[Senate Hearing 110-670]
[From the U.S. Government Publishing Office]
S. Hrg. 110-670
SPECULATIVE INVESTMENT IN
ENERGY MARKETS
=======================================================================
HEARING
before the
SUBCOMMITTEE ON ENERGY
of the
COMMITTEE ON
ENERGY AND NATURAL RESOURCES
UNITED STATES SENATE
ONE HUNDRED TENTH CONGRESS
SECOND SESSION
TO
RECEIVE TESTIMONY ON RECENT ANALYSES OF THE ROLE OF SPECULATIVE
INVESTMENT IN ENERGY MARKETS
__________
SEPTEMBER 16, 2008
Printed for the use of the
Committee on Energy and Natural Resources
----------
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46-015 PDF WASHINGTON : 2008
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Washington, DC 20402-0001
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
Karen K. Billups, Republican Chief Counsel
------
Subcommittee on Energy
BYRON L. DORGAN, North Dakota, Chairman
DANIEL K. AKAKA, Hawaii LISA MURKOWSKI, Alaska
RON WYDEN, Oregon LARRY E. CRAIG, Idaho
TIM JOHNSON, South Dakota RICHARD BURR, North Carolina
MARY L. LANDRIEU, Louisiana JIM DeMINT, South Carolina
MARIA CANTWELL, Washington BOB CORKER, Tennessee
ROBERT MENENDEZ, New Jersey JEFF SESSIONS, Alabama
BERNARD SANDERS, Vermont JIM BUNNING, Kentucky
JON TESTER, Montana MEL MARTINEZ, Florida
Jeff Bingaman and Pete V. Domenici are Ex Officio Members of the
Subcommittee
C O N T E N T S
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STATEMENTS
Page
Cantwell, Hon. Maria, U.S. Senator From Washington............... 6
Craig, Hon. Larry E., U.S. Senator From Idaho.................... 10
Domenici, Hon. Pete V., U.S. Senator From New Mexico............. 7
Dorgan, Hon. Byron L., U.S. Senator From North Dakota............ 1
Eagles, Lawrence, Global Head of Commodity Research, JP Morgan
Chase, New York, NY............................................ 35
Gheit, Fadel, Managing Director and Senior Energy Analyst,
Oppenheimer & Co. Inc., New York, NY........................... 50
Harris, Jeffrey, Chief Economist, Commodity Futures Trading
Commission..................................................... 29
Masters, Michael W., Managing Member/Portfolio Manager, Masters
Capital Management, LLC, Saint Croix, VI....................... 10
McCullough, Robert F., Jr., Managing Partner, McCullough
Research, Portland, OR......................................... 16
Murkowski, Hon. Lisa, U.S. Senator From Alaska................... 3
Newsome, James, Director, CME Group, New York, NY................ 42
Salazar, Hon. Ken, U.S. Senator From Colorado.................... 9
Sanders, Hon. Bernard, U.S. Senator From Vermont................. 9
APPENDIX
Responses to additional questions................................ 71
SPECULATIVE INVESTMENT IN
ENERGY MARKETS
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TUESDAY, SEPTEMBER 16, 2008
U.S. Senate,
Subcommittee on Energy,
Committee on Energy and Natural Resources,
Washington, DC.
The subcommittee met, pursuant to notice, at 2:30 p.m. in
room SD-366, Dirksen Senate Office Building, Hon. Byron L.
Dorgan presiding.
OPENING STATEMENT OF HON. BYRON L. DORGAN, U.S. SENATOR FROM
NORTH DAKOTA
Senator Dorgan. The hearing will come to order. This is a
hearing of the Senate Energy and Natural Resources Committee,
the Subcommittee on Energy. The purpose of the hearing today is
to discuss speculative investment in energy markets.
After yesterday's news about what is happening in our
financial markets in this country it is interesting to come and
unsettling, I suppose, to come to a hearing and discuss
fundamentals, discuss supply and demand, to discuss markets and
have people analyze for us what is happening. I recall chairing
a hearing in the Commerce Committee, a couple of hearings in
the Commerce Committee with respect to Enron. I don't make a
connection to Enron in this committee hearing.
But I make a connection to the soothing words provided to
us for over a long period of time with respect of what was
happening to wholesale electricity prices on the West Coast.
Those of us who raised questions about it were told, you don't
know what you're talking about. You're nuts. This is supply and
demand. For God's sake, why don't you get educated? Get a life.
I recall chairing hearings in the Senate Commerce Committee
and Ken Lay, the CEO of Enron came to testify. Jeffrey Skilling
came to testify and at the end of what we then knew was that it
was a criminal enterprise on the West Coast, at least in part.
Dramatic manipulation occurred there. Some speculation, but
also manipulation occurred in those markets. All along the way
those of us that were concerned about that and raising issues
were told, you know what? You're way out in left field. This is
the market that's working.
Sometimes the market doesn't work so well. Sometimes people
try to pervert and manipulate the market. Sometimes speculators
break the market. There are times when markets don't work very
well. It's why we have regulators, regulatory authority.
The regulators, to me, are very much like referees. I don't
know of any other method of the allocation of goods and
services that is better than the marketplace than the free
market. It is a wonderful, wonderful mechanism to allocate
goods and services.
But there are times when it needs a referee. The referee
ought to be wearing the striped shirt and blowing a whistle to
call the fouls. When referees don't exist or when referees
exist and are willfully blind, then things break down.
Now let me talk just for a moment about this hearing. It's
interesting to me that the price of oil and gas has moved very
rapidly up and now more recently moved down about a third of
the way. We are told by some that, well, you know what? This is
supply and demand that has caused all of this.
From July to July, in a 1-year period, the price of oil and
gasoline doubled. When asked, why? The regulator says
repeatedly, not just once or twice or four times, but six or
eight times. It is the market system of supply and demand. It
is the fundamentals.
Yet there's no one in this room today who can describe to
me what has changed with respect to the fundamentals that would
cause a doubling of the price of oil and gas in that 12-month
period. No one, I'm convinced, will be able to tell us the
reason for that change. The reason I'm pretty confident that no
one will be able to tell us the reason is that we've had these
discussions and hearings and opportunities before and there's
no information that exists that describes a change in
fundamentals that justifies a doubling of the price.
Now the American people paid that price. Some industries
are on the brink of collapse as a result of that price. It
caused an enormous burden for this country's economy to see the
price double. Now begin to recede some.
There are some who say to us, you know what? We believe
it's the market working and keep your hands off it and just
stay out of the way, would you? You don't understand it. It's
complicated and you don't have the capacity to understand.
There are others of us who remember lessons we should have
learned in the past. We insist on trying to understand what has
happened. My own belief, I might say, is that I believe
relentless, unbelievable excess speculation exists in this
marketplace.
I think there is much of the market that no one can see. I
believe the regulator has testified in this room that he didn't
have the ability to see that market very clearly or very
effectively. But notwithstanding the fact he couldn't see it,
he believed that the fundamentals of supply and demand are what
was driving the market.
I profoundly disagree with that as do some others. But
we'll have a discussion today with six witnesses. Three I
think, who have one view and three who have a different view.
In some cases the views will intersect. I think it will be an
interesting hearing. I hope we will learn from this hearing.
We have a vote that will start at 3 o'clock today. So I
believe it is only one vote. It's my intention to take a very
brief recess which should take no more than about 10 minutes
for me to go to the floor to cast the vote and come right back
because I do want to proceed through this hearing.
You know, let me just say again, the reason for the concern
about this issue is oil is not like just some other issue. This
economy runs on oil. The futures market for this commodity was
established, I believe in 1936. The establishment of that even
included a proviso dealing with the issue of excess speculation
because there has always been concern about the potential of
that happening and what we should do to deal with it.
I think that this is a very, very important time for us to
try to understand what has happened. I think what happened
yesterday on Wall Street leads me to the same conclusion on a
broader basis about other issues. But this issue has plenty
impact on this country's economy, a very big impact on this
country's economy. We ought to figure out what on earth is
happening? What can we do about it? What should we do about it?
How do we set it straight?
So I want to thank all of the witnesses who have come here
today to testify from very different points of view. I will
speak more about some of the issues, the Commodity Futures
Trading Commission, among others, later today as we get into
some questioning, but I want to call on the Ranking Member,
Senator Murkowski. Then I'll call on Senator Cantwell and
Senator Domenici. I'm hoping we can have a relatively brief
opening comments and then begin with the witnesses.
Senator Murkowski.
STATEMENT OF HON. LISA MURKOWSKI, U.S. SENATOR
FROM ALASKA
Senator Murkowski. Thank you, Mr. Chairman. I appreciate
you again having this very important hearing. I thank the
witnesses for their attendance here today. You note that we
have about an evenly divided, one on one side, one on the
other.
This is what I understand, at least in the energy
committee, this is our third time that we've had an opportunity
to discuss the topic in just the past 10 months. It was back in
April, most recently. We heard from several of the experts that
said, well speculation was playing a small role, if any role,
at all.
Then we also heard from some of the witnesses who contended
that speculation was indeed a very significant factor. From a
policymaking perspective, you look at that and say, ok, we've
got conflicting viewpoints here. We need to gather more
information. We need to really figure it out.
You're back here again. Again, we've got a table that is
divided. In the past 2 weeks now, we have seen two new reports
on speculation that have been released. One concludes that
speculation played a large role in increasing the crude oil
prices. The other report does not.
I do appreciate the fact that we have the authors of those
that were involved in that report here today. So that you can
walk us through how we can arrive at these differing
conclusions. Mr. Chairman, I don't want to take too much time
this afternoon, because I too, want to get to the panel.
But I do want to just very quickly reiterate a couple of
comments I had made at one of our last hearings and talking
about those factors that come into play when we're talking
about crude oil prices. I do believe, as you, that speculation
does play a role. I'm a co-sponsor of legislation that would
improve the data collection, enhance the market transparency,
provide the CFTC with the resources and the authority.
I think we all recognize that that will benefit. But I'm
one of those who believes that the speculation piece is one of
the pieces, but it's not the piece in the puzzle. It's not the
whole puzzle. It is one aspect of it.
We had a very interesting Senate wide Energy summit last
Friday. Several of the Senators used that opportunity to ask
questions about speculation. Many of the experts that were
gathered there repeatedly reaffirmed that there was another
factor. It was the factor of supply and demand that they felt
was of much greater consequence.
So again, we've got, we do have the issue of supply and
demand on the table. That is part of the components when we
look at price. Look at what has happened worldwide that
influences what we see between the supply of oil and the demand
for it, on the demand side, increases in consumption in China
and India.
Dr. Yergin spoke to the demand shock. That the oil markets
didn't anticipate when those two countries, China and India,
are essentially adding consumption in terms of about a million
barrels per day that we just didn't anticipate. How do you
factor that in?
On the supply side the disruptions that we've seen whether
it's Nigeria's production, Iraq's production level, the fact
here in the United States that our production levels have been
at their lowest that we have seen since the end of World War
II. We recognize that supply and demand, I recognize, that
supply and demand play an incredible when we look at pricing.
We also recognize that there are other factors in play.
I would like to, at this hearing, look to just that one
piece of the puzzle. We could have a whole hearing on is it
supply, is it demand, is it market speculation? I think the
purpose today is to talk about the market speculation piece.
So while I have much more that I would like to add. In
deference to my colleagues and the fact that we've got a vote
coming up, I will hold at this point in time and look forward
to the opportunity to question our witnesses. Thank you, Mr.
Chairman.
[The prepared statement of Senator Murkowski follows:]
Prepared Statement of Hon. Lisa Murkowski, U.S. Senator From Alaska
Thank you, Chairman Dorgan. And I want to thank our witnesses for
agreeing to be here today--some of you for the second time--to share
your views on speculation.
This will be the third hearing we have held on this topic in the
past 10 months. Late last year, and again in April, we heard from
several experts who told us that speculation was playing a small role,
if any role at all, in increasing crude oil prices--and we also heard
from witnesses who contended that speculation was a significant factor.
From a policymaking perspective, these conflicting statements made it
clear that we needed to gather more information to find out what was
really happening.
In the past week, two new reports on speculation have been
released. One concludes that speculation played a large role in
increasing crude oil prices, while the second does not. The authors of
each report have joined us today, and I look forward to hearing more
about their findings and recommendations.
Before we turn to their testimony, I want to reiterate some of the
comments I initially made last December. I do believe that speculation
factored into crude oil price increases earlier this year. Along with
more than 40 of my Republican colleagues, I am a co-sponsor of
legislation that would improve data collection, enhance market
transparency, and provide the CFTC with the resources and authority it
needs to ensure our commodity markets function appropriately.
But I also believe that speculation is just one piece of a larger
and more complicated puzzle. This became even clearer last Friday, when
our committee hosted a Senate-wide energy summit. Several Senators used
the occasion to ask questions about speculation. In response, the
experts before us repeatedly affirmed that another factor, supply and
demand, was of much greater consequence.
So before we spend the next few hours discussing speculation, I ask
my colleagues to stop, and consider for a moment, just a few of the
events that have led to an imbalance between the supply of oil and
demand for it.
First, on the demand side, we have seen significant increases in
consumption in China and India. Every year, those two countries use an
additional one million barrels per day. Dr. Daniel Yergin called this a
``demand shock'' that oil markets did not anticipate, and were not
prepared for.
There have been significant disruptions on the supply side as well.
In the first half of this year, up to 40 percent of Nigeria's
production was taken offline as a result of unrest and strife. Iraq's
production levels are just now returning to their pre-war levels. Here
in America, production has declined to its lowest level since the end
of World War II.
Since our hearing in April, of course, the price of oil has
declined substantially--last night, it closed at __ per barrel. The
Ranking Member of our committee, Senator Pete Domenici, asked about
this at the summit. The witnesses on our first panel pointed first and
foremost to supply and demand. As global economic growth has slowed
down, demand for oil has softened. With prices at record levels, new
prospects have been brought online throughout the world, including the
Thunder Horse field in the Gulf of Mexico. Alternative fuels are making
up an increasingly larger share of our fuel supply, and continued
improvements in technology are allowing us to do more with less.
To be fair, speculation was not categorically ruled out as a
possible factor. But the CFTC's new staff report has shed additional
light on this issue. Some of its findings are particularly revealing.
First, that: ``While there was an increase in the net notional
value of commodity index business in crude oil futures, it appears to
be due to an appreciation of the value of existing investments caused
by the rise in crude oil prices and not the result of more money
flowing into commodity index trading.''
And then: ``As crude oil prices were increasing during the period
December 31, 2007 to June 30, 2008, the activity of commodity index
traders in crude oil during this period reflected a net decline of
futures equivalent contracts.''
In fact, of the 550 swap clients whose trading data for June 30 was
analyzed, the CFTC concluded that 35 positions would have exceeded the
speculative limits of their markets--and most would have been in excess
by a small amount. In the crude oil market, it appears that only six
noncommercial investors were above NYMEX accountability levels--and two
were on the short side.
It is thoroughly established that supply and demand, not
speculation, was the principal driver of record oil prices in the first
part of this year. Despite having heard this from our nation's top
energy experts, and despite a new report from the agency that is in
charge of regulating our futures markets, some continue to claim that
supply and demand is nothing more than a myth. To me, this is simply
astonishing. Even the authors of the second report we are here to
discuss, ``The Accidental Hunt Brothers--Part 2,'' seem to acknowledge
that supply and demand has played at least as great a role as
speculation.
I understand the allure of blaming speculators for high oil prices.
But having reviewed the new report from the CFTC, and having listened
to the witnesses at last week's summit, it is clear that the single
most important issue that we can focus on as this Congress comes to a
close is supply and demand.
The energy challenges we face are the result of global forces, and
if we want to pay less at the pump, we must produce more of our own
energy. It's time to adopt an ``all of the above'' approach to energy
policy. In part, this will require greater oil and gas production here
at home.
For today, however, our focus remains on a small piece of that
larger puzzle. As the CFTC staff report makes clear, we do have some
work to do in this area. I look forward to hearing from our witnesses,
and to working with the CFTC to make sure it has the resources and
authority it needs to be successful going forward.
Senator Dorgan. Thank you.
Senator Cantwell.
STATEMENT OF HON. MARIA CANTWELL, U.S. SENATOR
FROM WASHINGTON
Senator Cantwell. Thank you, Mr. Chairman. I'll be brief.
Thank you for holding this hearing.
I want to welcome Dr. McCullough for being here, I'm sorry,
Robert McCullough for being here from the Pacific Northwest. I
first became familiar with his work when he exposed the smoking
guns of Enron's manipulation of the electricity market. So I
look forward to hearing what he has to say in his research
about the speculation in the futures market.
Mr. Chairman, I think that we've had many hearings now on
various committees here that really is pointing to the fact
that the CFTC's inability or unwillingness to look at the
regulatory framework is now really clear to us from everything
from credit default swaps to the derivatives market for oil
futures. It's causing us a problem. We need to have a more
aggressive response.
When the American economy has been on this economic roller
coaster of soaring gas prices and housing market bus, we've had
a CFTC who's done, I think, very little or really been asleep
at the switch when it comes to these key oversight, regulatory
issues. The importance of all of this is not lost on me or our
economy. Just this last week Alaska airlines announced lay offs
of hundreds of people, in fact, going to have a major impact in
our area and again, because of high gas prices.
We've seen this deregulated financial market grow from
about $13 billion in 2003 to $317 billion today, an
unbelievable growth in expansion in all this time, you know
when oil went from $27 a barrel to $147 a barrel. So I know
that the McCullough report and the Masters report are talking
about how smart money rushed into these markets. Now as we are
looking at shining a bright light, some of them are leaving the
market. I want to make sure that we have markets that are
properly policed.
Mr. Chairman we are going to talk about supply and demand.
But if I could just put up one chart* because the thing that I
think is most interesting here is that while supply and demand
have been relatively steady since 1997 growing at a small
increase all the way to 2008. We can see at about the time that
dark markets started to exist. It may not be the only issue,
but dark markets started to exist. Oil started flowing in and
in oil futures we saw this incredible run up in price.
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* Chart has been retained in subcommittee files.
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So for almost, you know, the better part of the last
several years, we have seen an incredible price spike. So I
want to make sure that we do our job, that we are doing the
oversight of the agencies that need to do their job. We learned
from FERC that they didn't do the proper oversight of the
electricity markets. I want to make sure that we don't continue
to make the same mistakes as it relates to the oil markets.
I thank the chair.
Senator Dorgan. Senator Cantwell, thank you very much.
Senator Domenici.
STATEMENT OF HON. PETE V. DOMENICI, U.S. SENATOR FROM NEW
MEXICO
Senator Domenici. Mr. Chairman, I was just going to ask
isn't that inaccurate? Didn't it start to come down? You don't
have the price coming down on that chart?
Senator Cantwell. I will gladly celebrate the fact that
oversight, I think, by us has chased a lot of money since July
out of the market and the price has dropped fifty cents a
gallon.
[Laughter.]
Senator Cantwell. So I will get that chart for you. I will
show you. I think Mr. McCullough will prove that it's the one
thing that has impacted price is the discussion by Congress and
its oversight.
Senator Dorgan. Let me just make a point. The full
committee has normally recognized the chairman and the ranking
member for an opening statement. For those that have just
arrived, I would like very much if we could just have opening
statements for a minute or so a piece beyond Senator Murkowski
and myself and then get to the witnesses because we're going to
have a vote starts about 3 o'clock. So with your cooperation, I
would appreciate it very much.
Senator Domenici.
Senator Domenici. Is that, you said those that arrived
late. Do I, even though I arrived a long time ago, fit within
the 1-minute rule? It's alright if I do.
Senator Dorgan. Why don't you start?
Senator Domenici. Alright. I'll try. Look, I had a
statement prepared, but since I've been at so many meetings on
this subject and haven't found any concrete evidence from any
witness that's credible on the subject of manipulation--not
speculation, but whether speculators manipulated--I won't use
my statement.
But I will say one thing. Since there is a statement made
by one of the witnesses, Mr. Masters, who's first and perhaps
will speak first, I want to comment on his report.
He issued a report that was analyzed by an economist named
Dr. Verleger, a rather prominent and I would have to say
Democratic economist--he was a White House employee in the
Carter Administration. I just want to say, just so everyone
understands that even when you write a report people don't
necessarily conclude that your report is right.
Dr. Verleger describes the report by one of our witnesses
as false: ``The Accidental Hunt Brothers-Act 2, by Michael W.
Masters and Adam K. White is the worst example of junk economic
analysis published in a very long time. The authors demonstrate
nothing in the article. It is devoid of any intelligent
content. One can make a stronger case for a rooster's crow
causing the sun to rise. Their report is an utter and complete
perversion of what we teach in economics.''
Now all I wanted to do was to tell you, Mr. Masters, that
there are some economists, even those whose hair has grown gray
compared to yours, having worked in the Carter White House, who
don't think your report is very accurate. There's another
person who is currently the president of Goldman Sachs who used
this report before another Senate committee. He used the report
of Dr. Verleger as an analysis of your report and its validity.
So I think I'm in good shoes with the president of Goldman
Sachs, Mr. Cohn, who used the report. I think I read well.
Although I didn't read it as well as I should because on the
rooster crowing, that's the whole punch line. I botched that
up.
[Laughter.]
Senator Domenici. He says it's a stronger case for a
rooster's crow causing the sun to rise. That's the way it was
written. I just read it wrong.
Having said that, I never would have thought of such a good
explanation, but I did read a little bit more about your
holdings and where you had investments, Mr. Masters. I think
you would feel very much at home sitting at the table with the
airline executives--every one of them has come and said there's
been manipulation. You have most of your holdings in the
airline industry. If you don't you can tell the committee that.
