
some would like them to. Oil demand indeed is slowing because
of the economic slow down here in the United States.
But the fundamentals have not turned yet enough. They
haven't flipped enough to discourage investors who want to
invest in and hold oil as a portfolio investment. In the
meantime, we on the physical side see nothing in the financial
markets themselves that indicates a desire to sell crude oil.
Thank you very much.
[The prepared statement of Ms. Emerson follows:]
Prepared Statement of Sarah A. Emerson\1\ Managing Director, Energy
Security Analysis, Inc. Wakefield, MA
---------------------------------------------------------------------------
\1\ Sarah A. Emerson is the Managing Director of Energy Security
Analysis, Inc (ESAI), an independent energy research and forecasting
firm located just outside of Boston, Massachusetts. Ms. Emerson joined
ESAI when the petroleum consulting practice was launched in 1986.
---------------------------------------------------------------------------
Good morning Mr. Chairman and distinguished committee members. I am
honored to testify before you today. I have been asked to provide a
physical market context for the increase in oil prices to over $100 and
the role of institutional investors in the oil markets.
introduction
We are witnessing striking developments in the global markets. The
price of crude oil has doubled since the beginning of 2007 and is at or
above $100 per barrel. The dollar has fallen precipitously and is now
worth only about 2/3 of a Euro. Oil exporting countries are pumping
``petrodollars'' into the global economy. Some estimates put that
amount at $4 trillion dollars as of the end of 2007.\2\
---------------------------------------------------------------------------
\2\ ``Oil Producers See the World and Buy it Up,'' NYT, Wednesday,
November 28, 2007, page A1.
---------------------------------------------------------------------------
This is the status quo, and as shocking as it seems, it appears to
be relatively stable. The weak dollar cushions the impact of the high
oil price on consumers outside of the U.S., the petrodollars provide
liquidity in investment which helps grow the global economy, especially
outside of the U.S. And one could argue the Fed's monetary policy,
designed to stimulate our slowing economy by lowering interest rates,
keeps the dollar weak, which in turn encourages investors to buy
commodities, especially oil, as a hedge against inflation.
But, as we witness these developments in the financial markets, it
is important to keep in mind that oil prices could only display this
kind of strength because of what has taken place in the physical market
for oil.
Over the 20 year period prior to 2003, the global oil market was
characterized by over-supply. The capacity to produce oil significantly
exceeded demand. Nominal prices were flat and real prices fell.
Years of relatively low oil prices supported oil demand not only in
the transportation sectors of the industrialized countries, but also in
the power generation, industrial and now chemical and transportation
sectors of the developing world. As a result, global oil demand caught
up with the capacity to produce oil. The spare capacity held by OPEC
has been reduced to a bare minimum. Specifically, in the 1980s, there
was as much as 15 percent sparecrude oil production capacity in the
global market. By the 1990s, that number had fallen to 7 percent. Now,
we are down to 2-3 percent.
In the meantime, with low consumer prices for much of the last two
decades, refining has been a fairly low-margin business, discouraging
investment except in countries where refiners are at least partially
protected by government policies such as price subsidies or import
controls. In sum, both global crude production and global refining have
very limited spare capacity relative to the previous two decades.
In addition to these structural factors, there have also been more
transient factors that have contributed to crude oil's march from $30
to $100. Some have been geopolitical events such as interruptions to
oil flows in Iraq and Nigeria or threats to the flow of oil in
Venezuela or Iran. There have also been supply chain mishaps like
pipeline explosions or hurricanes hitting refining facilities. In the
past, these surprise events might have a limited or short lived price
impact.
What is most striking about these events today is that, regardless
of the severity or the duration of the threat they pose to the supply
of crude or products, their impact on prices is tremendous because of
the absence of spare capacity (or alternative supplies). We are still
living in a world with little margin for error.
This brings us to 2007/2008 and the current run up in oil prices.
At the end of 2006, oil prices were sliding and OPEC decided to cut
production by as much as 1.7 million b/d. This decision had a
significant impact on the global balance for oil in 2007. In a typical
year, on a global basis, oil demand exceeds oil supply in the first and
fourth quarters and inventories decline. In the second and third
quarters, oil supply exceeds oil demand and inventories typically rise.
In 2007, oil demand exceeded oil supply in the first, third and fourth
quarters and was essentially balanced in the second quarter. In short,
the global market did not build supplies last summer to use this
winter. The global market dug a big hole. On average, in 2007 global
oil demand exceeded global oil supply by somewhere between 500,000 b/d
and 1.0 million b/d. A rally in oil prices in late 2007 was a foregone
conclusion.
There were other factors that affected the oil price in 2007, but
this basic story of a tight global market has been the physical market
backdrop for the run-up in prices. Can it account for the entire move
to $110? No I do not think so. But, the physical market has not
discouraged or disciplined the community of investors who want to buy
and hold oil as a portfolio investment.
Relief is on its way in the physical market. OPEC increased
production significantly in the latter half of 2007 and oil demand is
slowing because of the economic slowdown here in the U.S. But the
fundamentals have not turned enough . . . yet . . . to discourage
investors who want to invest in and hold oil. In the meantime, we see
nothing in the financial markets that indicates a desire to sell crude
oil.
Attachment.--The Factors Encouraging High Oil Prices
background paper
by sarah a. emerson
Sarah A. Emerson is the Managing Director of Energy Security Analysis,
Inc (ESAI), an independent energy research and forecasting firm located
just outside of Boston, Massachusetts. Ms. Emerson adapted this paper
from one she wrote for the Electric Power Research Institute.
During the 1950s, 1960s, and the early 1970s, oil prices were
``posted'' or set by the major integrated oil companies. Indeed, the
volume of trade in crude oil spot markets accounted for only about 15
percent of international crude oil transactions. Moreover, spot
transactions were possible only because the major oil companies needed
to balance their own supply and demand, unloading small surpluses and
covering minor deficits in the spot markets. The oil crises of 1973-74
and 1979-80 led to a threefold increase in prices, the adoption of
fixed prices by OPEC, and the abandonment of fixed volume contracts
between OPEC member countries and their customers. Higher world prices
for oil stimulated non-OPEC production and cut global oil demand. As a
result, in the market for the marginal barrel of crude (the spot
market) prices fell below OPEC's elevated and fixed price. Not
surprisingly, independent refiners, traders and even the integrated
majors bought more and more crude in the spot market. By the early
1980s, crude oil transactions at spot prices or prices tied to the spot
market accounted for more than 50 percent of total international crude
oil transactions.
Within OPEC, the role of swing producer in defense of higher prices
became increasingly untenable for Saudi Arabia. Ultimately, Saudi
Arabia abandoned this role, a market share war ensued and prices
collapsed in 1986. Since 1986, almost all of the world's oil has been
sold bilaterally with transactions linked to some kind of market-based
pricing, such as netbacks or formulas tied to spot, and more recently,
futures prices.
. . . Gives Way to Market Forces
The emergence of spot and futures markets in oil has led to two
decades of market forces as the organizing principle of the global oil
sector. The deregulation of domestic oil industries and the
liberalization of petroleum product pricing have proceeded all over the
world as countries have opted to integrate into the large, transparent
and relatively low priced global oil market. The view that market
forces, rather than government policies, were best suited to allocate
resources equitably was mirrored by the rise of Reagan-Thatcher
laissez-faire conservatism of the 1980s and the eventual collapse of
the Soviet bloc by the early 1990s. The devaluation of the Russian
ruble and the Asian financial crisis later in the 1990s showed the
folly of policies that ran counter to market forces in global capital
markets. More recently, the market-friendly approach adopted by the
Bush White House and China's accession to the World Trade Organization
(WTO) have again underscored the dominance of the ``market.''
Meanwhile, financial institutions have become important
participants in the futures markets, buying and selling paper barrels
of oil. Futures markets and the liquidity provided by speculators have
transformed the global oil market from one dominated by month-to-month
pricing to one driven by minute-to-minute pricing. A striking example
of the influence of speculation in the futures market on short-term
price direction has been the impact of the net position (long or short)
of the noncommercials (non-hedgers) on the price of WTI on the NY
Mercantile Exchange (NYMEX).\3\
---------------------------------------------------------------------------
\3\ A chart comparing the net long position of the non-commercials
with the price of WTI is included in the Appendix.
---------------------------------------------------------------------------
It is not just the existence of spot and futures markets and the
political preference for unfettered markets, however, that has allowed
the market to reign in oil. Over most of the last 20 years, the global
oil market has been characterized by over supply. The capacity to
produce oil has significantly exceeded demand. Nominal prices have been
flat and real prices have fallen.
The Era of Market Forces May be Coming to an End
Now as we face the next 20 years, the era of ``market'' as the
primary organizing principle may be coming to an end. Market forces are
under attack from many sides. This is, in part, due to the state of the
physical market itself. Years of relatively low oil prices have
supported oil demand not only in the transportation sectors of the
industrialized countries, but also in the power generation, industrial
and now chemical and transportation sectors of the developing world.
Global oil demand has caught up with the capacity to produce oil. The
spare capacity held by OPEC has been reduced to a bare minimum. That
cushion will not be replaced overnight, unless something distinctly
slows oil demand growth.\4\
---------------------------------------------------------------------------
\4\ A global balance that compares global oil demand with global
supply is presented in the Appendix. Spare production capacity is held
by OPEC and is presented graphically later in the text in Chart C.
---------------------------------------------------------------------------
In the meantime, with low consumer prices for much of the last two
decades, refining has been a fairly low margin business, discouraging
investment except in countries where refiners are at least partially
protected by government policies such as price subsidies or import
controls. In sum, both global crude production and global refining are
capacity constrained relative to the previous two decades.
But that is only part of the physical market story. The market
impact of the capacity crunch has been intensified by government
efforts to protect the environment. Policies to cut polluting emissions
have led to fuel specification changes that have chipped away at the
profitability of refining by forcing refiners to focus on investments
to refine predominantly medium sour crude into clean low sulfur
transportation fuels rather than investments to expand capacity. These
refining investments have barely kept pace with demand for cleaner
products, so the global market for clean products is supported not only
by tight distillation capacity but also limits on the upgrading and
desulphurization capacity available to make cleaner and lighter fuels.
High Oil Prices
In thinking about the factors that have led crude oil prices from
$30 to almost $100, some are structural factors that will take years to
change. Others are more transient factors that change almost daily. As
shown in the chart A* the structural factors include basic items such
as weighted average production costs and transportation, but they also
include supply chain factors such as the preference for just in time
inventories, limited refining capacity and thin spare production
capacity.\5\ These supply chain factors are not easily or quickly
changed and they have made the current era of pricing a departure from
the previous 20 years when companies carried a lot of inventory and
there was significant spare refining and production capacity.
---------------------------------------------------------------------------
* Charts A-F has been retained in committee files.
\5\ The values in this chart are the judgment of the author.
---------------------------------------------------------------------------
Charts B and C illustrate the elimination of spare capacity in both
refining and crude oil production. In the case of global refining
capacity, since 1990, the global utilization rate (here defined as
global demand/global capacity) has exceeded 90 percent, but since 2004
has exceeded 95 percent.\6\ 2004 was a remarkable year because oil
demand grew very quickly around the world, but especially in the U.S.
and China. Indeed, China's demand growth was extraordinary. Even though
China's oil demand growth has slowed since then, that one-year spike
drew a great deal of attention. China'sgrowth will continue on a steady
pace, but is unlikely to return to 2004 levels. In any event, the
enormous increase in oil demand in 2004 led to a commensurate increase
in crude oil production, especially in OPEC countries.\7\ That jump in
output eliminated a significant volume of spare capacity. Since then,
some spare capacity has been rebuilt as some new fields are brought on
line in OPEC countries and as global oil demand has slowed down
distinctly in 2005-2007. Indeed, oil demand growth in 2005 through 2007
has averaged about 1.2 million b/d whereas oil demand in 2004 was
roughly 3.0 million b/d on the back of the Chinese surge.
---------------------------------------------------------------------------
\6\ Data for chart B is based on the BP Statistical Review and
ESAI's own database.
\7\ Data for chart C comes from ESAI's own proprietary database.
ESAI maintains a country-by-country database of supply, demand,
inventories, refinery operations, crude production, production capacity
for crude oil and each petroleum product for the entire world. All of
ESAI's market analysis is based on a bottom-up approach to analyzing
supply and demand at the national regional and global level.
---------------------------------------------------------------------------
The other factors included in chart A are more transient factors,
which may have a shorter life span than structural factors. They
include short-term developments in supply and demand, geopolitical
events involving oil-producing countries like Nigeria, Iraq, Iran and
Venezuela, supply chain mishaps like pipeline explosions or hurricanes
hitting refining facilities. There is also speculation when
noncommercial traders buy crude oil either as a short-term speculative
investment or a hedge against something else like inflation. Each of
these categories of factors has different impacts. Under the supply and
demand developments, some factors have more lasting impact. The
previously mentioned oil demand surge in 2004 was driven, in part, by a
sudden acceleration in China's oil use. That was really a one-year
phenomenon, although China continues to post healthy demand growth.
Another example is the start up of a new oil field or a warmer or
colder than normal winter. The rest of the transient factors are
largely surprise events that are generally difficult to predict, but
also relatively short lived. Regardless of the severity or duration of
the threat these transient factors pose to the supply of crude or
products, their impact on prices can be tremendous because of the
absence of spare capacity in the global supply chain. This is well
known by speculators who are inclined to ``buy'' oil at the first news
of an actual or potential supply interruption.
Will Market Forces Bring Oil Prices Down?
In response to these oil market realities, a pure market economist
might contend that high oil prices will spur conservation and temper
demand growth while encouraging investment in crude oil production. The
result will be more supply and less demand and oil prices will fall
signaling the end of the current cycle. At current prices, even
development of the least conventional sources of liquid hydrocarbon
production (i.e., gas and coal to liquids and tar sand, shale and
bituminous deposits) is affordable. In short, conventional oil gets a
boost from the traditional investors and oil sands, bitumen, oil shale,
biodiesel, and other alternatives get a boost from the entrepreneurs.
The current boom cycle comes to an end, the market equilibrates and
prices fall.
The mean reversion, market equilibrates view of today's prices,
however, does not yield an accurate characterization of where we go
from here. Given that many of the factors that have led to $100 oil are
structural ones, the amount of investment in new production of oil (or
alternatives) and the demand restraint required to re equilibrate the
market is substantial. Moreover, the players in the market, whether
they are national governments or private companies, are either changing
altogether or developing new attitudes towards oil.
Governments May Not Think So . . . and May Intervene in Markets
In today's market, oil supply disruptions are perceived to be more
likely and more difficult to counteract. The recent strength in oil
prices is, in part, because they have internalized the energy security
concerns highlighted by the War in Iraq and terrorist attacks in and
outside of the Middle East. Civil unrest in Nigeria, the standoff
between the U.S. and Iran over nuclear weapons, and tensions between
the Bush Administration and President Chavez of Venezuela underscore
historical concerns about the security of supplies. In a well-supplied
market, the consequences of a supply disruption can be managed through
alternative supplies. In a capacity constrained market, however, every
disruption has more severe consequences. These energy security concerns
have moved energy higher on the public policy agenda in many countries.
Higher oil prices have also lent perhaps undeserved credence to the
claim that the volume of conventional oil production is at or very
close to its peak. Pinpointing the year in which conventional oil
production peaks or plateaus is unnecessary and far too contentious an
exercise. What matters is that alternative liquid hydrocarbons like
syncrudes from oil sands or bitumen and alternative fuels from biomass
and agricultural crops will increasingly become part of the liquid fuel
mix over the next few decades. The expansion of ethanol in the U.S.
gasoline pool is an early and instructive example of the trend towards
greater volumes of non-traditional hydrocarbons or non-hydrocarbons in
the petroleum product pool. This trend will become more widespread.
Regardless of the veracity of the ``Peak Oil'' argument, it has
raised a red flag about the longterm supply of conventional oil and its
adequacy for meeting oil demand. This has led the major stakeholders,
including producers, consumers and government regulators to rethink the
alternatives. In some countries, especially those without oil
production, the government response to these concerns is likely to be
more conservation. Regulations that improve efficiency and reduce
consumption seem almost inevitable in some countries. Likewise,
countries with dwindling oil production, which are becoming bigger and
bigger net importers are pursuing policies to secure foreign supplies.
Meanwhile, all net oil-importing countries are considering changes to
their energy mix if their resource endowments allow.
Finally there is the environment. Efforts to reduce emissions and
clean up fuels, especially transportation fuels, will continue around
the world. But behind those efforts is a far bigger environmental issue
for the global oil sector: reducing greenhouse gas (GHG) emissions.
In sum, the continued dominance of the ``market'' as the organizing
principle of global oil is under attack by two overriding concerns:
energy security and the environment. One could argue that these
challenges have always existed, but it seems clear that the absence of
``spare'' capacity in production and refining has dramatically
underscored the energy security issue while growing consensus on
climate change has transformed the environment issue. With this in
mind, market regulation in the petroleum sector is far more likely in
the next two decades than in the last two.\8\
---------------------------------------------------------------------------
\8\ The recent signing of the 2007 Energy bill into law already
signals more government intervention in the U.S. oil sector as it
raises CAFE (fuel economy) standards to 35 mpg by 2020 and calls for 36
billion gallons of alternative fuels used in transportation fuels by
2022.
---------------------------------------------------------------------------
Where Do We Go from Here
It is difficult to look very far out when examining the structural
factors shaping oil prices today, but one can say something about the
next 5 years or so with some confidence. As described earlier, the two
most important structural factors contributing to high oil prices are
tight refining capacity and limited spare crude production capacity.
But investment is underway and in the medium term those problems will
ease. *Charts E and F are projections of Charts B and C presented
earlier. Based on ESAI's analysis of global expansion of refining
capacity and production capacity, both improve. The refining capacity
projection indicates that the global utilization rate should fall below
95 percent. This is still a high number, but more consistent with the
1990s when oil prices were lower. The production capacity projection is
more speculative because it encompasses many countries with declining
oil fields and a handful of countries with expanding production. All of
the spare capacity is held in OPEC and the view in Chart F is probably
optimistic in magnitude but accurate in direction.
Beyond 2013, the picture is much more difficult to draw because the
structural tightness in the global supply chain never disappears. It
just improves and deteriorates depending on the ebb and flow of
investment and demand. With that in mind it is difficult to imagine a
return to $30 crude oil. At the same time, $90-100 crude oil will be
hard to sustain. In short, market equilibrium is much more loosely
defined and probably refers to a price range of $50-$80 with more
potential to break above that range than below that range.
Conclusions
The last two decades of deregulation and reliance on market forces
as the defining principle of the oil markets has run its course and, on
the margin, regulation is moving back into the oil patch. The
confluence of high prices, limited upstream and downstream spare
capacity, instability in producing countries and concerns over climate
change are encouraging coalitions that endorse change in energy
policies. Whether it is in the name of environmentalism, national
security, resource stewardship or mercantilism, many different
political and economic interests are looking for a change to the
regulatory status quo. Slowly their efforts will gain ground in
countries all over the world.
In the meantime, the global oil market remains perched on a three-
legged stool of high oil prices, a weak dollar and huge flows of
petrodollars into investments around the world. This stool has been
fairly steady over the last several months, but it does not represent a
status quo that will satisfy most governments. The high oil prices, in
particular, are a direct concern for consuming governments and an
indirect concern for producing governments if they see consumers
turning to conservation and alternatives. The weak dollar is a concern
for U.S. consumers and must make oil producers worry about inflation in
their economies. Consuming governments will be compelled to take action
to protect their economies. Producing governments will invest to
broaden their oil price windfall and, in the process, perhaps take the
edge off high prices. But it will take time to effectively slow demand
growth and increase supply growth. Moreover, slower demand and faster
supply will not be smooth and not commensurate, especially as
governments take a bigger role in markets. So the stool may rock, but
remain upright for some time. Oil prices will eventually moderate (and
the stool will topple), but prices will remain volatile and
unpredictable as the steps taken by governments unfold.
The Chairman. Thank you very much.
Mr. Book.
STATEMENT OF KEVIN BOOK, SENIOR ANALYST AND SENIOR VICE
PRESIDENT, FBR CAPITAL MARKETS CORPORATION, ARLINGTON, VA
Mr. Book. Thank you, Chairman Bingaman, Ranking Member
Domenici and distinguished members of this committee. Thank you
especially given what I do for a living is I analyze energy
policy in the geopolitics of energy for institutional
investors. So spending this time with you is a little bit like
spending the morning with Elvis.
I'm very, very grateful to be here. Part of this discussion
as well because I think you've done wonderful things on a
bipartisan way to engage corporations and citizens in what has
to be discussed which is how energy works and why it's
important for energy and environmental security to know these
things. So I'm very grateful for all of those things.
At the core of this discussion the global economies of
emerging nations have entered their energy hungry adolescence.
The policy decisions that will have 30 to 50 year implications
amid rapid change will require public and private sector
leaders to keep their heads. If history is any guide, it won't
be easy.
Since there's a lot of the same things probably that are
going to be said in our testimonies, I'm going to go a little
off script. But I want to make a point that every one of the
issues that has been cited by financial economists, Wall Street
types, academics, have been true as a result of what Ms.
Emerson said just now and what I'll suspect you'll hear again
and from others. They include insufficient working inventories,
refinery capacity constraints, the growth of China,
geopolitical risk, cost inflation and depreciation of the
dollar and the notion that non-commercial buyers are driving
prices up is also partially true today, I believe. Particularly
if you believe that investors are seeking value retentive
refuge from the falling U.S. dollar.
But what I would encourage is the thought that this
phenomenon certainly won't be true forever. It may not even be
true for long. Since you've kindly offered to put my written
testimony in the record, I want to just hit on a few points
that are incremental to what has already been said.
First, an institutional investor, these are the people that
are my firm's clients. They manage other people's money
professionally. Simply put those people will fire their money
managers when they lose them money. This pressure applies
equally to sovereign funds and hedge funds.
So CalPERS announced their plans to invest billions in
commodities and commentators said well, if they're doing it and
they're very conservative of the pension fund they must be by
charter, and every investor must be doing it. I think that's
partially true. Investors of all strides are indeed
diversifying into commodities. Some are buying. Some are
selling. Some who are buying today may be selling tomorrow. If
the funds flow into commodities is in fact elevating oil
futures and accumulating evidence of a slow down in oil
consumer nations could provoke a sell off as conservative
investors close their positions and aggressive investors sell
short.
Second, I want to draw a distinction between markets and
mobs. Markets price value and emotions move mobs. Markets tend
to reflect disagreement over price where as mobs reflect
uniformity of opinion. In market bubbles mobs of otherwise
rational actors may ignore readily available data that might
have discouraged their behaviors had they not been blinded by
fear, greed, or what 19th century author Charles MacKay,
Extraordinarily Popular Delusion and the Madness of Crowds.
It is not obvious to me that oil markets are over
saturated. The aggregate value of daily oil consumption is
about $7.5 billion. If every barrel for the next 8 years of
future delivery were contracted at today's prices which is a
hypothetical extreme and not a rational case, just to make the
point. The volumes could absorb about $20 to $25 trillion.
As our first witness noted open interest in oil recently
reached about 2.8 million contracts. That's about $280 billion
at $100 dollars per barrel. That is a significant amount of
money in its own right, but only about 1 percent of the
theoretical market size.
This is also not the only place for speculative money to
go. Investors buy stocks for tomorrow's cash-flows. They buy
commodities for tomorrow's scarcity.
Too many dollars chasing too few barrels can be
inflationary in the short term. In the medium term, however,
non-commercial dollars provide working capital, as you know, to
lower the cost of insuring future supply. In the long run
premium signal even higher cost projects may be rewarded.
This year WTI futures prices have risen about 10 percent.
With share prices of the three largest U.S. oil companies have
fallen about 9 percent. As companies respond to these price
signals those investments flows may shift.
Futures prices cannot trade ahead of distraction costs
forever. The price of oil is driven by speculation. The
economies are slowing as we're seeing. Eventually one of two
things will dispel the mob. Either oil will fill up storage
facilities and buyers will be physically unable to take
delivery. Or new capacity will show up to take advantage of
price premiums.
Just a couple comments on oil and I'll try to stick as
close as possible to the time as well. Dramatic policy shifts
and tax hikes can have self-defeating implications in a world
where you're effectively transitioning. I think that is the
vision of this committee. I think it's a good vision.
But let's look at what's happening right now. The market is
telling investors there's a high price because of scarcity.
Some of the marketers suggesting, and I don't think they're
right, that countries like this one, industrialized economies,
can't conserve, won't balance energy through environmental
stewardship and don't have the technology to produce
alternative fuels cheaply.
Others are suggesting that the production oil has peaked. I
think that twice during the last 6 months, you know, you found
big finds off the Brazilian coast. Currently high prices
encourage new technologies. Part of oil companies will have to
make those investments and operate those technologies for long
periods of time.
When you start to get into the production process, you
start to find things with new technologies. Oil production can
become very sticky because if you're going to invest your own
company, you don't necessarily have the option to stop
producing. Your board is expecting you to pay off the debt and
fund future operations. So volumes may show up even if the
price starts to soften.
The circumstance of peak access is not a fundamental
either. It's political. The majors are coming out. Last month
$3.7 billion were bid for drilling rights in the Gulf of
Mexico.
In this context you have to think that restricting where
the U.S. has oil will only transfer wealth and market power to
OPEC and this to my last point. OPEC can be, right now you can
say it's a little bit more of an effective cartel. Because at
$100 a barrel there's no reason for the weakest economies to
blow through their quotas and defect to fund their cash-flows.
That doesn't mean, however, that protection isn't the right
answer. These countries do control 80 percent of the world's
reserves. They may not be enthusiastic about inviting western
companies into their production bases, but they are
enthusiastic about potentially investing their money in the
downstream here in this country. Because they have very cheap
oil and they can make more money if they can turn that oil into
gasoline and sell it into our hungry market.
So I would caution against the protectionist response. I'd
also just close with the notion that we are probably reaching a
peak appetite for oil. As we get there we will diffuse new cars
into the vehicle fleet will be more efficient. We will
eventually get to flex fuel or more flexible fuel vehicles.
It's a lot of investment. It's a lot of time. But while we
get there, flexibility implies a choice in policies that
encourage petroleum investment will help keep that choice open
hence the cautious response to the idea of raising taxes on the
companies that produce oil here at home.
I've gone fairly off script, but I'm here for any
questions. I look forward to them at the appropriate time.
Thank you.
[The prepared statement of Mr. Book follows:]
Prepared Statement of Kevin Book, FBR Capital Markets Corporation,
Arlington, VA
Chairman Bingaman, Ranking Member Domenici and distinguished
Members of this Committee, thank you for the privilege of appearing
before you today. The views I will present this morning are my own and
do not necessarily represent those of my employer.
I would like to begin by offering my admiration for the comity and
caution this Committee has demonstrated in addressing the energy and
environmental security challenges facing the nation. Your efforts have
already engaged corporations and private citizens alike in a necessary
national discussion regarding the sources and uses of our natural
resources. All around the globe, emerging nations are entering into
their energy-hungry adolescence and the dislocations wrought by this
paradigm shift will require public and private sector leaders to keep
their heads. If history is any guide, it won't be easy.
During the last five years, the world's top energy economists have
offered a disarmingly variable sequence of explanations for the run in
crude oil prices. At the beginning of the decade, market watchers
counted days of demand cover, a measure of whether working inventories
contained sufficient oil to meet expected demand. Subsequently, many of
the same experts linked escalating prices to refining capacity
constraints, the growth of wealth in China, geopolitical risks in the
Middle East and Nigeria, cost inflation and, most recently, the
depreciation of the dollar relative to other currencies. Each of these
phenomena has correlated to, and sometimes predicted, oil prices. But
none of these explanations has proven consistently useful throughout
the decade or when back-tested against earlier data.
The same might be said for the notion that non-commercial buyers of
forward and futures contracts are driving up oil prices. This may be
partially true today, and it may even be somewhat price-predictive to
assess the flow of investor wealth into commodities, particularly if
one believes that institutional investors may be seeking a value-
retentive refuge from the falling U.S. dollar. But this phenomenon
certainly won't be true forever. It may not even be true for long. My
comments regarding investor motivations, market dynamics and oil
production are intended to suggest that an optimal policy response
should not ignore the historical tendency of the law of supply and
demand to govern long-term oil market outcomes.
an overview of institutional investors' incentives
Generally speaking, an ``institutional'' investor manages other
people's money professionally. One or several layers of management
expertise can lie between primary investors and markets. Institutional
investors themselves compete in the market for asset management
services. Widely variable charters constrain the asset classes that
different investment funds may hold and the strategies that
institutional investors may employ, but all asset managers share a
common trait: they are paid to retain, and ideally to augment, their
clients' wealth. Simply put, investors fire managers who lose their
money.