I can't stay here all afternoon. But I want to say, thank
you, Mr. Chairman, for the hearing. I believe, having looked at
what they have to say, that they're all excellent witnesses. I
think they're being very honest and some of them are being very
careful.
But I don't think, as a whole, there's any unanimous course
coming up here saying that we have another Enron on our hands.
That the oil price growth is equivalent to or even similar to
the Enron situation of which our Senator from the West Coast so
valiantly worked on and would so much like to make oil and gas
equate with. She has been unable to do that, even with her
sincere effort.
Senator Dorgan. Senator Domenici, you have----
Senator Domenici. Thank you, Mr. Chairman.
Senator Dorgan. You have planted a number of time bombs
here that will explode after you leave.
Senator Domenici. Yes.
[Laughter.]
Senator Dorgan. But Mr. Masters will be able to speak for
himself. I'll be recognizing him in a moment. I actually raised
the Enron issue. I indicated when I raised it that I wasn't
suggesting there was an Enron activity here.
What I was suggesting is those of us who raised the
questions about the manipulation of wholesale prices on the
West Coast, which we now know was stealing billions, over $10
billion and $20 billion from West Coast consumers. We were told
by everybody, including people on this committee just back off.
There's nothing going on here. This is the market system.
So I raise it only to say that this is the market and the
fundamentals and we've heard all that before. Whatever the
facts are we'll get on the table today from this panel. But I
was in fact, the one that raised the point of Enron. I chaired
the hearings of Mr. Lay and Mr. Skilling and others. My
colleague from the West Coast had a lot to do with this as
well.
But I'm not a stranger to the issue. I'm not a stranger to
being told that, get out of the way. You need to understand the
market. The market is working.
In my judgment the reason we're having these hearings is
the run up double in the price of oil in 1 year from July to
July is not justified by the fundamentals. I think what has
happened here is a casino like society has developed with
intense reckless speculation that has imposed an enormous
burden on this country in a way that I think is unfair. But
having said all that I say to those who have come in late,
again, I'm going to recognize the two on each side, just a
second. The two on each side, if you can give us a minute each,
then we'll go to the witnesses.
Let me start with Mr. Salazar then go to Senator Craig and
so on.
STATEMENT OF HON. KEN SALAZAR, U.S. SENATOR
FROM COLORADO
Senator Salazar. Mr. Chairman, I am interested in hearing
from the witnesses so I'll submit my statement for the record.
Senator Sanders has to preside at 3 o'clock. So with----
Senator Dorgan. With your permission, Senator Sanders and
then Senator Craig.
[The prepared statement of Senator Salazar follows:]
Prepared Statement of Hon. Ken Salazar, U.S. Senator From Colorado
Thank you Subcommittee Chairman Dorgan and Ranking Member Murkowski
for holding today's hearing on the impact of speculation on energy
markets.
Although the price of oil dipped below $100 a barrel yesterday for
the first time in many months, the role of speculation in the price
run-up of crude earlier this year is still prominent in our minds. As
much as some would like to dismiss this episode as a bad dream it is
our duty to understand exactly how and why prices spiraled as they did
and why they are still so high today. I believe speculation played a
significant role in driving up the price of oil and I believe we are
duty-bound to ensure this does not happen again. Certainly the strength
of the dollar has played an important role in these price movements as
well. I am looking forward to hearing from the experts called to
testify today their explanations for the spike and recent decline of
energy prices.
These are uncertain times for our economy. Families and businesses
are still suffering under the weight of high energy prices. We are all
disturbed by the recent failures of some of our nation's largest
financial institutions. When it comes to stabilizing our economy,
volatility in energy commodity markets is something we should eliminate
from the equation, to the greatest extent we can. As I have said
before, ensuring a rational and open crude oil market is a matter of
national and economic security. I look forward to advancing this
discussion during today's hearing.
Thank you, Mr. Chairman.
STATEMENT OF HON. BERNARD SANDERS, U.S. SENATOR FROM VERMONT
Senator Sanders. I apologize to the panel. I've got to
preside. I hope I'm not late.
I happen to think this issue and the issues that we're
raising in terms of speculation is of enormous significance.
The truth of the matter is is that in 2000 when you have people
say, when you look at speculation we're paranoid. We're into
conspiracy theory.
Hey look at recent history in the last decade. What was
Enron about? What the chairman was just saying is what people
were talking about Enron, the Enron folks were saying it's
supply and demand. In 2004, BP, formerly British Petroleum,
artificially increased propane prices. They cornered that
market. Then in 2006, the Amaranth hedge fund was responsible
for artificially driving up natural gas prices until they
collapsed.
What we have seen in January of this year oil was at $95 a
barrel, in July it was $145 a barrel. Now it is, last heard,
$92 a barrel. Does supply and demand play a role? Sure it does.
But does anyone think that that type of fluctuation is just
supply and demand or market fundamentals? I don't think so. I
think we're on to something. I think we've got to press this
issue.
Senator Dorgan. Senator Craig.
STATEMENT OF HON. LARRY E. CRAIG, U.S. SENATOR
FROM IDAHO
Senator Craig. Thank you very much. I just happened to
click the television before I came out. Oil could hit 90 today.
I guess we'll call that manipulating it downward. While some
oil experts were saying that as soon as the world economy
softened, and it has softened, and as soon as ours softened,
the market would head down. It's headed down.
Mr. Chairman, I would only suggest one thing. Please, don't
allow this committee to redefine manipulation as speculation or
anybody buying stocks, bonds and other kinds of derivatives
today in hoping they might go up would become a manipulator of
the market. Thank you. Thank you for the hearing.
Senator Dorgan. I don't believe that description exists
from this committee.
Senator Craig. We'll try to keep it that way.
Senator Dorgan. Senator Corker.
Senator Corker. Mr. Chairman, I'll think all of us come to
this hearing with--from our own insights and biases and I just
as soon go to the witnesses and listen to them and ask
questions. So thank you.
Senator Dorgan. Senator Corker, thank you very much. Let me
again thank all of the witnesses. We'll begin with Mr. Masters.
Mr. Masters is the Managing Member or the Portfolio Manager
of Masters Capital Management. Mr. Masters, thank you for being
with us. You may proceed. Let me say to all six and I will not
repeat it, that your entire statements will be made a part of
the permanent committee record and we will encourage you to
summarize.
STATEMENT OF MICHAEL W. MASTERS, MANAGING MEMBER/PORTFOLIO
MANAGER, MASTERS CAPITAL MANAGEMENT, LLC., SAINT CROIX, VI
Mr. Masters. Thank you, Senator. Perhaps I'll be able to
address the allegations from the Senator on those issues at
some point after my statement. Thank you, Chairman Dorgan and
members of this committee. I appreciate the opportunity to
address this committee on the role of speculative investment in
the energy markets.
WTI crude oil prices rose dramatically in 2008, from $95
per barrel in January to $145 per barrel in July. Then fell
just as dramatically back to around $95 per barrel today. It is
becoming very difficult for reasonable people to explain a $50
spike followed by a $50 drop relying exclusively upon supply
and demand rationale or a weak dollar hypothesis as their only
explanations.
In the first quarter of 2008 EIA was forecasting that
supply would exceed demand over the next 12 months. Despite
this fact WTI crude oil prices rose substantially. Oil prices
continued to rise into July at which point the EIA revised
their forecast and suggested that demand would outstrip supply.
But within a week, the WTI crude oil price began its
precipitous drop.
It is important to note that during the first 6 months of
2008 actual worldwide inventories for crude oil were
essentially flat. According to the inventory data, supply and
demand were in balance during this time period. It is certainly
reasonable to conclude that supply and demand cannot fully
explain crude oil's dramatic rise and fall during 2008.
Many people believe that the level of U.S. dollar has had a
significant impact on oil prices. This line of reasoning
maintains that countries whose currencies are strengthening vis
a vie the dollar will demand more oil because the price they
pay for oil falls when the U.S. dollar falls. In 2008, the U.S.
dollar index never weakened by more than 7 percent. Yet the
price of WTI crude oil climbed by as much as 50 percent.
Clearly a 7 percent weakening in the U.S. dollar cannot
fully explain a 50 percent increase in WTI crude oil prices.
Without question supply and demand fundamentals and a weakened
dollar have played some part in the rise and fall of crude oil
prices. But it is difficult to believe that they fully explain
the tremendous volatility that we have seen.
Our research took data from the CFTC Commodity Index CIT
report and used that data to estimate how much money was
allocated to the commodity indexes. With these numbers we were
able to estimate how many WTI futures contracts were held by
index speculators each week. By focusing on the change in the
number of contracts we were able to estimate the inflows and
outflows of the major commodity indexes.
From January 1 to May 27, index speculators poured over $60
billion into commodity indexes. As Chart One illustrates, this
led to the purchase of about 187 million barrels of WTI crude
oil futures. We believe this buying pressure contributed
greatly to the $33 per barrel increase in the WTI crude oil
price during this time period.
Then from May 27 to July 15, there were multiple hearings
held in both Houses of this Congress focused on the effect of
large speculators were having on food and energy prices. There
were several pieces of legislation introduced that were
designed to crack down on excessive speculation. In addition
the CFTC announced multiple initiatives and investigations with
the stated intent of determining what role speculators played
in oil's rapid price rise.
It appears likely that many of these index speculators were
concerned enough by what was occurring in Washington to pull
their money out of commodity index investments. Despite the
claims that they were passive, buy and hold or long term
investors, beginning on July 15 index speculators led a mass
stampede for the exits pulling out approximately $39 billion
from the GSCI. As chart 2 shows this resulted in the selling of
about 127 million barrels of WTI crude oil futures between July
15 and September 2, we believe this dramatic selling pressure
contributed greatly to the $29 oil price drop during those 7
weeks.
The bottom line is when index speculators pour large
amounts of money into the commodity markets and buy large
amounts of futures contracts, prices go up. When they pull
large amounts of money out, prices go down. These large
financial players have become the primary source of the
dramatic and damaging volatility seen in oil prices.
Congress needs to pass legislation re-establishing
reasonable and rigid speculative position limits at the control
entity level that apply to all commodities across all markets
including the over the counter swaps markets. Further Congress
should take action to ban or severely restrict the practice of
commodity index replication because of the damage it does to
the price discovery process of the commodities futures markets.
Thank you.
[The prepared statement of Mr. Masters follows:]
Prepared Statement of Michael W. Masters, Managing Member/Portfolio
Manager, Masters Capital Management, LLC., Saint Croix, VI
Thank you, Chairman Dorgan and Members of this committee. My name
is Michael Masters and I appreciate the opportunity to appear before
you today to address the role of speculative investment in the energy
markets. Last Wednesday, Adam White and I released two reports that
address this topic. I will provide hard copies of both reports to your
staffs and if more copies are needed, they can download the reports at
www.accidentalhuntbrothers.com.
The first report, entitled ``The Accidental Hunt Brothers,'' is a
comprehensive report that deals generally with two problems facing the
commodities futures markets: excessive speculation and Index
Speculation. It encompasses information from my May and June
testimonies before Congress as well as additional research we
performed. It was not written for academics, but is meant to be easy to
understand for people conversant with these topics.
I want to draw your attention to two chapters within the report.
Chapter Three presents all the evidence that we have compiled
indicating that institutional investors have had a large impact on
commodity prices. Chapter Seven deals with legislative solutions where
we argue that Congress should act to impose reasonable and rigid
speculative position limits (at the control entity level) across all
commodities in all markets, including the over-the-counter (OTC) swaps
market. In addition we encourage Congress to ban or severely restrict
the practice of commodity index replication because it consumes
liquidity, increases price volatility and damages the price discovery
function of the commodities futures markets.
The second report, entitled ``The Accidental Hunt Brothers--Act 2''
looks at dollars allocated to commodity index trading strategies in
2008 and the effects that those dollars have on West Texas Intermediate
(WTI) crude oil futures contracts.
This afternoon I would like to briefly summarize those findings for
you.
WTI crude oil prices rose dramatically in 2008 from $95 per barrel
in January to $145 per barrel in July. Since then, oil prices have
fallen just as dramatically to their current levels of around $100 per
barrel. Economists are now struggling to explain this massive
volatility strictly in terms of supply and demand fundamentals.
How can one explain a $50 spike in prices within a few months time
followed by a $45 drop in prices just a few months later? Can supply
and demand or a weak dollar really explain the roller coaster ride that
oil prices have been on?
supply and demand do not fully explain oil's price moves
The U.S. Energy Information Administration (EIA) is charged with
developing forecasts of supply and demand for the United States and the
rest of the world. When supply exceeds demand then world inventories
grow and vice versa. Chart 1* shows the EIA's monthly forecasts for oil
inventories on a 12-month forward-looking basis. This is their
professional estimate of what supply and demand will do worldwide over
the next 12 months.
---------------------------------------------------------------------------
* Charts have been retained in subcommittee files.
---------------------------------------------------------------------------
In the first quarter of 2008 the EIA was forecasting that supply
would exceed demand over the next 12 months. Despite this fact, WTI
crude oil prices rose substantially. Oil prices continued to rise into
July, at which point the EIA was forecasting that demand would outstrip
supply (a bullish sign). A week later WTI crude oil began its
precipitous drop.
It is important to note that during the first six months of 2008,
actual worldwide inventories for crude oil were essentially flat--they
barely changed. Therefore, supply and demand were in balance during
this time period. Clearly, supply and demand cannot fully explain crude
oil's dramatic rise and fall during 2008.
u.s. dollar weakness does not fully explain oil's price moves
Many people believe that the U.S. dollar has had a significant
impact on oil prices. This line of reasoning maintains that countries
whose currencies are strengthening vis-a-vis the dollar will demand
more oil because the price they pay for oil falls when the U.S. dollar
falls.\1
\---------------------------------------------------------------------------
\1\ Crude oil is priced in U.S. dollars around the world.
---------------------------------------------------------------------------
Chart 2 shows how the U.S. Dollar Index performed (on a percentage
basis) compared with the U.S. dollar price of WTI crude oil. Chart 2
also adjusts the WTI crude oil price, taking into account the weakness
in the U.S. dollar, in order to show what non-U.S. consumers would have
to pay for crude oil.
In 2008 the U.S. dollar never weakened more than 7%, yet the price
of WTI crude oil climbed by as much as 50%. For a non-U.S. consumer
prices peaked at 43% above their January 1st level. Clearly, a 7%
weakening in the U.S. dollar cannot come close to fully explaining a
50% increase in WTI crude oil prices.
Without question, supply and demand fundamentals and a weakening
dollar have played some part in the rise and fall of crude oil prices,
but it is difficult to believe that they fully explain the tremendous
volatility we have seen. In seeking to identify other factors that
might further explain this volatility, we turned our attention to the
trading patterns of Index Speculators.\2
\---------------------------------------------------------------------------
\2\ An Index Speculator is an institutional investor such as a
pension fund, university endowment or sovereign wealth fund that
allocates money to a commodity index replication strategy.
---------------------------------------------------------------------------
index speculation is a major cause of the dramatic movement in oil
prices
We took data from the Commodities Futures Trading Commission's
(CFTC) Commodity Index Trader (CIT) report and used that data to
estimate how much money was allocated to the Standard & Poor's Goldman
Sachs Commodity Index (S&P-GSCI) and the Dow Jones AIG Commodity Index
(DJ-AIG).\3\ With these numbers, we were able to estimate how many WTI
futures contracts were held by Index Speculators each week and
therefore how many contracts were bought and sold as a result.\4
\---------------------------------------------------------------------------
\3\ The S&P-GSCI and DJ-AIG account for between 85% and 95% of the
total investment in commodity index replication strategies.
\4\ The methodology for how we calculate these estimates can be
found at the back of my May 20th Senate testimony as well as in the
Appendix of our large report ``The Accidental Hunt Brothers.''
---------------------------------------------------------------------------
january 1, 2008 to may 27, 2008: oil prices skyrocket
From January 1st to May 27th, Index Speculators poured over $60
billion into commodity indices. As Chart 3 illustrates, this led to the
purchase of about 187 million barrels of WTI crude oil futures. This
buying pressure contributed greatly to the $33 per barrel increase in
the WTI crude oil price.
may 27, 2008 to july 15, 2008: congress threatens action
Then, from May 27th to July 15th, there were multiple hearings held
in both houses of Congress focused on the effect that speculators were
having on food and energy prices. There were several pieces of
legislation introduced that were designed to crack down on speculation.
In addition, the Commodities Futures Trading Commission (CFTC)
announced multiple initiatives and investigations with the stated
intent of determining what role speculators played in oil's rapid price
rise.
Those who advocate in favor of Index Speculators' participation in
the commodities futures markets highlight the ``passive,'' ``buy and
hold,'' ``long term'' nature of their investment strategy. In spite of
their stated intentions, it appears likely that many of these
speculators were concerned enough by what was occurring in Washington
to pull their money out of commodity index investments.
july 15, 2008 to september 2, 2008: oil prices plummet
Beginning on July 15th,\5\ Index Speculators led a mass stampede
for the exits, pulling out approximately $39 billion from the S&P
Goldman Sachs Commodity Index.\6\ As Chart 4 shows, this resulted in
the selling of about 127 million barrels of WTI crude oil futures
between July 15th and September 2nd. This dramatic selling pressure
contributed greatly to the $29 oil price drop during those seven
weeks.\7
\---------------------------------------------------------------------------
\5\ July 15th was a significant date because many Institutional
Investors make portfolio allocation decisions on a quarterly basis.
July 15th was the first day in the 3rd quarter following the index
``roll period.''
\6\ The Dow Jones--AIG commodity index did not experience outflows
during this period; it actually experienced a nearly $7 billion inflow.
But because the S&P-GSCI is 40% WTI crude and the DJ-AIG is only 16%
WTI crude there were a net 127 million barrels sold.
\7\ When Index Speculators liquidate positions they sell all the
commodities futures in the index. As a result 22 out of the 25
commodities in the index dropped in price right along with oil.
---------------------------------------------------------------------------
Our findings have been corroborated by a series of research reports
by Lehman Brothers that reached similar conclusions. In a July report,
Lehman estimates that $98 billion was poured into commodity indices
from 2006 to June 2008.\8\ And in an August report they estimate that
from June to August, $42.6 billion was liquidated by Index
Speculators.\9
\---------------------------------------------------------------------------
\8\ ``Index Inflows and Commodity Price Behavior,'' Daniel Ahn, et
al., Lehman Brothers, July 31, 2008, p.11.
\9\ ``Punctured Balloon,'' Daniel Ahn, et al., Lehman Brothers,
August 22, 2008, p. 1.
---------------------------------------------------------------------------
When Index Speculators pour large amounts of money into the
commodities markets and buy large amounts of futures contracts, prices
go up. When they pull large amounts of money out prices go down. These
large financial players have become the primary source of the dramatic
and damaging volatility seen in oil prices.
the cftc's new report on commodity swaps dealers and index traders\10
\---------------------------------------------------------------------------
\10\ ``Staff Report on Commodity Swap Dealers & Index Traders with
Commission Recommendations,'' Commodity Futures Trading Commission,
September 2008. http://cftc.gov/stellent/groups/public/@newsroom/
documents/file/cftcstaffreportonswapdealers09.pdf
---------------------------------------------------------------------------
Having based our analysis upon the CFTC's CIT data, we eagerly
anticipated the release of their report on commodity swaps dealers and
index traders, hoping to find richer and more revealing data. We were
greatly encouraged when they announced their special call and their
intent to ask for much more granular and detailed disclosures.
Unfortunately, after reading their report we are greatly disheartened
because it represents a step backward rather than a step forward. In
fact, the report raises more questions than it answers.
Our concerns center on three different areas: transparency,
accuracy and consistency.
Transparency
With regard to our first concern--transparency--our understanding
is that the CFTC sent out 43 letters, with two single-page forms
attached, asking for summary information of each swaps dealer and index
trader's gross long and gross short positions broken down by index
``brand'' (S&P-GSCI, DJ-AIG, etc.) and within each ``brand'' by
individual commodity. They also requested gross long and gross short
positions for single commodity transactions broken down by
``commercial,'' ``non-commercial,'' and ``intermediaries.'' These one-
page forms are to be submitted monthly by the 43 swaps dealers and
index traders that received them.
For the sake of transparency, we are perplexed as to why the CFTC
has released such a miniscule fraction of the data they collected.
Why have they not released the data on the different
``brands'' of indices or the breakdown within the indices of
all 33 commodity positions?
Why has the CFTC only released data for three of the last
nine months?
Why have they released none of the data on single-commodity
transactions, which might reveal the actions of non-Index
Speculators?
Why has the CFTC only revealed net figures rather than the
gross long and gross short positions that they were provided
with?
At least with the Commitment of Traders Report, the CFTC included
long and short information. Net figures, by their very nature, do not
tell the whole story. Net positions are only meaningful when viewed in
conjunction with gross long and gross short positions. Net position
data does not provide any information about price trends.\11
\---------------------------------------------------------------------------
\11\ People who advocate ``net positions'' believe that short
positions offset long positions. These are the same people who like to
say, ``for every buyer there is a seller,'' as if that explains
something about price movement. By definition, there has been a seller
and a buyer for every transaction in history, but the question is ``at
what price?'' Financial markets allocate based on price. If there are
more buyers than there are sellers at a certain price level then the
price will increase until every buyer is paired off with a seller.
---------------------------------------------------------------------------
It is this apparent unwillingness to provide even a basic level of
disclosure that has caused us to question the CFTC's commitment to
transparency.
Accuracy
Our second concern is accuracy. As one example, the CFTC data shows
that the notional value of index investments in Cotton grew from $2.6
billion to $2.9 billion during the March 31, 2008 to June 30, 2008
timeframe. That is an 11.5% increase. However, the price of cotton only
grew by 3%. That means that money had to flow into cotton during the
2nd quarter in order to make up the difference. This would result in an
increase in the futures equivalent position in cotton. Instead, the
CFTC data shows it unchanged.