On February 28, 2008, CalPERS, the California pension fund,
announced plans to invest as much as $7.2 billion through calendar year
2010 in commodities. At the upper bound, this could represent a little
less than 3% of the portfolio, a meaningful commitment to commodities
as an asset class. This was neither unexpected nor unheralded. The
first exchange-traded fund (ETF) created to track crude oil contract
prices began trading on the London Stock Exchange in July 2005. The
first U.S. oil ETF began trading on the American Mercantile Exchange in
April 2006. Oil ETFs typically buy and sell oil futures to enable
investors who might not buy commodities to replicate the performance of
oil markets. Oil ETFs largely resemble an earlier vintage of ETF, S&P
500 ``index funds'' that buy and sell S&P component equities.
At the time of the CalPERS announcement, several market
commentators extrapolated its implications, reasoning that, if
institutions as conservative as pension funds were buying oil, then
everyone else must be, too. I would respectfully submit an alternative
thesis. Investors of all stripes may be diversifying into commodities
markets, but they are not all buying. Some are likely to be selling,
and many of the investors who are buying today might well be selling
tomorrow, depending on their risk tolerances.
Hedge fund managers typically earn fixed management fees but the
bulk of their compensation usually derives from percentages of earned
profits. Because hedge funds may hold heavily concentrated positions or
illiquid investments, it can take fund managers days, weeks or months
to gracefully unravel their positions without destroying fund value. As
a result, most hedge fund charters limit the opportunities for
investors to ``redeem'' invested capital to narrow, periodic windows.
This can encourage hedge fund managers to pursue higher-risk
strategies, including investments that may result in short-term losses.
But the wealthy individuals and institutions who buy into hedge funds
pay premiums in return for high performance. These clients can grow
impatient and vote with their wallets if managers deliver sustained
losses. Managers of funds with smaller cash holdings could conceivably
exert downward pressure on oil prices by closing long positions in a
hurry to service a spate of redemptions.
Sovereign funds exist to diversify national wealth away from its
source. This is a matter of particular concern for oil-producing
nations and Asian export economies. Sovereign fund managers usually
have a single client, eliminating the competitive pressures for
performance that can force quick sales of securities or, for that
matter, discourage risky bets. Historic wealth transfers from largely
Western, consumer nations to the largely Eastern producer nations that
supply them have provoked timely calls for best practices and
transparency by the IMF and OECD. Transparency is warranted, but
protectionism is not. If fund managers are ``diversifying'' producer
nations' sovereign wealth into oil futures, this might suggest similar
economic circumstances to those that often motivate corporate stock
repurchases: managers may not see any better way to safely invest the
money. If this is true, new barriers--including bills like the ``No Oil
Producing and Exporting Cartels'' (NOPEC) Act--to U.S. investment might
further encourage dollar flight to commodity futures.
At the same time, there may be two offsetting forces influencing
sovereign investment in oil futures. Sovereign fund managers must
answer to their clients, after all, and leaders of Gulf Cooperation
Council nations have made known their concerns that the declining
dollar has eroded their largely dollar-linked national wealth. Since
oil trades in U.S. dollars, fund managers have an obvious motivation to
hedge. On the other hand, these same clients are also best positioned
to know when oil demand may be slowing, and they might well advise
their fund managers to lighten up on commodities ahead of a slowdown,
even if it means downward pressure on oil prices. This could
conceivably occur if EU-27 economic growth began to slow as a United
States slowdown continues, as oil could sell off at the same time that
the U.S. dollar appreciated relative to the Euro.
If funds flowing into commodities are indeed elevating oil futures,
then accumulating evidence of a slowdown within the world's biggest
oil-consuming economies could provoke an equal and opposite reaction as
conservative investors close their positions and aggressive investors
sell short.
markets, prices and mobs
The question remains unclear, in my mind, whether the oil markets
are vulnerable to manipulation by speculators, or whether speculators
are vulnerable to manipulation by the oil markets.
There is a lot of difference between a market and a mob. Markets
are driven by the value of a good or service; mobs are driven by human
emotions. Markets reflect disagreement over price; mobs typically
reflect uniformity of opinion. Retrospective analyses of market bubbles
often reveal how many otherwise rational actors caught up in the mob
ignored readily available data that might have discouraged their
behaviors, had they not been blinded by fear, greed or what 19th
Century author Charles Mackay termed ``extraordinary popular delusions
and the madness of crowds''.
Markets set prices for buyers and sellers, but market prices also
inform those buyers and sellers by summarizing the collective decisions
of market participants into a number and a direction. Numbers and
directions are objective truths, but their interpretation can be very
subjective. For example, the market could be suggesting that this--and
other--nations lack the willpower to adhere to conservation plans, the
flexibility to rebalance energy needs with environmental stewardship or
the technological wherewithal to produce economically-viable
alternative fuels.
Many market participants appear to believe with great certainty
that high prices signify peak oil production. This seems particularly
surprising now that, twice during the last six months, oil companies
have identified possible ``super-giant'' oil fields off the Brazilian
coast, underneath the salt layer and well within the reach of modern
technology. It might seem safer to assume that the moment when mankind
will have exhausted 50% of the oil molecules in the Earth's crust is
still a long way off, but that's not what the futures market may have
been thinking in March. A March 16, 2008 Financial Times story
entitled, ``Investors bet on $100 a barrel until 2016'' was the first
of many media reports I read that attributed the close of long-dated
crude futures as a shift in sentiment towards enduring scarcity. Indeed
there were bets out to 2016 on $100 oil, but not a lot of them. In
fact, only 108 December 2016 WTI contracts traded on March 14, 2008
(the date referenced by the article) as compared to 293,217 front-month
contracts.
The oil market isn't the only place for speculative money to go,
nor are oil markets obviously oversaturated. Crude oil is the most
widely traded commodity in the world. Daily oil consumption of about 86
million barrels has an aggregate value of approximately $7.5 billion,
discounting for quality. Commodities exchanges trade contracts for
physical deliveries eight years in the future. In theory, if every
barrel for the next eight years of future delivery were contracted at
today's price and volume assumptions, those contracts could absorb
about $20-25 trillion. Open interest in light sweet crude oil contracts
is approximately 2.5 million contracts. Each contract represents 1,000
barrels, making open interest worth $250 billion at $100 per barrel.
$250 billion is a staggering sum in its own right, but only about 1% of
the theoretical maximum market size, and a rounding error in contrast
to the global notional value of derivative instruments of all kinds,
which the Bank of International Settlements estimated in June 2007 to
be worth more than $500 trillion.
Capital markets and commodities markets play different roles in
wealth creation. The value of equity securities derives from investor
expectations that today's investments will deliver tomorrow's cash
flows. When equity values appreciate, corporations can sell treasury
stock or issue a follow-on stock offering to capitalize investment or
retire expensive debts. The value of commodities usually derives from
scarcity, at least in the short-term. The short-term effects of a
growing volume of dollars chasing a currently fixed number of barrels
can be inflationary in cases where new investment grows meaningfully
relative to the market size. For the intermediate term, however,
dollars spent by non-commercial bidders provide working capital that
doesn't have to come from either producers or commercial users,
lowering the transactional and financial costs of ensuring adequate
future supply. In the long run, dollars that rush into the oil markets
will play a very important role. The premiums above production cost
visible in today's oil market will ultimately have the effect of
encouraging future production by signaling producers that even higher-
priced projects like tar sands, tertiary oil recovery and alternative
fuels may be rewarded.
As companies begin to position themselves to respond to price
signals, investment flows may shift. This year, WTI futures prices have
risen about 10%, while the share prices of the three largest U.S.
integrated oil companies, ChevronTexaco, ConocoPhillips and ExxonMobil
have fallen about 9% on a market-cap-weighted average basis during the
comparable period. This suggests at a very cursory level that investors
would rather hold oil itself than the companies that produce it (it is
cursory to say this because the same investors don't always play
equities and commodities markets). A shift in investment flows into oil
companies and away from commodities may have predictive value as well
as a technical effect. Historical oil prices have normalized in
response to demand abatement, but also as a result of technology
improvements and the economic decisions made by nations that control
access to resources.
Investors have limited visibility into the true state of global oil
production. Divining the state of affairs requires constant attention
to the reserves and production data reported publicly by governments,
investor-owned companies and some state-owned firms as well as the
refiners who ultimately purchase oil for commercial use. Investors may
also consider proxies for consumption, like economic growth, and value
chain constraints, like freight and shipping indices, as well as a
range of third-party, proprietary sources that investigate everything
from the comings and goings of tankers to orders for specialized
capital equipment used for oil production. Some investors may be
overwhelmed by the sheer volume of data to the point where the marginal
benefit of incremental analysis exceeds the marginal benefit (or cost)
of making a bad investment. Ironically, other investors may rely in the
absence of empirical evidence on the signals generated by financial
markets for futures contracts, in which case the endless trumpeting of
rising WTI contract prices may create a ``feedback loop'' that seems to
suggest enduring scarcity.
Futures contracts cannot trade ahead of extraction cost forever. If
the price of oil is, as OPEC suggests, being driven by speculation,
then at least one of two things might happen to dispel the mob: either
oil will fill up storage facilities and buyers will be physically
unable to take delivery, or new capacity (or alternatives) will show up
on the market to take advantage of price premiums.
peak oil, peak access or peak appetite?
The price of oil goes up--and down--but it doesn't always move
smoothly. Commodities markets can be ``sticky''--that is, supply may
not immediately respond to price. The following, very brief description
of the exploration, production and refining sectors may help illustrate
some of the reasons.
First, let's be clear about what we mean by ``oil''. Geological
petroleum deposits take many forms. The word ``oil'' can apply to a
wide range of compounds of differing densities, viscosities and
purities. The petroleum industry classifies oils that contain more
natural gasoline and lower-density molecules as ``light'' and oils that
contain lower levels of sulfur and other impurities as ``sweet''.
Ultimately, the value of oil depends on the processing capabilities of
the refiners--the commercial customers--who buy it. Refiners consider
oils that are light and sweet to be ``high quality'' because they can
be distilled into transportation fuels, chemicals and industrial
products at lower fixed and variable costs than oils that are ``heavy''
and ``sour''. As global demand grows, oil companies are drilling deeper
for oil and producing, on average, barrels that are heavier and sourer.
Refiners' corresponding investment in new and higher complexity
refineries generates new market opportunities for exploration and
production companies (or divisions) to look again at resources they
once ignored.
Oils of similar composition tend to be interchangeable in the
short-term. In the intermediate term, refiners of higher-quality oils
who want to use lower-quality oils must invest in new refining
equipment capable of processing impurities. Operating these higher-
complexity refineries requires more energy, resulting in increased per-
unit costs. However, the finished products that refiners make from
oil--gasoline, diesel and jet fuel--are also commodities. Refiners must
accept the market price offered for the products they produce, because
any attempts to recapture additional costs by charging a higher price
are likely to be undercut by competitors who produce fuel at lower
marginal cost. As a result, the global refining industry as a whole
typically prefers to pay less for lower-quality grades. Price
relationships between oil grades tend to normalize over time because
refiners will eventually invest in highercomplexity equipment to take
advantage of sustained discounts for heavier or sourer oils. Similarly,
greater demand for low-quality oils can bid them up relative to high-
quality oils and diminish or stabilize demand for high-quality oils.
Thanks to high prices, oil companies are willing to consider new
technologies. Incremental technology improvements are expensive to
deploy. Oil companies will be most willing to put capital at risk when
they believe robust demand will reward their investments. Incremental
deployments of new technologies often bring rewards in the form of
process improvements as employees climb their ``learning curves''. In
subsequent deployments, oil companies can also take advantage of scale
economies by standardizing operations around new technologies. On the
other hand, oil production doesn't easily switch on and off, for a
variety of practical and economic reasons. Petroleum production takes
time; seven to ten years typically lie between the corporate decision
to proceed and delivery of oil to the market. Because executives at
investor-owned companies are accountable to shareholders, even if the
price of oil falls between the time company management puts money into
a project and the time production begins, oil companies may need to
operate at loss in order to generate enough cash to pay back their up-
front investments and fund future efforts.
Thanks to technology, it's easier to find oil. The days when a lone
wildcatter with a dowsing rod and big dreams could uncover a gusher of
Texas Tea with a hand drill ended decades ago. That's because most of
the readily accessible large oilfields discoverable through yesterday's
technologies are already in production. But this doesn't mean that the
world's oil supply has peaked. The Earth is a big place, and oil
deposits reside at varying depths throughout the Earth's crust all the
world over. New seismic and electromagnetic technologies and advanced
computer modeling make it possible for oil companies to identify
significant new petroleum deposits in places where it had never been
possible to look in the past, like underneath thousands of feet of rock
or seawater. Drilling technologies are becoming superficially similar
to endoscopic surgical techniques. In the not-too-distant future,
producers may be able to access underground reservoirs by creating
minimally intrusive surface holes and threading their drill-bits
between rock formations. Oil companies are getting more out of every
well, too. Enhanced oil recovery technologies using water and carbon
dioxide are enabling North American production volumes that exceed
original estimates by as much as 30% to 45%.
Are we on the other side of ``peak access'' to oil reserves?
Investor-owned companies face increasing barriers to drilling overseas
as oil-rich sovereigns renegotiate, expropriate and nationalize their
petroleum sectors to capture greater value from high prices. High
prices may also have made OPEC a more effective cartel. At $100 per
barrel, OPEC nations collectively generate about $3 billion each day.
When prices were $10 to $15 per barrel, the poorest oil exporters
sometimes exceeded their assigned quotas to keep national treasuries
solvent. Today, even weaker producer economies can afford to hold the
line on supply. Greater wealth means that the state-owned oil companies
that control more than 80% of global reserves can afford their own
advanced oilfield technologies and have fewer incentives to grant
favorable concessions to investor-owned oil companies. A telling sign
that the game is changing arrived last month, when oil companies bid a
record $3.7 billion for offshore drilling rights in the Gulf of Mexico.
In this context, restricting drilling where the U.S. has oil--including
the Arctic National Wildlife Refuge and the Eastern Gulf of Mexico--
will only transfer wealth and market power to OPEC.
Once again, protectionism is the wrong answer. Petroleum refining
is a tough business for the U.S. oil companies that must pay top dollar
for raw materials on the global market but end up selling a commodity.
The prospect of punitive taxation and escalating environmental
expenditures may make investor-owned companies understandably leery of
committing multiple billions of dollars towards the building and
expansion of their refineries. Not every oil company may regard
investment in U.S. energy infrastructure as a bad deal. For state-owned
oil companies, a new or bigger U.S. refinery could improve the profits
associated with production of lower-quality crudes by turning them into
gasoline to capture what has typically (but not always) been at a
premium to their unrefined value.
It may be that we are merely reaching our ``peak appetite'' for
oil. Energy crises provoke transformational efficiency gains, even
though they are expensive and take a long time to play out. Assessing
oil production limits requires an examination of the vehicles that use
petroleum-derived fuels, too. Today's cars, trucks and things that go
are already quite flexible and will become more so. Forecasts made by
the EIA, IEA and industry groups leave little doubt that many of the
vehicles on the road today are taking growing advantage of fuels from
non-oil sources that are similar in composition and performance to
petroleum distillates. Likewise, tomorrow's transportation fleet is
likely to employ liquid fuels of any origin much more efficiently than
today's fleet. Technologies like hybrid petroleum-electric propulsion
systems are now maturing. High prices are already provoking commercial
aviation companies to look for low-cost, high-yield design changes that
minimize energy lost to friction, like the wing ``tips'' frequently
installed on commercial airlines. It seems likely that a conservation
response is already underway and I believe the U.S. government is right
to encourage it.
New taxes could have self-defeating implications in the meantime.
Replacing the 230 million passenger vehicles on U.S. roads will take 15
to 20 years if we start today. Electric cars may require, among other
things, investment towards a more reliable power grid. Likewise,
diffusion of flexible fuel vehicles and E85 dispensers could require
more than $50 billion in incremental spending and will rely on
economic, large-scale production of cellulosic biofuels. A ``flexible''
vehicle implies a choice, and policies that encourage petroleum
investment will keep that choice open, even as policies this Committee
has enacted pave the road to future fuels. Corporate leaders of for-
profit companies must balance expected returns from 30-year projects
against the risks that federal budgets can change annually,
congressional polarities can reverse biennially and new regulators
might reinterpret existing law every four or eight years. Dramatic
policy shifts and tax hikes could make it harder, not easier, for oil
companies to transition to future fuels.
an afterthought regarding the u.s. relationship with petroleum
Addiction is the wrong metaphor. We didn't start refining oil by
accident. Oil continues to fuel 97% of the world's vehicles because
generations of engineers, corporate leaders and policy planners
selected it on the basis of its suitability. Oil is energy-dense,
readily transportable and plentiful relative to alternatives, even
despite the high prices of the moment. Allow me to suggest a different
metaphor. For the foreseeable future, petroleum will continue to fuel
industrialized societies the same way oxygen nourishes the body. Two
obvious conclusions emerge.
First, increasingly prosperous, growing populations will
require more oil, not less.
Second, a man who is short of breath is not addicted to
oxygen; he may just need to get in shape. We will need to use
oil more efficiently.
This concludes my prepared testimony. I will look forward to
responding to any questions the Committee might have at the appropriate
time.
The Chairman. Thank you very much.
Mr. Burkhard.
STATEMENT OF JAMES BURKHARD, MANAGING DIRECTOR, CAMBRIDGE
ENERGY RESEARCH ASSOCIATES, CAMBRIDGE, MA
Mr. Burkhard. Thank you, Mr. Chairman. It is an honor to
address the committee on the issue of the influence of non-
commercials on the price of oil.
First of all, who are these non-commercial investors? They
are more than just short-term, speculative, traders. They
represent a broad spectrum of investors ranging from managers
of pension funds and university endowments and other
institutional investors. They allocate investment capital based
upon a view of the world's need for oil and other commodities.
So why have oil prices been rising? The growing role of
non-commercial investors can accentuate a given price trend.
But the primary reasons why oil prices in recent years have
been rising are rooted in several factors.
One is the fundamentals of demand and supply, which we've
heard about. Geopolitical risks which do have a real impact.
Skyrocketing oil industry costs. More recently we've seen the
decline in the value of the dollar play a more significant
role, particularly since the credit crisis first erupted last
summer and energy and other commodities got caught up in the
upheaval of the global economy.
That to be sure the balance between demand and supply is
integral to oil price formation and will remain so. But there
are, what we call, new fundamentals that are behind the
momentum that push oil prices to their recent record high
levels. These new fundamentals are one, new cost structures and
two, global financial dynamics.
First, new cost structures. As oil prices have risen, so
has demand for the people and equipment that are needed to
find, develop and produce oil. Major shortages of equipment and
personnel have dramatically raised the cost of finding and
developing oil all around the world. The latest IHS CERA
upstream capital cost index, which is a sort of consumer price
index for the oil industry, shows that the cost of developing
oil fields has doubled in the last 3 years. In addition,
increasingly heavy fiscal terms on oil investments and in the
form of higher taxes and greater state participation mean that
much higher oil prices are needed to support development of new
supplies.
The second new fundamental is what we refer to as global
financial dynamics. The oil price has long reflected major
trends in the economy and geopolitics. For example in 1998 when
the oil price went down to $10 that was largely a reflection of
the fallout from the East Asian financial crisis.
Today two major trends are the decline of the dollar and
the rising economic clout of regions outside of the United
States. In the past half year in particular, lower interest
rates in this country in anticipation of further cuts in
interest rates has pushed the dollar lower. Amid great
turbulence and credit and other financial markets the influence
of the weak dollar on the oil market has grown.
Oil has become what we refer to as the new gold. A
financial asset in which investors seek refuge as inflation
rises and the dollar weakens. That key element of the oil as
the new gold story is the expectation that demand for oil will
continue to grow and thus be able to hold its value despite the
weak dollar and rising inflation. To degree an expectation of a
strong oil price environment is a bet on the future of China,
India and other high growth markets around the world.
Since the beginning of last year, eight of the ten largest
oil markets in the world have seen their currencies appreciate
significantly against the dollar. When the currency appreciates
against the dollar it diminishes the impact of an increase in
the dollar price of oil for that market. This helps to sustain
oil demand growth outside the United States.
If economic and oil demand growth remain vibrant outside
the United States and the dollar continues to weaken then
financial dynamics are likely to drive oil prices higher. In
addition the political and man power difficulties that are
currently constraining oil supply growth will not disappear
overnight. The desire for higher living standards in China,
India and other emerging markets will remain as strong as it
was in Europe, Japan and the United States in post World War II
period. Higher living standards mean longer life expectancy,
lower infant mortality and higher energy consumption.
This year just as economic worries began to mount oil
prices touched a new high of around $110 per barrel. Although
oil prices are just one factor that affects the global economy,
they are a significant one. Because the world economy was able
to take $70 oil in stride does not mean that it can easily
absorb $100 or higher.
Oil prices are fluctuating in line with the latest economic
signals. This will continue until a clearer view of economic
growth materializes. But one factor is clear. The price of oil
will reflect major swings in the value of the dollar both up
and down. Thank you.
[The prepared statement of Mr. Burkhard follows:]
Prepared Statement of James Burkhard, Managing Director, Cambridge
Energy Research Associates, Cambridge, MA
It is an honor to address this Committee on the relationship
between oil prices and the influence of noncommercial institutional
investors, sometimes referred to as market speculators. Trading in
futures markets establishes the reference price for nearly all crude
oil sold in the world. Crude oil futures trading activity on the New
York Mercantile Exchange--the largest in the world--is currently about
350 percent higher than in 2002.\1\ Noncommercial investors have
contributed to this increase. Growth in trading activity is coincident
with a rise in oil prices from $26 per barrel in 2002 to more than $100
in early 2008. The concurrence of these two trends has raised the
question about the level of influence that noncommercial investors have
in oil price determination.
---------------------------------------------------------------------------
\1\ The figure of 350 percent represents the increase in open
interest in NYMEX crude oil contracts, which is a proxy for levels of
trading activity. Open interest is defined by the US Commodity Futures
Trading Commission as ``the total number of futures contracts long or
short in a delivery month or market that has been entered into and not
yet liquidated by an offsetting transaction or fulfilled by delivery.''
---------------------------------------------------------------------------
What has been driving oil prices upward? It is primarily 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 in the past six months. But with noncommercial
investors playing a bigger role, the direction of a given price trend
can be accentuated. And since the credit crisis first erupted last
summer, energy and other commodities have become caught up in the
turbulence of the global economy.
noncommercial investors
The US Commodity Futures Trading Commission defines noncommercial
or speculative investors as those who are not physically exposed to the
commodity but trade ``with the objective of achieving profits through
the successful anticipation of price movements.'' This group of market
participants includes more than just short-term speculative traders. It
represents a broad spectrum of investors with different time frames and
motivations such as mangers of pension funds, university endowments and
other institutional investors. These investors increasingly view
commodities and oil in particular as an asset class. They allocate
investment capital based upon a view of the world's need for oil and
other commodities. For example, the California Public Employees
Retirement System (CalPERS), the largest public pension fund in the
United States, recently increased the amount it could invest in an
asset class that includes commodities. This move is part of a ``new
strategy to provide a hedge against inflation while diversifying
investments, thus mitigating losses during equity market
downturns.''\2\
---------------------------------------------------------------------------
\2\ CalPERS February 19, 2008 press release.
---------------------------------------------------------------------------
Noncommercial investors are an essential part of a futures market.
In the 1860s Chicago grain traders developed the first futures
contract: an agreement to buy or sell a commodity at a future date.
Farmers were able to offload price risk to speculative traders. In
exchange for providing price certainty to the farmer, the trader had
the opportunity to turn a profit--or a loss--from future price changes.
This allocation of risk remains the foundation of today's futures
markets.
Noncommercial investors can also provide another attribute of a
well functioning futures market: liquidity. Liquidity refers to how
quickly a counterparty can be found for a transaction. The current
turbulence in credit markets illustrates the dangers that materialize
when trading in a market becomes illiquid. Uncertainty and fear come to
the fore, which exacerbates market turmoil. Oil futures markets are
among the most liquid in the world--and have remained so despite the
upheaval in credit markets.
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 non-commercial 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.
new cost structures
In 2004 the price of oil (in nominal terms) averaged above $40 for
the first time ever. This was sparked by extraordinary demand growth
that reflected strong global economic expansion and a temporary surge
in the use of oil to generate power in China. Further demand growth in
2005 reduced spare oil production capacity to just 1 million barrels
per day (mbd)--compared with 4 to 6 mbd in the 1990s. Amid the
whittling away of spare capacity, political change and security worries
in several major oil exporting countries fueled anxiety about the
adequacy of oil supplies. With so little spare capacity, such fears
drove oil prices higher.
As oil prices rose, so did demand for the people and equipment
needed to find, develop and produce oil. But nearly 20 years of low oil
prices and industry consolidation meant ``a missing generation''--a
generation that skipped entering the petroleum industry. As a result,
major shortages of equipment and personnel dramatically raised the cost
of developing an oil field whether in the Gulf of Mexico, West Africa
or the Middle East. CERA and IHS have developed a series of indices to
measure changes in cost--sort of a Consumer Price Index for the energy
industry. Costs to build power plants and oil refineries have surged
higher. But the one most relevant to our discussion today is the latest
IHS/CERA Upstream Capital Cost Index. This index shows a doubling of
oil field costs over the last three years. In other words, companies
have to budget twice as much today as they did three years ago. Adding
to the cost pressure are increasingly heavy fiscal terms on oil
investments in the form of higher taxes and greater state participation
in oil projects. The net result is that much higher oil prices are
needed to support development of new supplies. Some projects that in
the past needed oil prices of $20 or $30 in order to move forward now
need price levels that are double that amount--or even higher.
It can take ten years or more to find, develop and begin production
from a new oil field, particularly if it is large and complex. Long
lead times and the severe upturn in costs have led to one of the most
significant changes in the oil market: a steep increase in long term
oil price expectations. For nearly two decades, until 2004,
expectations for long-term oil prices hovered around $18 to $25 per
barrel. Since 2004 the price of a futures contract to buy or sell crude
oil five years out has risen steadily. It topped $100 per barrel this
year. Five years is considered long-term from an oil market perspective
as opposed to the longer times that can be required to develop a new
oil field. The sustained breakout of oil prices from a relatively
narrow historical range along with global financial dynamics has
fostered greater interest in oil among financial markets.
global financial dynamics
The oil price has long reflected major trends in the economy and
geopolitics. Rising inflation, a rush to invest in commodities and
worrisome tension between the United States and Iran drove oil above
$100 per barrel in real terms in 1980. In 1998 the price of oil
collapsed largely because of the fallout from the Asian financial
crisis. Today, two major trends that are reflected in the price of oil
are the decline of the dollar and the rising economic clout of many
regions outside the United States.
Oil and the Dollar: The New Gold
The effect of a declining dollar on the price of oil first became
prominent in early 2005. The dollar had fallen about 35 percent
relative to the euro since 2002. OPEC generally imports more from
Europe than the United States, so a weak dollar damages terms of trade
from OPEC's perspective. The falling dollar contributed to the lifting
of OPEC's implicit oil price objective, which altered market
expectations about price and the balance between demand and supply. The
price of oil was nearing $50 per barrel--a very high price at the time.
In the past half year lower interest rates and anticipation of
further cuts in interest rates pushed the dollar lower. Amid great
turbulence in credit and other financial markets, the nature of the
weak dollar's influence on the oil market changed. Oil has become the
``new gold''--a financial asset in which investors seek refuge as
inflation rises and the dollar weakens. This may seem counterintuitive
at a time of weak oil demand in the United States, but today's dynamics
in the marketplace reveal oil's increasingly cosmopolitan nature. The
price of oil reflects not only demand and supply, but broader
macroeconomic and geopolitical changes such as the growing influence of
Asia, the Middle East, Russia and the Caspian countries.
Strong economic growth outside the United States has not only
supported growing oil demand but also propelled rising demand and
prices for many commodities. In addition to energy, food prices are
surging around the world. According to the International Monetary Fund.
global prices for cereals--wheat, rice, corn (maize), and barley--
increased 82 percent from 2000 to 2007. More than half of this increase
has been in the past two years. Recent data from China show food prices
pushing overall inflation to 8.7 percent--the highest level in more
than a decade.
A key element of the ``oil as the new gold'' story is the
expectation that demand for oil will continue to grow, and thus be able
to hold its value despite a weak dollar and rising inflation. To a
degree, an expectation of a strong oil price is a bet on the future of
China and India. The United States is the world's largest oil consumer,
but 75 percent of global demand is outside the United States. For
example, since the beginning of 2007 eight of the ten largest oil
markets in the world (excluding the United States and Saudi Arabia,
whose currency is pegged to the dollar) have seen significant currency
appreciation ranging from 9 percent (India) to 19 percent (Brazil).
When a currency appreciates against the dollar, it diminishes the
impact of an increase in the dollar price of oil in that market. Also,
regulated prices of gasoline and diesel in some key markets means that
consumers are not exposed to the full increase in the global market
price of those products. This places pressure on government and company
budgets, but if a given country enjoys strong economic growth it can
withstand, at least for a time, rising oil prices.
outlook
If economic and oil demand growth remain vibrant in large markets
around the world and the dollar continues to weaken, then financial
dynamics could continue to drive oil prices higher. But oil's role as a
financial hedge does not mean that its price will rise continuously.