We have identified several other apparent inconsistencies and
inaccuracies. Perhaps if the CFTC releases a new report with more
detailed and granular data, then these issues can be resolved. We note
that the CFTC states in their report that
. . . as a result of the survey limitations, there may be a
margin of error in the precision of the data which will improve
as the staff continues to work with the relevant firms and to
further review and refine the data.
I hope that as the new CFTC data is further refined, we will see
much more detailed disclosure to help the public discern if, in fact,
there are discrepancies in the data. Until that time, the question
remains as to whether or not commodity swaps dealers and index traders
submitted truly accurate data and whether or not it was compiled
accurately by the CFTC.
Consistency
Our final concern centers on the lack of consistency between the
CIT data that CFTC has been releasing to the public for more than two
years and this new data that they just released. There are vast
differences between the two data sets.
Using Corn as an example, the newly released data says that on
March 31, 2008, index traders held 362,000 contracts. However, the
April 1, 2008 CIT report shows them with a net position of 439,000
contracts--a difference of 77,000 fewer contracts in the new report
compared to the CIT data.
On the flip side, the newly released data for Wheat shows that
index traders held 194,000 contracts on June 30, 2008. However, the CIT
report from July 1, 2008 shows them with a net position of
approximately 178,000 contracts--a difference of 16,000 more contracts
in the new report compared to the CIT data.\12
\---------------------------------------------------------------------------
\12\ The new CFTC report lists the notional index investment in
Wheat at $8.7 billion and the price of Wheat on June 30, 2008 closed at
$8.435. Therefore, one would expect the futures equivalent position
size to be equal to 206,000, not 194,000. If the 194,000 figure should
in fact be 206,000, then that would mean a difference of 28,000
contracts instead of 16,000 contracts.
---------------------------------------------------------------------------
In 29 out of 36 data points, the index trader position size in the
CFTC's CIT report is significantly larger than the position sizes
implied in their new report. The new data is self-reported by commodity
swaps dealers based on the notional value of their OTC derivatives
outstanding, while the CIT data showed existing commodity swaps
dealers' positions on the exchanges. One must question the accuracy of
the self-reporting done by the swaps dealers.
With this new report, the CFTC challenges the validity of its own
CIT data. The CFTC has been releasing the CIT data for over two years,
and financial professionals rely upon that data for their analysis of
the markets. If the CFTC is saying that the old data is not accurate
and should be replaced with this new data, it would be natural for
people to question whether the new data is, in fact, any more accurate
than the old data.
For the reasons that we have outlined, we are seriously concerned
about this new data set. In his dissent, Commissioner Chilton repeated
similar concerns, saying
I am concerned that, while I believe the staff did a
tremendous amount of work in a short period of time, the agency
may not have received the type of comprehensive data sets
needed to make reliable analyses and conclusions. . . . Absent
compelling evidence, I believe that the most responsible course
of action is to refrain from making conclusions or declarative
statements based upon such limited and unreliable data.
In our opinion, it would be a mistake to replace the existing CIT
data with this new data that is less transparent, less accurate and
less consistent. If the CFTC believes that the CIT data is truly
inaccurate, then they should issue a press release and remove it from
their website immediately. As it stands right now the general public
cannot tell which, if any, of the CFTC's data sets are reliable.
Conclusion
Excessive speculation and Index Speculation in the commodities
futures markets are two problems that are not going to be resolved
until Congress takes action.
Congress needs to pass legislation re-establishing reasonable and
rigid speculative position limits at the control entity level that
apply to all commodities across all markets including the over-the-
counter swaps markets. Further, Congress should take action to ban or
severely restrict the practice of commodity index replication because
of the damage it does to the commodities futures markets.
If Congress fails to act, then our commodities futures markets will
remain excessively speculative and extremely volatile. There currently
is nothing to prevent Index Speculators from pouring more money back
into these markets and driving prices to new highs.
Senator Dorgan. Mr. Masters, you have a right to respond to
two things Senator Domenici said. One he asked about your
holdings and so on which suggested that your testimony relates
to your holdings. The second point was Dr. Verleger. Do you
wish to respond to that? I'll give you 2 minutes to do that
before we go on.
Mr. Masters. Sure, thank you, Senator. With respect to our
holdings, we have held many transportation positions. They're
certainly not all of our portfolio. They are a small component
of the portfolio.
We've held these positions in many cases, on and off, since
the beginning of 2000. The transportation names have been the
area we feel like we have some expertise in, and we have
consistently had positions.
Also during the last 12 months, we have had significant
energy positions as well, so the idea on the long side. So the
idea that we're coming up here to testify to alter our
portfolio performance is quite frankly, ridiculous. Senator,
you well know how hard it is to do anything up here, to pass
any legislation, to get anything done in both chambers of
Congress. The idea that I would come up here and try to alter
my portfolio's performance by changing congressional
legislation and then getting the President to sign a law is
outlandish. It's just not true. That's clearly not the reason
that I came up here.
With respect to Mr. Verleger, Mr. Verleger is entitled to
his opinion. I happen to disagree with his conclusions. He
disagrees with my conclusions.
Senator Dorgan. Mr. Masters, thank you very much. Next we
will hear from Mr. Robert McCullough, the Managing Partner of
McCullough Research in Portland, Oregon. Mr. McCullough,
welcome. You may proceed.
STATEMENT OF ROBERT F. MCCULLOUGH, JR., MANAGING PARTNER,
MCCULLOUGH RESEARCH, PORTLAND, OR
Mr. McCullough. Thank you, chairman. Thank you, Senators. I
was here 6 years ago commenting on regulatory indifference and
market anomalies. Obviously it was a pretty crazy thing to say.
In retrospect we've collected over $10 billion in settlements
and had many convictions.
The fact of the matter is there are mistakes so seductive
we make them again and again and again. Free enterprise is the
best system on the planet. But it works best when it is
transparent. If you can't see what's going on, we make terrible
mistakes.
The right answer here is we have to fix the CFTC reporting.
They have to have the staff. They have to have the powers. Most
of all they have to have the reports.
The report they issue, that we all read every week and I
thank you Dr. Harris. I read it carefully. It started out in
1924, showed up in its basic form now in the early 1960s.
Quite bluntly this is the moral equivalent of an antique
bought on Ebay. We need something more similar to the FERC
Electric Quarterly Report so we can actually address the
questions Senator Domenici raised. At the moment I don't know
the answers.
We lost 2 percent of the world oil production 3 days ago.
The price of oil has gone down 10 percent or more over the last
3 days. This is the wrong answer. We need to get to the facts.
Now the first chart I put up there was the price chart. We
all know that by heart. In fact because it was built on Friday,
it's now out of date.
The point of the matter is all that supply and demand study
from the EIA is that red line at the bottom. The smartest
people we know, who are working their tails off, were dead
wrong all summer. Good news is the prices have almost caught up
with their forecast. They look a lot smarter today than they
did last week.
Let's turn to the next chart. This chart shows net
withdrawals. Now this is actually the distillation of supply
and demand. On July 3, on a daily settlement price we hit a
peak. In July the EIA tells us that we were withdrawing more
oil from our stockpiles than we were in the previous month.
Supply and demand, which many of us have taught in college,
there's something wrong with this chart. The fact of the matter
is the prices should have gone up in July, not down. Now do we
know all of the facts? No, we do not even accumulate a quarter
of the facts we'd like to bring to this committee. But this is
not a pleasing chart. This leads us to a concern with what's
happening.
Can we move to the next chart? Ok, now this is a pretty
interesting one. As I said I go through Dr. Harris' work very
carefully. The CFTC Commitment of Trader's report tells us
whether non-commercial interests are increasing or decreasing.
We can calculate their net long position. In other words, are
they betting on the future price of oil?
Interestingly enough they're net long position went
effectively to zero before the peak. Now does this bother me?
Yes, it does. I hate press ants. If a stockbroker tells me he
can predict the future I fire him. There are a lot of people
who did a pretty good job here. They were diminishing their
position as the price increased. They were out when the price
collapsed.
Do I know whether that meant manipulation? I don't. But I
do know that by coincidence in July, we identified one player,
Vitol. We discovered that they 25 percent of the long
positions, non-commercial, long positions.
We also know that they say on their website they move 1.4
billion barrels of oil. By the way, I believe someone made a
comment of one million barrels a day. Vitol alone, dwarfs that.
This is what we know as an all accomplished. This is someone
who can execute market power.
Do we have any evidence that they're bad guys? Absolutely
not. Do we know that we have a market power position when one
guy is that big? Yes.
Let's turn to the last chart. Now just to raise the Enron
issue, this is a chart you haven't seen. You would have had to
lasted through the years of litigation to see it. This is
Enron's net position on the West Coast. You'll notice that they
drew their forward position to zero just before the prices
returned to market prices.
When we see something wrong going on, we would expect to
see omniscience. But it's not really omniscience, it's because
in oligopoly a player could execute enough to change the prices
and take unfair profits. Bottom line, we need an oil quarterly
report.
Thank you very much.
[The prepared statement of Mr. McCullough follows:]
Prepared Statement of Robert F. McCullough, Jr., Managing Partner,
McCullough Research, Portland, OR
Thank you for the invitation to testify today.
Six years ago, I appeared before this Committee to discuss market
pricing anomalies and regulatory indifference. Some mistakes are so
seductive that we feel impelled to make them again and again. Today, I
am discussing the same topic as before, probably with many of the same
actors and similar facts. At the heart of the matter is transparency--
markets that function in secrecy easily fall victim to manipulation. My
testimony today is based on a report issued by my firm on August 5,
which we have updated and reissued today.
Energy price regulation in the United States is now divided
haphazardly into three agencies: the Federal Energy Regulatory
Commission (FERC), the Federal Trade Commission (FTC), and the
Commodity Futures Trading Commission (CFTC). A fourth agency located in
the Department of Energy, the Energy Information Administration (EIA),
is in charge of collecting data and making forecasts.
The events in the oil markets over the past nine months make it
clear that none of these agencies or the nation's policy-makers
currently have enough information to make informed decisions.
On January 2, 2008 the price of West Texas Intermediate (WTI) crude
was $99.64 a barrel. Both NYMEX forwards and the EIA's Short Term
Energy Outlook predicted July prices in the range of $80 to $90 a
barrel--a gradual decline for the immediate future. The predictions
were off by 50%. This would be understandable if a major dislocation in
supplies had occurred, but there was no such dislocation.
Instead, by July 3, 2008, the price of WTI crude crested at
$145.31. Facile explanations published in the media include surging
demand for oil in China and India, faltering global sup-plies, and
expectations of dramatic changes in the Middle East.
The irony is that if any of these explanations were correct, the
price of oil would have re-mained at high levels. Yet in the following
four months, oil has gradually dropped close to and even below $100.
The EIA's forecast, which explicitly considers Chinese and Indian
consumption, global supplies, and a host of other factors, was
hopelessly inaccurate by mid-summer. It is now looking fairly good.
A careful review of the fundamentals does not explain why the price
of oil increased by 50% in the first six months of this year and then
fell by 50% in the next three months. Supply and demand stayed in rough
balance over the first nine months of 2008.
The obvious conclusion from the fundamentals is that prices should
have continued upwards in July, not declined precipitously.
When the standard explanations fail, this is a strong indication
that we are driving ahead of our headlights. A scientist in this
situation views this as a wonderful opportunity when theo-ries are
disproved by the facts. This is the case in the July price spike.
As Senator Cantwell said last week, eighty percent of Americans
believe that speculators are manipulating the price of oil. Clearly,
they are reacting to the same inconsistencies between prices and
explanations that bring us here today.
While the CFTC market surveillance efforts are both arcane and
insufficient, it does publish an interesting document on a weekly basis
called the Commitments of Traders Report (CoT). The first such reports
date back to 1924 and the Grain Futures Administration. The CoT was
introduced in 1962 and it has a vintage feel--using old-fashioned
terminology and unique statistics to cover a large subset of U.S.
forward markets. Among the markets is WTI Sweet Crude on the NYMEX.
This is a surprising chart. It shows that speculators, or non-
commercial traders in CFTC terminology, reduced their net position to
zero on the NYMEX as the price of oil soared. This traders' behavior
illustrated is troubling. In July 2001, Hunter Shively, an Enron
natural gas trader, showed similar prescience in a scheme to set prices
on the NYMEX Henry Hub forward market. Eventually, the CFTC discovered
his manipulation and prosecuted Shively.
A similar, though less well-documented exploit was conducted by
another Enron trader, Timothy Belden, in the electricity markets on the
West Coast during the Western Market Crisis of 2000-2001. Indeed, the
chart of Enron's forward positions and market prices during the
infamous ``California crisis'' is almost identical to the chart above.
The mechanics of such exploits, called Spot Forward Gambits, is to
create a large enough change in spot prices so that the forward curve
reacts to the new information. This effect is called a ``curve shift''
and is a common characteristic in many forward markets. Once the
forward curve has shifted, traders can liquidate their position at
favorable prices. Since the profits in the forward market can dwarf the
losses in the spot market, the net effect can be quite favorable for
the traders.
Such exploits are only possible when market players hold market
power--generally as a result of oligopoly or monopoly. In mid-July, a
reclassification of the trader, Vitol, revealed that such oligopoly
power is present in the NYMEX. Vitol held more than 25% of the for-ward
positions in sweet crude on July 15, 2008.
The resemblance of the July 3, 2008 oil price spike to earlier spot
forward gambits is troub-ling. Even more troubling is that data on WTI
Crude spot and forward prices gathered by FERC, the FTC, the CFTC, and
at the EIA is too insufficient to determine whether the price of oil
was manipulated. Even more disturbing, last week's CFTC report that
minimized the effects of speculation on oil prices chose to stop its
analysis in June, prior to the price spike.\1
\---------------------------------------------------------------------------
\1\ See, for example, the discussion of crude trading on page 4 of
the September 11, 2008 Staff Report on Commodity Swap Dealers & Index
Traders with Commission Recommendations.
---------------------------------------------------------------------------
Today, a double standard exists for data reporting and publishing.
For example, electricity market data is published in FERC's Electric
Quarterly Reports (EQR). Unlike the CFTC's weekly CoT, the EQR contains
all transactions by market participants, right down to locations,
quantities, and prices.
When market results look anomalous, the correct response is to
assemble and publish data so questions of market power and market
manipulation can be directly addressed. A good first step would be to
create an Oil Quarterly Report with the same level of detail as EQR. An
Oil Quarterly Report should include spot and forward trades for
bilateral transactions, and at both NYMEX and ICE. This data would
allow policy-makers to proceed on the basis of facts.
Thank you. This completes my comments.
[Charts have been retained in subcommittee files.]
Attachment
Date: September 16, 2008
To: McCullough Research Clients
From: Robert McCullough
Subject: Seeking the Causes of the July 3, 2008 Spike in World Oil
Prices (Updated)
Over the past two years the price of oil has roughly doubled. The
increase has surprised both the markets and official forecasters such
as the Energy Information Administration. This is a situation where the
savviest traders and the most sophisticated modelers have equally
failed to predict the rapid increase.\1\*
---------------------------------------------------------------------------
\1\* July 2008 NYMEX oil futures settled on June 1, 2006 traded for
$70.95 a barrel. The contemporaneous EIA forecast predicted a lower
price $67.00 per barrel at the end of their forecast period.
---------------------------------------------------------------------------
Although an intense public debate has emerged concerning the causes
of the price increase, to date little substantive work has been
undertaken. There are three reasons: first, a steady climb in oil
prices does not provide a good basis for most econometric modeling;
second, data is scarce and difficult to interpret; and third, three
different federal agencies share inconsistent mandates concerning oil
prices. More bluntly, we have the wrong tools; we lack even the most
elementary data; and no one agency is clearly in charge.
While medical symptoms may be uncomfortable to the patient, they
are useful tools for the internist. The price spike of July 3, 2008 was
so sharp that it provides an opportunity to seek causes. A central
advantage in reviewing June and July of this year is that the
traditional explanations for oil price increases, such as exchange
rates, storms, or major geopolitical events, were absent. Relatively
little happened in June and July of 2008 in any of these areas. Even
more significantly, the forward price curves followed the spike in spot
prices in lockstep. On June 2, 2008 the price of oil on the NYMEX was
$128.43 a barrel for December 2016. By July 3, the price for December
2016 had increased to $142.18 a barrel. By the end of July it had
fallen to $117.67 a barrel. By September 14, the price had slipped just
below $100 a barrel.
What happened in June 2008 that raised the forward prices of oil so
significantly? What happened later in July that caused the forward
price of oil for deliveries years in the future to fall even more
precipitously?
Pundits are quick to point to increases in demand in India and
China or blame price increases on the arrival of ``peak oil.'' While
they have the ability to extrapolate from minimal data, economists tend
to check the facts. Monthly data on national and in-ternational
production and consumption is published by the Energy Information
Administration as part of its short term forecast.\2\ Despite the
pundits' opinions, the supply demand balance in the U.S. appears to
have had little relationship to the price of oil this summer.
---------------------------------------------------------------------------
\2\ See http://www.eia.doe.gov/emeu/steo/pub/contents.html for
detailed monthly data on oil and other energy sources.
---------------------------------------------------------------------------
The following chart shows the relationship--or rather, absence of
relationship--between the reduction in U.S. crude inventory and spot
prices.
The U.S. continued to draw down its inventory of oil to meet
current needs until the end of August, even though prices began to drop
in early July. More puzzling, prices dropped throughout July even
though the drawdown of inventories in the U.S. was at the greatest
level in July--the exact opposite of what economic theory would lead us
to predict.
All available evidence indicates that the price spike of July 3 was
a form of market failure most likely due to the significant
concentration in the energy sector in recent years. There is no
evidence that a significant long term change in oil consumption or
production took place in June and then faded away in July. The events
this summer are eerily similar to Enron spot forward gambits in natural
gas and electricity, specifi-cally the timing of profit-taking which
appears to show considerable prescience.
oil
The U.S. is both the single largest consumer and a major domestic
and international producer. Traditionally, the ``seven sisters''
(Exxon, Mobile, Gulf, Socal, Texaco, Shell, and BP) long dominated the
industry. Five of the seven were U.S. companies. Industry consolidation
has reduced the number of sisters to five. Exxon, Mobile, Gulf, Socal,
and Texaco have all merged or been acquired over the past decade.
Today, we are down to five sisters, three of them U.S. based.\3
\---------------------------------------------------------------------------
\3\ The Energy Information Administration has produced an excellent
history of industry consolidation in the oil business. This has been
reproduced as Appendix A to this report.
---------------------------------------------------------------------------
Oil is a storable commodity. In economic theory this means that
market participants can choose to sell oil today or wait for a better
market tomorrow. The Organization of Petroleum Exporting Countries
(OPEC) exploits this facet of the oil market by setting production
targets, spacing out the production of oil over time.
A purely theoretical analysis of oil can be likened to the
consumption of a prime, irreplaceable vintage of wine. The consumer
calculates the benefit of opening the bottle after considering a desire
to hold a reserve against a future need. In a perfect world, forward
prices would reflect long term expectations of supply, technology, and
demand. The relationship between spot and forward prices would reflect
the time value of money.
In practice, the theoretical model asks too much of real consumers,
producers, and traders. Technology changes the rules frequently.
Reserves are difficult to evaluate and consumers change their
preferences continuously. Substitutes for oil were not even considered
possible until the past few years. Today, ethanol comprises an
increasingly large proportion of retail gasoline for most drivers in
the U.S.
In practice, oil's fundamentals are well known. New markets for
gasoline like those in the Far East have appeared. The emergence of
China and India as major consumers is no longer news. While price
shocks such as changes in OPEC policy, civil unrest in Nigeria, or
major storms that disrupt production in the Gulf of Mexico cannot be
easily predicted, longer term impact are well understood. Thus, we are
unsurprised to find that spot prices are more volatile than prices in
longer term markets.
Because oil is so important, forward markets for oil are critical
to the operation of the economy. The two most significant forward
markets are the New York Mercantile Exchange (NYMEX) and the
Intercontinental Exchange (ICE). Due to the two so-called ``Enron
loopholes'', only NYMEX is fully regulated by the Commodity Futures
Trading Commission (CFTC). Forward trades also take place in the over
the counter markets that are also unregulated by the CFTC.\4
\---------------------------------------------------------------------------
\4\ For a detailed discussion of the Enron loopholes see my
testimony entitled ``Regulation and Forward Markets Lessons from Enron
and the Western Market Crisis of 2000-2001'', May 8, 2006, http://
www.mresearch.com/pdfs/191.pdf
---------------------------------------------------------------------------
Concerns about the efficiency of the market include the
increasingly important role of speculators. In theory, speculators add
liquidity to forward markets by taking risks that producers and
consumers may not wish to accept. In practice, it is possible that a
sufficiently large speculative position will change forward prices and
even affect spot prices. In 2006, the hedge fund, Amaranth, had
accumulated a massive position in March and April natural gas futures.
From evidence collected by later investigations, Amaranth was
attempting to support a significant differential in forward prices by
repeated intervention in the market. Amaranth failed, but its impact on
the relatively large North American natural gas markets has created
fears that larger and better-funded entities could effectively set
forward prices.
The U.S. government has regulated commodity trading since the
1930s. Responsibility for oil is split haphazardly among the Federal
Energy Regulatory Commission (FERC), which has authority over
pipelines, the Federal Trade Commission (FTC) which operates the Oil
and Gas Industry Initiatives, and the CFTC which views oil as one small
part of a large portfolio of commodities. The responsibility for
forecasting and understanding the oil markets lies with the Energy
Information Administration. As noted above, no one agency has a clear
mandate to accumulate data, oversee mar-kets, and evaluate factors that
affect consumers.
The CFTC regulates part of the forward market in oil. FERC has
traditionally fo-cused on electricity and natural gas. The FTC's Oil
and Gas Industry Initiatives fo-cuses more on mergers and relies upon
OPIS, a market data firm, and the EIA for data.\5\ The EIA accumulates
some data and issues periodic forecasts. This disorga-nized approach
makes it difficult to obtain consistent data and even harder to deter-
mine the cause of price increases.
---------------------------------------------------------------------------
\5\ See http://www.ftc.gov/ftc/oilgas/gas--price.htm for a
description of collection efforts.
---------------------------------------------------------------------------
the current debate
An intense debate currently rages over the causes of recent price
increases. An amaz-ing degree of misinformation fuels the debate. For
example, one often reads that the increase in the price of oil is due
to the decline of the dollar relative to the euro. While exchange rates
are a small factor, the U.S. does not buy oil from the European Union,
so the exchange rates relative to Europe are not a significant factor.
The market basket of currencies used by the ten major nations that
provide oil to the U.S. has not changed markedly over time.
Overall, the U.S. dollar has only declined 10% relative to the
currencies of its primary oil suppliers.
However, shifts in world consumption are a significant factor. A
wealthier world consumes more oil. An analysis of the impacts of
international demand is a central part of every recent EIA forecast,
but regardless of the attention paid to China and other growing markets
for oil each EIA forecast has significantly under-run actual oil
prices.
The January 2008 EIA forecast, for example, predicted a steady fall
in oil prices in 2008, even after a detailed consideration of
international demand.\6
\---------------------------------------------------------------------------
\6\ Short Term Energy Outlook, January 8, 2008, page 9.
---------------------------------------------------------------------------
As noted above, the forward markets have done little better. The
NYMEX prices for January 8, 2008 also did not predict a sharp increase
in the price of oil.
While the EIA's forecast looked extremely poor by July, in
September it began to look quite a bit better. Of course, the
difference was the gradual reduction in the July 3, 2008 price spike.
The detailed components of the EIA's forecast including oil
production and con-sumption have been relatively accurate. The EIA
overestimated consumption, relative to actual August data, by 1.6%. An
offsetting forecast error underestimated production in August by .8%.
While these are relatively good forecasts of the world oil market, they
would not normally appear to explain a forecasting error of 26.72% in
crude oil prices.
Another side of the debate blames the price increases on excess
speculation. As yet, there is relatively little data accumulated on the
significance of excess speculation in the market for petroleum. As
noted above, forward oil markets are subject to partial market
surveillance. The one document that offers some insight into the
forward market for oil at the NYMEX is an outdated and not easily
interpreted report known as the ``Commitments of Traders Report.''\7\
If speculators have taken a commanding position by purchasing large
forward positions in oil, it is virtually impossible to detect given
the CFTC's current powers and procedures.
---------------------------------------------------------------------------
\7\ http://www.cftc.gov/marketreports/commitmentsoftraders/
index.htm
---------------------------------------------------------------------------
Still others debate that banks and hedge funds have gambled on the
forward oil market, bidding up the price of forward contracts. Their
impact on spot prices is not easy to understand unless speculators have
either colluded with producers or their activities are obvious enough
that the producers are restricting spot sales in order to sell the oil
later at higher prices. This argument does not fit with the facts of
the July 3 price spike which took place soon after Saudi Arabia
announced a significant increase in oil production.\8\ (The logical
impact of the production increase would have been a reduction in the
forward curve for oil.)
---------------------------------------------------------------------------
\8\ Saudis offer to boost oil production, USA Today, June 23, 2008.
---------------------------------------------------------------------------
A better model for the July 3 price spike would appear to be the
Enron market manipulation of the Henry Hub forward market on July 19,
2001.\9\ In this case Enron purchased a large quantity of spot gas and
took advantage of the price increase to sell at an artificial price in
the forward markets. Enron's positions dramatically exceeded the levels
that would provide legitimate economic hedges.
---------------------------------------------------------------------------
\9\ U.S. CFTC v. Enron Corporation and Hunter Shively, Complaint
for Injunctive and Other Equitable Relief and Civil Monetary Penalties
Under the Commodity Exchange Act, March 11, 2003.
---------------------------------------------------------------------------
There is a strong possibility that the high level of concentration
in the spot and forward oil markets have made the market strategies of
the principal market participants more significant than fundamentals at
least in the short term. This is consistent both with the inability of
forecasters and traders to foresee major market movements and also
explains the very tight correlation between spot and forward prices.
what did happen in june and july 2008?
As noted above, the most significant change in fundamentals, the
decision by Saudi Arabia to increase oil production in July, took place
immediately before the price spike. The most important events over this
two-month period were:
3-Jun Senator Cantwell chairs a
Senate Commerce Committee
hearing on oil market
manipulation and federal
authorities. Experts,
including George Soros,
testify that the CFTC has
been slow to react to the
energy crisis and that
speculation could be adding
as much as 20%-50% to the
price of oil per barrel.
13-Jun Fourth fall in US reserves
pushes up oil prices
17-Jun US Air Transport Association
asks Congress to impose new
restrictions on ``rampant
oil speculation''
17-Jun Iranian President Mahmoud
Ahmadinejad tells OPEC
meeting in Isfahan the rise
in oil consumption is lower
than the growth in
production; certain powers
are controlling the prices
in a fake way for political
and economic gains; blames
weakening of the US dollar
18-Jun Bush calls for end to US
offshore drilling ban
19-Jun Movement for the
Emancipation of the Niger
Delta blows up Chevron
pipeline; Chevron declares
force majeure, halts output
by 120,000 bpd; attacks
Shell's offshore Bonga
oilfield
20-Jun China raises raise petrol
and diesel prices by more
than 16% to reduce the gap
with soaring international
oil prices; Organization of
Islamic Conference meeting
in Kampala says, ``If we
(the Islamic world) produce
the bulk of the oil, why
can't we be party to
deciding what is a fair and
equitable price? Unless
OPEC returns to arrest the
situation, mankind will
cross the border of self
destruction.''
23-Jun Saudi Arabia hosts summit
attended by 36 nations in
Jeddah; announces plans to
increase output by more
than 200,000 bpd to 9.7
million starting in July
23-Jun Movement for the
Emancipation of the Niger
Delta announces ceasefire
23-Jun Congressman Stupak holds
eight-hour hearing on
energy market speculation;
experts testify that the
explosion of speculation in
the oil futures market
could be driving up prices
from $20 to $60 per barrel
26-Jun EIA sees $70/b average crude
price by 2015
26-Jun By 402 to 19, the House by-
passes legislation to
direct the CFTC to use its
emergency powers to take
immediate action to curb
speculation in energy
market
27-Jun Senate Republicans object to
Unanimous Consent to pass
the House-passed emergency
powers legislation
30-Jun Russian oil exports fell
5.3% to 757mln bbl in Jan.-
May; world oil prices drop
on unex-pected US stockpile
rise
9-Jul House Agriculture Committee
holds three hearings on
increasing CFTC authority
9-Jul Iran test-fires nine
missiles, including ones
capable of hitting Israel
15-Jul OPEC revises 2008 world oil
demand forecast to 1.20
percent from 1.28 percent,
citing an economic slowdown
and high fuel prices
15-Jul Majority Leader Reid
introduces the Stop
Excessive Energy
Speculation Act of 2008
15-Jul Federal Reserve Chairman Ben
Bernanke tells Senate
Banking Committee that the
US economic downturn would
prove more persistent, and
potentially more severe,
than initially thought
22-Jul Iran's Oil Minister Gholam
Hossein Nozari says that it
is unnecessary for OPEC to
change the current output
22-Jul US Senate invokes cloture on
the motion to proceed to
debate on Reid's Stop
Excessive Energy
Speculation Act of 2008
24-Jul CFTC Charges Optiver Holding
BV, Two Subsidiaries, and
High-Ranking Employees with
Manipulation of NYMEX Crude
Oil, Heating Oil, and
Gasoline Futures Contracts
24-Jul House Agriculture Committee
reports the Commodity
Markets Transparency and
Accountability Act of 2008
25-Jul US Senate fails to invoke
cloture on the Commodity
Markets Transparency and
Accountability Act of 2008
30-Jul House fails to pass the
Commodity Markets
Transparency and
Accountability Act of 2008
on a required 2/3 vote on
suspension of the rules
30-Jul White House announces its
opposition to legislating
new position limits to be
devel-oped by the CFTC
While many of these events might affect the price of oil, some of
them are more likely to affect long term markets rather than spot
transactions. Congressional hearings, for example, presage changes in
national policy that will most likely take place at a later date. Civil
unrest in Nigeria and production decisions by Saudi Arabia are more
likely to have short term impacts. Arguably, the most significant event
during this period was the Saudis' June decision to unilaterally
increase production in July. However, immediately following this
announcement, prices increased. As one trader remarked when the price
fell sharply after July 3, ``No news is good news, or in this case, no
news is bearish news.''\10
\---------------------------------------------------------------------------
\10\ Oil Drops Sharply, Associated Press, July 8, 2008.
---------------------------------------------------------------------------
To test the statistical significance of these events on the price
of oil, we have developed two different models:
Spot: A regression using EIA
weekly data and events with
short term impacts to
explain spot prices
Forward: A regression using spot
prices and longer term
events to explain forward
prices.
Time series data, especially from complex markets with unobserved
variables, can be difficult to interpret and analyze. A central
assumption of classical linear regression is that the error terms are
independent and identically distributed. This is seldom the case in
economic time series.
Fortunately, time series analytical methods provide reasonable
tools that can show useful results for a variety of economic time
series that possess a particular kind of non-standard error
distribution. Among the most useful of these methods employs the
Generalized Autoregressive Conditional Heteroskedastic time series
model (GARCH).
We considered a model for spot oil prices that used refinery
utilization and U.S. petroleum stockpiles as fundamentals. It also
included proxy variables for three short term events: the unrest in
Nigeria until the ceasefire announcement, the Saudi pro-duction
increase announcement, and the change in Chinese retail petroleum
pricing.
The statistical results for the model are excellent overall with
significance far better than the .01 level. Unfortunately, the proxy
variables for the three short term events are not significant at any
acceptable level. In the careful language of the statistician, we
cannot reject the hypothesis that these announcements had no impact on
spot oil prices. The results are reproduced in Appendix B.
The forward model used spot prices as a fundamental and the Saudi
announcement, the Russian production report, and the period between
introduction and the failure to pass the Commodity Markets Transparency
and Accountability Act of 2008. The high degree of correlation between
NYMEX forward contracts makes results for dif-ferent delivery periods
largely unnecessary. In this study we used forward contracts for
delivery in December 2016.
The results for the second regression were also highly significant.
As before, the proxy variables for the Saudi production increase and
Russian production news were insignificant. The proxy for the short-
lived Commodity Markets Transparency and Accountability Act of 2008 was
highly significant. Interestingly, this was the only va-riable that
would have affected excess speculation as opposed to supply and demand
fundamentals.\11
\---------------------------------------------------------------------------
\11\ No alternative specifications of these models were analyzed.
This decision was not made lightly. Statistical tests are based on the
submission of a specific hypothesis for testing. Repeated testing of
alternative hypothes-es is a practice almost certain to eventually
stumble on an apparently significant result.
---------------------------------------------------------------------------
One conclusion to be drawn from these statistics is that the news
stories cited by pundits to explain the dramatic spike in oil prices
have little or no explanatory power. While we can construct a
sufficiently complex explanation to explain any result, we have very
little evidence that explains the massive spike that occurred on July
3. A second conclusion is that the best forecast for future prices in
2016 is the daily spot price today. This is likely to occur only if the
daily spot price has more information than any set of fundamentals.
pivotal suppliers
Paul Samuelson taught generations of undergraduates, ``It takes
more than the existence of a competitor to create perfect
competition.'' As a general rule, a competitive market will require
more excess capacity than the market share of the largest market
participant. Stated more directly, a market where supply and demand are
in close balance, with no quickly available substitutes, is in danger
of seeing non-economic pricing if one supplier can withhold enough to
create a temporary shortage. As we also learned in college, the student
with the car gets to choose the movie.
The economic term for markets where the decisions of one supplier
can set prices is called monopoly or oligopoly. The supplier with the
ability to set prices is called the pivotal supplier.
We should, but we do not, have data to help determine whether we
currently have one or more pivotal suppliers in the oil markets. We do
know that if pivotal suppliers exist, the market decisions of the
pivotal supplier will be more important than changes in fundamentals.
Like the grocery consumer in a small town with few choices, the best
forecast of the pivotal suppliers' strategy is the current price. If
the pivotal suppliers are aggressively setting high prices, a wise
trader would forecast this state of affairs to continue to dominate the
market for the immediate future.
A trader who based its forward price quotes on fundamentals would
quickly go bankrupt in the face of a pivotal supplier. A sudden 14%
price increase unmatched by market fundamentals means that the market
strategy has changed. An intelligent trader would factor the market
strategy into long term prices. This is exactly the behavior that
occurred during the July 3 price spike.
If data on spot market transactions was routinely collected and
reported, as it is in other energy markets, we would be able to check
whether there is evidence of increasing market concentration. If well
head price data was routinely collected and reported, we could check
whether the increased prices were being paid directly to oil producers
or to pivotal suppliers in the U.S. market.
We can glean some information about market concentration and
markups relative to well head prices from CFTC and industry sources.
The information is not sufficient to conclusively answer the question,
but it is interesting enough to propose the need for additional
investigation by the FTC, the CFTC, or the EIA.
As mentioned above, the CFTC provides a weekly Commitments of
Traders Report CoT). A recent report (July 29, 2008) is reproduced
below.
The report is neither user-friendly nor substantially detailed. The
last block of data in the report shows the degree to which the four
largest traders dominate the ``long'' or supply positions. In the July
29, 2008 report the top four traders held 32.8% of the long positions.
One of the problems with this report is that the measure of
concentration used by the CFTC differs from the standard measure in use
by the FTC, the U.S. Department of Justice and the FERC. While one is
not necessarily superior, the more widely used Herfindahl-Hirschman
Index (HHI) has the virtue of being more readily compre-hended.\12
\---------------------------------------------------------------------------
\12\ A simple explanation of the HHI can be found at http://
www.usdoj.gov/atr/public/testimony/hhi.htm
---------------------------------------------------------------------------
While it is possible to translate the Commitments of Traders data
into the HHI, it is not possible to get a specific value. The best that
can be accomplished from the CFTC data is a range where,
mathematically, the actual HHI will be found. The fol-lowing chart
shows the HHI range for NYMEX crude since 2005.
Neither the low nor the high HHI bounds are close to the U.S.
Department of Justice guidelines for a concentrated industry. In fact,
given the lack of reporting outside of the NYMEX, a substantial degree
of market concentration could occur that would never show up in the
Commitment of Traders Report. It is significant, however, that the HHI
appears to be increasing over time, with a significant increase in July
2008. In the worst case, it is mathematically possible that one trader
could hold as much as one quarter of the open long positions on the
NYMEX from the data reported at the CFTC. If so, this trader would have
a commanding position and could well be a pivotal supplier.
A pivotal supplier would also have the ability to increase oil
prices above the well head prices paid to suppliers. Recent statements
by OPEC representatives clearly appear to indicate that they have some
concerns in this direction.\13\ Supplier production and pricing is not
transparent. Saudi Arabia, the world's largest producer, provides
relatively little data and the Venezuelan government's estimates of
crude oil well head receipts differ markedly from the EIA's estimates
for Venezuela.
---------------------------------------------------------------------------
\13\ See for example the comments of OPEC Secretary General
Abdullah al-Badri on June 24, 2008 reported in OPEC president sees no
easing of oil prices, Xinhua News Agency, June 28, 2008.
---------------------------------------------------------------------------
Though the data indicates an increasing differential, Venezuelan
crude is a very dif-ferent product from U.S. crude, so a number of
alternative explanations could be made for the differential.
vitol
On July 18, 2008, the CFTC reassigned Vitol from commercial to non-
commercial status. An unusual opportunity to analyze the impact of a
single trader on the CoT Report took place recently when the CFTC
reclassified a single firm from Commercial to Non-Commercial. The
reclassified report indicates that the trader held 144,856 open
interests. These positions are classified as ``spread positions'' since
they represent long positions in one contract and corresponding short
positions in another contract. Since the total open positions in the
NYMEX crude market is only 1,249,914, it indicates that this trader has
more than 10% of the NYMEX market. More significantly, Vitol had 25% of
the long positions owned by non-commercial interests (the CFTC's term
for speculators).
There is no evidence that Vitol was involved in any suspicious
activities. The evidence only shows that the levels of concentration
are significantly higher than those suggested by the CoT report. It is
also worth noting that Vitol's physical deliveries of oil are 1.4
billion barrels of oil, a vast amount, considering that U.S. oil
imports in 2007 were 4.9 billion barrels. Although CFTC reports do not
indicate which contracts were held by Vitol, the scale of its positions
was larger than all but two of the NYMEX contracts in sweet crude:
This corroborates the HHI calculations above that a substantial
degree of concentration may be present in the NYMEX forward markets.
the market risk premium
The enormous increase of speculation over the last few years has
coincided with an increase in the price of commodities. A metaphor
might be real estate: if speculators buy up attractive shorefront
property in order to profit from a projected price increase, they will
hoard a scarce commodity and increase the price of the property. This
is not a bad metaphor, but it is not entirely correct. The key
difference is that a forward contract for oil does not actually tie up
physical oil before delivery. A contract for future supply is simply a
promise to provide 1,000 barrels at a set price on a given date. Most
market participants plan to sell or ``offset'' the contract before
delivery. In theory, a perfectly workable forward market might be very
large compared to the spot market and still not raise prices, as long
as the market is characterized by the rules of perfect competition
(many suppliers, many consumers, transparency, and freedom of entry and
exit). To make the real estate metaphor more precise, imagine that the
speculator proposes selling a promise to supply beach property at a
given price at a future date. This promise would not tie up beach
property or cause a shortage in the short run.
Of course, the central question is ``what price?'' When you buy
insurance, the insurance company figures the risk it is insuring
against and then adds a profit to cover its risks. This is the risk
premium. The offering price for a forward contract is equal to the
forecasted price plus a risk premium.
Many students (and some traders, in my experience) are surprised to
learn that risk premiums can be positive or negative. This appears
counterintuitive until they realize that since they view themselves as
customers of the insurance company, they almost always see a positive
risk premium.
An example of how such premiums can vary involves a farm and a
bakery. The farmer is always ``long'' on wheat. While the farmer is
unlikely to run out of wheat, he faces an uncertain future in terms of
price. He would be happy to offer to exchange his wheat for a fixed
price even if he has to take a small loss against his best guess of
future prices. In selling his forward contract, he is willing to accept
a negative risk premium. The bakery has the opposite problem since it
must know the cost of the bread it plans to bake. The baker is happy to
pay a positive premium over the expected price to be able to plan
ahead. When the farmer and the baker meet to set the price of their
forward contract, the final risk premium will be set by haggling. A
savvy farmer might well receive a positive risk premium simply because
he is a better negotiator or, vice versa, the baker might enjoy the
upper hand.
What happens if the two cannot agree? They can call their brokers
at the Chicago Board of Trade and place orders for their forward
contracts in the wheat market. Their orders, and thousands of others,
will show up in the trading pit where a price will be hammered out by
the willingness of speculators--non-commercial traders in the parlance
of the CFTC--to take risks in the future price of wheat.
Speculators carry a portfolio of risks. When possible, they will be
hedged against a similar commodity. Since not all risks can be hedged,
the speculator will end up with a Value At Risk (VAR) that it must be
willing to accept in exchange for a profit. If the VAR is large, the
speculator will require a larger profit. If demand for a specific
contract is high, the speculator will end up with a large unhedged
position, its VAR will expand enormously, and it will either demand a
much larger risk premium or withdraw from further trading in that
commodity.
In the Western Market Crisis of 2000-2001 the VAR became so large
that all of the speculators abandoned the NYMEX forward markets on the
West Coast. Halfway through the crisis, open interests on both NYMEX
exchanges went to zero. Interestingly, Enron and others offered a
negative risk premium at the height of the crisis--they sold forward
contracts at less than the expected price. We now know that this was
because their own forecasts recognized that the crisis would not last
long and they needed to sell their forward contracts before the rest of
the market discovered that prices had been manipulated.
A simple rule of thumb for estimating risk premiums is to compare
the forward contract prices with the actual spot prices in the month of
delivery. Since forecast errors tend to cancel out over time, the
residual, positive or negative, is the risk premium. Unfortunately,
this simple technique works poorly where spot and forward prices are
increasing over a long period. Given the past two years in the WTI
crude market, this rule of thumb estimate is unworkable.
In a perfect world, we could view the difference in prices from the
EIA Short Term Forecast and the NYMEX forward curve to estimate the
risk premium. As mentioned above, the forward price is equal to the
forecast plus the risk premium. Unfortunately, the EIA forecast lacks
substantial credibility. Over the past seven months, the EIA has
apparently calibrated its forecasts to spot. While this avoids
recognition that EIA's analysis of fundamentals is not matching spot
prices, it also reveals a lack of precision in the estimating process:
While the EIA forecasts are not perfect, they do allow us to
compare the forecasted prices with the NYMEX forward curve. According
to economic theory, the forecast is the actual price expectation. The
NYMEX forward curve is the price traders require to take a forward
position. The difference between the two is an estimate of the risk
premium. These risk premiums range from $11.00 to a negative $4.00. It
is suggestive, although not definitive, that the risk premium
calculated in this fashion has fallen during the same period in 2008
where the substantial long positions were liquidated by the non-
commercial traders.\14
\---------------------------------------------------------------------------
\14\ There are more sophisticated tools. One approach is to see if
the variance of forward price estimates increases or decreases the
forward curve. Statistically, the term for this is GARCH in Mean. While
the mathematics can be complex, the explanation is simple. If the
relationship between spot and forward prices becomes difficult to
forecast, this will increase the VAR and require a larger risk premium.