Prior to the ascent in recent years, both gold and oil prices had been
mired in long-term price slump. In the late 1990s, $100 oil--or even
$80 oil--seemed preposterous. Today, $20 oil seems quaint.
The political and manpower difficulties currently constraining oil
supply growth will not disappear overnight. The desire for higher
living standards in China, India, the Middle East, Russia and elsewhere
will remain as strong as it was in Europe, Japan and the United States
in the post World War II years. Higher living standards mean longer
life expectancy, lower infant mortality--and higher energy consumption.
But just when the future seems preordained in the oil market, the
unexpected can unfold. It did in the decade following 1998, just as it
had several times since 1970. This year will be a stiff test for the
new oil price era that dawned on the world several years ago. Economic
growth is the single most important determinant of oil demand growth--
and the course of the global economy in 2008 is fraught with worries.
Financial innovation and the globalization of securities helped to
lubricate the wheels of the global economy during an extraordinary
expansion, but it also created risks that were not--and still are not--
fully understood. The US subprime mortgage meltdown is the most current
example of misunderstood risk, but is it the last?
Oil prices can remain high during an economic downturn. In the
early 1980s, one of the weakest periods of economic growth since the
depression of the 1930s, oil prices were at very high levels for
several years. But eventually, the economy and demand catch up: the
1986 oil price collapse was due to a multiyear decline in oil demand.
This year, just as economic worries began to mount, oil prices
touched a new high of about $110 per barrel. Although oil prices are
only one factor affecting the global economy, they are a significant
one. Because the world economy took $70 per barrel in stride does not
mean that it would easily absorb $100. If prices hover in the $90-$100
plus range for six months or more, then it would be increasingly
difficult to argue that high oil prices do not have a significant
impact on economic growth. Moreover, given the growing use of corn-
based ethanol, oil prices are now connected to food prices, which are
rising. And the increase in food prices is a major source of inflation
in many emerging markets around the world. Oil prices are fluctuating
in line with the latest economic signals--up and down. This will
continue until a clearer view of economic growth materializes. But one
factor is clear. The price of oil will reflect major swings in the
value of the dollar--both up and down.
The Chairman. Thank you very much.
Mr. Cota.
STATEMENT OF SEAN COTA, CO-OWNER AND PRESIDENT, COTA & COTA,
INC., PRESIDENT, NEW ENGLAND FUEL INSTITUTE, BELLOWS FALLS, VT
Mr. Cota. Honorable Chairman Bingaman and Ranking Member
Domenici, distinguished members of the committee, thank you for
this invitation to testify before you today. As both a
petroleum marketer and as a representative of two respective
trade groups that together represent our nation's independent
motor fuel consumption and heating fuel dealers, I appreciate
the opportunity brought to provide you with insight on extreme
volatility and record setting prices seen in the recent months
on the energy commodity markets.
I serve as the Petroleum Marketers Association of America's
executive, on their executive committee. PMAA is a national
federation of 46 States in regional associations representing
8,000 independent marketers that collectively account for
approximately half the gasoline and nearly all of the
distillate fuel consumed by motor vehicles and heating
equipment in the United States.
I'm also President of the New England Fuel Institute, a 60-
year-old trade association representing over 1,000 heating fuel
dealers in related companies in Northeastern United States. The
five member companies deliver about 40 percent of the nation's
home heating oil and many market diesel fuel, bio, heat,
propane, jet fuel and so on.
Finally I provide insight as co-owner and President of Cota
and Cota, Inc. of Bellow Falls, Vermont, a third generation,
family owned business operating as a heating fuel supplier in
Southeastern Vermont, Southwestern New Hampshire. My business
provides home heating fuel to approximately 9,000 homes and
businesses. Unlike larger energy companies most retail heating
fuel dealers are small family run businesses.
Also unlike larger companies, heating oil and propane
dealers deliver products directly to the doorstep of American
homes and businesses. Because of this close association with
our customers we have deep concerns for their well-being and
the general welfare of our communities. Few recognize the small
business nature of our industry. We recently have proposed an
array of measures to policymakers in Washington that can assist
our industry in assuring adequate supply of home heating fuel
and insulate the consumer from current volatility in excesses
that dominate commodities markets.
First we urge members of this committee and this Congress
to support our recent and standing request to the Bush
Administration to release all 1.97 million barrels of the
Northeast home heating oil reserve. Contrary to statements from
the Administration the release of this product from this
reserve may not be tied solely to crude--to heating oil
differentials for a trigger mechanism. This speculation driven
vault of futures market with a record price surge as seen in
recent months perhaps this measure could break the back of some
of this excess speculation.
Second we urge Congress and the Administration to implement
real and substantial reforms to existing law and Federal
regulation designed to fully insure transparent and accountable
and stable energy futures markets. For 2 years now the New
England Fuel Institute and the Petroleum Marketers of America
and their various allies in the energy market oversight
commission have asked for such changes and little has been
done. Consequences of inaction are now apparent and will only
continue to worsen. For the sake of all Americans and the
economy at large, you must act now.
It has become apparent that excess speculation on energy
trading facilities is driving this crude runaway train with
prices. One example, on January 3, 2008, one floor trader
bought 1,000 barrels of crude oil and immediately sold it at a
loss for about $600. The trader deliberately pushed the price
of the barrel of crude over $100 just because he wanted to tell
his grandchildren that he was the first person to ever buy
crude over $100.
Commitments in trading like this concerns PMAA and NEFI
members who argue that recent volatility in crude prices will
force small business and consumers to pay excessively high
energy prices that do not reflect supply and demand factors.
The rise in crude prices in the recent weeks, which has reached
$110.21 a barrel on March 13, 2008, this is dragged with every
single refined petroleum product, which is especially heating
oil. Just over 1 month also heating oil prices from February
11, 2008, to March 18, 2008, have risen from $2.65 a gallon to
$3.31 a gallon.
The price by it comes despite reports by the Energy
Information Administration, EIA, that heating oil inventories
remain around 5 year averages. Gasoline inventories have also
risen dramatically reaching a high of $3.33 per gallon on March
17, 2008, at nearly two-decade high inventory levels.
Many heating fuel companies like myself hedge in order to
protect the consumers against roller coaster volatility.
However, our ability to manage in these commodity markets in
order to set price on economic fundamentals has become less and
less reliable. As a result so do our hedging programs. As the
influence of price setting functions on unrelated and under
regulated markets in trading on over the counter and foreign
based exchanges continues to be the norm, American consumers
are forced to ride the speculative roller coaster on energy
prices.
For far too long insufficient oversight and transparency
has encouraged excessive speculation. Created a trading
environment that rewards trading misdeeds like that of the
Amaranth hedge funds and British petroleum. Loopholes in
Federal law that have created what I call these dark markets or
energy markets engaging in futures and futures like contracts,
swaps, derivative and trades have nearly no oversight and very
little Federal oversight and regulation. Today I believe the
vast majority of trading occurs on these unregulated dark
markets.
More specifically we urge Congress to take swift action to
bring light to these dark markets by one, closing the notorious
Enron loophole ripped open by the Commodities Futures
Modernization Act, which through its trillions of dollars have
poured since it was created in 2001. Virtually overnight the
Enron loophole freed all electronic markets from oversight.
Congress needs to close this loophole and close it for all
energy commodities thereby returning the CFTC statutory
authority that it lost in 2001.
As an important step in closing this Enron loophole
Congress must pass the Senate version of the CEA
Reauthorization Act included as an amendment on the 2007 Farm
bill, HR 2419, which is currently in conference. This
legislation will reauthorize the CFTC and bring greater
transparency and accountability to energy trading facilities
through an array of important policy reforms. It is stronger
than the CEA Reauthorization language drafted by the
Presidential Working Group currently under consideration in the
House Agriculture Committee. Further the Senate legislation
also gained bipartisan support from the United States Senators
Levin, Feinstein, Chambliss, Snowe, Cantwell, Coleman, Conrad,
Dorgan, Lieberman, Collins, Crapo, Durbin and Schumer.
Two, investigate CFTC's use of no action letters, which we
believe equate to a loophole for foreign markets to gamble with
American energy commodities and American economic interests.
Under no action letters the CFTC may provide regulatory
exemptions under certain conditions, which are--to which an
applicable form board of trade, FBOT, offers contracts for
delivery within the United States. The current process fails to
provide sufficient public notice and consultation and may not
take into full account the impact that these letters have on
markets.
Moreover, in order to obtain such exemptions CFTC requires
that a comparable regulatory authority be present in the
country, which the exchange operates. Congress should examine
whether or not Congress determines such regulatory authority be
comparable. Finally, we are concerned that no action letters
may be or have been requested by exchanges to establish
electronic platforms with the intent to circumvent United
States law.
Three, reduce the dominance of non-fiscal players in the
commodity markets. The commodity markets----
The Chairman. Could you sort of summarize the remaining
points you have to make, please?
Mr. Cota. The markets have been taken over by the financial
community. To reference George Soros from his interview
yesterday on CNBC, we are in the worst financial crisis that
this country has experienced since 1930. The crisis is
exacerbated by the lack of regulation in a variety of
investments, not the least of which is energy commodities.
Soros stated further without regulations, markets tend to
extremes, not equilibrium. Because of this weakness in the
United States dollar most of the speculative moneys going into
commodities through dark markets to park cash, which will
further exacerbate our economic crisis. This is now an economic
and national security crisis. Thank you, Mr. Chairman.
[The prepared statement of Mr. Cota follows:]
Prepared Statement of Sean Cota, Co-Owner and President, Cota & Cota,
Inc., President, New England Fuel Institute, Bellows Falls, VT
Honorable Chairman Bingaman, Ranking Member Domenici and
distinguished members of the committee, thank you for the invitation to
testify before you today. As both a petroleum marketer and as a
representative of two respected trade groups that together represent
our nation's independent motor vehicle and heating fuel dealers, I
appreciate the opportunity to provide you with our insight on the
extreme volatility and record setting prices seen in recent months on
the energy commodity markets.
I serve on the Petroleum Marketers Association of America's
(PMAA)\1\ Executive Committee and serve as PMAA's Brands Director. PMAA
is a national federation of 46 states 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.
---------------------------------------------------------------------------
\1\ Official website www.pmaa.org.
---------------------------------------------------------------------------
I am also President of the New England Fuel Institute (NEFI)\2\, a
60-year-old trade association representing well over 1,000 heating fuel
dealers and related services companies in the Northeastern United
States. NEFI member companies deliver over 40 percent of the nation's
home heating oil, and many market biodiesel, bioheat, propane,
kerosene, jet fuel, off-road diesel and motor vehicle fuels.
---------------------------------------------------------------------------
\2\ Official website www.nefi.com.
---------------------------------------------------------------------------
And finally, I provide you insight today as co-owner and President
of Cota&Cota, Inc. of Bellows Falls, Vermont, a third generation
family-owned and operated heating fuel provider in southeastern Vermont
and western New Hampshire. My business provides quality home heating
fuel to approximately 9,000 homes and businesses. Unlike larger energy
companies, most retail fuel dealers are small, family-run businesses.
Also unlike larger energy companies, heating oil and propane dealers
deliver product directly to the doorstep of American homes and
businesses.
Because of this close association with our customers, we have a
deep concern for their well being and the general welfare of our
communities. Not only do few recognize the small business nature of our
retail industry, but few also grasp also our deep commitment to
providing the highest quality products at the most affordable and
competitive prices. To this end, we have recently proposed an array of
measures to policy makers in Washington that can assist our industry in
ensuring adequate supply of home heating fuel and insulate the consumer
from the currently volatility and excess that dominate the commodities
markets.
First, we urge members of this committee and this Congress to
support our recent and standing request to the Bush Administration
release all 1.97 million barrels of the Northeast Home Heating Oil
Reserves. Contrary to statements from the administration, release of
product from the reserve need not be tied solely to a crude oil to
heating oil differential trigger mechanism.\3\ Federal law also permits
a release from the reserve under discretionary authority provided there
is a ``regional supply shortage of significant scope and duration.''\4\
We are indeed in the midst of such a shortage due to: skyrocketing
distillate demand overseas; the steepest decline in refinery runs in
over two years; infrastructure limitations and pipeline partitioning
due to the current transition to lower sulfur off-road diesel fuel; and
declining interest by small bulk plants and terminals to take on high
sulfur distillates such as jet fuel and heating oil due to the
backwardated market and, as mentioned, the transition to low/ultra-low
sulfur diesel. All of these factors will only further exacerbate the
already speculation-driven, volatile futures market and record price
surges seen in recent months.
---------------------------------------------------------------------------
\3\ 42 U.S.C. 6250b(a)(1).
\4\ 42 U.S.C. 6250b(a)(2).
---------------------------------------------------------------------------
Second, we urge on Congress and the administration to implement
real and substantial reforms to existing law and federal regulation
designed to ensure fully transparent, accountable and stable energy
futures markets. For two years now, the New England Fuel Institute, the
Petroleum Marketers Association of America, and their various allies in
the Energy Market Oversight Coalition have asked for such changes and
little has been done. The consequences of inaction are now apparent and
will only continue to worsen. For the sake of all Americans and the
economy at large, you must act.
It has become apparent that excessive speculation on energy trading
facilities is the fuel that is driving this runaway train in crude oil
prices. For example, on January 3, 2008, one floor trader bought 1,000
barrels; the smallest amount permitted, and sold it immediately for
$99.40 at a $600 loss. The trader deliberately pushed the price of a
barrel of crude oil over the $100 just because he wanted to tell his
grandchildren that he was the first person ever to buy crude oil over
$100.\5\
---------------------------------------------------------------------------
\5\ (BBC News, 2008).
---------------------------------------------------------------------------
In addition, in times of a national crisis, excessive speculation
can also exacerbate an emergency. An example of this comes from a Wall
Street Journal article from September 2005, wherein an oil trader
bragged about his profits following Hurricane Katrina. This futures
trader bragged that some traders made enough money in one week
following Katrina that they would not have to work for the rest of the
year. Comments like these concern PMAA and NEFI members who argue that
the recent volatility in crude oil prices will force small businesses
and consumers to pay excessively high energy prices that do not reflect
supply and demand factors.
And the rise in crude oil prices in recent weeks which reached
$110.21 on March 13, 2008 has dragged with it every single refined
petroleum product, especially heating oil. In just over one month,
wholesale heating oil prices from February 11, 2008--March 18, 2008
have risen from $2.65 to $3.31.\6\ The spike comes despite reports by
the Energy Information Administration (EIA) that heating oil
inventories remain around the five-year average.\7\ Gasoline prices
have also risen dramatically reaching as high as $3.33 on March 17,
2008.
---------------------------------------------------------------------------
\6\ Energy Information Administration, ``U.S. No. 2 Heating Oil
Wholesale/Resale Prices,'' February 11-March 17, 2008.
\7\ The EIA reported that U.S. heating oil inventories were to
remain within the 5-year average. See Ibid, ``Short Term Energy
Outlook,'' March 11, 2008.
---------------------------------------------------------------------------
Many heating fuel companies like mine hedge in an effort to protect
their customers against roller-coaster-like price volatility on the
energy commodity markets. Because of our industry's hedging activities,
we strongly support open, transparent and well-managed exchanges
subject to the rule of law. In fact, it is essential to businesses like
mine. My company began offering fixed price programs to our customers
twenty years ago. We enter into New York Mercantile Exchange (NYMEX)
based futures contracts with our suppliers, who purchase contracts for
future delivery and resell these contracts to me for a profit. In this
way, companies like mine are able to financially hedge heating fuels
for the benefit of the consumer, and help protect them against
uncertainty and volatility.
However, the ability of the commodities markets to set a price
based on economic fundamentals has become less and less reliable, and
as a result, so do our hedging programs. As the influence of price-
setting functions on unregulated or under-regulated markets continues
to grow, and as trading on over-the-counter and foreign-based exchanges
continues to become the norm, American consumers are forced to ride the
same speculative roller coaster as the energy trader. For far too long,
insufficient oversight and transparency has encouraged excessive
speculation and created a trading environment that rewards trading
misdeeds, like that of Amaranth Hedge Funds and British Petroleum.
``Loopholes'' in federal law have created what I call ``dark markets,''
or energy commodity markets engaging in futures or futures like
contracts, swaps and derivatives trades without adequate federal
oversight and regulation. Today, a vast majority of trading occurs on
these markets.\8\
---------------------------------------------------------------------------
\8\ Nearly all experts agree that a majority of trading now occurs
off of traditional exchanges like the NYMEX, and some estimate that
number to be 75 percent or more.
---------------------------------------------------------------------------
More specifically, we strongly urge Congress to take swift action
to bring light to the ``dark markets'' by:
1. Closing the notorious ``Enron Loophole,'' ripped open by
the Commodity Futures Modernization Act (CFMA)\9\ and through
which billions of dollars have poured since it was created in
2001. Virtually overnight, the ``Enron Loophole'' freed all
electronic markets from oversight. Congress needs to close the
loophole, and close it for all energy commodities, thereby
returning to the Commodity Futures Trading Commission (CFTC)
the statutory authority that it lost in 2001. As an important
first step in closing the Enron Loophole, Congress must: Pass
the Senate version of the CEA Reauthorization Act, included as
an amendment to the 2007 Farm Bill, H.R. 2419 is currently in
conference. This legislation will reauthorize the CFTC and
bring greater transparency and accountability to energy trading
facilities through an array of important policy reforms. It is
stronger than the CEA Reauthorization language drafted by the
Presidential Working Group and currently under consideration in
the House Agriculture Committee. Further, the Senate
legislation gained bipartisan support from U.S. Senators Levin
(D-MI), Feinstein (D-CA), Chambliss (R-GA), Snowe (R-ME),
Cantwell (D-WA), Coleman (R-MN), Conrad (D-ND), Dorgan (D-ND),
Lieberman (I-CT), Collins (R-ME), Crapo (R-ID), Durbin (D-IL),
and Schumer (D-NY).
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\9\ See 7 U.S.C. Sec. 2(h)(3), (g) (2006)
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2. Investigating the CFTC's use of ``no-action letters''
which we believe equates to a loophole for foreign markets
seeing to gamble with American energy commodities and economic
interests. Under the no-action letter process, the CFTC may
provide regulatory exemptions under certain conditions to an
applicable foreign board of trade (FBOT) offering contracts for
delivery within the United States.\10\ The current process may
fail to provide sufficient public notice and consultation, and
may not take into account the full impact that these letters
may have on the market. Moreover, in order to obtain such an
exemption, the CFTC requires that a ``comparable'' regulatory
authority be present in the country where the exchange
operates. Congress should examine whether or not it determines
such regulatory authorities to be ``comparable.'' And finally,
we are concerned that no-action letters may be or have been
requested and approved for exchanges seeking to establish
electronic platforms overseas with the intent to circumventing
U.S. regulatory authority.
---------------------------------------------------------------------------
\10\ See 17 CFR 140.99.
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3. Reduce the dominance of non-physical players in the
commodities markets: The commodity-related futures markets were
primarily created to provide industry participants with a tool
to manage inventory and future price related risks. However,
our industry's management tool has been dominated by investment
banks and hedge funds that profit from price volatility. This
market domination is an extremely significant contributor to
high gasoline, natural gas, diesel and heating oil prices.
Virtually every commodity has experienced price volatility,
reaching record levels from gold to wheat and it seems that
there is no end in sight.
Hedge funds and investment banks are not driven to provide
U.S. citizens the most affordable energy supplies; they are
driven to profit from volatility. PMAA and NEFI believe that
margin requirements for speculators who do not have the ability
to take physical delivery of their product should be
dramatically increased. Futures market officials could impose a
physical delivery component for traders to qualify for reduced
margins. Earlier this week, Congressman John Larson of
Connecticut announced legislation that would eliminate the
commodities markets as an investment tool and return the market
to the physical players and consumers that have lost faith in
its ability to reflect hard fundamentals.
We realize that there are several different policy recommendations
floating around Capitol Hill from an array of sources, including
legislators, commission and administration officials, futures trade
groups and the commodity exchanges themselves. We ask that your
deliberations take in to account all trading environments and all
energy commodities, not just the regulation of one commodity at the
exclusion of all others.
I thank you again, Mr. Chairman, and to your colleagues for this
opportunity to share my insight on this issue. I am open to any
questions that you might have.
The Chairman. Thank you very much.
Mr. Eichberger, go right ahead.
STATEMENT OF JOHN EICHBERGER, VICE PRESIDENT, GOVERNMENT
RELATIONS, NATIONAL ASSOCIATION OF CONVENIENCE STORES,
ALEXANDRIA, VA
Mr. Eichberger. Thank you very much and good morning. I
think it's fitting that I'm the last witness today because my
testimony is going to be quite different from what we've heard
already today. I represent the convenience and petroleum
retailing industry, which sells about 80 percent of the
gasoline in the United States. I thank you for the opportunity
to share that perspective today.
We've been hearing a lot about crude oil today because
that's the topic of the hearing. But I think Senator Barrasso
commented earlier that that's not really what your constituents
are talking about around the water cooler. They're not talking
about the $4 increase yesterday in the crude oil price.
But they probably are talking about the price of retail
gasoline in their neighborhood. That's what I'm here to talk
about. Hopefully give a little bit of understanding of what
happened to the market.
The retail petroleum marketplace is the most transparent,
competitive market in the nation. For no other product can your
constituents drive down the road, shopping for the best price
at 45 miles per hour. Our members have put their price on big
billboards on the side of the road to empower consumers to find
the best deal as easy as possible. Competition is thriving.
To me, this is a predominantly small business,
entrepreneurial industry. There are more than 115,000
convenience stores selling gasoline. Nearly 60 percent of those
are owned by companies that operate just one store. Despite
common misconceptions integrated oil companies and refining
companies only own and operate less than 5 percent of retail
outlets. This number is actually declining.
Convenience stores rely upon their daily operations to
generate revenue. This is getting increasingly difficult. In
2006, the average convenience store made only about $33,000 in
profit. Motor fuel sales represented two-thirds of gross
revenues, but only contributed to less than one-third to the
bottom line.
Retailers make their money by selling in store products
like coffee and sandwiches. Gasoline is predominately used to
draw customers to the store. This makes it critical that fuel
prices are as competitive as possible.
The competition for the consumer is extremely fierce. 73
percent of consumers say that price is the most important
factor when choosing a gasoline retailer. They are so focused
on price that 29 percent of them say that they would drive 10
minutes out of the way to save as little as three cents per
gallon. If you would run the numbers you'd see that they'd
actually lose money on this transaction. Yet it is exactly this
type of behavior that has created a situation in which
profitability at the pump has reached its lowest level in
history.
According to oil price information service in 2006 the
annual average national retail price for gasoline has increased
53 cents from 2006, has increased 53 cents to about $3.09 so
far this year. Meanwhile gross retail margins have dropped
nearly half a cent to 13.4 cents per gallon. This 13 and a half
cents must cover operating costs, like labor, rent and most
importantly credit card fees.
You may not realize it at $3.09 every time you swipe your
card at the dispenser the bank takes 7.7 cents from the
retailer leaving him with 5.7 cents to cover all of his other
expenses. Today the banks are making more on gas than the
retailers selling the product. This is putting tremendous
pressure on the market.
Crude oil, as we know, is the most significant component of
the retail price of gasoline. According to EIA in February
crude oil was responsible for 69.7 percent of the retail price
of gasoline. This is a sharp departure from historic norms.
Between 2000 and 2005, crude oil averaged only 45.3 percent of
the retail price. The increase in crude oil price has driven
the wholesale price of gasoline and put retailers in a very
precarious economic situation.
The price for an 8,000 gallon delivery has gone up more
than $4,000 in the last 2 years. Yet the average margin for
that delivery has actually gone down. Many retailers have been
forced to extend their credit lines while their creditors have
tightened lending terms to protect the liquidity of their
business. This situation is increasing costs incurred by the
retailer, forcing them to suspend investments necessary to
improve its operations and could ultimately jeopardize its
ability to obtain future delivery of motor fuel.
Clearly the impact of crude oil is being felt throughout
the economy, nationally and internationally. In January, 45
percent of consumers reported that gasoline prices already
affected their spending behavior. Retailers are increasingly
concerned of the growing liquidity problems they're facing as
they attempt to pass through higher cost of fuel. Even some
refiners are struggling to accommodate the higher cost of crude
oil.
Congress has a responsibility to monitor the markets to
protect against inappropriate behavior and this hearing is one
of those opportunities. However, I would like to advise caution
as you move forward. The motor fuels market is critical to the
economic welfare of the United States. Any legislative or
regulatory actions that could disrupt the market, reduce
supplies or cause unnecessary cost to the system should be
avoided whenever possible.
I urge Congress to work with the affected stakeholders to
identify challenges and develop solutions that benefit the
long-term interest of the motor fuel market. Thank you for the
opportunity. I look forward to your questions.
[The prepared statement of Mr. Eichberger follows:]
Prepared Statement of John Eichberger, Vice President, Government
Relations, National Association of Convenience Stores, Alexandria, VA
Chairman Bingaman, Senator Domenici, Members of the Committee. My
name is John Eichberger and I am vice president of government relations
for the National Association ofConvenience Stores (NACS). Thank you for
the opportunity to share with you today the effects of high crude oil
and motor fuel prices on the retail marketplace.
NACS is an international trade association comprised of more than
2,200 retail member companies. The convenience and petroleum retailing
industry in 2006\1\ generated $569.4 billion in sales and sold more
than 80 percent of the gasoline in the United States.
---------------------------------------------------------------------------
\1\ Data for 2007 is not yet available.
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This hearing focuses primarily on the factors influencing the price
of oil. While this is a very important topic and one with serious
implications for the economy in general and investors in particular, it
does not necessarily resonate with your typical constituent. However,
the downstream effects of crude oil prices, in particular the retail
price of gasoline, do have a profound impact on these individuals. It
is this level of trade that I will address today.
First, let me point out for the Committee that the retail petroleum
marketplace is the most transparent and competitive market in the
nation. For no other product can consumerscomparison shop for the best
value while driving down the road at 45 miles per hour. Retailers
advertise their motor fuels prices on billboards along the side of the
road, empoweringconsumers to wield an amazing influence over prices in
a competitive market. Yet, it is at the same time a market about which
there is much confusion.
the retail marketplace
Before we can begin to assess the impact of crude oil prices on the
retail marketplace, it is essential to have a basic understanding about
the composition of that market. Withoutspending too much time on the
topic, below is a snapshot of who controls the retail marketplace:
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
The convenience and petroleum retailing industry is dominated by
small, independent companies. These companies rely on their daily
retail sales to generate sufficient revenues tocover their operations
and provide a modest profit, a point reinforced by an April 1, 2008,
Associated Press story that appeared in dozens of newspapers and media
outlets this week. Just as they do not benefit from the corporate
revenues generated by the corporations which provide drink and snack
items sold inside the store, retailers do not benefit from the revenues
generated by their petroleum suppliers. In fact, the typical
convenience retailer in 2006 reported a pre-taxprofit of only $33,360.
competition drives price
Although motor fuels are a major source of revenues, representing
about three-quarters of a store's overall sales, they contributed only
about one-third to gross profits in 2006. By contrast, in-store items
were about two-thirds of overall gross profits but represented only
about one-fourthof overall sales. Consequently, it has become essential
for retailers to price motor fuels at a level that is sufficiently
competitive in the market to generate enough customer traffic
togenerate sales inside the store. Meanwhile, competition for the
consumer has become even more intense as retail prices have escalated.
In February 2008, NACS released its 2008 Consumer Fuels Report
which reported information obtained through interviews with more than
1,200 nationwide consumers conductedbetween December 2007 and January
2008. We sought a better understanding of consumers' behavior with
regards to the retail marketplace. What we learned helps explain why
retailers areunable to generate significant profits at the dispenser:
73% of consumers report that price is the most important
factor when choosing a retailer from whom to purchase gasoline
45% say that high gas prices have had a ``very significant''
effect on their spending behavior
29% say they will drive 10 minutes out of their way to save
3 cents per gallon
The bottom line is consumers feel the pressure of higher gasoline
prices; they are shopping for the best-priced gasoline; and they will
go out of their way to save as little as a fewcents per gallon. In
addition, the competitive market has become even more so with the
popularity of gasoline pricing websites which enable consumers to plan
their routes to take advantage of lower prices. Retailers understand
these dynamics and are aggressive about pricing motor fuel to maximize
their customer volume and their in-store sales potential.
higher retail costs do not mean higher retail profits
While retailers set their prices to remain competitive in the
marketplace, their profitability at the pump is determined by their
costs, which have been increasing substantially inrecent years.
According to the Oil Price Information Service (OPIS) weekly report,
Retail Fuel Watch, the average national retail price for regular
unleaded gasoline has increased 53 cents per gallon from the average of
2006 to the most recent week reported. Meanwhile, retail gross margins
(the difference between retail price and wholesale cost) have declined
0.4 cents.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
It is important to remember when considering profitability in the
petroleum industry, one must not take a snapshot approach. At any given
time throughout the year, a retailer may be losing money per gallon
sold or may be making more than the averages demonstrated above.