This approach does not allow numerical results for small
datasets: significant amounts of data are required to perform the
calculations. The results from the beginning of January 2008 to the end
of July 2008 indicate that the risk premium has become negative over
this period.
---------------------------------------------------------------------------
Overall, non-commercial market participants liquidated their long
positions in 2008. As they liquidated their positions, the risk premium
fell approximately $30 per barrel.
spot forward gambits
In July of 2001, Hunter Shively, a mid-level Enron gas trader,
initiated an exploit to manipulate Henry Hub natural gas futures on the
NYMEX. The CFTC complaint provides a blueprint on how to conduct a spot
forward gambit:
B. The Manipulative Scheme
23. On or about July 19, 2001, Shively, with the
assistance of at least one other Enron natural gas
trader, engaged in a scheme which manipulated prices in
the HH Spot Market, and had a direct and adverse affect
on NYMEX Henry Hub August 2001 Futures, including
causing prices in NYMEX Henry Hub Futures to become
artificial.
24. Defendants' manipulative scheme involved a plan
among Enron traders to purchase an extraordinarily
large amount of HM Spot Market natural gas within a
short period of time (the ``Manipulative Scheme'').
25. Defendants effectuated their Manipulative Scheme
through a variety of acts and practices that were
intended to, and did, manipulate prices in the HH Spot
Market. NYMEX August 2001 Henry Hub Futures were
affected by Defendants' Manipulative Scheme as well,
including causing NYMEX Henry Hub Futures prices to
become artificial.
26. Enlisting the assistance of the East Desk Enron
trader who managed the HH Spot Markel on EOL,
Defendants bought a very large amount of natural gas in
the HH Spot Market in a very short period of time,
approximately fifteen minutes, in the morning of July
19, 2001, causing prices to rise artificially.
27. Immediately following the prearranged buying
spree, Enron began unwinding its HH Spot Market
position and prices declined in that market. Prices in
the HH Spot Market declined in the first ten minutes
while Enron unwound its position.
28. Before Shively implemented the scheme, other
Central Desk traders learned that Shively was going
over to the East Desk to bid up the HH Spot Market. The
head of Enron's NYMEX desk was also informed of
Shively's plan. Later, at some point during Enron's HH
Spot Market trading, an Enron trader indicated to the
Central Desk that the East Desk was ``bidding up'' the
HH Spot Market. Shortly thereafter, a trader at the
Central Desk stated that the East Desk was going to
sell the HH Spot Market.
29. To ensure the participation of the Enron East
Desk trader who managed the HH Spot Market on EOL,
Shively agreed to cover any trading losses that trader
incurred by participating in the Manipulative Scheme.
30. On or about July 19, 2001, to cover the losses of
that East Desk trader, Shively directed that over
$80,000 be transferred from an administrative trading
account he controlled to the trading account of the
Enron East Desk trader who agreed to participate in the
Manipulative Scheme.
31. Shively acted in the scope of his employment in
carrying out and directing the conduct of other Enron
employees in furtherance of the Manipulative
Scheme.\15
\---------------------------------------------------------------------------
\15\ Docket H-03-909 CFTC Complaint, March 12, 2003, pages 5-6.
A similar, though less well-documented exploit was conducted by
Timothy Belden in the winter of 1999. Enron's senior west coast trader
gradually accumulated a portfolio for forward contracts. His position
was so large that it became the dominant risk position for the entire
corporation. While this speculative position would have appeared
foolhardy based on the fundamentals (even Enron's own forecasts
indicated that it was a foolish speculation), it was not nearly as
speculative as it appeared. Belden's trading position showed
prescience. His liquidation of his long position was even more
prescient since he sold his inventory just before the California energy
crisis ended in June 2001. We now know his prescience was no more or
less than the product of his market manipulation efforts. If FERC's
Electric Quarterly Report had been in existence in 1999, Belden's
dramatic gamble would have been detected quite early and the Western
Market Crisis might well have been averted.
In summary, a powerful case can be made for market power, not
fundamentals, as a contributing factor to the oil price spike on July
3, 2008. The spike has the following characteristics that cast doubt on
fundamentals and speculation as causes:
1. Short duration, reflecting no specific supply disruption
or increase in demand.
2. Events in June, to the degree they were present, should
have lowered the prices in July, not increased them.
3. A large speculative position was liquidated just before
the spike.
4. Long term prices followed the very brief spike in lockstep
fashion.
5. Evidence exists, both anecdotally and statistically, for
increased concentration in the NYMEX long positions.
6. Evidence exists that may indicate an increasing
differential between some well head receipts and market prices.
Five Recommendations
1. The FTC and the CFTC should accumulate data on spot and
forward markets for oil that will allow the identification of
market shares. If supply and de-mand are tight, this is exactly
the situation where economic theory would pre-dict the
existence of pivotal suppliers. Given the probability that
market par-ticipants have a very good idea of the market shares
and pricing, there is no logical public policy reason why this
information should not be accumulated and provided to
regulators and decision-makers.
2. The current chaotic state of CFTC market surveillance
should be corrected. At the moment, the department store
detective only watches one exit. This is worse than useless
because it provides the illusion of market surveillance while
allowing sufficient room for any offender to escape
observation.
3. The Commitments of Traders reports should be expanded to
incorporate the same concepts and measures used elsewhere in
the industry. Specifically, the report should provide HHI for
both NYMEX and ICE. It is important to include data on forward
trades in the OTC transactions. In sum, we will only be able to
detect the influence of excess speculation if we have the
measure of the entire market, not just a portion.
4. The CFTC should adapt FERC's detailed Electric Quarterly
Report to oil transactions. It is logical that reports for
electricity would be useful in evaluating the situation in oil.
5. The EIA should develop a methodology for reporting well
head prices for the ten largest suppliers to the U.S. This
report should be issued on the same frequency as other EIA
reports so that regulators and decision-makers can make
contemporaneous judgments concerning price spikes.
[Charts and appendixes A and B have been retained in subcommittee
files.]
Senator Dorgan. Mr. McCullough, can you do that chart one
more time? I missed the front part of your explanation. I'm
sorry.
Mr. McCullough. May I stand?
Senator Dorgan. Yes, please.
Mr. McCullough. This chart took hundreds of hours of
investigated research. We were able to reproduce Enron's net
position through the crisis. In the course of the fall of 1999,
long before anyone worried about electricity in the Northwest,
Enron--advanced electric position. They bought so much forward
from a single largest risk element--was West Coast Electricity.
Over the course of the crisis when they said it would take
two to 4 years to resolve. Instead they drew their position
down by April. In fact they went negative on April 1, 2001,
when the prices weren't deep. Soon afterwards the price
collapsed.
They were either omniscient or guilty. We now know after 6
years of litigation and many convictions, they were guilty.
This is a pattern that concerns me. We need to be able to
determine whether we're seeing similar behavior in oil. Thank
you.
Senator Dorgan. Mr. McCullough, Vitol, as my understanding,
is a foreign company. Where is it based?
Mr. McCullough. Switzerland. It's privately held. So
there's almost no data on Vitol publicly available. In fact the
only way I knew it was Vitol is I read the Washington Post.
Senator Dorgan. Alright. Thank you very much. Next we will
hear from Jeff Harris, the Chief Economist from the Commodity
Futures Trading Commission. My understanding is the Commodity
Futures Trading Commission has sent a North Dakotan down to
testify, is that correct?
Mr. Harris. Yes, that's right.
Senator Dorgan. That's rather underhanded.
[Laughter.]
Senator Dorgan. Mr. Harris is the Chief Economist and where
are you from in North Dakota originally?
Mr. Harris. In the heart of Walsh County, Park River.
Senator Dorgan. Thank you very much, Dr. Harris for being
with us. You may proceed.
STATEMENT OF JEFFREY HARRIS, CHIEF ECONOMIST, COMMODITY FUTURES
TRADING COMMISSION
Mr. Harris. Thank you. Good afternoon, Chairman Dorgan and
Ranking Member Murkowski and other distinguished member. My
name is Jeffrey Harris and I am testifying today as the Chief
Economist of the CFTC and not on behalf of the Commission. But
we actually do have hard data on these subjects.
I appreciate the opportunity to testify in front of you
about the CFTC's recently released staff report on commodity
swap dealers and index traders. In response to questions about
the role of index traders in our markets, the CFTC announced in
May that it would be using its special call authority to gather
new and detailed information from swap dealers on the amount of
index trading occurring in our markets. Last week the CFTC
released its staff report which compiled substantial
information on index futures and other transactions that are
being conducted through swap dealers.
The special call was intended to capture all commodity
index trading for activity for month end dates beginning
December 31, 2007, through June 30, 2008, and continuing
thereafter. Staff analyzed key commodities including crude oil,
corn, wheat and cotton in this report. While the preliminary
survey results represent the best data currently available
about swap dealers and commodity index trading, there are
limitations to this data due to the time and resource
constraints and the complexity in the amount of data that we
received.
With that in mind, the CFTC staff report found that on June
30, 2008, the total amount of commodity index trading, both
over the counter and on exchange activity stood at $200
billion. Of this amount $161 billion was tied to commodities
traded on U.S. markets that are regulated by the CFTC. For
NYMEX crude oil the net notional amount of commodity index
investment rose from about $39 billion in December to about $51
billion in June, an increase of more than 30 percent.
However this rise appears to have resulted from the
increase in the price of oil which rose from approximately $96
to $140 per barrel over the same period. Measured in
standardized futures contracts equivalent these figures
amounted to an 11 percent decrease in the aggregate positions
of commodity index traders during this 6-month period from
approximately 408,000 contracts to 363,000 contracts. We're
looking at the types of entities that are investing in
commodity indexes.
Not surprisingly, staff found a significant percentage of
these index investments were held by pension funds, endowments
and other large institutions. The CFTC staff survey also
revealed that 9 percent of the commodity index trader's
investments, excuse me, were held by several large sovereign
wealth funds, primarily located in North America, Europe and
Asia. Staff also looked to determine whether the clients of
swap dealers were putting on over the counter and exchange
positions that would have exceeded exchange position limits or
accountability levels in crude oil. Looking at our most recent
report of June 30, the survey data identified 35 of these
instances in 13 markets, out of 550 different clients trading
at more than 30 of the markets analyzed.
In light of the preliminary data and the findings, the
Commission made several recommendations that include enhanced
transparency, increased reporting and information and improved
controls and practices used to oversee the markets while
keeping the futures markets competitive, open and on U.S. soil.
In addition to the special call in analysis, the Office of the
Chief Economist continues to examine and analyze trading in the
regulated futures markets. My staff played a central role in
producing the July 2008 interim report on crude oil, working
with the inter agency task force on commodity markets which did
not find evidence to support the view that non-commercial
trading has been systematically driving price changes in the
crude oil market.
CFTC staff continues to analyze the markets utilizing
detailed agency data that includes positions of various groups
of traders that includes index traders, hedge funds and other
non-commercial entities. In the market for crude oil we
witnessed a significant run up in prices through mid July 2008,
as we know, with prices falling substantially through the past
2 months. The chart that I included in my testimony displays
this price pattern along with net price positions or net
positions, excuse me, of the commercial entities, swap dealers
who bring index fund positions to these markets and speculators
in the crude oil futures markets.
As displayed in the chart while oil prices were rising
dramatically during the first half of 2008. The net speculative
positions were actually decreasing. This pattern mirrors the
data that we've collected through our special call to swap
dealers and commodity index traders, showing that commodity
index net long positions in NYMEX crude oil contracts fell by
11 percent during the same 6-month interval.
My staff continues to analyze the markets to work with the
interagency task force on commodity markets. I expect that we
will update and supplement the analysis that we provided in the
interim report on crude oil in the next few weeks. Thank you
for the opportunity to appear before you today to discuss the
CFTC's economic analysis and staff report on commodity swap
dealers and index traders. I'd be happy to answer any questions
you might have. Thanks.
[The prepared statement of Mr. Harris follows:]
Prepared Statement of Jeffrey Harris, Chief Economist, Commodity
Futures Trading Commission
Chairman Dorgan, Ranking Member Murkowski, and other Subcommittee
Members, thank you for inviting me to testify before the Energy
Subcommittee. My name is Jeffrey Harris and I am the Chief Economist at
the Commodity Futures Trading Commission (CFTC or Commission). I am
testifying today in my capacity as Chief Economist and not on behalf of
the CFTC. My testimony today will focus on the CFTC's staff report on
the commodity swap dealers and index traders issued Thursday September
11, 2008.
The CFTC recognizes that a secure, reliable, and sustainable energy
future is of great importance to the American people. We are acutely
aware that high commodity prices have been, and continue to be, painful
for American consumers. We are also aware that speculative activity can
affect the price discovery and risk management roles of the markets we
regulate. With that context, let me summarize what the Commission is
doing to insure that the markets that we regulate are serving the
public interest.
The CFTC continuously monitors and analyzes trading in the markets
we regulate. We collect and analyze data on a daily basis, and monitor
positions, price movements and activity in these markets. The CFTC data
includes positions and trading of noncommercial traders like hedge
funds and other managed money traders. As noted in the Interim Report
on Crude Oil produced by the Interagency Task Force on Commodity
Markets, staff did not find evidence from this data to support the view
that noncommercial trading has been systematically driving price
changes in the crude oil market.
Despite these findings, the CFTC continues to analyze the data for
evidence of such a connection. During the last year, the CFTC has been
systematically reviewing satellite markets that complement and compete
with the centralized and regulated futures markets in the United
States, in order to determine whether satellite markets are having an
impact on regulated futures markets. As you know, a combination of
Congressional and Commission action has resulted in increased
regulation of trading on exempt commercial markets and increased
transparency and reporting of trading on foreign boards of trade that
seek access to trade contracts linked to any U.S. regulated contract.
More recently, the agency has been reviewing the role of swap
dealers and index traders and whether their connection to the futures
markets is having an impact on the price of commodities. In May, the
CFTC announced that it would use its special call authority to gather
new and detailed data from swap dealers on the amount of index trading
occurring in the OTC markets. Last week, the CFTC released its staff
report, which compiled substantial information on index funds and other
transactions that are being conducted through swap dealers.
cftc report on swap dealer and index trader activity
The staff report represents a survey of swap dealers and commodity
index funds to better characterize their activity and understand their
potential to influence the futures markets. This type of a compelled
survey relating to off-exchange activity is unprecedented, but the
growth and evolution in futures market participation and growing public
concern regarding off-exchange activity supported the need for this
extraordinary regulatory inquiry.
In June 2008, Commission staff initiated a special call to futures
traders, which included 43 request letters issued to 32 entities and
their sub-entities. These entities include swap dealers engaged in
commodity index business, other large swap dealers, and commodity index
funds. The special call required all entities to provide data relating
to their total activity in the futures and OTC markets, and to
categorize the activities of their customers for month-end dates
beginning December 31, 2007 through June 30, 2008, and continuing
thereafter. The scope of the survey attempts to answer the following
questions:
How much total commodity index trading is occurring in both
the OTC and on-exchange markets?
How much commodity index trading is occurring by specific
commodity in both the OTC and on-exchange markets?
What are the major types of index investors?
What types of clients utilize swap dealers to trade OTC
commodity transactions?
To what extent would the swap clients have exceeded position
limits or accountability levels had their OTC swap positions
been taken on exchange?
The preliminary survey results represent the best data currently
available to the staff and the results present the best available
snapshot of swap dealers and commodity index traders for the relevant
time period. However, as a result of the survey limitations, there may
be a margin of error in the precision of the data, which will improve
as the staff continues to work with the relevant firms and to further
review and refine the data. As entities continue to provide monthly
data to the Commission in response to their ongoing obligation to
comply with the special call, Commission staff will continue to examine
the data, refine the specific requests, and further develop the
analysis.
findings
In analyzing the total OTC and on-exchange positions for index
trading, the report focuses on three quarterly snapshots--December 31,
2007, March 31, 2008, and June 30, 2008--and has thus far revealed the
following data:
Total Net Commodity Index Investments: The estimated
aggregate net amount of all commodity index trading (combined
OTC and on-exchange activity) on June 30, 2008 was $200
billion, of which $161 billion was tied to commodities traded
on U.S. markets regulated by the CFTC. Of the $161 billion
combined total, a significant amount of the OTC portion of that
total likely is never brought to the U.S. futures markets.
Net Notional Index Values vs. Total Notional Market Values:
For comparison purposes, the total notional value on June 30,
2008 of all futures and options open contracts for the 33 U.S.
exchange-traded markets that are included in major commodity
indexes was $945 billion--the $161 billion net notional index
value was approximately 17 percent of this total.
--The total notional value of futures and options open contracts on
June 30, 2008 for NYMEX crude oil was $405 billion--the $51
billion net notional index value was approximately 13
percent of this total.
--The total notional value of futures and options open contracts on
June 30, 2008 for CBOT wheat was $19 billion--the $9
billion net notional index value was approximately 47
percent of this total.
--The total notional value of futures and options open contracts on
June 30, 2008 for CBOT corn was $74 billion--the $13
billion net notional index value was approximately 18
percent of this total.
--The total notional value of futures and options open contracts on
June 30, 2008 for ICE-Futures US cotton was $13 billion--
the $3 billion net notional index value was approximately
23 percent of this total.
Crude Oil Index Activity: While oil prices rose during the
period December 31, 2007 to June 30, 2008, the activity of
commodity index traders during this period reflected a net
decline of swap contracts as measured in standardized futures
equivalents.
During this period, the net notional amount of commodity
index investment related to NYMEX crude oil rose from about $39
billion to $51 billion--an increase of more than 30 percent.
This rise in notional value, however, appears to have resulted
entirely from the increase in the price of oil, which rose from
approximately $96 per barrel to $140 per barrel--an increase of
46 percent.
Measured in standardized futures contract equivalents, the
aggregate long positions of commodity index participants in
NYMEX crude oil declined by approximately 45,000 contracts
during this 6 month period--from approximately 408,000
contracts on December 31, 2007 to approximately 363,000
contracts on June 30, 2008. This amounts to approximately an 11
percent decline.
Types of Index Investors: Of the total net notional value of
funds invested in commodity indexes on June 30, 2008,
approximately 24 percent was held by ``Index Funds,'' 42
percent by ``Institutional Investors,'' 9 percent by
``Sovereign Wealth Funds,'' and 25 percent by ``Other''
traders.
Clients Exceeding Position Limits or Accountability Levels:
On June 30, 2008, of the 550 clients identified in the more
than 30 markets analyzed, the survey data shows 18
noncommercial traders in 13 markets who appeared to have an
aggregate (all on-exchange futures positions plus all OTC
equivalent futures combined) position that would have been
above a speculative limit or an exchange accountability level
if all the positions were on-exchange. These 18 noncommercial
traders were responsible for 35 instances of either exceeding a
speculative limit or an exchange accountability level through
their aggregate on-exchange and OTC trading that day. Of these
instances:
8 were above the NYMEX accountability levels in the natural
gas market;
6 were above the NYMEX accountability levels in the crude
oil market;
6 were above the speculative limit on the CBOT wheat market;
3 were above the speculative limit on the CBOT soybean
market; and
12 were in the remaining 9 markets.
These combined positions do not violate current law or regulations
and the amounts by which each trader exceeded a limit or level were
generally small. However, there are a few instances where a
noncommercial client's combined on-exchange futures positions and OTC
equivalent futures positions significantly exceeded a position limit or
exchange accountability level.
In light of the preliminary data and findings, the Commission made
the following preliminary recommendations.
preliminary recommendations
1. Remove Swap Dealer from Commercial Category and Create New
Swap Dealer Classification for Reporting Purposes: In order to
provide for increased transparency of the exchange traded
futures and options markets, the Commission has instructed the
staff to develop a proposal to enhance and improve the CFTC's
weekly Commitments of Traders (COT) Report by including more
delineated trader classification categories beyond commercial
and noncommercial, which may include at a minimum the addition
of a separate category identifying the trading of swap dealers.
2. Develop and Publish a New Periodic Supplemental Report on
OTC Swap Dealer Activity: In order to provide for increased
transparency of OTC swap and commodity index activity, the
Commission has instructed the staff to develop a proposal to
collect and publish a periodic supplemental report on swap
dealer activity. This report will provide a periodic ``look
through'' from swap dealers to their clients and identify the
types and amounts of trading occurring through these
intermediaries, including index trading.
3. Create a New CFTC Office of Data Collection with Enhanced
Procedures and Staffing: In order to enhance the agency's data
collection and dissemination responsibilities, the Commission
has instructed its staff to develop a proposal to create a new
office within the Division of Market Oversight, whose sole
mission is to collect, verify, audit, and publish all the
agency's COT information. The Commission has also instructed
the staff to review its policies and procedures regarding data
collection and to develop recommendations for improvements.
4. Develop ``Long Form'' Reporting for Certain Large Traders
to More Accurately Assess Type of Trading Activity: The
Commission has instructed staff to develop a supplemental
information form for certain large traders on regulated futures
exchanges that would collect additional information regarding
the underlying transactions of these traders so there is a more
precise understanding of the type and amount of trading
occurring on these regulated markets.