However, only by analyzing a complete market cycle can one obtain a
clear understanding of aretailer's potential profitability.
There was a time when retailers would receive notification of price
changes once a day. The price set in the morning was often sufficient
to cover operations for the entire day. Morerecently, however, due to
the dynamic nature of the market and the advent of technology,
wholesale prices fluctuate several times throughout the day. Given the
slim operating margins onwhich retailers operate, they must ensure that
the gallons they sell will generate sufficient revenues to purchase the
replacement gallons at the new wholesale price. In a perfect world, if
they learn their next load will cost an additional 10 cents per gallon,
they would increase their retail prices 10 cents to cover the next
shipment. Unfortunately, their competitors may not be incurring the
same increase in costs and may not enable the retailer to increase
prices to that extent, at least not immediately. According to the U.S.
Energy Information Administration, the statistical arm of the U.S.
Department of Energy, it may take several weeks before a change in the
wholesale price of gasoline may be fully reflected in the retail price.
(Source: U.S. Energy Information Administration, ``Gasoline Price Pass-
through,'' January 2003).
Because of the market delay in passing through wholesale price
changes, during periods of escalating wholesale prices, retailers
typically experience a decline in gross margins.However, the opposite
is true when wholesale prices decline-retailers seek to completely pass
through costs previously incurred and to recover their lost margins by
holding retail prices steady for as long as competition may allow. But
at some point, one retailer in a market will begin to drop prices in
search of additional customer volume, and others will follow suit to
avoid losing in-store sales. This is why it is necessary to look at a
retailer's operation from the perspective ofa complete market cycle,
the duration of which can vary greatly.
A significant cost not represented in the OPIS report of average
gross margins is credit card fees. Whenever a consumer uses a credit
card to purchase any product or service, the banksthat issue the card
and that process the transaction collect a set of fees. For petroleum
retailers, this typically equates to about 2.5 percent. As gasoline
prices have gone up, so have the fees associated with these
transactions. Over the time period represented above when gasoline
prices increased from $2.56 to $3.09, credit card fees increased from
an average of 6.4 cents to 7.7 cents per gallon. While this increase
may not seem significant, to the retailer this automatically reduces
potential profitability. Subtracting credit card fees from the OPIS
reported margins during that time period, retail profitability declined
from 7.4 cents per gallon to 5.7 cents. Credit card companies and their
banks now make more per gallon sold than does the retailer. In fact,
the convenience and petroleum retailing industry paid $6.6 billion in
fees in 2006 while generating only $4.8 billion in pre-tax profit.
Compounding the impact of credit card fees is the fact that
consumers are increasingly turning to this form of payment as prices
increase, for a variety of potential reasons. The typicalconsumer does
not often carry sufficient cash to pay for a $50 gasoline fill-up,
consequently plastic payment has become the default currency for many.
For others, their household budgetsmay not have sufficient cash flow to
cover increasing fuel expenses, leaving credit as their best option to
finance purchases.
crude oil drives wholesale costs
The price of crude oil is a significant factor in the retail price
of gasoline. Each month, the U.S. Energy Information Administration
reports the breakdown of retail gasoline prices into four sectors:
crude oil, taxes, refining, and distribution/marketing. This last
category includes all the factors that are incurred after the product
leaves the refinery, including pipelines, terminals, distribution and
retail. The latest data available is for February 2008 and indicates
that crude oil at the time contributed 69.7% to the retail price of
gasoline. This is a sharp departure from historic norms. Crude oil's
average contribution from 2000 through 2005 was only 45.3%. Meanwhile,
the relative contribution of the other components has declined:
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
retailers struggle with liquidity
The overall impact on retailers of higher crude oil prices, and the
resulting increase in wholesale and retail gasoline prices, is
profound. Not only have consumers become more pricesensitive resulting
in lower margins, but the overall economics of retail operations have
become more challenging. As margins have remained static on a cents-
per-gallon basis over the past few years, inventory costs have not.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
The combination of increased inventory costs with declining
profitability has created a potential liquidity crisis for retailers.
Retailers now must pay more for the inventory they sell, reducing cash
flow and increasing liabilities. Compounding this increase in costs,
many retailers incur additional fuel surcharges for each delivery as
their distributors seek to cover the increased expense of the fuel
required to power their trucks. (Similar surcharges also apply to the
delivery of in-store items.) This has greatly reduced the ability of
cash flow from fuel sales to purchase replacement gallons.
Consequently, many retailers are forced to extend their lines of
credit to keep fuel in their tanks. This has brought with it additional
costs. In addition, terms extended to retailers may have historically
required payment within 10 days. Now that creditors are seeking to
ensure their own liquidity, these terms may have been reduced to 7 days
or even fewer. Many of these creditors are actually wholesale
distributors servicing multiple retailers and they are running into
their own credit limits in their efforts to keep their customers
supplied with fuel. As more inventory is purchased on credit, the
additional payments of interest have further reduced cash flow.
After months of operating on credit, while wholesale costs have
continued to increase and gross margins have remained stagnant or
declined, many retailers are approaching the limit of their available
credit. This forces companies to delay or suspend investments in their
operations and, in the most dire circumstances, threatens their ability
to keep fuel in their tanks.
conclusion
It is clear that the price of crude oil has a profound impact on
the domestic motor fuels market, and in particular its retailers and
their customers. With higher prices, motor fuelsretailers regularly see
that increased price volatility reduces already slim margins. In the
last few years retailers have continued to see both gross and net
margins decrease to the level where they are at historic lows on a
percentage basis and the lowest since the the early 1980s on a cents-
per-gallonbasis. Quite simply, motor fuels retailers cannot survive on
fuels sales alone and have to either reinvent themselves to expand
their in-store offers or sell what is often a multi-generation, long-
term community-based business.
While motor fuels retailers are as frustrated by the current state
of the industry as consumer and policy-makers, I would caution the
Senate to proceed carefully when consideringpolicy options. The motor
fuels market is critical to the economic welfare of the United States
and any legislative or regulatory actions that could disrupt this
market, reduce supplies, or cause unnecessary costs to the system, and
ultimately consumer, should be avoided whenever possible. I urge
Congress to work with motor fuels retailers and other affected groups
to come to a solution that addresses the dynamics of the marketplace
and affects long-term change.
Thank you for the opportunity to share the perspective of the
nation's convenience and petroleum retailing industry on the impact of
crude oil prices on the retail motor fuels market. Iwelcome your
comments and input at this hearing and in the future on how we can help
create a system that addresses our nation's motor fuels challenges and
can affect permanent change to a system that frustrates both consumers
and retailers alike.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
The Chairman. Thank you all very much. I think it's
excellent testimony. Let me start questioning.
Mr. Burkhard, let me ask you about your comment, oil is the
new gold. That raises some concerns on my part. I think for a
long time people have seen gold as something to invest in order
to essentially hedge against what is happening in other
financial markets. It's a way to hedge against the decline of
the value of the dollar.
I think we've seen what's happened to the price of oil, of
gold. As more and more people have gone into that market and
bought gold or bought gold futures, or whatever it is they're
buying. That's something which doesn't affect the daily lives
of most people.
It doesn't affect the folks Mr. Eichberger was talking
about, primarily in the sense that I don't need to go buy gold
everyday to get to work. But in the case of oil, I do have to
go buy gasoline refined from that oil to get to work. If we
have the same thing happening with oil where it is become a
refuge.
I think you referred to it as people investing in oil
seeking a refuge from the decline of the value of the dollar.
If that is having the effect of driving up the price of oil and
thereby impacted what I have to pay in order to get gas to come
to work, isn't that something we ought to try to confront and
deal with in the financial market some way or other, to try to
discourage the investment in oil strictly as a refuge against
volatility elsewhere?
Mr. Burkhard. I don't know if it should be discouraged or
encouraged. But what's happening is the impact of the dollar is
simply a reflection of broader macroeconomic trends that are
underway. The large forces that have been putting downward
pressure on the price of oil are really at the roots of oil
being viewed as a hedge against inflation.
Oil has a different supply and demand dynamics relative to
gold, but because of those dynamics it has placed it in a
position where it can act as a hedge against inflation.
The Chairman. My understanding is the value of the dollar
is declining because of our budget deficit, because of our
trade deficit, because of a whole bunch of factors. But I
understood your testimony to be that the decline of the value
of the dollar is driving up the price of oil.
Mr. Burkhard. That has been one of the factors that has
contributed to it. Yes.
The Chairman. Therefore we got more and more people just
investing in oil in order to find that refuge against declining
value in other assets, in this case, the dollar.
Ms. Emerson, you referred, I think, in your testimony to
the fact that the physical market does not in any way
discourage investment in oil. Should we be doing something?
Senator Dorgan in his early comments talked about the margin
requirements if you want to go in and buy oil.
Is there anything that should be done in a regulatory way
or legislative way to discourage oil from being invested in by
folks who have no earthly need to be buying oil?
Ms. Emerson. There's no quick fix. There's no easy tool for
doing that. I would actually agree that the margin requirements
should be raised.
The Chairman. But should they just be raised for oil. I
mean, I don't feel a burning desire to raise the margin
requirements if someone wants to go out and speculate on gold.
Ms. Emerson. Yes, I don't think I can speak to the entire
range of commodities. But in the case of oil, I do think it
seems to be that the ratio between how much money you have at
stake and how much you can make is striking. So I think that
would be one step to take.
The Chairman. So you think having a different margin
requirement for oil would make sense, a difference than the
margin requirement for something like gold.
Ms. Emerson. Again, I only feel I can speak thoughtfully to
the oil situation. I do think that the margin requirements are
a little--I do think that's one tool that the Congress has. But
I--or legislation would result in.
There really aren't any other easy fixes. I mean, say,
drawing down the SPR, which I wouldn't necessarily recommend.
The Chairman. Mr. Book, did you have any comment on any of
this?
Mr. Book. I think that that's a--I don't entirely disagree
or agree. I think that the margin requirement, it's an
experiment that deserves a lot of thought. Senator Dorgan
mentioned that there was 20 days of money chasing each day of
oil or something like that. I think it may have hit 280
billion, be closer to 30.
The question is whether or not the market requires 30 days
of money chases each day of oil in order for it to keep that
market well supplied. I'm not sure that we know that. There may
be an optimal size. Margin requirements are the way to start
that experiment and that's reasonable.
The Chairman. Senator Domenici.
Senator Domenici. Thank you very much, Senator Bingaman.
Let me just say to all of you, in particular to you, Mr.
Harris, as you represent a larger group within your umbrella
organization. I hope the American people understand what you
said and what has been said here today about how much is being
invested for oil by people that are not going to use the
product.
Investors are not buying a tanker full of oil--they're
buying instruments of credit and instruments of purchase and
sale and the like. If the people understood that, I guarantee
you that they would insist that we find out, absolutely,
whether that's impacting on the price of oil. I don't believe
they would sit for a minute as a group, the American people,
and let the price of oil rise as high as it is if a large
percentage of that increase is being driven by speculators who
are not going to use the product. That's the people you
regulate. Speculators, right?
They're good for America. But for me, after today's
testimony, I'm seriously wondering how much we have made by way
of mistakes in not further regulating--at least for the
American investment--how people could invest in oil that they
were not going to use themselves. The more I hear, the more I
get concerned.
Please understand all of you at the table, I have heard
five or six major and minor reasons that represent traditional
factors for high prices. I believe every single one of them.
But I somehow believe that maybe there is something else when
it comes to the American investor who might be driving this
market up because of pure speculation. This is a very rich and
ripe market.
I want to also tell you that some of you know I work
diligently around here. Some of you think I know an awful lot
about what I'm doing. I knew how to proceed when we put the
Energy bill together, but I'm telling you I'm learning this
one. So don't think I know as much as I knew about the bill we
put together for the United States on energy three years ago.
This is a very confusing subject that seems to confuse
everybody.
I don't think, Mr. Chairman, that just because this is
difficult and confusing that we ought to let it go. Some of you
testified that speculators are not playing that much of a role.
Things may be going alright at some of your firms, but I'm not
sure of that, and I'm not sure they're alright for everyone
else.
Let me just ask, just to have a little bit of dialog with
you. Mr. Cota, I believe you recommended the legislation that
Congressman Larson of Connecticut introduced, which would
eliminate non- commercial investors in the commodities market.
You said that you recommended that approach. I don't assume
anything has happened to that bill, has it?
Mr. Cota. It's currently just being introduced right now.
Nothing has happened at this point.
Senator Domenici. Ok. May I ask, Mr. Harris, do you support
that kind of legislation?
Mr. Harris. I would focus on the fact that speculators are
intimately related to hedging in these markets. I think futures
markets in particular. You speak to the fact that nobody buys
or sells oil, but futures markets in particular is set up to
discover prices and to transfer risk. To the extent that we
eliminate an entire group of traders from the market, I think
that would be detrimental to both of those functions of the
market.
Senator Domenici. This would eliminate non-commercial
investors in the commodities market, the whole commodities
market. Your response is that you don't know what would happen.
But what do you think may happen? Can you tell me why you
oppose it? What do you think is going to happen?
Mr. Harris. We're not in the business of prognosticating,
but I believe, I guess, my statement was that we if we remove
an entire group of traders from the market that take on risks
that other people don't want that that diminishes or eliminates
the entire need for a market. In particular it's futures
markets are there to hedge risks and transfer risk from one
party to another. I think part of my testimony is showing that
the longer term futures contracts in crude oil in particular,
signify that people are worried about future prices of oil and
speculators and hedgers alike are transacting at longer and
longer horizons to try and hedge against those price changes.
Senator Domenici. See, I don't know what that means. You're
giving me an answer that I don't understand. Explain that to me
in ordinary language.
Mr. Harris. Somebody who wants to buy oil for instance,
they have to contract it. It's not like stopping at the gas
station. You can't just get 4,000, four million gallons of oil
delivered today. So the futures markets operate in projecting
out future needs of purchases of oil.
One of the risks of future needs is that if you need oil
next September, you could wait until next September or next
August and purchase that oil. The risk that you take in that
chance is that oil between now and August goes up in price. So
in this regard you might come to the futures market to lock in
the price to buy the oil in September.
So you can transfer the risk from your balance sheet or
your books right now to some other counter party who's willing
to take the risk that oil prices might go up between now and
August in our markets. If you eliminate the counter party that
is willing to take that risk it puts me, again, at more risk as
a producer, as a manufacturer or as a convenience store
operator that I don't know on any one day what I'm going to get
for the price. I can't lock in a price in the futures market.
Senator Domenici. Ok. So that overall set of transactions
has some benefit, in your opinion, in terms of investors and
the financing of crude oil from the supplier to the ultimate
user. Is that right?
Mr. Harris. Yes.
Senator Domenici. Alright. Ms. Emerson, I appreciated your
testimony very much. I understand how hard you have worked on
trying to answer some of these questions that seem to you to be
intractable.
But you have a chart in your testimony which I think at
least puts you on record as giving your best estimates. You've
got one chart that shows the factors lifting oil prices. I wish
you would have had it blown up so everybody could see. But
maybe we'll just talk about it. Based on that chart and the
rest of your testimony, can you tell me how much speculation
contributes to an $83 barrel of oil?
Ms. Emerson. This, as you can see, because this chart is
only $90 or $85. It was made well before the recent run up in
prices.
Senator Domenici. Yes. I guessed $83, but how much would
speculation contribute to $85 oil?
Ms. Emerson. You know I'm reluctant to put a specific
dollar sign on that because I think what----
Senator Domenici. What percent is it?
Ms. Emerson. I don't think you can even put a percent. I
don't think that moves the dialog forward, trying to identify a
specific dollar amount for speculation. I think it's, you know,
it's--can we say today's price is $85 fundamental and $20
speculation. I think that kind of layer cake analysis it's not
really useful to us because----
Senator Domenici. Ok, now let me tell you, ma'am, and
excuse me. I'm not interested in a view of the layer cake
impact. I'm interested in how we can understand the problem.
Now if you don't have that box in there at all in your analysis
then I would say let's button up the hearing. It's one thing if
an expert says there is nothing, no speculation involved. But
you say there is some.
Ms. Emerson. Ok.
Senator Domenici. You understand?
Ms. Emerson. Yes.
Senator Domenici. I'd just like to know what percent you
think it is because it's rather significant if you look at your
chart A. I'm not able to put on exact percent on the
``speculation'' box--is it about ten percent?
Ms. Emerson. Let me define speculation and then I'll give
you that number.
Senator Domenici. Ok.
Ms. Emerson. Speculation, and I think I want to make a
distinction between investment and the casino example used
earlier. Speculation, and I think part of the reason of the
hearing is in part the purchasing of oil by institutional
investors. I think Mr. Book here mentioned the California
pension fund purchasing oil.
To me this is buying an asset to hold like you would buy an
equity to hold. They're buying that for their members of their
pension plan to hold value. That's one kind of speculation.
Then on top of that, of course, there is some day-to-day
trading that is perhaps a little bit more short term. Not
necessarily where you're buying the oil to hold it as an
investment in your portfolio.
If I were to add the two of those together to get back to
your question, you know, and I had to give you, and this is a
gut call. If I had to say, I'd say the fundamental price is
probably somewhere in the 1980s or 1990 or 1995 at the most.
Probably there is some additional strength in the price as a
result of not just sort of the gamblers in the casino, but in
terms of actual institutional investors who see this as a way
to hold value when they can't hold value necessarily in the
equity markets or they want to diversify their portfolio.
Senator Domenici. I understand your statement. Your
explanation to us now makes sense to me. I just think
eventually in my own analysis I have to go back beyond this and
see if I could organize in my thoughts what would be the case
if we did not permit oil to be speculated upon in any way, even
the decent way that you mentioned.
If we, from the beginning, had said that isn't going to be
around, I believe there still would have been plenty of capital
for oil. I believe people would have invested in it. But they
would have been closer to the ultimate user than to the faraway
investor.
I can't do that yet, but I can have somebody look at it for
me. I thank you very much. Thank you, Mr. Chairman.
The Chairman. Thank you.
Senator Dorgan.
Senator Dorgan. Mr. Chairman, thank you. Let me make a
couple of comments and then ask a couple of questions.
I want to hold up the quote from Mr. Gage who has testified
before this committee. This is November 6. I think the price of
oil was around $85 then.
But here's what he said. He's one of the top analysts with
Oppenheimer. He said there's no shortage of oil. I'm convinced
that oil prices shouldn't be a dime above $55 a barrel. Oil
speculators including the largest financial institutions in the
world, I call it the world's largest gambling hall that's open
24/7. Totally unregulated, like a highway with no cops and no
speed limit.
You know, I don't know. Thank you. I don't know what all
the facts are. I don't disagree with what's been said. I think
the value of the dollar has an impact.
I mean you'd have to be drunk not to understand when you
run $800 billion yearly trade deficits you're not going to have
some effect on the value of the dollar. I mean, you know,
everybody understands that's coming at some point. So, I
understand all of this has an impact.
I also think there's a fairly substantial amount of
evidence that there's too much speculation. We had EIA, Mr.
Caruso say it was about 10 percent of the price. I don't know
what it is. He thinks, Mr. Gage thinks it's about $30 a barrel.
Mr. Harris, you don't think it's very much.
Now Mr. Harris, I want to tell you. I mean I've read about
the speculative bubbles. This is not quite that. I mean I know
that they used to sell tulip bulbs during tulip mania for
$25,000 a tulip bulb. Sounds a little nuts four centuries
later, doesn't it? But it happens. You have speculative binges.
I think there's some speculation going on here. We do have
as was referenced by a question a moment ago, we have people
involved and interests involved now. They are buying oil they
will never get from interest that have never had it all to
provide liquidity.
I'm all for liquidity. Every market needs liquidity. I
think we're way beyond liquidity here. I understand that, you
know, we put on blue suits and then we come and describe what's
happening. But we really don't know what's happening except
drivers know. Truckers know. Airlines that close their doors
know.
We need to think about, as best we can, what kind of a
normal market mechanism should exist and how would it work? I'm
involved with Carl Levin to try to close the Enron loophole
with some of my colleagues. It's an unbelievable loophole.
Mr. Harris, my understanding is that your staffing at the
CFTC at a time when we need referees is somewhere near a 33-
year low and that third of a century, you're at the low point.
At a third of a century when we've got these run up and these
dramatic markets and you're supposed to be the referee. My
understanding also is that you come and testify to us based on
what you know not on what you can't know because a substantial
amount of that, I call it dark money, a substantial amount of
that dark money is elsewhere. You can't see it and you don't
know it.
It's why, for example, a 32-year-old trader with a hedge
fund named Amaranth, as you know, held huge sway over the price
this country paid for natural gas not so long ago. It
controlled, I think, 70 percent of the natural gas commodities
of this country. You all, the CFTC, finally said, that you
can't do that, you've got to stop. Finally you said that. They
he just went to the intercontinental exchanges. Then you
couldn't see him. He continued to do it anyway.
So, you tell us what you know today. I appreciate your
being here. But you can't tell us what you don't know. There's
a lot that's dark for you.
So, and Mr. Book, you either have bad judgment or bad
vision suggesting your performing in front of Elvis here. I
mean does anybody here look like Elvis to you?
[Laughter.]
Senator Dorgan. But I appreciated the comment of coming to
the Congress, but this is not an Elvis committee. Let me ask--
--
The Chairman. I think all of us take exception to that
comment.
[Laughter.]
Senator Dorgan. When you said it I immediately leaned over
to the chairman. I said, it's unbelievable he would refer to
the chairman and the vice chairman as Elvis, but at any rate,
we're pleased that you're here.
Mr. Book. I think highly of Elvis, sir.
[Laughter.]
Mr. Book. You.
[Laughter.]
Senator Dorgan. Let me ask about this issue of margin
requirements. It is so interesting to me that if you want to go
in the stock market and buy a margin you pay about a 50 percent
margin, I think. If you want to go control some oil or natural
gas at the moment, you pay 5 to 7 percent. So you can control a
substantial amount of the commodity with a very small
investment.
Does anybody here think that that ought to be changed? Mr.
Cota?
Mr. Cota. Yes, Senator. The amount of leverage that you get
in these markets is just tremendous. You're doing ten times the
amount of leverage trading by having a low margin requirement
in commodities. It should be the same as all other equities
because we become an investment tool. It's no longer about the
base commodity.
To answer Senator Domenici's question from earlier about
how much we're paying to excess speculation. I think it's a
minimum of a dollar a gallon. You know that's very significant.
As to your point, Senator Dorgan, which is completely
accurate, nobody can prove that because there's no data. The
Amaranth's study was done by the Senate Investigations
Committee was as close as we got. They had a figure of about 20
percent minimum. That was back when crude oil was trading about
$50 a barrel. So we're way beyond that.
Senator Dorgan. It took them well over a year to do that
study. It took them subpoena power. It was something that
couldn't have come from our regulators, which I think,
describes this deep hole that exists where dark money moves
around. Without transparency. I think the market is not working
properly.
Now I don't want oil to go back to $10 because I think what
happens is you dry up all investment for development here at
home. But neither do I want it to go to $110 because investment
banks and hedge funds, who never want, in most cases, don't
want to take possession of oil ever, just want to effectively
gamble in the marketplace. So the victim here is the consumer
and the country.
I mean it's not insignificant that two airlines have closed
their doors in the last couple days. It's not significant that
was on the news last night, the truckers said, you know, we
can't continue doing this. So I want the price to be
reasonable.
I do think, however, this hearing that the chairman has
called, and I appreciate it, is about the issue of speculation.
Is there something happening in the marketplace that we don't
quite understand that you can trace to speculation? The EIA
says yes, but it's only about 10 percent. Others say it's much
more. But it has a profound impact and will continue to have a
profound impact on this country.
There are certainly other things we have to do. We're going
to borrow $800 billion in fiscal policy this year. I know they
say that the Federal budget deficit is going to be 400. It's
not.
We're going to borrow $800 billion in fiscal policy. We're
going to borrow $800 billion in trade policy. That's $1.6
trillion against this economy in 1 year. That's unsustainable.
So I know there are all kinds of other issues. But the
price of oil has a profound impact on virtually everything else
as well. I think there's a substantial portion of that that has
no relationship to supply and demand.
Mr. Harris, do you agree with my analysis that at a
critical time when we need a referee, you can't see a lot of
what you should be able to see and your staffing is at a 33-
year low?
Mr. Harris. I think it's a fairly well known fact that
we're at historically low staffing. It's a fairly well known
fact that we're at historically high volumes in every commodity
asset to monitor. So I would be supportive of, I guess, the
reauthorization of our, that's pending now in front of
Congress. That would be a positive development from our
standpoint.
Senator Dorgan. The issue that you can't see a lot of what
you need to see in order to really understand all of the
markets?
Mr. Harris. I think one of the things I wanted to bring
forth on my testimony today is that we--in these markets we
actually do know quite a bit. The natural gas case with
Amaranth in particular, went to highest futures. We also have
pending legislation in front of Congress on that to try to
close some of those loopholes.
In the crude oil markets though we do have an information
sharing agreement with the FSA for instance where's there's a
large amount of trading in crude oil in the Brent contract and
in ICE Futures UK. We get daily reports from the ICE Futures UK
on trading activity in their markets in addition to the West
Texas intermediate on NYMEX. So one of the--and part of our
data and the large trader data as well is that we can identify
large groups of traders classified by speculators or managed
money in the case that I presented today where we can look at
what groups of traders are doing. So we do have some tools to
dig fairly deeply into these markets where you probably don't
have the same capacity, for instance in the stock market, to
understand who's buying and selling on a daily basis.
Senator Dorgan. Mr. Chairman, I've exceeded my time. But
let me just say what's going on these days with the Fed and our
country's decision makers is that there's not a lot of risk for
being a big speculator because if you're big enough in this
country, we'll just take care of your losses at some point
along the way which should raise another discussion, another
committee perhaps.
The Chairman. Thank you.
Senator Barrasso.
Senator Barrasso. Thank you very much, Mr. Chairman.
Following up with Mr. Harris. Alan Greenspan actually 4 years
ago, argued that in a tight market where supplies are not
easily expanded that the futures investing does impact price.
That was a time when oil was at $40 a barrel.
Now watching all your charts, I got the impression that you
weren't necessarily agreeing with the former chairman of the
Fed on that. Would you like to expand because I see Ms. Emerson
moving her head yes, up and down?
Mr. Harris. The impression is futures markets do serve a
price discovery function. So in the sense that, as I mentioned
earlier, people forward contracting looking to purchase oil in
the future will use the futures markets to do that. I can't
speak to whether I agree or disagree.
We've heard that there's a large speculative premium for a
number of years now. One of the issues there is we heard that
it was $50 a barrel. Then it's $60 and now we're at $100.
I find it hard to believe that the speculative premium
could be that variable over that short a period of time. We do
see prices still reacting to fundamental changes in political
risk around the world. It seems to make a little bit more sense
to me.
Senator Barrasso. Do you draw a distinction between the
markets where you have good oversight? When I think of
excessive speculators, there's hedge funds, general asset
managers, pension funds or sovereign wealth funds. To me a
difference is that sovereign wealth funds do have actually a
control over the supply from some nations. Some nations have a
wealth funds that have that.
Is that something you feel you have enough information to
comment on and if that impact is different than a hedge fund or
a general asset manager?
Mr. Harris. We do have fairly rich information, I would
say. We're aware of the sovereign wealth fund issue. I'm not
aware that we identified how sovereign wealth funds trades in
our data.
Senator Barrasso. Mr. Book, then, if I could ask you. You
wrote the Associated Press article of March earlier this year
where they talked about sovereign wealth funds adding
speculative heat to the already red hot market. I think your
comment was: while Persian Gulf sovereign funds would be taking
a risk since oil prices could decline, it isn't the worst
investment idea you could have, Book added, if you control the
oil supply. Would you like to comment on that?
Mr. Book. I would love to. I think that if you believe in
markets you believe in transparency. If you believe in
transparency, you believe in shame. Price discovery and actors
in markets who exploit markets routinely should be excluded
from markets.
I do believe that fund managers, as a profession, are not
the same thing as oil producers as a profession, nor sovereigns
as a profession. In fact, the sovereign wealth funds will have
an incumbent on them, not just for oil, but for all commodities
and all investments to make clear the distinctions in who
controls the money and who controls the decisions. I think with
clarity there is no problem.
I also, as I suggested in the article, I think that there
are reasons why you might not want to do that. You might, if
you paid this guy to diversify you out of the oil revenues that
make your country go and then he puts you back in oil, that may
not be the best performing fund manager you could hire. So it's
not clearly the best decision. It may simply reflect, as I said
in my testimony, that there aren't a lot of other good
investments available right now for professional investment
managers of any stripe, whether they be sovereign, hedge,
mutual or other.
Senator Barrasso. Our abilities, in the United States, to
regulate sovereign wealth funds in terms of what they're able
to do in international markets would be quite limited would you
say?
Mr. Book. Yes. The way they can invest can be through
regulated vehicles. Again I think that the appreciation and
their assets under management has occasioned already among the
OECD and the IMF vigilance. I think it's appropriate. I also
think it's important to not judge before we know.
Senator Barrasso. Ms. Emerson, in your written testimony
you concluded it with consuming governments will be compelled
to take action to protect their economies. What specific
government policies would you propose or endorse right now in
terms of what we as a consuming nation should be, will be,
compelled to take to protect our economy?
Ms. Emerson. The way I see this problem is it's a
structural one. There's no quick fix. I think that the kinds of
policies that I see as being critical are going to be polices
to conserve, to promote fuel efficiency.
I mean, if you look at it from the U.S. prospective, it's
all about transportation fuels. It's not about anything else.
And we've made some steps last year with raising the CAFE
standards and of course the EPA is considering CO2
emissions regulations, which would indirectly improve fuel
economy as well.
We just need to be as vigilant and as aggressive on
conservation and fuel efficiency as we can be because I don't
see us rebuilding a whole lot of spare capacity. We're not
going to return to $30 oil, certainly not in my lifetime.
Senator Barrasso. You had made the issue of transportation
fuels. That, Mr. Cota, if I could visit with you for a second.
I think people are able to be good windshield shoppers at 45
miles an hour like Mr. Eichberger talked about driving around.
I drive around the State of Wyoming. All of us drive around
our States, long distances between one community and other. You
can't shop on that one main street when you're 75 or 100 miles
away. You may see a jump in prices, as I did this last week,
driving around Wyoming. Maybe 25 cents per gallon and all the
prices in one community may be 25 percent higher or lower than
another community even though they're all pretty close in
price. But that differential of $3 to $3.25 per gallon is a 7-
percent difference.
Would you like to comment on that and why that differential
can be so great?
Mr. Cota. I think that deferential could exist in the
current market simply because of the volatility that's
occurred. There has been a 70-cent change in the wholesale
price within a 30-day period. So just depending on just a
matter of days what could occur within that market could
justify that.
There have been a number of days where just the high and
the low in some of these contracts has had us spread as high as
20 cents a gallon within the day. That's just one day. So, you
know, I get price changes as often as three times a day. Often
I don't know what I actually paid until I've actually gotten
the invoice the next day and it's draft out of my account. So
that would explain that. It goes to underscore the volatility
that we have in the markets.
To bring up your point on the sovereign funds, which I
think is really critical. That's a national security issue. If
you have a sovereign fund that doesn't particularly like the
United States and you want to go in a dark market through a
derivative type of bilateral deal. You're selling the commodity
that you want to also hurt the other guy with, you could make a
huge impact for very short money both to jeopardize that
economy and maximize your own commodity.
We would have no way of knowing. There is no oversight. You
don't even have the data.
Senator Barrasso. Mr. Eichberger, anything else you'd like
to add?
Mr. Eichberger. I think Mr. Cota kind of nailed it on the
head is that the volatility in the wholesale market is
tremendous. I was with a retailer earlier this week who told me
over a &ree day period he had something like a 20 cent increase
in his wholesale cost in one day, a twelve cent drop the next
day and an eight cent increase the following day. The
volatility is incredible. Retailers are constantly chasing that
cost where their competition will allow them to do.
In different markets, competitive pressures are very
different. The cost basis of their operations are very
different. The distribution challenges of getting product to
those retail locations could be very different. So the
variables that influence retail price are huge.
Senator Barrasso. Thank you, Mr. Chairman. I think I've
exceeded my time.
The Chairman. Senator Lincoln.
Senator Lincoln. Thank you, Mr. Chairman. As usual thanks
for bringing us together on an important issue, but a very
complicated one as well.
Just a couple of questions. Mr. Harris, you said repeatedly
I think that future markets existed to discover prices and
limit risk. You just I think answered Senator Barrasso's
question with a version of that.
I guess, although I do agree to some degree that that
exists in a properly functioning futures market. I guess, would
you also agree the flip side of that, that an improperly
functioning futures market could distort prices and certainly
inadequately limit risk resulting in the kind of excessive
speculation that perhaps could exist?
Mr. Harris. I totally agree. In fact that's the mandate of
our organization is to monitor and investigate any activity
that might be deemed suspicious, manipulative or otherwise in
the market. So we do have----
Senator Lincoln. Do you feel like you're agency or your
department's got the adequate means to be able to do that?
Mr. Harris. I don't work for the enforcement division in
particular. I think it's pretty well known again that we're at
low staffing levels. We're at record volumes in these markets.
We're doing the best that we can. We have record numbers of
enforcement cases as I understand. We have hundreds of
investigations going on any given day in these markets to try
and make sure that there is no nefarious behavior going on in
any market.
Senator Lincoln. Ms. Emerson, following up on Dr.
Barrasso's question about what countries can do. You also, and
I'm apologizing because I had to excuse myself and these
questions may have been asked, but you did touch on the impact
of biofuels and other new fuels and the effect that they could
have on the price of oil is certainly of particular interest to
me. Many of us come from agricultural-based States and
innovative States.
My State has a diversity of feedstocks that could be used.
We've got a lot of interest among our Ag community. But also in
terms of the innovation and technology that people are looking
for in renewable fuels.
I'd like to hear, I guess, more about what you believe and
how you believe that maybe, perhaps, that could affect oil
markets and what needs to be done to grow those industries
properly in a way that could make a positive impact.
Ms. Emerson. I think biofuels, both in the United States
market and also in the global market are, must be seen as a
portfolio approach. They're not a magic bullet.
Senator Lincoln. Right.
Ms. Emerson. But they certainly can be part of the
solution. Obviously they have to be developed in a way that
deals with the food or fuel issue and with the inflation issue.
So you have to look very closely at the kinds of import, excuse
me, input materials and the way in which they're grown.
Then now we have the issue of are they grown in such a way
or are the biofuels manufactured in such a way that they use
more energy and/or emit more CO2. So I tend to be a
little bit of a biofuels skeptic only because I find there's
more emotion and excitement than careful planning with
biofuels. Maybe that's what you have to do. Maybe you have to
start with the excitement and then sort of throttle back and
come up with the appropriate plan.
Senator Lincoln. Second to Hollywood, we're all about
glamour here in Washington.
[Laughter.]
Senator Lincoln. So you may be correct that creating the
enthusiasm and excitement for things is what gets us started
and then, obviously, practicality. I have a research physician
in my house and certainly looking for the practicality. But I
know in our State everything from algae to chicken litter,
poultry litter to, you know, switch grass and a whole host of
other things, looking at those as alternative for fuel and
energy are great ideas in a sense that they're feed stocks that
make sense and don't necessarily distract from other places in
the marketplace. So your point is well taken in terms of making
sure that we create that balance in terms of where those feed
stocks come from.
Mr. Eichberger, your testimony you mention that the affects
of the increased use of credit cards to purchase fuel at
convenience stores and the fees that are a part of that
transaction. I have just met with my Arkansas marketers,
petroleum marketers. I heard an awful lot about that issue.
They, our petroleum marketers, are seeing, as you say, not
only the volatility and the fluctuation in terms of price at
the pumps. What they have to deal with, but also the lack of
transparency. As well as what, you know, when that volatility
happens what happens to them in terms of their cost of doing
business.
Could you expand any on your testimony as to how extensive
you believe that problem is and what your association would see
as a solution to that?
Mr. Eichberger. It is the number one issue facing the
retail market today. In 2006 overall convenience stores paid
$6.6 billion in credit card fees. They only generated $4.8
billion in profit.
This is an escalating situation. The card will assess a fee
of about two and a half percent on average on every gallon
sold. As the price of gasoline goes up, their revenues go up.
Yet they have absolutely have no risk in terms of buying
product, putting in the ground, making sure you don't release
in the environment, making sure that everybody is filling up
properly and you're doing all your business operations. They
just skim it right off the top.
So as retailers who are constantly chasing the volatile
wholesale markets and trying to figure out how they're going to
be able to break even on gasoline to see seven and a half cents
from every gallon come right out of their pocket, it's a major
issue. A lot of retailers are in the situation where it is make
or break. If something is not done to level the playing field
and give them some relief at the pump, they may not be able to
make a profit on gasoline in the long term. It could really
destroy their economic well being.
Senator Lincoln. I appreciate that. You certainly confirmed
what I've been hearing at home. So thank you. Thank you, Mr.
Chairman.
The Chairman. Senator Murkowski.
Senator Murkowski. Thank you, Mr. Chairman. Thank you
ladies and gentlemen for your testimony this morning.
Mr. Eichberger, listening to you this morning, we recognize
that--we're always looking for some scapegoat, somebody to
blame. The guy that you're getting the gas from at the pump
seems to be the quickest and easiest but it reminds me of, you
know, the scene in the airport where you've got the customer
who is chewing out the ticket rep there for the cancellation of
their flight. To a certain extent the retailers are in that
situation. So I think your testimony here this morning was
important for people to hear and to understand.
Ms. Emerson, I think you said at least a half dozen times
here this morning there is no single answer. There is no silver
bullet. This is complicated. This is complex.
But it seems that we are very, very quick to try to attach
blame. But if we were to just take some of the profits from the
oil companies, all would be fine in the world. I think it is
important to understand how many different factors really go
into what affects the price of oil. Why we're seeing what we're
seeing today.
As I listened to all of you, well, it's not clear to me
that any one of you is wiling to attach a percentage or a price
on what the speculation is in terms of all those factors that
go into the price of oil. We recognize that speculation does
play a role, maybe some of you think it's a much more limited
role than others. But the other factors, the supply and demand,
the geo-political factors, the oncoming role of China and
India, it's clear to me that we're looking at this and
recognizing all that comes into it.
Mr. Burkhard, in your testimony you mentioned these new
fundamentals and the first was the aspect of the cost structure
and the reality that the labor and the materials that go into
it are just continuing to increase. Then the second of those
fundamentals was the global financial dynamics. You speak again
of the role of China and India.
I look at those two fundamentals that you've identified and
I just see them continuing. Does this mean in your opinion that
the price of oil will continue to rise because we're not able
to contain these two areas or do we plateau it at some point
here?
Mr. Burkhard. The--first of all can't continue to rise
forever. On the cost side, over a long period of time there
will be more people and equipment entering the industry. But
one important thing to keep in mind is in for most of the 1980s
and 1990s for a generation, there is a whole generation of
people that skipped entering the petroleum industry because of
low prices and industry consolidation. So it's going to take
time to reinvigorate the ranks of particularly on the technical
side of the oil industry. But 10, 15 years, we hope to see more
relief on that front.
On the China, India issue, their aspirations for higher
living standards are like anywhere else in the world. But there
are limits in terms of price that those countries can take.
They are, on average, the per capita income is lower than it is
here in the United States.
So when we get to--if we were to have a sustained oil price
of let's say 110 to 120. By sustained, I mean 6 months or more,
not a day or two. We would expect to see demand, even in those
countries start to be negatively affected and push that could
over time begin to take some of the pressure off price.
Senator Murkowski. I don't think any of you have
specifically mentioned the growing role, the domination really,
of the nationally owned oil companies and what role this may
play in driving up the prices worldwide. Could someone speak to
that? Ms. Emerson?
Ms. Emerson. It is absolutely the case where we're seeing a
shift in the balance of power among oil companies from the
integrated majors that we all know to national oil companies
around the world. That's in part because they, in their host--
in their home countries they hold a lot of reserves. Actually
they've become much larger companies and often times they're
backed by their government in some of their investments.
I think some commentators have said that this is just all
together a bad development. I think that's a too simplistic. I
think some of the national companies that I personally deal
with are making very big steps to invest in oil production and
in oil refining. They will probably significantly impact some
of these capacity restraints that we have.
So I think we have to adjust our thinking a little bit to
understand that, you know, they're big players too now. It's
not just about the Exxons and BP and Shell.
Senator Murkowski. So you're viewing it as a positive in
the sense that it will add to capacity.
Ms. Emerson. Yes. What we're seeing is significant
investment in capacity and from many national oil companies or
companies that are technically private, but behave a little bit
like national oil companies.
Senator Murkowski. But what about their aspect then as a
nationally owned oil company to really attempt to control, to
what extent they can, the available prices. Are you not as
concerned about that aspect of it?
Ms. Emerson. I think it's a complicated issue. You have to
look at national oil companies in terms of whether they are
part of a net importing country or part of a net exporting
country. So the decisions that a CNPC to a Chinese company
would make would be different than a Saudi Aramco would make.
I think in the case of the national oil companies in net
exporting countries they're making so much money. They are
definitely pumping that, to some degree back into capacity. Not
necessarily maybe as much as we would like, but certainly
they're building that capacity. That's a good thing.
But it does mean that it's going to be those companies
controlling the flow more so than in the olden days when Exxon
and Mobil were sort of controlling the flow for the global
market. You know, it depends a little bit on how you perceive
the objectives of their governments.
Senator Murkowski. Mr. Cota.
Mr. Cota. The national oil companies, the exporting
national oil countries and their companies have more subtle yet
very large impact. It's in how they are taking the United
States dollars, which they will continue to take into
diversifying their portfolio. Then they in that way, part of
that diversification to get out of United States dollars is to
do the arbitrage deals to buy Euros, other foreign currencies
and in the last form of cash which is commodities.
So in their efforts in these predetermined arbitrage
programs of diversifying their portfolios they are driving up
the same thing that they're trying to diversify out of. So
they're making a large impact by increasing the price,
inadvertently, I don't think directly and inadvertently because
they're trying to get out of United States dollars. As the
United States dollar goes down everyone's buying commodities
worldwide in United States dollars, not just energy. As you
diversify out of the United States dollar because that's
declining, you're going to go into commodities, which is going
to drive the price up and which is going to return more to
them.
Senator Murkowski. My time is up, but Mr. Book had a
comment. Let me ask him.
Mr. Book. Senator, I just--I did speak to that briefly in
my written remarks. I just wanted to point out that if you're
going to satisfy global petroleum demand, you're going to need
an and within demand, not an or. So the good thing about the
national oil companies is that as they become richer and gain
access to greater technology, they add to global supply on the
market, typically when they make the investments that have been
discussed.
The other part of and was mentioned earlier, it's bio-
fuels, it's alternatives, unconventional sources of petroleum.
It is also access where you can have it. We are--I go to Norway
sometimes to see clients. They have national sovereign wealth
and oil producing, I think they might be importing, but I don't
know.
They say they take the--they like to tease me because we
don't produce all of our offshore oil. Yet they're one of the
greenest, sort of, national economies in terms of their ethos
and their culture. They have paired responsible production with
conservation. If you're going to get to and, I think
responsible production and conservation are both parts of the
story.
Senator Murkowski. Alaska wants to help there. Thank you,
Mr. Chairman.
The Chairman. Thank you.
Senator Cantwell.
Senator Cantwell. Thank you, Mr. Chairman. Panelists, thank
you for being here. There was an earlier testimony this week in
the House by oil company executives and an executive from Exxon
Mobil was quoted as saying, ``based on supply and demand
fundamentals that they have observed that they estimate the
price of oil should be about $50 to $55 per barrel.'' That's
what the oil company executives believe.
I think this hearing is very important. So I'm asking
starting with you, Mr. Burkhard and Mr. Book. Did you predict
that oil prices a year ago would be at $100 a barrel without a
major oil supply shock or disruption? Did either of you predict
that?
Mr. Book. I'm wrong currently. I have this year's price at
$85.
Senator Cantwell. Mr. Burkhard.
Mr. Burkhard. We were lower than the current price too
because of the impact of the dollar and the rising cost as
well.
Senator Cantwell. If I asked you to predict what oil prices
are going to be in 6 months, do you think you could give me a
good basis for that?
Mr. Burkhard. I could describe to you in detail the
assumptions that would go into the outlook, but whether that
actually happens or not is a different story. But it's if the
dollar does weaken more than it's difficult to see oil prices
declining.
Senator Cantwell. Mr. Book, do you want to comment on that?
Mr. Book. I believe in fact that $85 reflects a couple of
things that do make sense to me. I'll enumerate them even if
I'm wrong about the magnitude. The marginal nonevect barrel is
probably $70.
Senator Cantwell. Ok. Actually you've already made my
point, which is just this that we didn't, no one predicted this
without a major oil shock. Here's where we are today.
When you are asked to predict again, which is trying to
have some predictability in the markets with some certainty so
people can hedge with some expectation, so that they can
protect themselves. Yet we're basically saying this is all over
the map. We don't have the fundamentals here. We don't have the
fundamentals that are giving everybody the certainty and
predictability we would like to see.
It wasn't that long ago. I became a Senator in 2001 and at
that time OPEC was doing all they could to keep oil prices
between $22 and $28 a barrel. So my point is this thing is way
out of control and it's causing great impact to the economy. I
just don't understand why we aren't being way more aggressive.
I plan next week when the FTC is before the Congress
committee to ask them to hurry up and expedite the rules that
were given to them in the new Energy bill on anti-manipulation
provisions to make sure that petroleum markets, just like
electricity markets, have the proper oversight. But Mr. Harris,
my question is for you, just yes or no. Do you believe in
closing the Enron loophole? Yes or no?
Mr. Harris. Yes, absolutely.
Senator Cantwell. So the CFTC will support that. Under your
current authority while you may be able to look at the ICE
markets, you don't have any ability to do any enforcement of
wrongdoing. Is that correct?
Mr. Harris. That's right.
Senator Cantwell. So, a big problem exists today in the
fact that we have online trading that doesn't have the
enforcement and oversight. So we--to me, I don't care how many
people we have. I mean, we ought to be able to, Mr. Chairman,
get the oversight.
That reminds me, you know, it took the Snohomish County PUD
$100,000 to prove that Enron manipulated markets. It didn't
take a lot. It didn't take the FERC to do that. Although they
later found that, it took a little industry to bait a little
entity to hammer home the point.
My second point is in this chart, Ms. Emerson. If you
could--your chart on factors lifting oil prices you have just
in time. My question is how much does the industry moving from
a 30-day actual physical supply of oil to a just in time
trading on paper of supply impacted the market in not having--
in basically making a lot tighter supply and thereby more
speculation.
Ms. Emerson. I think, absolutely, the movement to just in
time inventories has exacerbated the tendency of the supply
chain to respond or prices to respond very quickly to supply
chain hiccups. You know back in the 1980s and early 1990s we
had as much as 30 days and we're probably around 22 days now of
supply that the physical market is holding. To the degree that
you reduce your capacity, you reduce your inventories. That,
yes, absolutely, you cede control to others in terms of short-
term price dynamics because you can't discipline the speculator
by dumping some oil into the market.
You know in the olden days we used to talk about Brent
squeezes. You know, someone would buy a bunch of Brent cargoes,
but Shell or BP would just add another cargo and that would
discipline that behavior out of the markets. So yes, you're
right without the spare capacity and without the additional
inventory it does make short-term speculation or short term
trading have a bigger impact.
May I also respond to your other question just to be sure?
Senator Cantwell. It's up to the chairman. I'm out of time
but it's up to the chairman. But I will just say these things
are a lot clearer.
Mr. Cota, thank you for your testimony. I think you were
very crisp. I think when the oil industry is coming to us
saying that they, in fact, see problems in this. It's time for
us to clearly list out the things that need to happen and
closing the Enron loophole. Basically looking at how to make
sure that there's more physical supply for less speculation,
making sure that the FTC gets about their job.
It's just clear there is not--we can't go from 2001 at 28
to where we are today at over 100 and then having people play
these guessing games and thinking that we're going to have any
kind of functioning markets. There's just too much going on
here. If we were going to protect our economy we have to be a
lot sharper at closing what are the lack of functioning market
trends that are absent here. I think they're pretty clear. So,
go ahead Ms. Emerson.
The Chairman. Ms. Emerson, go ahead. Give whatever response
you want and then Senator Sessions has some questions.
Ms. Emerson. I'll just do 2 seconds and that's just to say
about this issue of is the fundamental price at $50 or $80 or
$90. One of the things that I wanted to make clear in my
testimony this morning is that 2007 we had a very strong
fundamental development which did move prices well above $50
for supply/demand reasons. So I don't want to leave the
impression that the potential speculative premium is something
between $50 and $100. It's probably closer to $80 and $100.
The Chairman. Alright. Senator.
Senator Cantwell. For a lot of families even that is a big
difference. Thank you.
The Chairman. Senator Sessions.
Senator Sessions. Ms. Emerson, it seems a little odd to me
that you and Mr. Book seem to think that the national
governments that are taking ownership of the oil in their
country in contradiction to normal free market principles is
not a problem. Mexico has tremendous reserves, yet their
production is down. That's generally accepted because of
corruption, inefficiency that is typical in these country's
governments and in their production capacity.
Isn't that a factor in the decline? Venezuela, showing a
decline in their production, has large reserves. Isn't that a
factor?
Ms. Emerson. I absolutely agree that these countries are
pursuing policies of resource nationalism. Their policies may
or may not be beneficial to consuming governments.
Senator Sessions. But I'm talking about their own country.
In the short run or at least, it seems to me, they're not very
effective in producing oil and putting it on the market.
Because they're inefficient and less efficient and productive
than private oil companies that have to compete on the
marketplace.
Second, isn't the biggest winner in all of this countries
who own their oil reserves? When the prices go up dramatically,
aren't Saudi Arabia, Hugo Chavez, and people like that just
counting the money? Nothing has changed in their country. They
have the same amount of production and they're getting more
than two times what they were getting just a few years ago for
their oil reserves.
Ms. Emerson. Absolutely. But I would make a distinction
that there are different kinds of producers. I wouldn't
necessarily put Venezuela and Mexico which are having terrible
problems for both political and institutional reasons with some
of the Persian Gulf producers who are absolutely investing.
Senator Sessions. Is production increasing in some of the
Persian Gulf countries?
Ms. Emerson. Their production capacity is increasing.
Senator Sessions. They're taking advantage of these high
prices.
Ms. Emerson. Absolutely.
Senator Sessions. A little more effective than some other
countries. What is the average? I've heard various figures. I'd
like to know what is generally considered to be a fair estimate
of the profit that oil companies make today on a gallon of gas.
How many cents per gallon?
Mr. Eichberger, you're in the business of----
Mr. Eichberger. Yes, Senator. Probably the best proxy you'd
have is the Energy Information Administration breakdown on the
retail price of gasoline. They do it each month. They break it
down to what crude oil contributes, taxes, refining and then
everything below refiner.
If you look at the average for 2007 refinery operations and
profit was 17 percent.
Senator Sessions. 17 percent.
Mr. Eichberger. 17 percent.
Senator Sessions. So a $3 gallon is 30, 45 percent--45
cents per gallon.
Mr. Eichberger. A $3 gallon would be 51. It would be 51
cents on a $3 gallon. But you have to keep in mind that's also
their operation cost as well, not just profit.
Senator Sessions. Right. I was at a town meeting and a
local, one of your guys, I guess, pointed out to me at $100 a
barrel at 42 gallons a barrel. He wrote it on a napkin and gave
it to me. That's $2.52 right there plus all the other costs
that go into it.
But I'm told it only costs in Saudi Arabia about $8 a
barrel to produce a barrel of oil to get it out of the ground.
Mr. Cota. Probably less.
Senator Sessions. So I mean this is a huge amount of money
that's going now perhaps over 80 percent of the oil of the
world today is owned by governments. Is that correct? So when
the OPEC meets and they talk about production levels. They
control their production. They are taxing the American
consumer. That's what they're doing because this is not a free
market price. It's a cartel.
OPEC is, in itself, a price fixing mechanism. They work to
fix the price. I think one sense of what we ought to do is
focus on an inter-net foreign policy that deals honestly with
that question.
I would like to ask, whoever would like to comment on it, a
question about diesel fuel. It's very troubling to me the price
of diesel fuel is considerably higher, Mr. Eichberger, at your
stations than gasoline. It should be less.
Diesel automobiles get 35 to 40 percent better gas mileage,
Ms. Emerson, which would be one of the ways to conserve. Fifty
percent of Europe's automobiles are diesel. Why are we having
such a high price for diesel fuel? Mr. Cota, I see you raise
your hand.
Mr. Cota. Part of it has to do with our new flavor of
diesel, ultra low sulfur diesel. So we now produce the highest
quality diesel on the planet. We were a net importer of diesel
prior to having this new standard.
Now with the arbitrage of the dollar and the Europeans
having a higher demand. They import diesel and export gasoline.
So because the Euro is so strong, our diesel in the United
States is going to Europe. Much like our bio----
Senator Sessions. I asked the Energy Department that a few
weeks ago and they told me we're not exporting diesel to
Europe.
Mr. Cota. You can take a look, I, well, I'm not a trader. I
don't work for the government. My understanding is that the
arbitrage deals are encouraging cargoes in New York Harbor to
go to Europe.
Senator Sessions. Mr. Burkhard.
Mr. Burkhard. I think a fundamental reason for that, for
the increase in diesel prices, is that is where demand globally
has been strongest, China and Europe in particular. The demand
for diesel, globally, for several years has been much stronger
than gasoline.
Senator Sessions. My time is up. But I guess my question is
why aren't we seeing any move to refinery? In the pure cost
factor, even with the higher grade of diesel fuel that you
referred to, it still should be produce-able at less cost than
a gallon of gasoline, should it not?
Mr. Cota. It's all what the crack spread is and the
refiners say. That's a question for the API group. They can
tailor outputs. We are the last economy to focus on gasoline.
The rest of the world, as was stated, is moving toward the
diesel because it's cleaner and higher efficiency.
Senator Sessions. Mr. Chairman, I just hear that a lot from
my trucking community.
The Chairman. Go ahead if you have any additional
questions.
Senator Sessions. I would like to follow up a little bit on
that. It seems to me that there's a slow transition. Would any
of you comment on that? A slow transition to a diesel economy.
When I ask about it, the Energy Department official said it was
a lack of refinery capacity. Mr. Book and Ms. Emerson.
Mr. Book. Senator, there's a transition from the light duty
vehicle perspective is about 230 million cars and SUVs that
have to cycle out of the fleet and diesel vehicles to cycle in.
So from the fuel side of the story there is the part of the
story have been discussed. The other part is how do you get
higher efficiency vehicles into the fleet and get rid of the
ones that were there before?
Scrap yard rates for cars are now at about 5 percent, 5.5
percent, which means you have a 15 to 20 year waiting period.
In the 70s the height of that energy crisis, you were in the 12
to 13 percent scrap rate. So to the extent that you can get
into a different car, you need to not to just have the new car
made, the fuel to put in it, but you've got to get the old one
off the road.
Senator Sessions. But it's still selling for substantially
more than gasoline, which indicates to me that there's a large
profit being made.
Ms. Emerson.
Ms. Emerson. Senator, you raise a really critical question.
I think this is the big issue that needs to be addressed. The
United States refining industry is configured with catalytic
cracking and coking to take medium sour crude oil and turn it
into gasoline. We're not configured to maximize diesel
production. We're configured to maximize gasoline production.
Right now refiners in the United States are working very
hard with their gasoline configurations to make additional
diesel because diesel demand is growing. It's growing. It's the
only fuel right now that's growing in terms of--and it's
growing fast. Part of the reason it's growing is because we're
importing Chinese products in San Francisco and driving them to
New England.
So it is the trucking demand is what is--so we have a
structural problem there in that we have a refinery kit that
really wants to make the gasoline. So the refiners are doing
what they can to bend and tweak that to make more. They
absolutely want to make more. And at the same time we have a
very strong demand for.
Mr. Eichberger. Senator, if I could also add. I think you
heard about the fleet turnover. I think we need also to look at
Federal policy to a degree. The auto industry is not really
being encouraged to produce a whole lot of the new diesel
engines. They're being encouraged for just flexible fuel
vehicles, hybrid vehicles, higher efficiency gasoline vehicles.
The cars coming in imports are predominately going toward
hybrid and the domestic auto manufacturers are going to
flexible fuel vehicles.
So there is a preference through Federal policy to go to
biofuels, to go to higher efficiency gasoline, the electric
hybrid cars rather than going to the cleaner, more powerful,
more efficient diesel engines that we've been talking about the
last 5 minutes. Until we figure out and get away from this
prejudice against new generation, fossil fuel powered vehicles,
diesel is not really going to take off in a consumer's mind
when you look at vehicles they can purchase from auto
manufacturers. I think we need to balance our priorities,
looking long-term.
We have a bio-fuel, renewable fuel standard we need to
implement. But if we also want to increase fuel economy we need
to look at all options and make sure they're all on the table
and not prejudiced against one verses the other. I think that's
a challenge that we have going forward from a policy
perspective.
Senator Sessions. My only bafflement is why, with this kind
of margin for diesel, we aren't seeing more refining coming
forward to meet the demand that already exists?
Mr. Cota. Senator Sessions, with the profitability and
refineries are measured in crack spreads. There's a gas crack
and there's the distillate crack. Typically in the summer, in
the spring and in the fall, refineries will switch their
production to maximize whatever they think the seasonal demand
is going to be. I think for the first time refineries are
looking seriously hard, as was alluded to earlier, about
maximizing more diesel.
Truckers are pretty smart when they know about efficiency.