5. Review Whether to Eliminate Bona Fide Hedge Exemptions for
Swap Dealers and Create New Limited Risk Management Exemptions:
The Commission has instructed staff to develop an advanced
notice of proposed rulemaking that would review whether to
eliminate the bona fide hedge exemption for swap dealers and
replace it with a limited risk management exemption that is
conditioned upon, among other things: 1) an obligation to
report to the CFTC and applicable self regulatory organizations
when certain noncommercial swap clients reach a certain
position level and/or 2) a certification that none of a swap
dealer's noncommercial swap clients exceed specified position
limits in related exchange-traded commodities.
6. Additional Staffing and Resources: The Commission believes
that substantial additional resources will be required to
successfully implement the above recommendations. The CFTC
devoted more than 30 employees and 4000 staff hours to this
survey, which the Commission is now recommending to produce on
a periodic basis. Other new responsibilities will also require
similar additional staff time and resources. Accordingly, the
Commission respectfully recommends that Congress provide the
Commission with funding adequate to meet its current mission,
the expanded activities outlined herein, and any other
additional responsibilities that Congress asks it to discharge.
7. Encourage Clearing of OTC Transactions: The Commission
believes that market integrity, transparency and availability
of information related to OTC derivatives are improved when
these transactions are subject to centralized clearing.
Accordingly, the Commission will continue to promote policies
that enhance and facilitate clearing of OTC derivatives
whenever possible.
8. Review of Swap Dealer Commodity Research Independence:
Many commodity swap dealers are large financial institutions
engaged in a range of related financial activity, including
commodity market research. Questions have been raised as to
whether swap dealer futures trading activity is sufficiently
independent of any related and published commodity market
research. Accordingly, the Commission has instructed the staff
to utilize existing authorities to conduct a review of the
independence of swap dealers' futures trading activities from
affiliated commodity research and report back to the Commission
with any findings.
In sum, this special call data and analysis has given the CFTC a
snapshot of the OTC market. While the report's findings are useful and
instructive, the data collection and analysis need to continue if the
agency is to get a clearer, moving picture of this vast marketplace.
The Commission's recommendations include enhanced transparency,
increased reporting and information, and an overall modernization of
several rules, regulations and practices used to oversee the markets.
These changes will improve controls while ensuring that our futures
markets remain competitive, open, and on U.S. soil.
office of chief economist recent analysis of crude oil markets using
large trader data
In addition to the special call data and analysis, the Office of
the Chief Economist (OCE) continues to examine and analyze trading in
the regulated futures markets. OCE staff played a central role in
producing the July 2008 Interim Report on Crude Oil, working with the
Interagency Task Force on Commodity Markets. Utilizing the detailed
data included in the CFTC's Large Trader Reporting System, we continue
to monitor and analyze various groups of traders, including index
traders, hedge funds, and other non-commercial traders.
In the market for crude oil, we have witnessed a significant run-up
in prices through mid-July 2008, with prices falling substantially
during the past two months. Figure 1* below displays this price pattern
along with the net positions of commercial entities, swap dealers (who
bring index fund positions to these markets), and speculators in the
crude oil futures markets. As displayed in Figure 1, while oil prices
were rising dramatically during the first half of 2008, net speculative
positions have been largely falling. This pattern mirrors the data
collected by the special call to swap dealers and commodity index funds
showing that commodity index net long positions in NYMEX crude oil
contracts declined by approximately 11 percent during this same six-
month interval.
---------------------------------------------------------------------------
* Graphic has been retained in subcommittee files.
---------------------------------------------------------------------------
The Office of the Chief Economist continues to work with the
Interagency Task Force on Commodity Markets and expects to update and
supplement the findings produced in the July 2008 Interim Report in the
near future.
conclusion
The CFTC is working hard to protect the public and the market users
from manipulation, fraud, and abusive practices in order to ensure that
the futures markets are working properly. Thank you for the opportunity
to appear before you today to discuss CFTC efforts in ensuring the
integrity of the futures markets. I would be happy to answer any
questions you may have.
Senator Dorgan. Dr. Harris, thank you very much for your
testimony. The vote has started. We will attempt to recess and
be back in about 10 minutes. So the committee will stand in
brief recess.
[Recessed.]
Senator Dorgan. The subcommittee will come to order. Our
next witness will be Mr. Lawrence Eagles from JP Morgan. Mr.
Eagles, thank you for being with us. We would ask you to
proceed.
STATEMENT OF LAWRENCE EAGLES, GLOBAL HEAD OF COMMODITY
RESEARCH, JP MORGAN CHASE, NEW YORK, NY
Mr. Eagles. Thank you very much, Mr. Chairman and members
of the committee. My position in JP Morgan is Global Head of
Commodity Research and I'm here in replacement of Blythe
Masters, the Head of JP Morgan's Global Commodities business
who sends her sincere apologies that she can't make it today.
My background, I'm a trained economist. I've got over 20
years experience in commodity research, energy in particular.
I've recently joined JP Morgan from the International Energy
Agency in Paris, which is the independent policy advisor to
OECD governments.
While I was at the IEA I made the assessment that triggered
the release of the international emergency all stocks following
the devastation reeked by Hurricanes Rita and Katrina. I've
advised OECD governments on financial flows in energy markets.
I helped to draft the GA communicade on the issue in Osaka this
year.
Let me note at the outset that JP Morgan's commodity
business has no incentive to see energy prices rise nor does JP
Morgan Chase as a whole benefit from higher energy prices.
Higher energy prices hurt our customers. They weaken the
economy and therefore they hurt us.
We believe that high energy prices are fundamentally a
result of supply and demand. That said, we strongly support the
efforts of the CFTC to identify and prosecute anyone found to
be manipulating the energy markets. Manipulation though,
shouldn't be confused with a legitimate trading activity.
Financial commodity hedging on regulated U.S. markets as
producers and consumers of energy protect themselves from price
movements. It keeps our energy markets liquid and strong and
provides vital price transparency. Investors and speculators
provide the liquidity that enables producers and consumers to
offset risk and restricting this activity could have adverse
consequences for the U.S. economy, long term oil supplies and
could actually end up shifting that activity overseas in more
lightly regulated markets.
Today's question is whether passive investment flows have
caused oil prices to rise. I reject that assertion. First, we
found no causal relationship between investment flows and
energy prices.
No one disputes that the rapid growth of investment flows
into commodity futures has occurred. But that investment has
not in fact caused commodity price inflation. There's a very
strong correlation between the consumption of Tylenol and the
frequency of headaches, but that doesn't imply causality. If
passive index investing drives commodity prices higher than all
prices in a given commodity index should rise at the same time.
Yet we've observed distinctly different trends between
commodity subgroups regardless of investment flows.
Second, we found no evidence of inventory builds that would
indicate market manipulation. There may be unreported stocks in
places like China and India. But that's a symptom of a rush to
achieve supply security. That's not manipulation.
Because spot markets have to clear regardless of what is
happening to the futures market, spot markets actually lead
futures markets and not vice versa. The absence of inventory
builds supports our assertion that fundamentals of supply and
demand are driving current fuel prices.
Third, high oil prices show that the market is working to
curb demand. Increased energy demands from China, India and the
Middle East are set against a background of harder to get
supplies. That's an explosive price combination.
When you look back at statistics, if you look back over
history you'll always see supply and demand matching. If you
get poor supply growth, you'll get poor demand growth because
supply and demand have to balance. It's prices that tell you if
there's tightness.
In developing economies there are often price caps and
subsidies. So all the necessary de-facto fuel rationing has to
take place in developed economies where consumers are prepared
to pay more.
Fourth, production is getting much more expensive. Recent
oil findings in Brazil at five kilometers deep and require
penetration through a vast salt crust. These finds may be huge,
but getting this oil out of the ground is going to be
expensive.
It's going to require significant infrastructure and
technological hurdles to be overcome. If it costs more to get
oil out of the ground, we're going to have to pay more at the
pump and academic work linking oil prices to interest rates,
therefore no longer holds.
Fifth, the weak dollar bears some responsibility for the
rapid oil price increase and that was shown in a recent study
by the IMF which showed that the impact of the weaker dollar
could actually cause a greater than one for one increase in the
price of commodity in the short term. But it is not the only
explanation.
Sixth, I think and very importantly we have had severe
constraints, not just in the upstream, but also in the refining
sector which is amplified oil price increases. Our use for
crude oil is in the refined product form. So if the price of
refined products goes up, the price of crude oil goes up too.
Recent experience in the diesel market demonstrates this
relationship. Over the first half of the year, we had almost a
perfect storm in terms of increase supply issues. It's a vital
factor. I think it probably explains most of the $50 run up in
prices earlier this year. But it's poorly understood.
Finally, Mr. Chairman, in recent months, evidence has
directly contradicted the assertion that passive investment is
causing oil prices to rise. The latest CFTC report reveals a
decline in commodity investment as the oil price continues to
surge. While price pressures have eased across all commodity
markets in recent weeks, the reason is no cause for cheer. The
unifying factor is a broad weakening of economic conditions.
We fully support efforts to make energy markets more
transparent and to increase information available about
commodities themselves. At the same time the CFTC's report
clearly implies index fund's investors are not to blame for
recent price increases. Arbitrary changes in fund flows could
reduce that liquidity, diminish investment and ironically,
could actually cause increased prices and volatility in the
future.
Recent experience indicates we cannot afford to make this
mistake. Thank you very much. I'm very happy to answer any
questions that should arise.
[The prepared statement of Ms. Masters follows:]
Prepared Statement of Blythe Masters, Managing Director, Head of Global
Commodities, JP Morgan Chase, New York, NY
introduction
Mr. Chairman and members of the Committee, I am Blythe Masters,
appearing on behalf of JPMorgan and SIFMA, of which I am the present
chairman. I am responsible for JP Morgan's Global Commodities business.
By background, I am a trained economist, with a BA in economics from
Trinity College, Cambridge in the UK. I appreciate the opportunity to
present our views on the role of speculative investment in energy
markets.
jpmorgan does not benefit from higher energy prices
Before addressing specifically the conclusions in some of the
recent analyses, I would like to describe what JPMorgan's Commodities'
business does, and what JPMorgan as an institution does, to show what
effect higher energy prices have on our businesses.
JPMorgan's Global Commodities business provides risk management
services, develops investor products and makes markets in energy
products around the world. The business is focused on serving corporate
clients (including producers and consumers of commodities) as well as
investor clients. We stand as intermediaries between our clients and
the markets, and we act as risk managers.
Rising energy prices have a significant effect on our clients and
therefore on our business. As prices rise, not only do producers tend
to hedge less, taking advantage of the favorable price trend, but
consumers and investors also tend to postpone transacting, not wanting
to lock in high prices. The effect is that overall business volumes
decrease and risk increases, which hurts our business. Our Commodities
business has no incentive to see energy prices rise and in fact
benefits much more in a lower-priced environment.
Moreover, JPMorgan Chase overall does not benefit from higher
energy prices. Our Retail Financial Services business serves millions
of individual customers in the United States, with branches in
seventeen states. Our Card Services business has more than 155 million
cards in circulation, the vast majority in the United States. Our
Commercial Banking business serves 30,000 clients nationally, including
corporations, municipalities, financial institutions and not-for-profit
entities with annual revenue generally ranging from $10 million to $2
billion. JPMorgan Chase is core to the US economy, and rising energy
prices result in a weaker economy--consumers struggling to pay for
gasoline or energy to heat their homes, businesses having to cut back
on investment, defaults rising. As Jamie Dimon, our Chairman and CEO,
has stated, ``The weaker the economy gets, the greater the impact could
be across all our lines of business.'' Higher energy prices hurt our
customers, weaken the economy and therefore hurt us.
One of the truly regrettable consequences of the focus on energy
speculation has been to detract from what we believe is a critical
issue facing the United States: the development of a long-term energy
policy. It is because JPMorgan benefits from a strong US economy that
we strongly support the development of a comprehensive US energy
policy, one that would reduce our dependence on foreign energy and
promote the development of alternative energy in an environmentally
responsible manner. We support the efforts of the CFTC to weed out and
prevent market manipulation, but we fundamentally believe that high
energy prices are a result of supply and demand, not excessive
speculation. I will now turn to our analysis of the role of speculation
in energy markets.
the impact of speculators on commodity markets
What we are addressing here today is the impact of investment flows
on energy prices, and oil prices in particular. But this debate is not
exclusively an oil issue. The same arguments are being discussed in all
the primary commodity markets from corn to copper. These commodities
form the backbone of the world's industrial and economic system and
have a disproportionate impact on the finances of low income groups and
developing nations, understanding the root cause of such price rises is
extremely important.
From the prime vantage point that JPMorgan Chase has across a broad
spectrum of commodity markets, we can see the arguments from many
different perspectives. And we can see that the arguments are often
very inconsistent.
the growth of index fund investment and its impact on commodity prices
Media and political analysis has often focused on the category of
investment flows from passive investors, in particular, those
investments generally categorized as index funds. They have been widely
blamed for rising prices because they have typically been seen as long-
term buyers of commodities, rather than being on both buy-and sell-
sides of the market as hedge funds and other speculators tend to be.
No one disputes the rapid growth of investment flows into commodity
futures--we estimate that the money under management in these commodity
indices has increased from $10-15 bn in 2003 to $146 bn at the end of
2007 and $200 bn at the end of June 2008. But we have to be very
careful in asserting that because commodity prices have risen over the
same period one has caused the other. There is a strong correlation
between the consumption of Tylenol and the frequency of headaches but
that does not imply causality.
You do not have to scratch too deeply behind these assertions to
question the validity of the arguments.
Firstly, if you invest $1mln dollars in a commodity index fund in
2003 of course you would see the value of your investment increase by
exactly the same amount as the index it was invested in. Commonsense
would tell you that before leaping to a conclusion, you need to see
what the net money flows are after you strip out the capital gain
associated with these trades. When you do that you find no meaningful
relationship between the flows of money coming in and the change in the
oil price.
Secondly, index funds tend to hold a basket of commodities, so if
investment money is moving one commodity, it should be moving all
commodities at the same time. It does not. While there has been a
general trend for commodity prices to rise, within that you see
distinctly different trends between commodity sub-groups.
These two factors together argue strongly that spot commodity
prices in general are not being driven by fund flows, but fundamentals.
The linkage between physical and futures markets is also important
to understand. Some recent analysis confuses a trading link between the
two with a pricing link.
Futures markets have a much more important economic role than
simply allowing the hedging and transfer of risk over different time
periods. The standardization of commodities traded on futures exchanges
offers price transparency that cannot be achieved with the multitude of
grades and delivery locations of the spot commodity market. But the
concentration of trading in the futures contracts provides a reference
point which spot traders use as a benchmark. They then price their spot
commodity as either a premium or a discount to the futures price. That
links the spot and futures market from a quotation perspective, but
that does not mean that one determines the other.
We had a very clear example of this in the oil market in 2006, when
storage tanks in the US Midwest, the pricing point of WTI, were full up
due to a combination of increased Canadian pipeline flows, refinery
shutdowns and the lack of any infrastructure to ship surplus oil out of
the region. As a result, WTI traded at massive discounts to
international crudes such as Brent, and US Benchmarks such as Mars and
Light Louisianna Sweet crude. This is a classic example of how spot
markets have to clear, regardless of what is happening to the futures
market--and how spot markets lead futures and not visa versa.
This is important. High school economics students will be able to
tell you that if fund flows into commodity markets artificially push
spot prices above this equilibrium clearing level, you will distort the
market. That distortion will be manifested in a build in stocks. Where
was that stockbuild in the oil market between July 2007 and July 2008
when prices rose from $70 to nearly $150/barrel? Where was it when
London Metal Exchange stocks were at near zero levels when copper,
nickel and zinc prices hit record highs? Where was it when we had the
recent surge in wheat and rice prices, or coal come to that?
Some observers point out that this argument does not hold if
traders are secretly holding stocks. But have you seen the size of a
VLCC--you can't hide one in your back garden. You can't hide an oil
storage tank or offloading facility either. Yes, in oil we know that
several countries have been building strategic reserves, and don't
report the buying, nor do many non-OECD countries report stock levels.
But that is not an issue for the markets--if they see more physical
buying and supplies tightening, the price rises. This is not fund flows
lifting prices, it is not fund flows replicating the Hunt Brothers
squeezing the silver market. It is however a strong argument for more
data transparency--which we would fully support.
High prices are there for a reason--to choke off demand. If the oil
market is working efficiently and effectively you will never see
shortages. You will see consumers being priced out of the market, but
shortages will only occur if there is a sudden supply shock--not a
structural shift.
But what if these investment flows are lifting forward prices? What
does that mean?
What it does not mean is that the man at the pump is paying more
for his oil--that is determined by the spot market. Higher forward
prices should mean more investment: producers can lock in high prices,
and can guarantee a cash flow. They send a strong signal to consumers
to invest in energy efficient technology, or to look for substitutes.
In the oil and metals industry it may take 5-10 years for an
investment to come to fruition--try hedging that risk in a futures
market that only had significant liquidity six months forward--as we
had in oil a decade ago. Now we have futures markets liquid three to
five years forward. Financial intermediaries such as JPMorgan make
markets going out a decade or more.
These fund flows have provided a huge economic service to the US
and to the world economic system. But are these fund flows distorting
the futures markets--again, the answer is no. Look at the latest
medium-term analyses--they show that despite these record high prices,
and record investments, we will still see crude oil supplies getting
very tight again in five years time. These high prices are clearly
justified.
Look outside of the commodities and you get more evidence that
index fund flows are not driving commodity prices. Look at commodities
that are difficult for speculators to access: coal, rice, rubber, minor
metals, uranium. All of these commodities have seen sharp price rises
at some point over the past five years--yet they do not appear in the
main commodity indexes.
There is a much simpler explanation for a generally rising trend in
oil prices: strong economic growth in highly populous countries--China
and India in particular.
GDP per capita in these countries has risen above the threshold
level (usually seen around $1000-$2000/capita) where the population
shifts from a subsistence level to consumer status. As their income
expands, naturally they want to have access to the same goods as we
enjoy in the developed world--housing, running water, better and more
food (more meat) electricity, cars, washing machines and so on. Such a
rapid expansion requires significant increases in primary commodity
consumption.
But supply growth has been poor. The increase in China's oil demand
since 2003 has required the discovery of new oil supplies roughly the
equivalent of Iraq, or Libya or Angola. However, this growth in demand
has come at exactly the same time as the world has struggled to add new
production capacity. According to the International Energy Agency's
Medium Term Oil Market Report in July 2008, non-OPEC crude oil supplies
have been static or in decline since 2004.
Most of the additional growth has been provided by either OPEC,
biofuels or Natural Gas Liquids--the latter of which can not be readily
transformed into the much-in-demand transportation fuels.
Quite simply, if you do not have the supply, you have to ration
demand--and in the free market we do this with price. And as the
government sets the price in many developing countries, it is the
developed countries that have to cut back. And the higher your income,
the higher the price needed to curb demand.
Oil is also getting more expensive to get out of the ground. No one
would debate that. Yet some analysts point to Hotelling's Rule to imply
that oil prices are being inflated by fund flows. No academic would
invoke this if they understood the oil market, no oil market analyst us
this if they understood the academic debate. Hotelling implies that
that even if oil is running out, the price of oil should rise by no
more than the rate of interest. But he was very clear that this rule
only held true if production costs remain constant. In fact, the
escalation of production costs has been unprecedented and therefore his
assessment has no relevance in today's world. There has been a massive
increase in marginal costs since 2003.
Recent finds in Brazil are five kilometres deep and require
penetration through a vast salt crust. These finds may be huge, but
getting this oil out of the ground will not come cheaply and there will
be significant infrastructure and technological hurdles to overcome. It
is not speculation or fear of peak oil which is leading to higher
prices, but the reality of getting oil out of the ground.
We don't think fear of peak oil is pushing prices higher, but
prices are reflecting the higher cost of getting oil out of the ground
in more and more challenging locations.
This does not however mean that oil prices stick like glue to the
marginal cost--currently $70 to $100/barrel at current costs. Marginal
cost provides a rough estimate of where oil prices should gravitate
over time. But in the short run, the true marginal cost can be
determined by the price at which OPEC is willing to take off or add
oil, the price at which corn ethanol is available, or the availability
of diesel supplies to a market constrained by ever-tighter product
specifications, limited flexibility in refining capacity and surging
diesel demand.
The weaker dollar has also had an impact. Academics can debate the
precise mechanism for days, but simplistically, a commodity's price is
determined by the supply and demand for the commodity not by the
currency it is denominated in. If the dollar weakens, the value of oil
has not changed globally, so the price in dollar terms has to increase.
In fact, a recent study by the IMF showed that the impact of a weaker
dollar could actually cause a greater than a one-for-one increase in
the price of a commodity. But the impact is not just on the sales
price--costs in the oil and other commodity industries are often
denominated in dollars as well, so a weaker dollar can raise the
marginal cost of production too. But, regardless of this, oil prices
have generally risen by much more than the dollar has depreciated,
highlighting that this is only one background feature of many.
OPEC has also gained renewed importance in the market. It was slow
to raise output in 2007 when demand was increasing, and prices only
started to decline when Saudi Arabia ramped up production in July 2008.
It has been argued that higher prices are actually leading to less
investment and supply as producer countries seek to maximize their long
term revenue flow. That is a possibility, although I would argue that
the recent decision by Saudi Arabia to increase output sends a clear
signal that there is also concern about the impact demand destruction
is having on their future market prospects. But regardless of your
view, that is a symptom of high prices and political dynamics, not an
impact from fund flows.
The oil market has also had problems in the refining sector, which
have amplified the rise in the oil price. In fact, we believe that the
tightness in global diesel markets was the key factor behind the oil
price rally over the past year. It is not a simple mechanism, or one
that is easy to understand without an in-depth understanding of oil
market functioning. Many traders and analysts will be able to tell you
that diesel has been driving the market over the past few years, but
few will be able to explain the mechanism, but when you think about it
in first principle terms, it is intuitive.