Diesels run a lot more efficient. Otherwise we'd be running
gasoline-powered tractor-trailers, but we're not. As this trend
goes, if the profitability, I mean, the crack spread with
distillates is going to remain very high, the refiners will
switch the refining over time, but it takes a huge amount of
time and a huge amount of capital investment in order to do
that. The crackers like $400 million for a refinery or a coker.
The Chairman. Thank you very much. I think it's been useful
testimony. We will try to sort through it and figure if there
are any initiatives we can pursue in this committee. Thank you
very much.
[Whereupon, at 11:47 a.m. the hearing was adjourned.]
[The following statement was received for the record.]
Statement of Victor J. Cino, President, Pyramid Oil Marketing
I. The Clinton and Bush Administration have allowed mergers
of oil companies in the last ten years which have decreased
dramatically competition in the United States.
Crude oil price began to rise dramatically after four
critical mergers of major oil producers, two during the Clinton
Administration, and two more during the Bush presidency. In
1998, BP merged with Amoco. In 1999, Exxon merged with Mobil.
In 2001, Chevron acquired Texaco, and in 2002, Conoco Inc.
merged with Phillips Petroleum. All these mergers reduced the
number of competitive oil producers in the marketplace. Less
competition led to an easier path to higher crude oil prices.
II. The major oil companies utilized tragic events to foster
fear that oil supplies would be disrupted and allowed them to
increase prices at will, regardless of ample world supply.
The major oil companies benefited enormously from
devastating and tragic events which hit the United States, and
which made it easier for them to increase crude oil prices: 9/
11; the Iraq War, and Katrina. The average price of oil in 2001
was $17 per barrel, but after 9/11, the average price of crude
oil in 2002 went to $24 per barrel. Larger hikes in crude oil
occurred in 2003 and 2004 after the Bush Administration went to
war against Iraq. Crude prices shot up to $27 per barrel in
2003 and $36 in 2004, doubling the price of a barrel of oil in
just three years.
The Iraq War kept prices climbing into the summer of 2005.
The price of oil continued its rise above $40 per barrel. Then
in the fall of that year, Hurricane Katrina devastated New
Orleans, disrupted for a few days, Colonial Pipeline supply
heading to the Northeast, shut down, for about two weeks, 20%
of refinery production in the Gulf of Mexico, and cut off
supply temporarily to the West Coast. Crude oil and gasoline
prices soared even though the Northeast and the West coast
possessed enough above ground stocks of crude and gasoline
supply to last 45 days.
The media mistakenly suggested then that there would be
major long term supply disruptions resulting from Katrina, and
so the average price of crude oil in 2005 shot up even higher
to $50 per barrel. But even though oil and gasoline supply
began to flow normally within three weeks, crude oil remained
at $50, and oil prices never retreated after Katrina.
Fed by doom and gloom news over oil supply by an
overzealous national media aching for shock news, and an oil
industry which continued to feed misinformation to the American
public. Oil commodity traders began to hike up the value of
crude futures, and thus the average price of oil artificially
rose again in 2006 to $56 per barrel, doubling the price of oil
from its average price in 2003.
Oil traders have played an important role in driving up the
price of oil since they have recognized that the major oil
companies no longer have any restrictions on its ability to
raise prices here in the United States and elsewhere.
III. Major oil companies have a national influence on the
media, the Executive branch of the U.S. government as well as
the Congress.
Historically, major oil companies have effectively
influenced the national media by releasing information
conducive to generating fear that oil supply disruptions could
occur. This year is no different. A few months ago it was
Kurdish rebel attacks coming out of Iraq and into Turkey that
would disrupt oil supply. This past week oil strikes in
Scotland and Nigeria allowed Traders to hike up oil prices by
purchasing oil futures on that news, and oil companies
predictably followed suit and did just that, jumping to an
incredible $120 per barrel. On Tuesday, April 29, a New York
Times article claimed that oil supply was not keeping up with
rapidly rising global demand and ``the outlook for oil signaled
an unprecedented scarcity of oil.''
That statement can be no further from the truth as
evidenced by the historical twenty five year ability of the oil
industry to meet demand world wide crude oil, gasoline and
distillates.
The argument that major third world countries are
increasing demand so rapidly that oil supply cannot keep up
with demand is absolutely false and is not based on the
historical data. There is more than ample supply worldwide to
meet oil demand. The argument is being used by oil
propagandists to help drive up the price of oil worldwide.
The growing economies of China and India would push global
energy demand for crude oil in the year 2030 beyond the limits
of oil producers to supply. The New York Times reported just a
few months ago, but the truth is that oil demand from these two
major economies is barely making a ripple in the ability of the
oil industry and OPEC to supply world needs.
The price of crude oil also keeps rising because of the
political and financial influence of the major oil companies on
the Congress and the Bush Administration. Large amounts of
political contributions have created enormous oil industry
influence in Washington for politicians to stand on the side of
big oil and do nothing about rising crude oil prices. The
president is from an oil state and his family has strong ties
with the Saudis. His administration, consequently, will do
nothing to discourage higher crude oil prices.
IV. There is a general apathy on the part of governments and
consumers when faced with rising oil prices because the major
oil companies have too much strength and financial clout to
fight, and now with recent mergers and huge profits, they are
more formidable.
Oil and gasoline consumers have demonstrated a distinct
indifference to the rising prices of crude oil. It is an apathy
based on consumers' essential resignation to the idea that we
can do nothing about rising oil prices because of the
overwhelming power and financial strength of major oil company
producers and oil producing nations.
Given these reasons why crude oil prices are so high, where
should the price be? I think the price of a barrel of crude oil
today should be close to $50, the price a barrel of crude oil
just after Hurricane Katrina hit New Orleans. This price takes
into consideration all three major events which adversely
affected crude oil prices, and were the events most responsible
for a doubling of price from year 2000 when a barrel of crude
was $23.
V. Why the price of crude oil is close to $120 per barrel.
Oil price increases have been artificially induced to rise by
major oil producers, OPEC, oil lobbyists and media friends of
big oil. Historical data suggests that crude oil supply has met
demand easily.
In the past ten years, worldwide oil demand increased by
12.7 million barrels per day, from 73.3 million barrels per day
(mbd) in 1997 to 86 mbd in 2007, but oil producers easily met
that additional demand, producing as much crude oil as demand
required.
In fact, except for a few short term disruptions to the
supply of crude oil, producers have met crude oil demand
worldwide for the past thirty years, and have shown during this
period how sophisticated and efficiently balanced the system of
oil supply and demand has worked, almost to perfection
That stated, there is no viable reason for the current
price of crude oil to be hovering at $120 per barrel.
Therefore, one must conclude that the current price of crude
oil has been artificially induced by the fear of short supply
as a result of the three major events that shook the world, and
which have provided the major impetus and opportunity for world
oil producers to continue to raise prices of crude oil
unchecked since 2005.
With an existing balance of supply and demand prevalent,
there is no other reasonable explanation as to why oil rose
almost 400% from its level of $23 per barrel in year1999 to
almost $120, except that the control of oil by the major oil
producing countries and big oil, have trumped the law of supply
and demand. What can we expect in the near future?
VI. New discoveries of crude oil are clearly demonstrating
the world's ability to meet crude oil demand and the record of
discovery proves that. It is nonsense for anyone to think that
we are running out of oil or in short supply, even for the
short term.
I think the discovery of new oil reserves and increased
production of oil in African countries, Canada and elsewhere,
as well as the development of new technology for extracting oil
from the ground, combined with an expected global economic
slowdown, will create the conditions for lower oil prices over
the next five years.
Angola, with eight billion barrels of proven reserves, is
already producing 1.4 million barrels per day, and while Sudan
produced a nominal 380,000 barrels per day, that figure is
expected to climb dramatically. Chad produced approximately
157,000 barrels per day. More oil producers in the marketplace
translates to more competition and lower prices.
Also, the world is finding more oil. Proven crude oil
reserves are increasing yearly. Canada is now extracting oil
from sand and shale. The U.S. Energy Information Administration
asserts that Canada's proven oil reserves exceed 176 billion
barrels. Its market for this secure source of oil is the U.S.
More oil availability means lower prices.
By contrast, Iraq boasts 115 billion barrels of crude
reserves, Iran has 136 billion barrels, and Saudi Arabia,
weighs in at 262 billion barrels. There is no doubt that the
Saudis can increase oil production at the turn of a spigot, and
since the U.S. is prepared to defend Saudi Arabia in an
overheated Middle East, it can aid the U.S. by cranking out
more oil.
VII. Current levels of proven crude oil reserves worldwide
are more than ample to meet crude oil demand for thirty to
fifty years.
Total proven crude reserves worldwide stand at an
incredible 1.31 trillion barrels. Can anyone seriously believe
then that these countries will not be able to meet any kind of
increased oil demand for the next fifty years, given the
extraordinary amount of oil reserves they have available? The
question still remains, however, at what price?
VII. The major oil companies have shifted their refinery
production from gasoline to distillates because the refiner
gross profit on diesel and other distillate products have risen
dramatically to 61 cents per gallon , while the refiner gross
profit on gasoline is now just 20 cents per gallon.
United States fuel oil needs are primarily based on the use
of consumer and industry demand for gasoline, while economies
overseas in Europe, China and India rely more heavily on crude
oil. Since the major oil companies are making more money on
distillates, they have shifted refinery production to
distillates and shipping this product overseas where they can
make 61 cents per gallon on diesel, for example.
Consequently, there has been less buildup of gasoline
inventory from this shift in refinery production in the United
States which would have driven down the price of gasoline as a
result of current declining demand resulting from a slowing of
the economy.
VII. What can our government do to halt the rising of oil
prices in the marketplace when traditional laws of supply and
demand are being trumped by the tragic and serious manipulation
how then can we as consumers become a factor in reducing oil
prices? What can we really do to thwart this seemingly
unstoppable rise in oil prices?
A. The government must immediately step in. as
President Nixon did in the early 70s and impose price
controls on the entire oil industry, particularly where
it affects United States consumers: at the refinery
gross profit level and at the gasoline pump.
B. Immediately demand the oil companies to begin
using their huge profits and vast resources to begin
constructing four and perhaps five refineries in
strategic locations throughout the United States.
Refineries will assist in production dramatically,
lessen the impact of shocks to the flow of oil and
gasoline into the economy, and make us more
independent.
C. Consider the breakup of recent oil mergers
mentioned earlier which have caused a complete lack of
oil competition and helped contribute to rising oil
prices and a downtown turn in the United States
economy. For the long term we can encourage Washington
to provide funding for the research and development of
hydrogen fuel cells which can replace fossil fuel as a
source of energy.
D. We can take seriously the role of renewable energy
in meeting our energy needs by demonstrating a serious
attitude to increasing the use of soft energy: solar,
biomass, that is, wood, landfill gas and ethanol, for
example, hydroelectric energy and wind energy. We can
express that attitude in a major effort to change our
energy sources. Soft energy accounts for 7% of our
total energy sources. We need to double that amount in
the next five years and oil prices will drop
accordingly.
E. We can think conservation by purchasing hybrid
automobiles. We can take public transportation in big
cities. We can turn off the lights at home and at the
office. We can turn down the thermostats at home, We
can ride bikes and walk instead of drive. Above all, we
need to think about cutting back on our energy usage.
If all these efforts come into play, the price of oil
will be declining and not rising.
F. The United States Senate needs to take a serious
look at commodity traders activities to determine if
there has been any manipulation of oil commodities
which have driven up the price of crude oil.
APPENDIX
Responses to Additional Questions
----------
Responses of Jeffrey Harris to Questions From Senator Bingaman
Question 1. Do you disagree that increased market participation of
institutional investors and increased volatility of oil prices are
correlated?
Answer. The Commodity Futures Trading Commission (CFTC) Office of
the Chief Economist (OCE) agrees that market volatility can be affected
by different traders in the futures markets. We monitor and measure
volatility in a number of ways. These include volatility measures using
daily and intraday prices from futures markets as well as implied
volatility measures computed from prices in markets for options on
futures. Generally speaking, we find that volatility in the NYMEX WTI
Crude Oil contract has been relatively stable over the past five years,
by each of these measures. While oil prices have been rising, the
variability of price changes (volatility) on a daily or intradaily
basis has not been rising concurrently.
To examine the question of the role and impact of speculative
activity in price changes from a year ago, OCE has closely tracked
changes in speculative positions to determine if those changes have
played a role in pushing prices upwards. We have done this multiple
times for various time periods. We have not found a consistent
relationship between the positions that speculators take and subsequent
price moves, but we continue to closely monitor and test the data.
Question 2. I am hoping you can further explain the CFTC's position
on the role of institutional investors on oil prices. We had Guy Caruso
testify before this committee last month that more than 10% of today's
oil prices are likely the result of speculation. On Tuesday, we heard
the major oil companies testify before the House Committee on Energy
Independence and Global Warming that speculation is an important factor
in today's high prices. The other five witnesses on this panel make
compelling cases that institutional investors are playing a key role in
determining the oil price. Your organization seems to be the lone voice
arguing that increased market participants investing in commodities
does not affect the price of those commodities.
Answer. At the CFTC, we are very aware of the increase in the price
of crude oil and its impact on Americans. We have also heard the
statement by some that speculators are the cause of this increase and
our analysis has looked very closely to try to find evidence of that.
It is true that all futures market participants impact the overall
prices of a commodity--that is the very essence of the markets. We are
rigorously analyzing the markets daily to discover what is driving
these high prices.
Using some of the most comprehensive data available to market
regulators anywhere in the world, OCE has closely examined the buying
and selling behavior of every group of market participants in crude oil
futures markets. Based on our analysis of this data, to date, CFTC
staff economic analysis indicates that broad-based speculative or
manipulative forces are not driving the recent higher futures prices in
commodities across-the-board.
Because our comprehensive data set allows the OCE to know what
groups of traders are buying and selling each day and we know how
prices change each day, many of our tests examine the relations among
position changes by various trading groups, including managed money
traders (this category includes hedge funds) and swap dealers (who
bring the growing investments of commodity index funds to our markets).
OCE has analyzed the behavior of these different trading groups in the
crude oil markets over numerous time periods to see whether their buy
and sell activities induce daily price changes in the market. The only
consistent outcome from these analyses has been that speculative
traders appear to react to price changes--that is, speculative traders
will be net buyers in the market on the day following price increases
and net sellers in the market on the day following price declines.
We consistently find that crude oil price changes are related only
to trading arising from groups within our commercial categories (which
include producers, manufacturers, and others). On days when groups of
commercial traders are net buyers in the market, subsequent prices
increase and when these traders are net sellers, prices subsequently
fall. We consider this evidence that markets are functioning properly.
Comparing the various participant categories, commercial traders are
the most likely to consistently have information about the fundamental
value of oil.
Question 3. Does the CFTC believe that other commodities are
similarly unaffected by increased investment? For instance, does the
CFTC maintain that the price of gold and agricultural commodities is
affected only by supply and demand for the physical products?
Answer. Generally speaking, the answer is yes. Based on our
analysis, OCE believes that futures markets are generally reflecting
supply and demand conditions for the physical products. The fundamental
supply and demand conditions in many agricultural markets are very
tight, and in many of these markets we have seen very high prices.
Ethanol has increased demand for corn. The USDA projects that
approximately 30 percent of the current year's corn crop will be used
to produce ethanol. This demand increase has, by all accounts, resulted
in higher corn prices. In addition, this demand increase is having
ripple effects. Land diverted to corn tightens the available supply for
other crops, raising the prices for those crops as well as inducing
higher dairy and livestock prices because of the increased costs of
feed. Poor growing conditions around the world, most especially two
successive years of drought in Australia, have reduced wheat supplies.
World demand for agricultural commodities continues to be very strong,
even in the face of high prices. In addition, other fundamentals such
as a weak dollar and increased demand from around the world has
impacted the markets.
Question 4. According to EIA, the fundamental supply-demand balance
cannot explain more than $90 of the current price of a barrel of oil.
How would CFTC explain the difference between that price and today's
$100+ market prices? Does CFTC feel that it has a more thorough
understanding of oil market fundamentals than EIA?
Answer. We are very aware of the increase in the price of crude oil
and its impact on Americans. We have also heard the statement by some
that speculators are the cause of this increase and our analysis has
looked very closely to try to find evidence of that. To date, OCE has
not seen any analyses or data that point to a particular target price
for oil. As you know, the CFTC is not a price-setting agency nor do we
predict prices for commodities, rather the CFTC's mission is to oversee
and regulate the trading of commodity futures and options in the U.S.--
in which price discovery occurs--and accordingly, our expertise is in
this area.
OCE believes the data we collect on a daily basis is adequate for
supervising the futures markets and oil trading done on those markets.
We have comprehensive and detailed data on various groups of
speculators and, based on the buying and selling of these traders, our
analysis shows little evidence that changes in speculative positions
are systematically driving up crude oil prices.
Question 5. Please describe to us the means by which the CFTC goes
about educating itself on oil market issues. How many staff positions
are dedicated to oil market issues? Does CFTC regularly engage either
EIA or private oil market analysts as it seeks to better understand oil
markets?
Answer. The CFTC is organized into Divisions with specific areas of
expertise, including the Office of the Chief Economist, the Division of
Market Oversight, the Division of Clearing and Intermediary Oversight,
the Office of the General Counsel, and the Division of Enforcement.
The Commission program that is most directly involved in oil market
issues is the Division of Market Oversight (DMO) surveillance program.
Four economists are assigned to the oil complex as part of their
surveillance responsibilities. (In addition, supervisors and support
staff also work on assignments that involve the oil complex.) These
market surveillance professionals closely and continuously monitor
trading activity in the petroleum futures markets in order to detect
and prevent instances of possible price manipulation. Surveillance
staff members receive daily reports identifying all large long and
short positions in NYMEX petroleum futures and options-on-futures
markets. Using these reports, Commission economists monitor trading in
the petroleum markets, looking for large positions and trading activity
that reveal attempts to manipulate petroleum prices. In addition, our
analysts monitor prices and price relationships, looking for price
distortions evidencing manipulation. They also maintain close awareness
of supply and demand factors and other developments in the petroleum
markets through review of trade publications, and through industry and
exchange contacts. CFTC surveillance staff routinely reports to the
Commission on surveillance activities at weekly market surveillance
meetings, including information about market fundamentals and
monitoring of trading activity throughout the markets. In addition,
surveillance staff, who continually monitor the markets for potential
problems, will immediately alert the Commission and senior staff
whenever there are significant, time-sensitive developments in the
markets. Staff of the Energy Information Administration (EIA) has
attended these surveillance meetings on several occasions. DMO also
consults with relevant government agencies (such as EIA in the case of
energy products), commercial participants (such as oil producers,
consumers and marketers), and independent analysts and information
providers (such as Platts or OPIS in the case of energy products).
In addition, the Division of Enforcement (DOE) has a successful
history of investigating and prosecuting energy cases. It currently has
more than a dozen ongoing crude oil manipulation investigations. In the
process of investigating energy cases, DOE trains its professionals on
the various nuances of the market. Furthermore, in certain situations,
DOE hires professional experts to assist in fully exploring both
physical and derivative trading issues.
In the other Divisions, staff work on a range of different market
issues, including issues involving crude oil. Generally speaking, the
CFTC employs a number of economists, surveillance experts, attorneys,
enforcement investigators, and IT professionals who collectively work
on crude oil market issues such as surveillance, new product approval,
financial integrity, data gathering and analysis, and enforcement.
Question 6. If CFTC believes that oil markets tightness alone
justifies the current $100+ oil price, I would think that your
organization must also believe that removing 70 thousand barrels per
day from the market to add to the Strategic Petroleum Reserve is adding
to upward price pressure. Could you tell us how much your organization
believes the SPR fill is adding to the price of oil?
Answer. Commission staff has not undertaken an analysis of the
effect on the cash market for crude oil of removing 70 thousand barrels
per day from crude supplies. The Commission's exclusive jurisdiction
and thus the primary focus of its regulatory activities centers on the
trading of commodity futures and options, rather than the physical
market. The CFTC's mission is two-fold: to protect the public and
market users from manipulation, fraud, and abusive practices; and to
ensure open, competitive and financially sound markets for commodity
futures and options. As part of our efforts to prevent manipulation, we
monitor cash market information as part of our ongoing surveillance of
futures markets, such as the NYMEX crude oil futures market. As a
starting point for cash market information on crude oil, we typically
look to the EIA.
Question 7. It is my understanding that your organization has
concluded that there is no relationship between increased market
participation and increasingly volatile oil prices because you have not
found a statistically-verified causal relationship. It strikes me that
causality is very difficult to prove with statistics, and I suspect
that no single variable could pass that test at the moment. Have you
run similar kinds of statistical analyses on other single variables
influencing oil prices--such as OPEC production decisions, or inventory
levels--and compared the results?
Answer. While I agree that statistically-verifiable causal
relations can often be difficult to demonstrate, I am confident that
OCE's analysis is rigorous. Noisy data and small data sets often lead
to low power tests--the idea that a test may not be able to uncover a
relation that actually exists, for example. As I have noted, however,
our tests have uncovered statistically verified relations between
groups of commercial traders and price changes, suggesting to me that
our analysis is thorough and accurate. We have also taken steps to
ensure our conclusions are rigorous, measuring positions of various
combined groups (all non-commercial participants lumped together, for
instance) and measuring the relation between speculative positions and
price changes over different time periods (ranging from the late 1990s
through the present) and over various futures contracts (examining
positions in the nearby contract alone, positions in the nearby
contract and the next month contract combined, etc.).
The CFTC's mission is to oversee and regulate the trading of
commodity futures and options in the U.S., and as such our focus and
expertise is in that area. While we monitor inventory levels, spot
market developments and other macroeconomic factors, our analysis has
not included a similarly rigorous look at macroeconomic data.
Question 8. Does your organization believe that it has sufficient
oversight and regulatory authority to fully understand oil market
trading activity? Can you have a complete picture of the market without
data on trade in over-the-counter markets?
Answer. As stated in testimony approved by the Commission and given
before the Senate Homeland Security and Governmental Affairs Committee
on May 20, 2008, ``The Commission has the authority it needs to
continue to work to promote competition and innovation, while at the
same time, fulfilling our mandate under the Commodity Exchange Act to
protect the public interest and to enhance the integrity of U.S.
futures markets.''
There are amendments to the CEA that are now part of the Farm Bill
conference report that largely reflect the Commission's recommendations
on the need for some additional tools to oversee trading done on Exempt
Commercial Markets, as well as the imposition of self-regulatory
obligations on these markets. These provisions represent bipartisan
efforts to find the right balance of enhanced market oversight and
transparency while promoting market innovation and competition.
Additionally, the Commission's anti-fraud authority over the
transactions on these markets will be clarified and strengthened.
Finally, the penalties that may be imposed for violating the anti-
manipulation prohibitions of the CEA will be raised from $100,000 to
$1,000,000 per violation. The Commission strongly supports this
legislation that would give it additional necessary oversight of the
markets, particularly energy trading.
The central focus of the Commission's oversight of oil market
trading activity is, by mandate of the Commodity Exchange Act (CEA),
futures trading activity in oil-related contracts on CFTC-regulated
exchanges. The Commission does not have any direct regulatory authority
over domestic or foreign oil cash markets, bilateral OTC oil
derivatives transactions or oil futures contracts traded on foreign
boards of trade.
The CFTC's ability to monitor oil futures contracts traded on CFTC-
regulated markets, such as NYMEX's benchmark West Texas Intermediate
(WTI) crude oil futures contract, is extremely robust. Traders with
positions in regulated exchange contracts like the WTI contract are
subject to a daily reporting requirement when their positions exceed a
Commission-set ``large'' position threshold. Large trader position
reporting enables CFTC staff to detect whether such traders may be
engaging in manipulative conduct. Current position reporting thresholds
ensure that about 85-90% of the outstanding open interest in any
contract is subject to reporting. When the CFTC's surveillance staff
finds that a trader's market behavior is troublesome, it has a number
of available powers to correct the condition, including the forced
liquidation of the trader's position.
In addition to large trader position reports, the Commission also
receives daily transaction data from all of its regulated exchanges.
This data provides a complete audit trail of all trades that occur in
the contracts listed on those exchanges. The CFTC's surveillance staff
uses this data to closely scrutinize trading activity, especially
during key trading periods such as the final trading day of a contract.
Of course, with respect to oil products traded on CFTC-regulated
exchanges such as NYMEX, the exchanges themselves have independent
obligations, under Section 5 of the CEA, to actively monitor their
contracts for manipulation and other abusive conduct and to takes steps
to prevent such behavior. Given their mutual obligations and interests
in this area, staff of the Commission and the exchanges traditionally
work very closely together and buttress each other's efforts in
deterring and detecting problematic conduct.
Although the Commission does not have any direct regulatory
authority over domestic or foreign oil cash markets, bilateral OTC oil
derivatives transactions or oil futures contracts on foreign boards of
trade, it does have tools that enable it to see a wide swath of
activity in these markets. For instance, many bilateral OTC oil
derivatives transactions are executed through voice brokers and brought
to NYMEX's Clearport facility for clearing. Because all positions
cleared through Clearport are subject to the Commission's large trader
reporting requirements, the CFTC has a significant insight into who is
holding large OTC oil derivatives positions at any one time.
The Commission is likewise able to learn information about activity
off of its regulated markets by virtue of the requirement that traders
who are subject to the large trader reporting requirement in an
exchange-listed futures contract, like the NYMEX WTI contract, must
make available to the Commission, upon request, any pertinent
information with respect to all other positions and transactions in the
commodity in which the trader has a reportable position. This
information can include, for instance, the trader's positions on other
reporting markets, OTC positions held pursuant to any of the CEA's
exemptive or excluding provisions, positions held on exempt commercial
markets or exempt boards of trade, and positions held on foreign boards
of trade.
To the extent that a Foreign Board of Trade (FBOT) with direct
access to US-based members lists any contract that settles off of the
settlement price of a contract listed on a CFTC-regulated exchange, the
Commission's policy has been to establish information-sharing
arrangements with that FBOT or its regulator to gain position
information about the linked contract. For example, ICE Futures Europe
trades a WTI crude oil futures contract that settles off the benchmark
NYMEX WTI contract. Accordingly, the CFTC has an information--sharing
arrangement with the UK's Financial Services Authority (FSA) so that
CFTC staff receives on a weekly basis position reports for the ICE
Futures Europe WTI crude oil futures contract. During the last week of
trading, the position data is reported on a daily basis. With this
information, CFTC surveillance staff knows the positions and identities
of members/customers who meet or exceed position-reporting requirement
levels in the ICE Futures Europe WTI contract, and considers that data
along with the large trader reporting information that it receives from
NYMEX for its WTI contract.
Question 9. Could you comment on whether the reporting requirements
for the NYMEX could offer a competitive advantage to trading platforms
that are not similarly regulated--such as foreign exchanges, or over-
the-counter markets?
Answer. There is no indication that the reporting requirements for
NYMEX offer a competitive advantage to trading platforms that are not
similarly regulated. Reporting requirements are a necessary component
of a good market surveillance program and are designed to prevent such
problems as manipulation and artificial pricing. In October 2007, the
Commission amended its Rule 18.05 to make explicit that ``reportable
traders'' in the regulated futures markets must disclose all their OTC
positions, as well as their cash market and forward market positions,
in response to a request from the Commission. See Maintenance of Books,
Records and Reports by Traders, 72 Fed. Reg. 60767 (October 26, 2007).
In doing so, the Commission asserted that it was highly speculative to
conclude, and very unlikely, that market participants would move their
trading activity to unregulated or non-transparent venues, or trade at
a level below the reportable level on the regulated exchange, in order
to avoid the consequences of holding positions that were reportable to
the CFTC. The Commission also noted that as traders in the OTC markets
have become more aware of credit considerations and the benefits of
transparency, they have been moving their positions onto exchanges
where the exchange clearinghouse enhances creditworthiness, the market
is transparent and reporting requirements are in place. Finally, it
should be noted that some FBOTs, including ICE Futures Europe (which is
regulated by the FSA), also impose position reporting requirements.
Therefore, we believe that it would be highly unlikely that a trader
would elect to trade a futures contract on ICE Futures Europe rather
than on NYMEX solely because of reporting requirements.
Responses of Jeffrey Harris to Questions From Senator Domenici
Question 1. In your testimony, there are several charts that
reference trading on the New York Mercantile Exchange. Do you have any
information or data on transactions occurring on the Intercontinental
Exchange?
Answer. Yes. Although the CEA does not currently provide for direct
CFTC regulatory oversight over activity on exempt commercial markets
(ECMs), such as the Intercontinental Exchange of Atlanta (ICE), the
CFTC does have the ability to collect considerable information
regarding trading activity on these markets.
Under CFTC Rule 36.3, ECMs are required to provide the CFTC with
transaction data for those contracts that average five or more trades
per day. This required data is essentially a contract's trade register
reflecting the specifics of each trade executed in the contract,
including the quantity, price and execution time for each transaction.
This data must be provided to the CFTC by way of a weekly report
reflecting the daily trading registers for the preceding week. CFTC
staff currently receives trade register data for a number of contracts
traded at ICE, as well as for contracts at other ECMs.
In addition, the CEA provides the Commission with the authority to
issue special calls to ECMs for certain purposes, including obtaining
data that it deems necessary to enforce the anti-manipulation
prohibition applicable to ECM transactions. In the case of ICE, the
CFTC's Division of Market Oversight has issued three special calls
requiring ICE to provide ongoing information related to its cleared
natural gas swap contracts that are cash-settled based on the NYMEX
physical delivery natural gas contract. In each case, the information
requested has been analogous to information that the CFTC receives from
regulated futures exchanges, including NYMEX.
As noted above, Congress recently approved the Farm Bill conference
report which contains, among other things, legislative provisions
recommended by the Commission to require large trader position
reporting for significant price discovery contracts on ECMs, require
ECMs to adopt position limits or accountability levels for such
contracts, impose self-regulatory responsibilities on ECMs with respect
to significant price discovery contracts and establish CFTC emergency
authority over these contracts. We are hopeful that this legislation is
enacted soon to give CFTC these additional and necessary authorities.
Question 2. To what extent does different regulatory treatment of
the U.S. futures exchange as compared to the over the counter market,
contribute to higher crude oil prices?
Answer. The CFTC Office of the Chief Economist (OCE) analyzes some
of the most comprehensive data available on trading in futures markets.
Although there exists a large and robust market for over-the-counter
trading in crude oil, the growing volume of trading on NYMEX suggests
that U.S. futures exchanges are successfully offering contracts that
are attractive to the marketplace. We find little evidence that changes
in speculative positions are systematically driving up crude oil prices
in these markets. Increased trading activity usually indicates a good
level of liquidity in the marketplace. In turn, greater liquidity
usually reflects more accurate prices. The OCE has no evidence that
different regulatory treatment of exchange-traded futures contracts and
OTC contracts leads to higher prices. Indeed, the U.S. regulatory
structure in this area has remained largely unchanged during the past
decade and yet oil prices have gone up, down and remained steady at
various time during this period.
Question 3. Can you quantify the number of commercial versus non-
commercial investors in the trading of oil contracts?
Answer. Yes, the Commission receives daily reports on all large
traders in all regulated futures markets. For the NYMEX WTI Crude Oil
futures contract, these reports account for about 97 percent of the
long open interest and 96 percent of the short open interest. On April
22, 2008, there were 299 non-commercial traders in this market, who
held 40 percent of the long and 35 percent of the short open interest,
respectively. On this same date, there were 123 commercial traders, who
held 58 percent of the long and 62 percent of the short open interest,
respectively.
Question 4. he characteristics of the typical commodity investor
are changing. In your opinion, do you think this is beneficial for the
market? Why or Why not? And what impact has it had on the price of
crude oil?
Answer. Markets, in general, provide more accurate prices when
participation is high. As noted above, increased participation usually
indicates a good level of liquidity in the marketplace, which, in turn,
typically generates more accurate prices. Indeed, the increased
participation in crude oil futures markets has been a positive
development in our ability to monitor and surveil these markets. The
CFTC's Division of Market Oversight (DMO) collects data on participant
behavior precisely because we are concerned about the prospect for
manipulation and other abuses in our markets. The addition of, or
growth in, any group of market participants is closely monitored by
CFTC staff in this light. The growth in commodity index trading in
these markets has been largely mirrored by growth in commercial trading
activity as well, and we continue to see a healthy mix of commercial
and non-commercial activities in oil futures markets. Given the fact
that we find little evidence that changes in speculative positions are
systematically driving up crude oil prices in these markets, we see
benefits but do not see corresponding negative implications of this
growth.
Question 5. What type of additional regulation, or oversight, of
energy commodities trading would be the most damaging or most
beneficial, to the interests of the U.S. consumer?
Answer. Congress recently approved the Farm Bill conference report
which contains, among other things, legislative provisions recommended
by the Commission to give the agency additional regulatory and
enforcement tools necessary to continue to effectively oversee the
futures industry. Among other things, the legislation would provide the
agency with essential oversight over contracts trading on Exempt
Commercial Markets (ECMs)--a type of electronic trading facility
offering (among other things) energy derivatives products. Under
current law, ECMs are not subject to full CFTC regulatory authority.
The new legislation outlines criteria for when an ECM contract should
be considered a significant price discovery contract (SPDC) and gives
the CFTC the authority to require large trader position reporting for
SPDCs; require an ECM to adopt position limits or accountability levels
for SPDCs; require an ECM to exercise self-regulatory responsibility
over SPDCs in order to prevent manipulation (among other things);
exercise emergency authority regarding SPDC transactions. We are
hopeful that this legislation is enacted soon to give the CFTC these
additional and necessary authorities.
From my vantage point as the Commission's Chief Economist, the
futures markets are functioning as intended--to provide risk management
and price discovery for market participants. Any policy that would
adversely affect these critical functions may have unintended
consequences harmful to consumers. Competitive and open future markets
require both hedgers and speculators so that commercial interests can
hedge their commodity price risks and businesses can rely on discovered
prices to plan and commit resources as needed.
Question 6. What regulatory policies need to be implemented to
assure the competitive workings of energy derivative markets?
Answer. As discussed above, the CFTC is an independent agency with
the mandate to regulate commodity futures and option markets in the
United States. Broadly stated, the CFTC's mission is two-fold: to
protect the public and market users from manipulation, fraud, and
abusive practices; and to ensure open, competitive and financially
sound markets for commodity futures and options. The Commission
utilizes a principles-based regulatory structure. We rely on self-
regulation with rigorous federal oversight, which has a long history of
ensuring properly functioning futures markets. Nevertheless, when
abuses come to the attention of the Commission, they have been
investigated and the appropriate enforcement actions taken. The
Commission has very broad enforcement authority and during the past
seven years the Commission has brought enforcement actions against
Enron and BP, dozens of other energy companies, and more than one
hundred energy traders. A list of cases filed by the Commission in the
energy sector is attached. These cases were based on violations of the
CEA ranging from manipulation to attempted manipulation and
manipulative acts such as false price reporting.
As noted above, Congress recently approved the Farm Bill conference
report which contains, among other things, CFTC legislative provisions
recommended by the Commission to require large trader position
reporting for SPDCs on ECMs, require ECMs to adopt position limits or
accountability levels for SPDCs, impose self-regulatory
responsibilities on ECMs with respect to SPDCs, and establish CFTC
emergency authority over these contracts. We are hopeful that this
legislation is enacted soon to give CFTC these additional and necessary
authorities.
Question 7. Earlier this week the Secretary of Treasury, Henry
Paulson put forth a proposal to combine the Securities Exchange
Commission and the CFTC. Does the CFTC support or oppose this proposal?
What impact if any would this proposal have on the commodity markets?
Answer. The Commission has not issued a statement opposing or
supporting the recommendations of the Secretary of the Treasury's
``regulatory blueprint.''
CFTC Acting Chairman Walt Lukken has made the following statement
in response to the blueprint:
It is essential to examine ways to enhance the
competitiveness of U.S. financial markets and seek improvements
to the regulatory structure. Policymakers all strive for good
government solutions that protect the public, reduce
duplication and enhance competition and innovation. While I am
still studying the Blueprint's many recommendations, I applaud
Secretary Paulson and the Treasury Department for their work on
this critical undertaking and for recognizing the CFTC model of
regulation as an advantageous one.
The CFTC utilizes a flexible and risk-tailored approach to
regulation aimed at ensuring consumer protection and market
stability while encouraging innovation and competition.
Congress gave the CFTC these powers with the passage of the
Commodity Futures Modernization Act (CFMA) in 2000, which
shifted the CFTC's oversight from a rules-based approach to one
founded on principles. This prudential style is complemented by
strong enforcement against market abuse and manipulation as
evidenced by the $1 billion worth of penalties assessed by the
CFTC since the CFMA. The regulatory balance fostered by the
CFMA has enabled the futures industry to thrive and gain market
share on its global competitors with volumes on the U.S.
futures exchanges increasing over 500 percent since 2000.
During recent economic stress, these risk-management markets
have performed well in discovering prices and providing
necessary liquidity.
At this stage, it is somewhat preliminary to state what impact the
proposal could have on the commodity markets. Notably, the blueprint
recommends that the SEC adopt a principles-based regulation of
securities exchanges and clearing organizations modeled after the
CFTC's principles-based approach, before contemplating combining the
agencies.
Responses of Jeffrey Harris to Questions From Senator Tester
Question 1. Oversight is only as good as the information available
to the overseers. As the chief economist of the CFTC, do you have all
the information necessary to ensure that speculators cannot
significantly affect the price of oil, irrespective of the market it is
traded on? If not, what can we do to make sure you have all the
information you need?
Answer. As stated in testimony approved by the Commission and given
before the Senate Homeland Security and Governmental Affairs Committee
on May 20, 2008, ``The Commission has the authority it needs to
continue to work to promote competition and innovation, while at the
same time, fulfilling our mandate under the Commodity Exchange Act to
protect the public interest and to enhance the integrity of U.S.
futures markets.''
There are amendments to the CEA that are now part of the Farm Bill
conference report that largely reflect the Commission's recommendations
on the need for some additional tools to oversee trading done on Exempt
Commercial Markets, as well as the imposition of self-regulatory
obligations on these markets. These provisions represent bipartisan
efforts to find the right balance of enhanced market oversight and
transparency while promoting market innovation and competition.
Additionally, the Commission's anti-fraud authority over the
transactions on these markets will be clarified and strengthened.
Finally, the penalties that may be imposed for violating the anti-
manipulation prohibitions of the CEA will be raised from $100,000 to
$1,000,000 per violation. The Commission strongly supports this
legislation that would give it additional necessary oversight of the
markets, particularly energy trading.
The central focus of the Commission's oversight of oil market
trading activity is, by mandate of the CEA, futures trading activity in
oil-related contracts on CFTC-regulated exchanges. The Commission does
not have any direct regulatory authority over domestic or foreign oil
cash markets, bilateral OTC oil derivatives transactions or oil futures
contracts traded on foreign boards of trade.
The CFTC's ability to monitor oil futures contracts traded on CFTC-
regulated markets, such as NYMEX's benchmark WTI crude oil futures
contract, is extremely robust. Traders with positions in regulated
exchange contracts like the WTI contract are subject to a daily
reporting requirement when their positions exceed a Commission-set
``large'' position threshold. Large trader position reporting enables
CFTC staff to detect whether such traders may be engaging in
manipulative conduct. Current position reporting thresholds ensure that
about 85-90% of the outstanding open interest in any contract is
subject to reporting. When the CFTC's surveillance staff finds that a
trader's market behavior is troublesome, it has a number of available
powers to correct the condition, including the forced liquidation of
the trader's position.
In addition to large trader position reports, the Commission also
receives daily transaction data from all of its regulated exchanges.
This data provides a complete audit trail of all trades that occur in
the contracts listed on those exchanges. The CFTC's surveillance staff
uses this data to closely scrutinize trading activity, especially
during key trading periods such as the final trading day of a contract.
Of course, with respect to oil products traded on CFTC-regulated
exchanges such as NYMEX, the exchanges themselves have independent
obligations, under Section 5 of the CEA, to actively monitor their
contracts for manipulation and other abusive conduct and to takes steps
to prevent such behavior. Given their mutual obligations and interests
in this area, staff of the Commission and the exchanges traditionally
work very closely together and buttress each other's efforts in
deterring and detecting problematic conduct.
Although the Commission does not have any direct regulatory
authority over domestic or foreign oil cash markets, bilateral OTC oil
derivatives transactions or oil futures contracts on foreign boards of
trade, it does have tools that enable it to see a wide swath of
activity in these markets. For instance, many bilateral OTC oil
derivatives transactions are executed through voice brokers and brought
to NYMEX's Clearport facility for clearing. Because all positions
cleared through Clearport are subject to the Commission's large trader
reporting requirements, the CFTC has a significant insight into who is
holding large OTC oil derivatives positions at any one time.
The Commission is likewise able to learn information about activity
off of its regulated markets by virtue of the requirement that traders
who are subject to the large trader reporting requirement in an
exchange-listed futures contract, like the NYMEX WTI contract, must
make available to the Commission, upon request, any pertinent
information with respect to all other positions and transactions in the
commodity in which the trader has a reportable position. This
information can include, for instance, the trader's positions on other
reporting markets, OTC positions held pursuant to any of the CEA's
exemptive or excluding provisions, positions held on exempt commercial
markets or exempt boards of trade, and positions held on foreign boards
of trade.
To the extent that a Foreign Board of Trade (FBOT) with direct
access to US-based members lists any contract that settles off of the
settlement price of a contract listed on a CFTC-regulated exchange, the
Commission's policy has been to establish information-sharing
arrangements with that FBOT or its regulator to gain position
information about the linked contract. For example, ICE Futures Europe
trades a WTI crude oil futures contract that settles off the benchmark
NYMEX WTI contract. Accordingly, the CFTC has an information-sharing
arrangement with the UK's Financial Services Authority (FSA) so that
CFTC staff receives on a weekly basis position reports for the ICE
Futures Europe WTI crude oil futures contract. During the last week of
trading, the position data is reported on a daily basis. With this
information, CFTC surveillance staff knows the positions and identities
of members/customers who meet or exceed position-reporting requirement
levels in the ICE Futures Europe WTI contract, and considers that data
along with the large trader reporting information that it receives from
NYMEX for its WTI contract.
Question 2. Is there any practical reason that the Enron loophole
should not be closed immediately? Is there any reason that oil futures
should be exempted from any CEA requirements, irrespective of the
market they are traded on?
Answer. With respect to the first question: No. Adoption of
amendments to the CEA contained in the Farm Bill conference report,
recently approved by the House and Senate, will close what some have
referred to as the ``Enron Loophole.
With respect to the second question: Oil contracts traded on
regulated futures exchanges are subject to all the regulatory
requirements outlined in the CEA. The CFTC amendments that are part of
the Farm Bill conference report would require that any ECM contracts
that serve a significant price discovery function be subject to
regulatory requirements comparable to those that govern trades on CFTC-
regulated exchanges.
Question 3. Are there any tools or authorities that could be given
to the CFTC to better enable your organization to ensure both that the
price of oil reflects the true market signals of supply and demand, and
that there will not be a significant over investment, in the form of an
oil bubble, that could put our economy or energy security at risk? Is
your organization sufficiently capable of preventing over speculation
and future oil bubbles?
Answer. As discussed above, the CEA amendments that are part of the
Farm Bill conference report would significantly enhance Commission
oversight over the trading of significant price discovery contracts on
ECMs. The Farm Bill amendments would thereby strengthen market
surveillance, and also include separate provisions that would enhance
CFTC anti-fraud coverage and penalties.
The CFTC has several tools in place to prevent ``over
speculation.'' The Commission has utilized its authority to set limits
on the amount of speculative trading that may occur or speculative
positions that may be held in contracts for future delivery. The
speculative position limit is the maximum position, either net long or
net short, in one commodity future (or option), or in all futures (or
options) of one commodity combined, that may be held or controlled by
one person (other than a person eligible for a hedge exemption) as
prescribed by a regulated futures exchange and/or by the Commission.
In conjunction with CFTC efforts, the exchanges themselves have
independent obligations, under Section 5 of the CEA, to actively
monitor their contracts for manipulation and other abusive conduct and
to takes steps to prevent such behavior. Given their mutual obligations
and interests in this area, Commission staff and the exchanges
traditionally work very closely together and buttress each other's
efforts in deterring and detecting problematic conduct.
As part of its ongoing surveillance program, Commission staff
monitor daily large-trader reports to ensure compliance with Commission
and exchange position limits. In order to achieve the purposes of the
speculative position limits, both the Commission and exchanges treat
multiple positions on an exchange 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 10 percent or
greater financial interest. The rules are applied in a manner
calculated to aggregate related accounts.
Question 4. Do you see increased trading of oil futures following
events that may decrease the supply of oil, such as geopolitical events
or natural disasters? Do these tend to be driven by the users/producers
of oil or by the noncommercial investors? If they are driven by the
noncommercial investors, would this be considered excessive
speculation?
Increased trading in oil futures markets does indeed result from
fundamental supply and demand factors like natural disasters and
geopolitical events. As risks increase around the world, commercial
entities that rely on oil supplies extend their risk management
operations further into the future. Recent research by the CFTC's
Office of the Chief Economist highlights the fact that crude oil
futures contracts now trade out beyond 8 years, whereas the longest-
term contracts in 2000 were only 4 years in duration. Participation in
these longer-term contracts indicates that commercial traders are
looking to lock in future delivery prices in an uncertain environment.
Furthermore, in our research, non-commercial traders (including hedge
funds) were largely net sellers in contracts beyond 4 years, suggesting
that non-commercial traders are not speculating that oil prices will
rise further.
______
Responses of Kevin Book to Questions From Senator Bingaman
Question 1. Do you disagree that increased market participation of
institutional investors and increased volatility of oil prices are
correlated?
Answer. I do not dispute the positive correlation between rising
noncommercial volumes and increased volatility, but due to the nature
and motivation of noncommercial trading, I do not think the correlation
is sufficient to suggest a causal link and I would suggest that reverse
causation is possible and even likely. Traders who participate in
commodities markets are attracted to volatility. Entire classes of
institutional investors pursue ``special situations'' characterized by
risk and uncertainty as a way to diversify their funds under management
away from conventional market moves. They may be pursuing the oil
market with greater interest as a result of uncertainty and price
volatility derived from non-financial events.
Question 2. I'd like to explore your statement that many
institutional investors see the current price as evidence of the theory
that we have reached the global peak oil production capacity. This
strikes me as somewhat circular, in the sense that institutional
investors are pushing the oil price upward, and then seeing that price
increase as evidence of tight fundamentals, which then pushes the price
further upwards. Is it your sense that the institutional investors, on
balance, believe that we have reached peak oil production capacity? How
important is this perception in the current marketplace?
Answer. You are correct, Senator, that I intended to suggest a
circularity--investors responding to price signals by investing and, in
turn, perpetuating price signals--because that is the nature of the
feedback loop that can underlie market bubbles. Your questions are
extremely prescient because they get to the heart of what investors do.
Investors make money buying and selling securities, not underlying
fundamentals. Sometimes it can be more important to short-term
investors to know what the market will do next than it is to know what
the underlying fundamentals of the market are, or should be. In
investment parlance, those who argue fundamentals in the face of market
dynamics are often said to be ``fighting the tape''--because the nature
of free and open markets is that they can fall prey to mobs. I do not
believe that many of the better-educated, more-experienced investors I
serve are convinced we are at either a geological or logistical
``peak'' in global oil production, however, and many have expressed
their reticence to reposition their portfolios as if this were the
case. If more long-term, large-scale investors were convinced we had
arrived at peak oil, I would suggest that the stocks of alternative
fuels companies--ethanol producers, coal-to-liquids names, natural gas
fueling services, as well as companies with advantages in alternative
fuels, like Shell and ChevronTexaco--might have displayed tremendous
appreciation relative to the market. This has not yet occurred.
Question 3. You point out that oil is the most widely traded
commodity in the world, as evidence that the oil market is not over-
saturated. While it is certainly true that oil is the most actively
traded commodity, it is also still a small fraction of the equities
market. It seems to me that a small percentage of equities investment
moving into commodity markets is still a lot of new activity for the
commodity markets. Could you elaborate on why you believe that oil
markets are not saturated?
Answer. I offer the volume of oil trading as evidence of market
complexity, not as a comment on its saturation. My view that the oil
market is not oversaturated derives from the size of the market eight
years into the future relative to its size today--the oil market can
hold about 100 times more money than it currently does. The out years
in the market are less widely invested than contracts with nearer-term
expiry dates. My computation in preparation for the hearing was that
the open interest in NYMEX crude had an average expiration of 11.59
months. Listed equities have far greater value than commodities, but it
seems premature to conclude that wealth transfer from commodities will
continue indefinitely. At higher prices, it gets more expensive to buy
oil contracts. Selling out of stocks to generate those funds would
cause prices of those stocks to fall. Before long, those cheaper
stocks--some of which include reserves owned by investor-owned
companies--might be better investments than crude itself, and funds
flow could reverse.
Question 4. How long do you see this strong relationship between
the dollar and the price for oil remaining in tact? And, is it safe to
say that this relationship would not be as strong without the
proliferation of institutional investors in the oil market?
Answer. I believe the inverse relationship between the U.S. dollar
and oil futures is likely to continue as long as oil trades in dollars,
for reasons that have much more to do with the investment needs of oil
producers than the behaviors of non-commercial traders. Ultimately, the
currency-adjusted value of oil sales must pay the oil producer's costs
plus a reasonable return on investment. Middle-Eastern oil producers
procure services, labor and products for related and supporting sectors
of their economies in other currencies, including Euros and Pounds.
They also continue to peg their native currencies to the U.S. dollar,
not least because a large portion of their national wealth is held in
dollars and dollar-denominated instruments. A falling dollar makes it
more expensive for oil producers to produce oil and diminishes the
value of their national wealth, ultimately encouraging producers to
demand a higher price to maintain parity with expectations. I would not
conclude that institutional investors necessarily accelerate the rise
of crude vis-`-vis the dollar's fall; slower demand and a weaker
currency basket in Europe could lower producers' indifference point at
the same time that non-commercial traders sell oil futures.
Question 5. Historically, we've become accustomed to thinking of
high oil prices causing recessions. It seems that this time, we might
well be seeing a recession that--through a weak dollar and weak
financial markets--is causing high oil prices. In your opinion, would a
more healthy U.S. economy, with a stronger currency and a lower risk of
inflation, likely result in lower oil prices?
Answer. The challenge of macroeconomic analysis of oil markets is
the breadth of subject matter. I am no expert on government fiscal
policy and would be hesitant to predicate my answer on the notion that
a recession is causing high oil prices. In general, it is reasonable to
believe that healthy economies consume more oil. On the other hand, it
would be imprudent to discount the structural shift in consumer
behaviors likely in the event of a sustained recession and full
economic recovery. Drivers who feel the pinch of high prices now are
likely, based on historical precedent, to switch into higher-efficiency
cars when next they can afford to purchase them. Those cars might be on
the road 10-15 years given the high quality of today's fleet and the
policy changes to fuel economy standards enacted by this Committee. In
this case, you might see a growing economy with flat and potentially
even declining oil demand. Whether or not this would offset demand in
other regions of the world, however, remains unclear. Countries without
market prices for energy often rely on subsidies to maintain civil
order, and consumption would need to slow everywhere--a likely outcome
of a recession that spreads from the U.S. to its trade partners, not a
global recovery--for demand effects to bring prices down.
Responses of Kevin Book to Questions From Senator Domenici
Question 1. Is there any benefit to the market for allowing non-
commercial investors (speculators) to participate? Do they lead or do
they follow?
Answer. Non-commercial investors generally make transactions
cheaper. At the theoretical extreme, without non-commercial dollars,
either the buyer or seller of oil would either sign longer-term
contracts or put more money into every transaction. Longer-term
contracts would give market power to sellers in this time of scarcity
and could lead to high prices even if oil and oil products demand
slowed. Putting more money into every transaction (either because the
oil seller would need to borrow money for operations rather than
selling forward or because the oil buyer would need to put the money up
front first) would increase the cost of transactions even if interest
costs were the only factor (about a 5% surcharge at a 10% cost of
capital and the 11.59 months' average contract life, but potentially
much, much more). As to your second question, speculation of any kind
theoretically requires investors to ``lead'' because they are betting
on their expectations of the future, but many of those expectations can
be informed by past performance--rightly or wrongly--so it would be
fair to say that non-commercials both lead and follow.
Question 2. What would happen to the price for oil if the ability
of non-commercial investors to participate in the market was limited?
Answer. I would expect the price to rise somewhat, but the effect
would depend on the extent of the limits. My prior reply addresses the
range of potential price effects at the logical extreme--somewhere
between 5% cost of capital effect and perhaps a 100-fold price increase
if each barrel sold today incorporated every noncommercial dollar (both
ends of the range are unlikely). Any incremental change to the margin
requirement or participation rules might produce subtle effects that
might take anywhere from one year to eight years to play out given the
extent to which the market is invested into the future.
Question 3. Does the trading of oil derivatives benefit the
American consumer, and if so, how?
Answer. In my view, the American consumer benefits from oil
derivatives trading in two principal ways. First, refiners can buy
options for oil to hedge against price and supply disruptions. Second,
oil sellers--many of whom are publicly traded companies--earn income
from derivatives sales that pass through to common shareholders,
including American consumers.
Question 4. Some analysts see financial flows continually moving
from the stock market to commodity markets, seeking the best return at
the lowest risk. If this is an accurate characterization of the futures
market, to what extent does it raise the average price and volatility
of crude oil?
Answer. I echo the conviction that asset managers will always, in
the long run, allocate investment capital to its highest-return, risk-
adjusted use, but there are short-term limits to the merchantability of
different classes of securities, and investors who are chasing returns
in any one asset class--whether it be stocks in general, stocks of a
certain type, bonds, venture investment, real estate or commodities--
may discover that rising prices lower returns and uncertain ``exit''
windows make the commodities markets unattractive for more than a small
portion of their funds under management.
Responses of Kevin Book to Questions From Senator Tester
Question 1. Oil has become essential to our everyday lives, our
economy and our security. Should national security concerns be
considered in how oil is regulated and managed? Do you have any
concerns with oil becoming the new gold?
Answer. While I appreciate the ways in which oil and gold are
similar--as a currency-neutral repository for wealth--I do not think
the analogy holds in scale or scope. Gold has valid industrial
applications for electronic circuits, but derives its scarcity premium
from its value as a precious metal. Oil is useless to most of the world
in its raw form--only refiners of oil can typically extract value for
themselves--and it takes 420 gallons of oil to add up to a single ounce
of gold at today's prices. As a result, I would expect that most of the
world's wealthiest people will probably prefer to keep gold in the safe
deposit box and the vault, rather than oil.
Moreover, oil's importance to economic security derives from its
availability, not its scarcity. The greatest risk the U.S. economy can
suffer is a supply interruption severe enough to prevent transportation
and industrial activities from occurring. Sudden price changes are also
disruptive, but only for the short term. Over the long haul, the U.S.
economy is one of the best positioned purchasers of crude oil at any
price as long as it is available to markets. As global markets become
better supplied and better managed, U.S. wealth becomes its own form of
energy security. The best hedge against unanticipated events remains
the U.S. Strategic Petroleum Reserve, followed closely by aggressive
conservation strategies, alternative fuels programs and end-user
education.
Question 2. If speculation is found to be artificially inflating
the price of oil, what can we do to reduce this? In your opinion, is
the CFTC sufficiently capable both of regulating all markets on which
oil futures are traded to ensure speculation is not affecting the price
of oil and of acting quickly and effectively when problems arise?
Answer. The Committee rightly identified one of the ``throttles''
that control how funds flow into and out of the commodities market--the
margin requirements imposed on traders. To the extent that price levels
and volatility occasion a regulatory response, I believe existing CFTC
powers are adequate and, in the event the current language of the
Senate Farm Bill passes into law, likely to be augmented to include
reporting on positions on the Intercontinental Exchange. To your second
question, I would offer a somewhat cautionary response: the greater the
regulatory burden imposed on any market, the higher the transaction
costs associated with trading on that market. As the world continues to
globalize outside of the reach of U.S. regulation, I would urge this
Committee and its peers to be careful not to drive commerce outside the
U.S. to less-well-regulated, less free, less open markets.
______
Responses of Sean Cota to Questions From Senator Bingaman
Question 1. Do you disagree that increased market participation of
institutional investors and increased volatility of oil prices are
correlated?
Answer. Increased market participation of institutional investors
and increased volatility of oil prices are correlated. As an ever
increasing number of non-commercial investors enter the market to buy
commodities as an inflation hedge against the weak dollar, the demand
for commodities increases which results in increased volatility and
excessively high prices. The weak dollar tends to raise prices for
commodities denominated in that currency. They become relatively cheap
for non-dollar buyers and offer investors, such as hedge funds, a way
to hedge themselves from any further weakening of the U.S. Dollar.
Until the dollar appreciates against other currencies, we will continue
to see investors flock to U.S. commodities, and their continued
investment in commodities will only serve to further dislocate the cost
of energy from the very economic fundamentals to which the markets were
intended to look for direction.
Currently, there is no regulatory authority or federal law that
would limit the amount of money flowing into energy commodities from
non-commercial investors. That is why the New England Fuel Institute
(NEFI) and the Petroleum Marketers Association of America (PMAA) are
looking at possible increases in margin requirements for non-commercial
investors to pay up-front before they enter into futures contracts.
Stock market investors generally are required to keep more cash in
margin accounts (around 50%) whereas futures investors only post
margins between 5-7%.
Question 2. I understand that your operating costs are
substantially increased, and that holding inventory is much more
expensive in this high price environment. But could you explain to us
why you don't simply pass on the cost to consumers? Why does this
affect your margins so strongly?
Answer. Several reasons, some competitive, some due to the lack of
sophistication of the small businesses that make up the industry, and
some are due to the increased underwriting requirements of banks.