Crude oil is not much use to anyone in its raw form--a couple of
power stations around the world may use it for fuel, but that is it.
Our use for crude oil is in the refined product form--gasoline, diesel,
petrochemicals and fuel oil. Each of these refined products is a
commodity in its own right, with a price determined by the supply and
demand for that product. If we sum the values of all of these refined
products we get the price that refiners will be willing to pay for a
barrel of crude oil. So if the price of refined products goes up, the
price of crude oil goes up too.
So if we have strong demand for diesel fuel, but not enough
refinery capacity or crude supply to meet it, diesel prices will rise,
and that will raise the value of the product slate, and so the price of
crude oil rises as well. If the supply of crude oil is too high,
refiners will make a bigger profit and will store more crude. If the
supply of crude is tight, their profits will be less, marginal
producers will cut runs--and there will be less diesel supply.
In the past year, demand for diesel has been so strong that prices
have had to rise to record premiums to crude oil to restrain demand. In
many ways the diesel market has endured a ``perfect storm.''
Europe is consuming ever-more diesel as tax incentives
encourage its consumers to switch to diesel cars.
A market failure has led to China's teapot refineries being
closed down, leading China to seek more diesel from an already
tight international market.
Widespread shortages in the retail market prompted China to
order an increase in stock levels ahead of the Olympics.
Power shortages in South Africa and Chile prompted a surge
in diesel for backup generators.
To cap it all, there was a natural gas pipeline accident in
Australia which, again, caused a surge in diesel demand. Only
when some of these pressures on the diesel market eased
(unfortunately partly due to a spreading global economic
slowdown) did oil prices start to decline.
Importantly, as oil prices embarked on the largest part of this
surge, commodity index investment declined. It is not just our analysis
that shows this, but also the most recent and comprehensive analysis by
the CFTC.
Similarly, when we look to other markets there has also been an
easing of pressure. Some of this has been a response to improved
investment: crop yields have increased, investment is underway in the
base metals, and international oil companies are reinvesting a greater
portion of cash flow than would be seen in any other industry.
Unfortunately, while price pressures have eased in oil (and many
other commodity markets) the unifying factor is a widening weakening of
economic conditions. But even as we weather this downturn, we must be
aware that the fundamentals that underpinned this commodity boom are
unlikely to completely go away.
We recognize that there is a need for more information, and we
fully support efforts to make these markets more transparent. But we
have to recognize that one of the main areas where we lack fundamental
information is on commodities themselves. There have been times when
estimates of the Brazilian coffee crop have fluctuated between 30 and
50 mln bags; when traders have believed there have been secret
stockpiles of metal building up around the world, only to see them
``wiped out'' by a dramatic upward revision to demand. The discrepancy
between crude oil supply and petroleum product demand has exceeded 1
mb/d because we only get reliable data 18 months late. We have no idea
of the true production capacity of many major oil producing countries
in the world. There is little surprise that pundits jump to the wrong
conclusions over the drivers of commodity prices.
Similarly, if we want to regulate markets, we need to know whether
they are functioning properly from a supply and demand perspective
first.
But while we support the need for more transparency, for both
financial and fundamental data, it is imperative that we recognize the
benefits that additional liquidity from investment flows provides.
Commodity producers can now invest in the future with the financial
tools that will help them mitigate risk and lock in profitable returns.
Arbitrary changes in fund flows could reduce that new-found liquidity,
resulting in lower investment and ironically exactly the opposite
effect that was intended--higher prices in the future.
[Graphics have been retained in subcommittee files.]
Senator Dorgan. Mr. Eagles, thank you very much. Next we
will hear from Dr. James Newsome, the Director, this says
Director. Are you President?
Mr. Newsome. No.
Senator Dorgan. Ok.
Mr. Newsome. Changed titles, that's all.
Senator Dorgan. Changed titles. Director of the Commodity
Mercantile Exchange in New York. Mr. Newsome, thank you for
being with and you may proceed.
STATEMENT OF JAMES NEWSOME, DIRECTOR, CME GROUP, NEW YORK, NY
Mr. Newsome. Thank you, Mr. Chairman. I appreciate the
opportunity to present the views of the CME Group this
afternoon. The CME Group is the parent of the CME Incorporated,
the Board of Trade over the city of Chicago, the New York
Mercantile Exchange and COMEX. We'll refer to them as the Group
of Exchanges.
The CME Group Exchanges are neutral marketplaces. They
serve the global risk management needs of our customers and
producers and processors who rely on price discovery provided
by our competitive markets to make important economic
decisions. We do not profit from higher crude nor energy
prices.
Our congressionally mandated role is to operate fair
markets, to foster price discovery and the hedging of economic
risk in a transparent, efficient, self regulated, environment,
overseen by the CFTC. The CME Group Exchanges offer products in
all major asset classes including futures at options based on
interest rates, equity indexes, foreign exchange, agricultural
commodities, energy, metals and alternative investment
products.
Speculators make markets work for the benefit of the
hedgers and for all who look to efficient markets for the best
source of price discovery. Our markets operate in a global
economy. Impediments to legitimate speculative activity on U.S.
regulated markets will drive trading off exchange and overseas.
We support proposals to materially improve the enforcement
capabilities and machinery of the CFTC, especially of cares
taken to avoid driving trading off of the regulated markets
into dark pools.
We support greater transparency through expanded, mandatory
reporting of energy trading and position information to the
Commission in accordance with its recent recommendations.
Additionally, we applaud the Commission's preliminary
recommendations in the report released last week to encourage
clearing of OTC transactions, which would effectively provide
greater transparency and oversight to OTC energy swaps. We are
also working with the Commission to offer secure, central,
counter party clearing facilities for other OTC transactions
which will help control systemic risk in that market and offer
regulators far greater insight into the positions of market
participants.
We believe the disclosure of trading and position
information to a regulator with sufficient resources to analyze
and act upon unusual or suspicious activities will deter most
potential manipulation and assure punishment of those foolish
enough to attempt a manipulation. This is the philosophy upon
which our internal market regulation has been based and why it
has been so successful. We clearly understand that the recent
surge in the price of many commodities, particularly energy,
has inspired Congress to look for assurance that the only price
drivers are legitimate supply/demand factors.
Some who claim expertise or special mileage have asserted
that the entire price inflation can be laid at the door of
speculators and/or passive index funds that have invested
billions in commodity contracts. However, these arguments are
flawed. Specifically, Mr. Masters' claim that buy and hold
index traders poured more than $60 billion into the major
commodity indexes in January through May of this year resulting
in the purchase of approximately 187 barrels of WTI crude oil
futures and causing WTI crude prices to soar by nearly $33 a
barrel as a result of this buying pressure.
This has been proved false in every material aspect. Our
careful evaluation of market participants and trading patterns
are to the contrary as are the findings of the CFTC. The recent
CFTC report finds that index traders were actually reducing
their positions in WTI futures contracts and in the OTC futures
equivalent substitutes at the same time that the price was
escalating.
Most every competent economist who has looked at real data,
rather than using uniformed best guesses and who has applied
legitimate economic analysis concludes that neither speculators
nor index funds are distorting commodity prices. We worry that
legitimate economists will be ignored and that important
legislation may be shaped by false economics that is profoundly
flawed in both its methodology and logic.
Mr. Chairman, we're strong proponents of securing all of
the relevant information from all sources and fairly testing
the hypothesis and reconfirming previous academic studies. The
evidence to date respecting the impact of speculation on index
trading in energy markets parallels the results we have found
in our markets. We support the CFTC's continuing efforts to
improve the quality of data from over the counter sources and
to assure that a thorough analysis informs any subsequent
legislative or administrative efforts to deal with the
uneconomic price inflation.
Thank you, Mr. Chairman.
[The prepared statement of Mr. Duffy follows:]
Prepared Statement of Terrence A. Duffy, Executive Chairman, presented
by James Newsome, Director, CME Group, Inc., New York, NY
I am Terrence Duffy, Executive Chairman of Chicago Mercantile
Exchange Group Inc. (``CME Group'' or ``CME''). Thank you Chairman
Dorgan and Ranking Member Murkowski for this opportunity to present our
views.
CME Group was formed by the 2007 merger of Chicago Mercantile
Exchange Holdings Inc. and CBOT Holdings Inc. CME Group is now the
parent of CME Inc., The Board of Trade of the City of Chicago Inc.,
NYMEX and COMEX (the ``CME Group Exchanges''). The CME Group Exchanges
are neutral market places. They serve the global risk management needs
of our customers and producers and processors who rely on price
discovery provided by our competitive markets to make important
economic decisions. We do not profit from higher food or energy prices.
Our Congressionally mandated role is to operate fair markets that
foster price discovery and the hedging of economic risks in a
transparent, efficient, self-regulated environment, overseen by the
CFTC.
The CME Group Exchanges offer a comprehensive selection of
benchmark products in all major asset classes, including futures and
options based on interest rates, equity indexes, foreign exchange,
agricultural commodities, energy, and alternative investment products
such as weather and real estate. We also offer order routing, execution
and clearing services to other exchanges as well as clearing services
for certain contracts traded off-exchange. CME Group is traded on
NASDAQ under the symbol ``CME.''
Speculators make our markets work for the benefit of hedgers,
commercials and for all who look to efficient markets for the best
source of price discovery. Our markets operate in a global economy;
impediments to legitimate speculative activity on regulated U.S.
markets will drive trading off exchange or overseas.
We unequivocally support proposals to materially improve the
enforcement capabilities and machinery of the CFTC, especially if care
is taken to avoid disadvantaging regulated U.S. markets for the benefit
of dark pools. We support expanding the mandatory reporting of energy
trading and position information to the Commission in accordance with
its recent recommendation. We share the view of regulators and
legislators on the need for greater transparency most famously
expressed by Justice Louis Brandeis:
Publicity is justly commended as a remedy for social and
industrial diseases. Sunlight is said to be the best of
disinfectants; electric light the most efficient policeman.
--Justice Louis Brandeis, Other People's Money, and How the
Bankers Use It, 1933
We believe that disclosure of trading and position information to a
regulator with sufficient resources to analyze and act on unusual or
suspicious activities will deter most potential manipulators and assure
punishment of those foolish enough to attempt a manipulation when all
of their actions are visible to the regulator. This is the philosophy
upon which our internal market regulation has been based and why it has
been so successful.
The recent highly promoted declarations that commodity prices are
being driven by speculators and index funds, rather than the expected
forces of supply and demand lack any basis in fact or theory. The
proponents of the plans to eliminate speculators begin with their
inability to forecast prices based on their understanding of supply and
demand and jump to the conclusion that their inability to predict price
movements demonstrates that the market is not operating correctly.
Most every competent economist who has looked at real data, rather
than using uninformed, wild guesses, and who has applied legitimate
economic analysis concludes that neither speculators nor index funds
are distorting commodity prices. We worry that legitimate economists
will be ignored and that important legislation may be shaped by
spurious economics that is so profoundly flawed in its methodology and
logic that it could be used to prove that lung cancer causes cigarette
smoking. Expert economists who reviewed the work of Masters, McCullough
and Eckaus found, among other flaws, that:
Those authors' unfamiliarity with industry fundamentals
resulted in misinterpretation of petroleum statistics;
The authors confuse the consequence of demand for physical
product and demand for derivatives;
The failure of the McCullough model to forecast oil prices
is due to problems in the model, not problems in the market;
The Masters' model of futures markets is overly simplistic,
and does not correspond to any of the hundreds of academic
research articles on futures published over the last 50 years.
The characterization and measurement of ``excessive
speculation'' are arbitrary and meaningless;
Claims that speculators are the cause of increased
volatility misstate volatility trends;
Master's claim that tough talk from Congress is behind the
recent sharp fall in oil prices rests on incorrect facts and
borders on the absurd; and
McCullough consistently conflates speculation and market
manipulation to justify his conclusions.
We are strong proponents of securing all of the relevant
information from all sources and fairly testing the hypothesis and
reconfirming previous academic studies. The evidence to date respecting
the impact of speculation and index trading in energy markets parallels
the results we have found in our markets. We support the CFTC's
continuing efforts to improve the quality of data from OTC sources and
to assure that a thorough analysis informs any subsequent legislative
or administrative efforts to deal with uneconomic price inflation.
speculation is essential to efficient, liquid markets
Fuel and food prices recently bounced to levels that are shocking
and painful to consumers and the economy. We share the concerns of this
Committee regarding the impact these prices are having on the daily
lives of U.S. consumers. Unfortunately, the pressure to reverse rising
prices has led some to look for a simple causal agent that can be
neutralized with the stroke of a pen. The favored culprit is the
traditional villain--speculators. But speculators sell when they think
prices are too high and buy when they think prices are too low. They
are not a unified voting block and are on both sides of every market.
Speculative selling and buying send signals to producers and processors
that help keep our economy on an even keel. High futures prices for
corn induced farmers to bring new acreage to market. High forward
energy prices encourage exploration and new technology to exploit
existing untapped reserves.
Futures markets perform two essential functions--they create a
venue for price discovery and they permit low cost hedging of risk.
Futures markets depend on short and long term speculators to make
markets and provide liquidity for hedgers. Futures markets could not
operate effectively without speculators and speculators will not use
futures markets if artificial barriers or tolls impede their access.
Blaming speculators for high prices diverts attention from the real
causes of rising prices and does not contribute to a solution. The
publicly available data has been relatively consistent over time in
demonstrating that speculators in crude oil futures contracts have been
relatively balanced as between buy and sell positions in the market.
These data have been ignored by commentators who have wrongly suggested
that speculators are uniformly on the buy side and are thus pushing
prices up on that basis. The weight of the evidence and informed
opinion also confirms that the high prices are a consequence of normal
supply and demand factors. The Wall Street Journal surveyed a
significant cross section of economists who agreed that: ``The global
surge in food and energy prices is being driven primarily by
fundamental market conditions, rather than an investment bubble . . .
.''\1
\---------------------------------------------------------------------------
\1\ Bubble Isn't Big Factor in Inflation, By Phil Izzo (May 9,
2008; Page A2.)
---------------------------------------------------------------------------
The traditional production/consumption cycle that has governed
prices in commodity markets is stressed by the confluence of a number
of factors.
David Hightower, author of the Hightower Report, summed up the
supply/demand situation in corn last year as follows: `` We have
experienced three consecutive years of record corn production . . . and
three consecutive years of declining ending reserves. Supply has put
its best team on the field and demand keeps winning.''
masters' analysis is wrong
The academic work and the contemporaneous explanations of price
movements in commodities markets have been largely ignored by a few
vocal critics, who have gained an undue share of attention by making
sensational claims. In May of this year Michael W. Masters, who
operates an off-shore equity investment fund in the Virgin Islands and
who by his own admission has never had any actual experience as a
futures trader, began a cascade of charges that commodity index funds
were responsible for unnatural price escalations in commodity markets.
In particular, his allegations focused on crude oil futures and the
underlying crude oil market. We have previously provided detailed
explanations as to how the crude oil futures market and physical market
interact, how prices are determined, and the common commercial
practices and activities that comprise these markets. Among other
things, we have emphasized that crude oil is truly a global commodity
and that prices in crude oil futures markets are primarily driven by
the market fundamentals of the far larger physical market for the crude
commodity. We explained that Mr. Masters was dead wrong. NYMEX had
repeatedly examined and tested for evidence that would support Masters'
fundamental thesis about market performance and had consistently found
that his charges had no basis in fact. NYMEX shared these results in
its submissions to Congress.
On September 10th, Mr. Masters updated his so-called ``analysis,''
including his allegations about crude oil market participation, price
determination and performance. On September 11th, the Commodity Futures
Trading Commission (CFTC) released a detailed report that included
definitive data and analysis regarding index-long market participation
in a group of commodities, including crude oil. Unlike Mr. Masters who
guessed at or simply assumed the facts, the CFTC report by contrast
provided definitive and unambiguous information as to whether the index
funds were increasing or decreasing their positions in a manner that
could support Mr. Masters' claims. In addition, the CFTC report
provided futures price information that enabled readers to perform the
equivalent analysis that Mr. Masters purported to perform in reaching
his conclusions.
The information the CFTC provided also was sufficient to enable
readers to evaluate the performance of the methodology Mr. Masters
purported to perform in reaching his assertions about index-long
participation in commodities markets. It should be noted that a core
assumption made by Mr. Masters is that all index trading wherever it
occurs will inevitably be hedged only on the regulated futures markets.
The CFTC report, by comparison, is careful to note that its analysis is
set forth in terms of ``futures-equivalents,'' thus referring to
activity both on the regulated and transparent futures exchanges as
well as in less transparent OTC markets. The unambiguous result of the
CFTC analysis, which is based on the best data available today, and its
direct implication is that Mr. Masters was wrong about everything;
about participation by index-longs, about the price impacts from index-
longs, and about how to even count participation by index-longs.
Mr. Masters asserts in Chart 1 that ``Index Speculators'
Stockpile'' of WTI crude oil futures was approximately 520,000
contracts on January 1, 675,000 futures contracts on April 1,
and 680,000 futures contracts on July 1 (all this year). By
contrast, the CFTC's definitive numbers were: 408,000 futures-
equivalents on December 31, 2007; 398,000 on March 31; and
363,000 on June 30. Mr. Masters' claim that futures contracts
are ``stockpiled'' is meaningless. He overstates by 27.4% in
January and 87.3% by the end of June the number of contracts
held by index funds. Mr. Masters is not only disturbingly off
the mark, he shows an unmistakable pattern of significant
growth through the first half of the year (over 30% growth--
well over 30 when looking at the early June peak) when the
actual trend is significantly downward--11% down. In other
words, Mr. Masters is completely lost.
Mr. Masters emphatically asserts--his ``update'' is devoted
to this--that crude oil futures prices follow, virtually in-
step, the path followed by his asserted (and completely wrong)
levels of index-long participation. He shows crude oil price
rising by nearly 50% over the same time period and attributes
the rise in its entirety to the rise in index-long
participation. This is the essence of Mr. Masters' price-
determination theory and he stresses it in his update: when
index-long participation grows, the price rises, and, when
index-long participation drops, the price decreases. Mr.
Masters uses this theory, one which has been repeatedly
disputed by responsible energy market economists as well as by
NYMEX in its previous submissions, to explain the rise and fall
of crude oil prices during 2008. Mr. Masters expressly
attributes the rise in crude oil prices from January to May to
increases in long-index positions (which, in fact, did not
happen) (2nd bullet point on p.1 ``Update ''). He also
expressly attributes the fall in prices from July 15th to
September 2nd to reductions in index-long positions (another of
his assertions--given his track record, we had better wait for
the legitimate information) (p. 4 ``Update ''). The CFTC report
allows the reader to apply Mr. Masters' price determination
theory to the real long-index participation data. Its report
shows that, as long-index participation fell, prices rose. We
of course do not intend to claim that the causality runs in
this directions--lower long-index participation, higher prices.
We just wish to identify the clear, unmistakable and
unambiguous factual refutation of Mr. Masters' thesis.
Mr. Masters asserted in his May 20th Congressional testimony
that index-long positions in commodities' markets were equal to
$260 billion in March 2008. The CFTC calculated actual notional
value of index long positions in commodities' markets to be
$168 billion in futures-equivalents, an overstatement by Mr.
Masters of a mere 54.7%.
Even where there appears to be similarity between Mr.
Masters' assertions and the CFTC's fact finding, Mr. Masters'
``methodology'' nonetheless results in making sweeping
assertions that are the complete opposite of the CFTC's
findings. Mr. Masters, for instance asserts that index-long
positions increased in value by $60 billion during the first
five months of 2008 (``Update . . .'' p. 1 and 3). The
Commission reports that long-index investments increased by $54
billion between December 31, 2007 and June 30, 2008; not
identical but arguably close. But Masters further claims that
long-index positions in crude oil increased from 520,000
futures equivalent to over 700,000 during that time period (an
increase of 34.6%). As was noted above the CFTC clearly states
that actual index-long positions in crude oil were reduced from
408,000 to 363,000 (a reduction of 11%). Mr. Masters seems to
miss the most basic fact--that the value of long positions
increase with rising prices. In other words, while the total
notional value of futures equivalent positions held by index
traders increased during the first six months (from $39 to $51
billion), the CFTC report demonstrates that this increase in
overall value is entirely due to increases in the price of
crude oil rather than to increases in the sizes of positions.
Indeed, contrary to claims made by Masters and others, the
number of futures-equivalent crude oil positions held by index
traders actually declined rather than increased during this
period, indeed a decline of approximately 11%.
The CFTC's data on the individual commodities also strongly
suggests the inadequacy of the methodology that Mr. Masters
asserts to have employed. (We emphasize that we have made no
effort to check the work performed by Masters.) Mr. Masters
asserted in his May 20 testimony that 95% of the long-index
positions in commodities are tied to either the Standard & Poor
Goldman Sachs Commodity Index or the Dow Jones AIG index. When
looking at the changing relative value relationships between
oil, wheat, corn and cotton summarized on p. 3 of the CFTC
report and the changing prices over the three dates, this
assertion becomes very dubious. Yet, giving Masters the benefit
of the doubt that he properly executed his stated methodology,
his methodology strongly appears to be wrong. Therefore, if he
performed the methodology right, it is the wrong methodology.