The retail petroleum industry marks up product on a cents per
gallon basis, not on a percentage basis. As prices have doubled or
tripled, the margins as a percentage have gone down dramatically. On a
cents per gallon margin basis, other costs have increased and retailers
are slow to recognize them. These expenses include:
Diesel and other transportation costs have risen and do not
show up until after the sales to the consumer have occurred.
The average dealer has one day supply of fuel, and these costs
appear later.
Credit limits with suppliers have not increased, yet cost
(heating oil specifically but others are similar) have gone
from around $1.00 per gallon in 2004 to around $3.50 currently.
Limits which allowed payment in 30 days are now reached in 10
days or less. This requires increased Lines of Credit with the
local banks and the corresponding increased costs.
As prices are increasing, it is taking longer for customers
to pay for the fuel, further increasing credit line requirement
needs.
Customers are running out of disposable income, and are
increasingly using their credit cards for payment. This cost is
another 10 cents per gallon which is often not accounted for in
the dealer margins. It also increases the cost of credit card
transaction fees, a major burden for petroleum marketers, as
mentioned in testimony by fellow panelist John Eichberger from
the National Association of Convenience Stores.
Wholesale prices to dealers today change as much as 3 times
per day. Dealers often deliver products at higher cost without
the corresponding increase to consumers because they do not
know what the cost is until after the sale occurs.
Dealer competition further erodes margin as dealers are
reluctant to increase prices in our very competitive
marketplace. Our segment of the energy market (retail heating
fuel and motor vehicle fuel dealers) is the only one with
direct contact with the consumer. Consumers complain, and fuel
dealers (wrongly) are reluctant to pass along the increased
costs. Finally, at a time when dealers need to rely on their
banks more, banks are more rigorous with their underwriting for
loans.
These are just some of the reasons why margins are affected, and
why the consumer will continue to see increases in costs even if and
when prices begin to stabilize.
Responses of Sean Cota to Questions From Senator Domenici
Question 1. How much of the recent $100-plus oil prices we have
been seeing can be contributed to speculation?
Answer. While there is much debate on the actual percentage or
dollar amount per barrel or per gallon that can be attributed to what I
term the ``speculative premium,'' it is clear that the numbers are
significant. This is the general consensus of a majority economic
analysts and market experts, including OPEC and major American oil
companies (as evidenced by Exxon-Mobil's statements before the House of
Representative's Select Committee on Energy Independence and Global
Warming, only days prior to my own appearance before your committee).
I've have come to the conclusion that excessive speculation on
energy commodity markets have excessively driven up the price of crude
oil (and, consequently, all refined petroleum products) without the
supply and demand fundamentals to justify the recent run-up from about
$50-60 dollars per barrel in early 2007, to over $110 today. We have
now moved beyond the previous inflation adjusted high of $104 in 1979,
but without an equivalent disruption to oil availability that was
experienced during that decade. The numbers don't add up.
However, to be able to accurately ``add up'' all of the numbers,
you must have full market transparency. Unfortunately, this is perhaps
the biggest barrier to obtaining an accurate percentage calculation of
the per barrel cost of non-commercial speculative investment in crude
oil, natural gas and other energy products. As I mentioned in my
testimony, much of the non-commercial involvement in the commodities
markets is isolated to the over-the-counter markets and foreign boards-
of-trade, which, thanks to a series of legal and administrative
loopholes, are virtually opaque. The U.S. Congress needs to work
urgently to remedy this issue and bring full transparency to all
trading environments.
Several other energy analysts and national trade ground and
consumer groups have agreed with the above and are asking for margin
increases. According to Fadel Gheit, Managing Director and Senior Oil
Analyst at Oppenheimer & Co. Inc., who testified before the Senate
Committee on Homeland Security and Governmental Affairs Permanent
Subcommittee on Investigations at the hearing entitled, ``Speculation
in the Crude Oil Market,'' stated that ``Oil prices were close to $60
in August 2007 and rose sharply to almost $100 in November 2007,
although there were no changes in world oil supply or demand. Oil price
volatility has attracted a large and growing number of speculators
seeking the highest profit in the shortest time. Volatility, however,
has an adverse impact on the oil industry because it increases
uncertainty, and distorts market fundamentals, which could result in
poor investment decisions in securing adequate reliable supply to meet
global energy demand.''
Question 2. In your testimony you mention legislation that
Congressman John Larson introduced, which would eliminate non-
commercial investors in the commodities market. Do you support this
legislation?
Answer. While NEFI and PMAA support efforts to rein in the
excessive speculation in order to level the playing field between non-
commercial and commercial players, we are still considering Congressman
Larson's (D-CT) proposal. NEFI and PMAA's goal is to minimize the role
of non-commercial investors in energy commodity markets and return the
market power back to the physical players. Congressman Larson's efforts
should be further analyzed by a bi-partisan commission or a non-
partisan agency (such as the GAO) so that Congress obtains the
necessary information to formulate effective policy solutions.
Question 3. In your testimony, you discuss regulatory gaps. What
regulatory policies do you believe need to be implemented to assure the
competitive workings of energy derivative markets, including those that
are not regulated under the Commodities Exchange Act?
Answer. First and foremost, Congress must pass the 2007 Farm Bill
(H.R. 2419) which includes a very significant amendment added by
unanimous consent in the Senate, the ``Commodity Futures Trading
Commission (CFTC) Reauthorization Act of 2008'' (Title XIII). The
legislation is an accumulation of numerous studies done by the Senate
Permanent Subcommittee on Investigations, the Presidential Working
Group on Financial Markets (PWG) and input from the CFTC's
Commissioners, energy commodity exchanges, market participants, energy
consumers and members of our coalition.
Secondly, revisit the use of the so-called, ``no-action letters,''
issued by the CFTC which allows foreign boards of trade (FBOT) to
virtually circumvent U.S. regulatory policy. NEFI and PMAA are
especially concerned that the current no-action letter process may have
opened a door to domestic exchanges and financial interests looking to
trade U.S. Commodities overseas with the intent of circumventing U.S.
federal oversight. According to Michael Greenberger, who was previously
the Director of the Division of Trading and Markets at the CFTC from
September 1997 to September 1999, the ``FBOT no action process was
initiated for exchanges that were organized and operated in foreign
countries. It was never intended for the no action process to apply
when foreign exchange obtaining no action FBOT status is bought by a
U.S. entity; operated in the U.S. with trading engines in the U.S.; and
with U.S. delivery contracts being traded on that exchange. This is now
the trading exemption the Intercontinental Exchange (ICE) based in
Atlanta, Georgia is operating with U.S. trading engines in the U.S.
while trading, inter alia, West Texas Intermediate crude oil
contracts.'' ICE is essentially regulated by the U.K. Financial
Services Authority's regulatory requirements which are generally
believed by Michael Greenberger to have lax regulatory policy as
compared to CFTC's regulation of exchanges and transactions.
Congress should revisit the use of no-action letters by the CFTC.
It should determine if legislative correction is necessary in order to
bring full transparency and accountability to FBOTs that trade U.S.
destined commodities and/or allow U.S. access to their platforms. It
should especially examine existing no-action letters to determine if
any need be withdrawn in order to preserve stability in the energy
markets and in order to protect the American consumer and the economy
at-large.
Question 4. What type of commodities trading oversight, would be
the most damaging or most beneficial, to the interests of the U.S.
Consumer?
Answer. The most beneficial type of commodities trading oversight
for the interests of the U.S. Consumer would be to restore the
authority to the CFTC before the passage of the Commodity Futures
Modernization Act (CFMA) of 2000 (Public Law 10-554). NEFI and PMAA
consider the definition of ``Enron Loophole'' to be the collective
statutes found in this law that aim to exempt energy commodities from
portions of the act and deregulate energy trading.
Of most concern are the following:
7 U.S.C. Sec. 1(a)(14) which defines energy and metals as
``exempt commodities.''
7 U.S.C. Sec. 2(d)(2), (h)(3) and (g), exempt most over-the-
counter energy derivatives trades, trading on electronic energy
commodities markets and energy swaps.
Additionally, as mentioned above, Congress should review CFTC
Regulation 140.99, setting forth the requirements for issuance of no-
action letters and other letters of exemption and interpretation.
Congress should also evaluate existing no-action letters for
withdrawal, as mentioned in the prior answer.
It is our belief that full transparency and accountability
requirements, such as those that apply to traditional markets like
NYMEX, should apply to all trading environments. What is good for NYMEX
is good for ICE, and all OTC and derivatives exchanges.
______
Responses of John Eichberger to Questions From Senator Bingaman
Question 1. Are there any panelists who disagree that increased
market participation of institutional investors and increased
volatility of oil prices are correlated?
Answer. I am not a crude oil market analyst and NACS does not focus
its research on the upstream side of the business, therefore my ability
to accurately answer this question is severely limited. I can say that
if reports are true and investors are indeed shifting their portfolios
to the commodities market to offset the risks inherent in the stock and
bond markets, this influx of capital would have an inflationary effect
on the price of those commodities. However, I am not qualified to make
a definitive cause and effect correlation regarding the actual observed
behavior of the crude oil market.
Question 2. I understand that your operating costs are
substantially increased, and that holding inventory is much more
expensive in this high price environment. But could you explain to us
why you don't simply pass on the cost to consumers? Why does this
affect your margins so strongly?
Answer. Retailers would like nothing more than to pass on to their
customers any additional costs incurred in the system. However,
competition makes this increasingly difficult. Today's consumer is
acutely aware of retail prices and aggressively shops for the best
available price.
According to a national survey of more than 1,200 individuals
conducted on behalf of NACS between December 2007 and January 2008, 73%
of consumers say that price is the most important factor when selecting
a retailer from which to buy gasoline. In addition, a sizeable portion
of consumers will inconvenience themselves to save money on gasoline:
32% will turn left across a busy intersection for 1 cent per gallon and
29% will drive 10 minutes out of their way to save 3 cents.
According to the NACS State of the Industry reporting financial
performance for 2006, motor fuel sales generated two-thirds of a
store's revenues but comprised only one-third of gross margins. Sales
of in-store items, like coffee and sandwiches, are the primary profit
center for a convenience store. To generate sufficient sales inside the
store, a convenience store must generate sufficient customer traffic.
This necessitates competitive prices at the pump. Retailers are
constantly under-pricing one another in an effort to generate greater
customer volume with the hopes of selling them more items from inside
the store.
Competitive pressures determine what price a retailer may charge
for motor fuel and still generate sufficient customer volume.
Meanwhile, costs determine a retailer's profitability at the pump. Yet
costs can be very different for every retailer and, consequently, the
motor fuel margin required to sustain a business model can likewise be
quite different. For example, one retailer may experience an increase
in wholesale costs of 10 cents per gallon while his competitor's costs
increased only 5 cents. Further, each retailer may receive deliveries
at different times of the week, thereby exposing each to different
wholesale costs (wholesale prices often change several times in one
day). Rents and lease terms for each retailer may be different, as
might the strength of their inside the store sales, each of which would
affect the break-even calculations on the motor fuel business. Each of
these variations in cost structure between competing retailers affects
their competitive positioning in the market and potentially compromises
their ability to pass through increases in cost while remaining
sufficiently competitive in motor fuels prices to attract the requisite
number of customers.
Responses of John Eichberger to Questions From Senator Domenici
Question 1. Can you explain why the price of gasoline did not track
oil prices in the last quarter of 2007? Crude oil prices increased by
$29 per barrel or the equivalent of $.69 cents a gallon but gasoline
prices have increased by $.32 cents per gallon or by half as much. Can
you explain the disconnect here, especially when we are seeing the
opposite trend since the beginning of the year, when gasoline prices
increased by a greater percentage than crude oil prices?
Answer. According to the U.S. Energy Information Administration,
the retail price of gasoline can be broken down into four components:
crude oil, taxes, refining, and distribution/marketing. The follow
chart replicates EIA's reported data:
----------------------------------------------------------------------------------------------------------------
Retail Price Crude Oil Taxes Refining Dist/Mktg
----------------------------------------------------------------------------------------------------------------
July 2007 $2.965 56.8% 13.4% 18.4% 11.4%
----------------------------------------------------------------------------------------------------------------
August 2007 $2.786 60.4% 14.3% 13.5% 11.8%
----------------------------------------------------------------------------------------------------------------
September 2007 $2.803 64.3% 14.2% 12.8% 8.6%
----------------------------------------------------------------------------------------------------------------
October 2007 $2.803 67.6% 14.2% 10.1% 8.1%
----------------------------------------------------------------------------------------------------------------
November 2007 $3.080 68.3% 13.0% 10.0% 8.7%
----------------------------------------------------------------------------------------------------------------
December 2007 $3.018 68.1% 13.2% 8.1% 10.5%
----------------------------------------------------------------------------------------------------------------
January 2008 $3.043 67.9% 13.1% 7.8% 11.1%
----------------------------------------------------------------------------------------------------------------
February 2008 $3.028 69.7% 13.2% 9.9% 7.2%
----------------------------------------------------------------------------------------------------------------
March 2008 $3.244 71.8% 12.3% 8.0% 7.9%
----------------------------------------------------------------------------------------------------------------
As can be seen, the refining sector's contribution to the retail
price of gasoline during the last half of 2007 diminished greatly while
the contribution of crude oil escalated. This was largely the reason
why retail prices remained relatively stable during this six-month
period--profitability at the refining level was diminishing.
Consequently, wholesale prices for gasoline were not tracking upwards
with crude oil because most of these raw material costs were being
absorbed at the refinery.
It is not reasonable to expect that any corporation could continue
operations while sustaining diminishing returns, especially not in the
long-term. By the beginning of 2008, the decline in the refining
sector's contribution to the retail price of gasoline stabilized.
Meanwhile, wholesale prices for gasoline began to climb at the
beginning of February. One can look at data reported by the Oil Price
Information Service for insight into what has happened thus far in
2008.
----------------------------------------------------------------------------------------------------------------
National Average
National Average National Average Retail Gross
Wholesale Price* Retail Price Margin
----------------------------------------------------------------------------------------------------------------
January 7, 2008 $2.514 $3.078 $0.096
----------------------------------------------------------------------------------------------------------------
January 14, 2008 $2.417 $3.074 $0.189
----------------------------------------------------------------------------------------------------------------
January 21, 2008 $2.327 $3.016 $0.222
----------------------------------------------------------------------------------------------------------------
January 28, 2008 $2.340 $2.983 $0.176
----------------------------------------------------------------------------------------------------------------
February 4, 2008 $2.383 $2.976 $0.126
----------------------------------------------------------------------------------------------------------------
February 11, 2008 $2.341 $2.954 $0.146
----------------------------------------------------------------------------------------------------------------
February 18, 2008 $2.444 $2.992 $0.081
----------------------------------------------------------------------------------------------------------------
February 25, 2008 $2.560 $3.112 $0.083
----------------------------------------------------------------------------------------------------------------
March 3, 2008 $2.573 $3.153 $0.111
----------------------------------------------------------------------------------------------------------------
March 10, 2008 $2.613 $3.195 $0.112
----------------------------------------------------------------------------------------------------------------
March 17, 2008 $2.682 $3.269 $0.115
----------------------------------------------------------------------------------------------------------------
March 24, 2008 $2.629 $3.257 $0.156
----------------------------------------------------------------------------------------------------------------
March 31, 2008 $2.708 $3.268 $0.090
----------------------------------------------------------------------------------------------------------------
Change: + $0.194 ChangAverage: $0.131
----------------------------------------------------------------------------------------------------------------
* OPIS Rack prices do not include taxes and freight.
The wholesale price of gasoline has increased to the same degree as
has the retail price of gasoline, although not always on the same
schedule as can be seen looking at the volatility in retailer gross
margins over the first quarter of 2008. Part of the reason for the
increased price at wholesale could be found by analyzing the trends in
EIA data which show that the refining sector's contribution to the
retail price of gasoline stopped its downward spiral in 2008, thereby
more completely transferring increases in the price of crude oil to the
wholesale price of gasoline.
It is also instructive for Congress to consider the annual cycle of
gasoline prices when considering the influences on the current market.
NACS has been tracking the retail price of gasoline on a weekly basis
since January 2000, using data reported by EIA. Analyzing this data,
one can identify certain times throughout the year during which retail
prices have historically escalated. One of these periods is February
through June, during which time the motor fuels supply transitions from
winter-specification fuel blends to summer-specification blends.
In the winter, gasoline is formulated with a higher evaporative
tendency. This makes it easier for vehicles to start in the cold winter
months. In the summer, however, these fuel formulations combine with
warmer weather to contribute to the formation of smog. Therefore, in
the summer months, the evaporative nature of gasoline (measured in
terms of Reid Vapor Pressure and expressed as volatility) must be
reduced. This requires refiners to remove additional components from
their gasoline blends, leading to fewer gallons available from each
barrel of oil and a higher cost of production.
In February, refineries begin the process of drawing down winter-
blend fuels, which typically can't be delivered to wholesale outlets
after May 1. (Some fuel blends are required weeks or months earlier,
further complicating the system.) To accommodate these deadlines,
refiners must estimate fuel needs months in advance and begin producing
the more expensive summer-grade gasoline in February. Consequently, any
unexpected increase in demand can significantly decrease the supply of
winter-grade gasoline, causing the retail price of gasoline to increase
while stocks of the more expensive summer-grade gasolines are built up.
The duration and the severity of the spring price increase has
varied over the past eight years. Between 2000 and 2006, prices
increased an average of 30-plus cents each spring from early February
to the seasonal peak. In the past two years, increases in crude oil
prices have likely contributed more to the retail price than has the
spring transition and separating the two is very difficult. However,
during the time frames in question the retail price of gasoline has
increased $0.707 in 2006 and $1.044 in 2007.
Understanding how environmental policy, such as that establishing
seasonal volatility standards, affects the production and supply of
motor fuels is important when considering the overall performance of
the market.
Question 2. In your testimony, you state that the price of crude
oil is a significant factor in the retail price of gasoline and that
consumers feel the pressure of higher gasoline prices. In your opinion
what is the key to making gasoline prices cheaper?
Answer. Regardless of external influences, economics dictates that
when supplies for any object are greater than the relative demand,
prices will decline. For years, retailers have been constant advocates
for more plentiful and fungible motor fuel supplies. NACS led the
charge to stop the further proliferation of boutique fuels because the
resulting patchwork of fuel regulations inhibited the efficient
distribution of fuels to market, thereby increasing costs. There are
several examples in which additional supplies have mitigated increasing
prices. Three such examples include:
When the fuel additive MTBE was removed from the gasoline
pool in the spring of 2006 and the reformulated gasoline
markets on the eastern seaboard had to switch to ethanol, there
was not enough supply in that particular market at that
particular time and ethanol prices spiked to more than $200 per
barrel on the spot market. An influx of Midwestern and
Brazilian ethanol offset the supply shortage and prices came
back down.
In the aftermath of Hurricanes Katrina and Rita, the
Environmental Protection Agency utilized its newly authorize
authority to waive certain regulations concerning on-road
diesel fuel. This successfully increased supplies and mitigated
price spikes, keeping America's trucks on the road.
Also in the aftermath of Hurricanes Katrina and Rita, the
rapid escalation of retail gasoline prices resulted in a
substantial increase of imported gasoline from Europe and other
locations. The surge in imports helped balance supplies with
demand and put downward pressure on retail prices.
If substantial inventories of additional crude oil were brought
onto the market, despite the non-commercial activities in the
commodities exchanges, I believe that prices would begin to withdraw
from their highs. Furthermore, if additional supplies were to have a
dampening effect on prices, it is conceivable that non-commercial
investors would begin to transfer their capital away from the crude oil
commodities market and invest in markets with more favorable economic
indicators for long-term return.
The United States Congress must consider opportunities to increase
the physical supply of transportation fuels. The Energy Independence
and Security Act of 2007 created a bold program to require the use of
36 billion gallons of renewable fuels. This is a component of the
solution, but even with revolutionary developments in the production of
these renewable fuels, petroleum-based fuels will continue to be the
primary energy source for the United States for the foreseeable future
and policies must not discount this fact.
The market will respond to additional supplies of transportation
fuels, but it will respond more quickly to additional supplies of
transportation fuels which are compatible with the existing
distribution infrastructure. The more investment required to
accommodate a new fuel product, the slower and more costly will be its
adoption by the market. Congress would do its constituents a great
service by focusing its efforts on promoting the availability of
fungible and compatible transportation fuels. This can be and should be
done concurrently with efforts to develop and market the next
generation of energy sources.
______
Responses of Sarah Emerson to Questions From Senator Bingaman
Question 1. Do you disagree that increased market participation of
institutional investors and increased volatility of oil prices are
correlated?
Answer. No, I agree that the increased market participation of
institutional investors has contributed to crude oil price strength in
the futures markets. Under a strict definition of price volatility
(frequency of price changes), I am not certain that the institutional
investors have specifically influenced volatility.
Question 2. You note that ``the physical oil market has not
discouraged or disciplined investors . . . '' I agree with this
statement, and believe that OPEC has failed to calm markets to the
maximum extent of its ability. Could you talk to us about why OPEC
might not be making a concerted effort to calm markets, as it has done
in the past?
Answer. OPEC's ability to calm markets is limited by all the other
bullish factors affecting price. With tight capacity all through the
supply chain, any disruption or event related to oil markets is
interpreted in a bullish manner. OPEC adding crude to the market to
soften prices does not have the significant impact it had back in the
1980s and 1990s when spare capacity in the supply chain made the entire
market more sensitive to supply increases. In other words, from a
supply/demand point of view, there was more downside price risk in the
past than there is today. So, for OPEC to calm the markets today they
would have to embark on a significant campaign to soften markets,
raising production significantly and discounting their prices. At this
point, there is not enough consensus in OPEC to embark on this
campaign. That lack of consensus is in part because OPEC is worried
about a recession in the US and more broadly in the rest of the world.
They don't want to add crude to the market if demand is slowing down. I
think it is clear that there are differences of opinion within OPEC as
to the optimal price level. Some countries are very concerned that the
high prices will destroy demand. Other countries with more pressing
fiscal requirements are less concerned about the long term impact on
demand and alternative fuels of high prices. The other point to keep in
mind is that the majority of OPEC crude oil is medium sour quality and
yet the growth in demand is in clean sweet transport fuels, so
additional OPEC crude does not provide a substitute for WTI which is a
light sweet crude oil. As a result, additional OPEC crude is helpful to
the degree that it can go through the sophisticated refiners of the
world to make the clean petroleum products. That's not to say
additional OPEC crude isn't helpful, it just has more of an arm's
length impact on light sweet oil prices on the futures exchanges.
Question 3. You refer to government policy as an unknown variable
that will affect future oil prices. Is it reasonable to predict that
government policy success in reducing U.S. oil demand--reaching what
Mr. Book referred to as our ``peak appetite for oil''--would lead to
downward pressure on oil prices?
Answer. To the degree that we can slow our demand growth for
transportation fuels, we would remove a significant component of global
oil demand growth (not withstanding the current slowdown in economic
growth and oil demand). Oil demand growth would be concentrated in Asia
and the Middle East. Oil prices would be weaker than if we did nothing
and our economy would be more insulated from oil prices.
Question 4. How long do you see this strong relationship between
the dollar and the price for oil remaining in tact? And, is it safe to
say that this relationship would not be as strong without the
proliferation of institutional investors in the oil market?
Answer. I do not have any idea how long this will last, but as the
Fed continues to lower interest rates and the US economy slows, it is
hard to see any reason for the dollar to strengthen, so I believe we
are stuck in the current mutually-reinforcing situation between the
weak dollar and strong oil for some time to come.
Question 5. Historically, we've become accustomed to thinking of
high oil prices causing recessions. It seems that this time, we might
well be seeing a recession that--through a weak dollar and weak
financial markets--is causing high oil prices. In your opinion, would a
more healthy U.S. economy, with a stronger currency and a lower risk of
inflation, likely result in lower oil prices?
Answer. Absolutely, we are at today's situation in part because our
economy is suffering in so many different ways. A healthy economy and a
stronger dollar might remove this investor desire to hedge against
inflation by buying commodities.
Responses of Sarah Emerson to Questions From Senator Domenici
Question 1. As you know, China is experiencing double-digit gross
domestic product growth on a consistent basis. The 2004 economic surge
in that country brought on a tangible significant rise in oil
consumption at a pace unexpected by oil producers. What impact has this
economic growth had on the price of global commodities . . .
specifically oil?
Answer. China's oil demand growth has been striking, although it
has moderated from 2004 levels. That growth coupled with China's
building and filing its own SPR has absolutely contributed to strong
demand for oil, but we have seen other periods in history when global
oil demand has grown faster than the last couple of years and prices
have not risen this high. China is a medium sized piece of the puzzle.
There are many other factors that are also contributing to the strong
oil prices.
Question 2. To what extent is the falling value of the U.S. dollar
contributing to keeping the price of crude oil high?
Answer. I believe this has been a significant factor since late
summer/early fall 2007 and continues to be a factor which keeps
institutional investors interested in commodities (inc. oil) and will
continue to do so for the foreseeable future.
Question 3. What would be the likely effects on the U.S. economy
and financial markets if the crude oil transactions took placed in a
different currency?
Answer. This would add one more layer of complexity to pricing and
given the weak dollar would most likely increase the cost of oil to
Americans because, in essence, we would have to buy euros (or Yen, etc)
to buy oil and our realized price would reflect not only the cost of
the oil but the cost of the euro. On the other hand, this would also
increase the cost of oil to everyone else in the world who has been
buying cheap dollars to buy oil. To the degree that higher costs
accelerate a slowdown in oil consumption elsewhere, oil prices might
actually drop in the global market. This could yield benefits for the
American economy. But this is a truly complicated question. Defining
the overall impact on the US economy is difficult.
Question 4. To what extent are Japan and Europe, countries with
major currencies, protected from increases in the price of oil, and is
this protection likely to result in major changes in competitiveness
that might damage the U.S. economy?
Answer. Any country, against whose currency the dollar weakens,
benefits when they buy a dollar denominated good such as oil. So, they
absolutely benefit from having currencies stronger than the dollar and
this must enhance their competitiveness. On the other hand, US exports
are cheaper and that enhances our competitiveness. Again it is
difficult to define the overall impact of stronger currencies in other
countries.
Responses of Sarah Emerson to Questions From Senator Tester
Question 1. If speculation is found to be artificially inflating
the price of oil, what can we do to reduce this? In your opinion, is
the CFTC sufficiently capable both of regulating all markets on which
oil futures are traded to ensure speculation is not affecting the price
of oil and of acting quickly and effectively when problems arise?
Answer. I do not have enough knowledge of the CFTC's activities,
structure or mandate to comment on their capabilities.
Question 2. Oil has become essential to our everyday lives, our
economy and our security. Should national security concerns be
considered in how oil is regulated and managed? Do you have any
concerns with oil becoming the new gold?
Answer. I do not equate oil with gold. Oil is a strategic commodity
that has a significant impact on the everyday lives of every American.
Gold is not. But, I do see the desire to ``hold'' oil as a hedge
against inflation as an interesting new development. I do think the
U.S. must think of oil in terms of its national economic security. This
means thinking more boldly about conservation and alternative fuels,
and it means having a more defined use of the SPR. It also means
looking more closely at how these financial markets for oil are
regulated. I believe in unregulated markets and in free and unfettered
trade, but oil is special. The oil markets need widely set boundaries
so that they do not become a hazard to the economy.
______
[Responses to the following questions were not received at
the time the hearing went to press:]
Questions for James Burkhard From Senator Bingaman
Question 1. Do you disagree that increased market participation of
institutional investors and increased volatility of oil prices are
correlated?
Question 2. How long do you see this strong relationship between
the dollar and the price for oil remaining in tact? And, is it safe to
say that this relationship would not be as strong without the
proliferation of institutional investors in the oil market?
Question 3. Historically, we've become accustomed to thinking of
high oil prices causing recessions. It seems that this time, we might
well be seeing a recession that--through a weak dollar and weak
financial markets--is causing high oil prices. In your opinion, would a
more healthy U.S. economy, with a stronger currency and a lower risk of
inflation, likely result in lower oil prices?
Questions for James Burkhard From Senator Domenici
Question 1. Is there any benefit to the market for allowing non-
commercial investors (speculators) to participate?
Question 2. Does the trading of oil derivatives benefit the
American consumer and the economy? If so, how?
Questions for James Burkhard From Senator Tester
Question 1. In your testimony, you stated that oil is becoming the
new gold. I would like to know whether commodities that are essential
to our economy and national security should be open to speculators. I
understand that they bring liquidity to the market and allow for the
reallocation of risk, however are there other mechanisms that could be
used to effectively manage the oil futures market without placing the
price of oil at the whim of speculators and hedge fund managers?
Question 2. What can be done to protect our economy and our country
from an over investment in oil? Is there a possibility of over
investment or speculation leading to an unsustainable oil bubble?
Question 3. If speculation is found to be artificially inflating
the price of oil, what can we do to reduce this? In your opinion, is
the CFTC sufficiently capable both of regulating all markets on which
oil futures are traded to ensure speculation is not affecting the price
of oil and of acting quickly and effectively when problems arise?