Mr. Masters has successfully captured a number of headlines by
trumpeting the supposedly massive inflow of funds by index
traders into the regulated futures markets. Yet, as noted
above, index trader positions were actually declining during
this period. Moreover, the CFTC report is also helpful in
providing some realistic context for the overall level of
participation by index traders. Specifically, their report
compares the notional value of the futures-equivalents held by
index traders to notional values for positions in the regulated
futures and options contracts traded on markets regulated by
the CFTC. Simply put, the notional index values are relatively
modest by comparison. For example, even if one was to assume
that somehow 100% of index positions ended up being hedged on
futures markets, for NYMEX Crude Oil, this would still
constitute only 13% of the total notional value for NYMEX Crude
Oil futures and options positions. In this regard, the CFTC
notes at the outset of its report that such a result is
unlikely due to internal netting of positions by swap dealers.
Remarkably, given how fundamentally wrong Masters is about all of
the assertions that can be tested against the CFTC's fact finding--and
that is the overwhelming majority of Masters' assertions--he never
offers any room for qualification in any of his ``work.'' Contrast that
with the work of the community of responsible scholars of energy
markets who are actual economists and who have analyzed recent price
behavior in crude oil markets--including Phil Verlager, Dan Yergin,
Robert Weiner and Craig Pirrong to name several but by no means all--
and each typically identifies in their own analysis where they need to
perform additional work to fortify their conclusions. In fact, it is
only fair to contrast it with previous testimony and submission
provided by the Exchange where, among other things, we identified our
own efforts to consider and evaluate theories of price influence with
which we disagreed.
Mr. Masters is dismissive of oil market fundamentals. He has not
made any serious effort to uncover the fundamentals. In general, he
simply asserts that supply and demand have been in balance and that
there has been no change in world inventories over the first six months
of 2008. Frankly, we are not even sure what he means by this, but
whatever he means, he is at odds with both the US Department of
Energy's Energy Information Administration and the International Energy
Agency.
In both of their recent market reports, each agency speaks to
uncharacteristic changes in OECD inventories during the second quarter
this year. In its September report, EIA speaks to an over 1 million
barrel per day drop from the ``average build . . . during this time of
year'' for OECD countries during the second quarter. Inventory
information is notoriously complex to ascertain in the world oil
market. US inventory information is released on a weekly basis and is,
probably, the most reliable in the world. The IEA reports OECD
countries' information on a monthly basis. The IEA then revises these
monthly data, which are reported about six weeks after the fact, in two
successive monthly reports. The numbers are commonly revised and
frequently the first revision is one direction while the second
revision can be in the reverse direction. As for non-OECD cumulative
inventory information, it is essentially uncertain. EIA indirectly
reports on it but does so as a residual calculation based on estimates
for production and consumption (and what it knows about OECD
inventories), and claims no certainty over it.
This is why Mr. Masters' dismissive reference to world inventories
is problematic. Nobody would seriously suggest that they know for a
certainty current world inventory levels. In addition, though, he is
factually wrong about what is known. The EIA's current report indicates
that there were indeed changes in world inventories during the first
half of the year--600,000 barrels per day decrease during the first
quarter and 280,000 barrels per day increase during the second quarter.
In addition, the EIA's data regarding the first half of the year
inventories were revised in its most recent report as they were in last
month's report, but each report still indicates that world inventories
have in fact changed during the first half of the year. (The August EIA
report indicated that world inventories were drawn down 300,000 barrels
per day during the first quarter and raised 330,000 barrels per day
during the second quarter.) The fact that EIA and IEA revise their data
each month is manifestation of the complexity in even ascertaining the
correct level of inventories, much the less attempting to understand
the relationship that may exist between changes in inventory levels and
changes in price. (It also highlights some of the uncertainty regarding
core market fundamentals that can have an impact on and be factored
into price levels.) Mr. Masters does not seem to even understand these
subtleties let alone address them, which raises additional questions
respecting his qualifications.
NYMEX has provided Congress detailed taxonomic descriptions of how
the futures market interacts with the physical market for oil with
special emphasis on the role of arbitrage and its corollary impact,
price convergence. In those submissions, we also explained in detail
how index-long position taking would impact the oil futures and
underlying physical crude oil markets. We also provided the results of
market analyses we performed to examine the impact of financial non-oil
participants in the futures market as well as to search for evidence of
price-related impacts from index-long participation in futures or OTC
markets. The consistent result was that there was no evidence to
support impacts on price or price volatility by financial non-oil
participants or by long-index participation in the markets. These
evaluations began in 2004 and included looking at 2007 through the
middle of 2008. In the tradition of balanced economic analyses, we can
only assert that we found no evidence to support these impacts.
Twice, in recent congressional testimony the CFTC has reaffirmed
the validity of its own 2005 analysis.\2\ The CFTC's analysis parallels
the conclusions of many other economists who have also studied the
issue of causation in the context of speculators and commodity futures
prices.\3
\---------------------------------------------------------------------------
\2\ During his appearance before the Senate Appropriations
Committee on May 7, 2008, CFTC's Acting Chairman Walt Lukken stated
that the CFTC's recent revisitation of the 2005 CFTC study using more
current data for energy market trading affirmed the conclusions reached
in the 2005 study. This conclusion mirrors the views of the majority of
53 economists surveyed by the Wall Street Journal in May 2008, which
indicated that the global surge in food and energy prices is being
driven primarily by fundamental market conditions, rather than an
investment bubble. Wall Street Journal, May 9, 2008, page A-2.
Similarly, the US Department of Energy's Energy Information Agency's
``Short Term Energy Outlook'', published in May 6, 2008, evidenced the
tightness in world oil markets, with growth in world oil consumption
outstripping growth in production in non-OPEC nations by over 1 million
bbls/day, and dramatically increased demand coming from China, India
and other parts of the developing world.
\3\ See, for example, Antoshin and Samiei's analysis of the IMF
research on the direction of the ``causal arrow'' between speculation
and commodity prices in ``Has Speculation Contributed to Higher
Commodity Prices?'' in World Economic Outlook (September 2006):
``On the other hand, the simultaneous increase in prices and in
investor interest, especially by speculators and index traders, in
commodity futures markets in recent years can potentially magnify the
impact of supply-demand imbalances on prices. Some have argued that
high investor activity has increased price volatility and pushed prices
above levels justified by fundamentals, thus increasing the potential
for instability in the commodity and energy markets.
What does the empirical evidence suggest? A formal assessment is
hampered by data and methodological problems, including the difficulty
of identifying speculative and hedging-related trades. Despite such
problems, however, a number of recent studies seem to suggest that
speculation has not systematically contributed to higher commodity
prices or increased price volatility. For example, recent IMF staff
analysis (September 2006 World Economic Outlook, Box 5.1) shows that
speculative activity tends to respond to price movements (rather than
the other way around), suggesting that the causality runs from prices
to changes in speculative positions. In addition, the Commodity Futures
trading Commission has argued that speculation may have reduced price
volatility by increasing market liquidity, which allowed market
participants to adjust their portfolios, thereby encouraging entry by
new participants.''
Similarly, James Burkhard, managing director of Cambridge Energy
Research Associates testified to the Senate Energy Committee on April
3, 2008 that: ``In a sufficiently liquid market, the number and value
of trades is too large for speculators to unilaterally create and
sustain a price trend, either up or down. The growing role of 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.''
---------------------------------------------------------------------------
Neither the CFTC's study nor reference to the supply/demand factors
driving the market has calmed the critics who demand an easy solution
to high prices, which they claim can be mandated without cost or
consequence. This vocal group, which does not include any competent
agriculture or energy economists, insists that driving index funds and/
or speculators from the markets will bring prices back to the correct
level.
The proponents of this plan do not understand the role of
speculation. They do not understand that there are speculators on both
the buy and sell sides of the market. Moreover, they fail to grasp that
imposing artificial costs and constraints on speculation in markets
regulated by the CFTC is likely to drive prices to artificial levels,
which can distort future production decisions and cause costly
misallocation of resources of production. Such constraints also may
well result in the shift of activity to less regulated and transparent
markets abroad, which could shift this activity off the CFTC's radar
screen.
The proposal to exclude pension funds and index funds from
participating in commodity futures markets is not constructive. These
funds use commodity exposure to manage risk in their portfolios.
Barring them from regulated U.S. futures markets will only push them
offshore or into over-the-counter trading. Surely Congress does not
desire to impose a remedy that materially and negatively impacts our
domestic energy futures markets and produces no compensating public
policy benefit.
Regulated futures markets and the CFTC have the means and the will
to limit speculation that might distort prices or distort the movement
of commodities in interstate commerce. Acting Chairman Lukken's recent
testimony before the Subcommittee on Oversight and Investigations of
the Committee on Energy and Commerce United States House of
Representatives (December 12, 2007)\4\ offers a clear description of
these powers and how they are used.
---------------------------------------------------------------------------
\4\ http://www.cftc.gov/stellent/groups/public/@newsroom/documents/
speechandtestimony/opalukken-32.pdf
CEA Section 5(d)(5) requires that an exchange, ``[t]o reduce
the potential threat of market manipulation or congestion,
especially during trading in the delivery month . . . shall
adopt position limitations or position accountability for
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.
It is clear that speculation is an important component of the
futures markets, but there is a point when excessive
speculation can be damaging to the markets. As a result, the
CFTC closely monitors the markets and the large players in the
markets, in addition to position and accountability limits, to
detect potentially damaging excessive speculation and potential
manipulative behavior.
conclusion
CFTC-regulated futures markets have demonstrated their importance
to the economy, the nation's competitive strength and America's
international financial leadership. We have the means and the power to
protect our markets against speculative excesses on our markets and are
committed to doing so.
Senator Dorgan. Dr. Newsome, thank you very much. We
appreciate your testimony. Finally we will hear from Mr. Fadel
Gheit, who is the Managing Director and Senior Energy Analyst
from Oppenheimer and Company in New York. Mr. Gheit, thank you
and welcome.
STATEMENT OF FADEL GHEIT, MANAGING DIRECTOR AND SENIOR ENERGY
ANALYST, OPPENHEIMER & CO. INC., NEW YORK, NY
Mr. Gheit. Thank you for having me. I am not an economist.
I don't have a portfolio that would benefit from lower oil
prices.
I talk to oil companies. I talk to people who invest in oil
stocks. I do not trade the commodity. My company does not trade
the commodity. My comments today will reflect my own view, not
my company's view.
Oil is unlike any other commodity that we deal with. It is
has a lot to do with supply/demand. But more it has to do with
true politics, whether other factors that can not be
quantified.
The oil markets are not free markets. Let's not kid
ourself. With 51 percent of the global supply is controlled by
a cartel and Russia, there is no free market. It is not a free
market. We like to think it's free market, but it's not.
Supply and demand are impacted by government action, taxes
and subsidies. Oil demand increase only in those countries in
the last year or so, only in the countries that have subsidized
oil prices, everywhere else where people paid full price,
demand declined. But despite that the weakness in the market in
general oil prices moved up by more than $50 to $148 only to
collapse to $90 or $95. Oil prices remain inflated and should
go lower. The fact of the matter if it was not for the
financial player the decline would have been even steeper.
Having said that, despite the invasion of Georgia, despite
the 10-day disruption of oil flow from Harbhajan, which was one
million barrel per day, despite the two hurricanes, oil prices
in the state of going up as any trained economist would have
told you, oil prices actually came down between $15 and $20
until finally the financial market meltdown which brought oil
prices lower. Oil companies did not believe in $60 oil, let
alone $100 oil and then it went to $140, they just threw their
arms in the air and said, we don't know. We cannot make any
sense out of that.
I had a chance 3 years ago to spend long hours talking
about the oil markets with the Secretary General of OPEC, who
also happened to be the head of the Economic Analysis for the
Cartel for 14 years. That was the week of Hurricane Katrina and
oil prices hit $62. He was very unhappy with the spike in oil
prices. As he put it, he said, it will kill the goose that lay
the golden egg. It is not in our best interest to have oil
prices significantly above $45. That was 3 years ago.
Last year the Secretary General of OPEC said that the fair
price of oil should be $55. Our Energy Secretary at the time
said that energy prices are moved up by speculation, but it
would help if OPEC increased oil supply. Our own President said
that I will ask our friends in OPEC to put additional oil on
the market.
But despite all this, oil prices moved higher and continue
to move higher. Then when you have a major investment bank
predicting that oil prices will end the year at $170. So OPEC
Secretary General said, I go for that, oil prices should go to
$171.
We cannot blame OPEC for the rising oil prices. There is
plenty of supply as we seen that oil prices basically are
coming down very sharply because they are not supported by
market fundamentals. Who gains from higher oil prices? I can
tell you.
We pay for every dollar of speculation. We drain our
resources by $4 billion a year. In my estimation oil prices
have been inflated by at least $10 in the last 5 years. That's
$200 billion on the conservative side.
Self regulated markets do not work. If they worked we
didn't need an IRS. We don't need a cop to give a traffic
violation because people obviously, wouldn't do otherwise.
The bottom line here is that I think oil prices continue to
reflect a high level of speculation which is needed, but when
excessive information comes into play, it destroyed the market
completely. Thank you.
[The prepared statement of Mr. Gheit follows:]
Prepared Statement of Fadel Gheit, Managing Director and Senior Energy
Analyst, Oppenheimer & Co. Inc., New York, NY
Good afternoon.
I am here today to share my personal views on the impact of
speculation on the oil markets. I believe the energy markets in recent
years have been driven more by speculation than by industry
fundamentals of supply and demand. Oil prices peaked in July at more
than $148/b, despite softening demand, to more than double their levels
a year earlier. Since then, oil prices declined by more than 36%
despite supply disruptions. Speculation has disconnected oil prices
from market fundamentals.
As a managing director of oil & gas research at Oppenheimer & Co.
Inc., I closely follow the energy markets for the sole purpose of
advising investors in energy stocks. I do not trade energy future
contracts or manage investments that could gain from lower energy
prices. I have no vested interests in declining energy prices, and in
fact, the energy stocks that I own for many years would decline further
with lower oil prices.
I testified on the impact of speculation on oil prices on December
11, 2007, before the Senate Permanent Subcommittee on Investigations of
the Committee on Homeland Security and Governmental Affairs and the
Subcommittee on Energy of the Committee on Energy and Natural
Resources. Oil prices then averaged $90.02/b, up 47% from $61.22/b a
year earlier. When I testified before the House Subcommittee on
Oversight and Investigations of the Committee on Energy and Commerce,
oil prices closed at $132.57/b, or double the $66.27/b a year earlier.
Although oil prices are down 36% from their peak in July, and down 1%
for the year, they are still 43% above the year-ago level.
Even after the recent decline, I believe that oil prices are still
inflated and their current levels do not reflect market fundamentals.
The price decline was a result of selling of oil future contracts by
financial players on fears of slowing oil demand due to the weak global
economy and the meltdown in the financial markets. The fact that the
decline in crude oil prices has continued despite the Russian invasion
of Georgia, the 10-day disruption of oil production from Azerbaijan due
to the pipeline explosion of the Turkish pipeline, and the recent
hurricanes in the Gulf of Mexico, proves that oil prices are inflated
and that they are disconnected from supply and demand fundamentals.
Many people believe that the recent drop in oil prices was a result
of pending legislation allowing more drilling in the U.S. Although we
should pursue all options, including opening federal land to
exploration, this is unlikely to have any meaningful impact on our
dependence on foreign oil for years. I believe energy conservation and
increased use of alternative energy sources, including renewable
energy, is a much better strategy and should be a top priority in any
future energy legislation. However, I think the investigations by the
Senate and the House have contributed to the recent decline in oil
prices by exposing the role speculators played in creating the oil
price bubble.
I have been an energy analyst for more than 22 years, and spent six
years before that working for a major oil company. I follow 22 energy
companies including the majors, the integrated, the independent
refiners and the domestic oil and gas producers. I communicate
regularly with the companies I cover, and none of them either publicly,
or privately, indicated they expected oil prices to reach, let alone
exceed, $100/b. Some even ridiculed $60/b oil and declared it to be
unsustainable.
Only a year ago several OPEC ministers said that the surge in oil
prices was not due to lack of supply, but due to excessive speculation
and a weak dollar. OPEC repeatedly said that the ``fair'' price for oil
is around $55/b. Our Energy Secretary last October agreed with OPEC
that speculations, not market fundamentals, were the cause of the run-
up in oil prices. That was before he reversed his opinion last June,
and agreed with the Treasury Secretary that oil prices reflected supply
and demand fundamentals, not excessive speculation.
Three years ago, after hurricane Katrina, I had two long
discussions with the secretary general of OPEC, Dr. Adnan Shehab-Eldin,
Ph.D, who was also the head of OPEC Economic Analysis for the past 14
years. He expressed deep reservations about the surge in oil prices to
$62/b because of its potential negative impact on global economic
growth, energy demand, and potential energy conservation and switching
to renewable sources. He believed that OPEC prefers to see oil prices
closer to $45/b, not $65/b. The unprecedented surge in oil prices was,
in my opinion, more due to excessive speculation rather than increased
global demand, a weak dollar, or supply concerns.
Self-regulated markets don't work, especially when there are huge
sums of money to be made. There are always people who will try to beat
the system in markets that are tightly regulated by the government, let
alone self regulated. I liken self-regulated markets to trying to
enforce the speed limit without traffic cops or speeding penalties, or
collecting taxes without filing with the IRS. The self-regulated
markets are like private clubs making up their own rules. They will
fight change, but should not be given that option. Government agencies
should not defend the right of a few to make huge profits at public
expense.
Speculation is not illegal, but excessive speculation could result
in serious economic dislocation. Investors speculate when they buy or
sell stocks and financial players speculate when they buy or sell
future oil contracts. Speculators provide the needed liquidity to
facilitate trading transactions between commercial hedgers who end up
taking physical delivery of the commodity. But, since financial
speculators have no intention of taking physical delivery, they usually
roll over their hedge positions. They generate huge profit if prices
move in line with their bets, up or down. Excessive speculations,
however, tend to magnify and exacerbate price movements and create
volatility that could disconnect prices from market fundamentals as has
been the case in recent years.
Oil is unlike any other commodity where prices are usually based on
supply and demand. That is because the oil markets are not free markets
since more than half of the world supply is now controlled by OPEC and
Russia, while demand is impacted by government taxes and subsidies.
Sharply higher oil prices reduced demand in most countries, except
where prices are subsidized, like in China, India, and in oil exporting
and developing countries. High oil prices limited access to new energy
resources as they strengthened the hand of national oil companies,
while significantly increasing government take, including royalties,
taxes, fees, and tariffs. High oil prices remove the incentive for oil
exporting countries to grant new concessions to international oil
companies. That explains why high oil prices did not result in
increased supply and did not fully impact demand.
I believe the government must regulate the oil markets, and limit,
not eliminate financial speculation, which is needed to facilitate
trading transaction by commercial hedgers. The CFTC should raise the
margin requirement, set trading limits, require transparency, prevent
conflict of interests, and limit trading to government regulated
exchanges in compliance with U.S. rules.
Senator Dorgan. Mr. Gheit, thank you very much for being
with us today. We appreciate the testimony of all six of you. I
should mention, Mr. Harris, when I said it was underhanded to
send a North Dakotan to testify, I only meant that being a
North Dakotan you had such great credibility that make my job
more difficult.
[Laughter.]
Senator Dorgan. Let me ask you some questions, Mr. Harris,
then I have questions for the rest of the panelists as well.
I've read carefully the CFTC reports and the most recent report
says the following, ``This preliminary report is not able to
accurately answer and quantify the amount of speculative
trading occurring in the futures market'' on page two. Was that
an accurate statement that comes from the report?
Mr. Harris. Yes, the report was focused on index traders in
particular. So it wasn't a comprehensive survey of everybody in
the marketplace.
Senator Dorgan. But isn't it also the case that previous
reports by the CFTC, they take the same position. That they are
not able to accurately answer and quantify the amount of
speculative trading. The issue of classification of traders is
what is germane in key here.
If they're not classified properly you're pretty clearly
unable to get the result so you can analyze the result. We have
been told by Mr. Newsome who's testified here that he's not
able to see much of what exists out there in over the counter
and elsewhere. So if one isn't able to see much of what exists.
If the classifications have grown less precise, as you say in
your report, the classifications have become less precise as
both groups may be engaged in hedging and speculative activity.
By the way, the classifications are done by the CFTC. So if
they're less precise, but done by the CFTC and you can't see
everything out there, I would understand why you would say that
you're not able, accurately, to quantify that which is
speculative. Is that a fair statement?
Mr. Harris. I think this is one good highlight of this
recent report that we have. This is the first time we've
actually dug into the positions of individual traders to look
beyond the trading that they do on our markets. This is our
first foray into looking at the over the counter positions
among different traders.
So in that regard this marks, sort of the unprecedented
level of activity that we've dug down into our data to try and
look at what's behind the position.
Senator Dorgan. If you look at what's behind the position,
but you indicate that your classification is a weakness?
Mr. Harris. The classification----
Senator Dorgan. Less precise, a weakness.
Mr. Harris. The classification for instance that Mr.
Masters used for the supplemental report includes trader
positions of all types. It includes the positions of all index
traders, for instance, which might include positions that don't
relate to index trading. So in that regard if you take that
data and extrapolate from it, you might be making errors.
But we've always been pretty clear about what our data is
and what our data is not. I think part of what we have in our
recommendations here is some recommendations looking forward to
try to improve upon that and look at different ways to produce
data.
Senator Dorgan. I understand you want to improve upon it
looking forward, but your chairman has given us very specific
conclusions repeatedly, over a period of time that he knows
that this is the fundamentals. This is supply and demand. He's
continued to insist that over time and doesn't deviate from
that.
That's a curious way, it seems to me, for the regulator to
do its job at a time when you see prices doubling in a year in
which, I'm going to ask Mr. Eagles in a few moments, he said
it's supply and demand. I'd like, in fact, I'd like anybody to
be able to answer this on the panel. What happened in supply
and demand in 1 year that justified a doubling of the price of
oil?
Mr. Harris. I can speak to what I think what our chairman
was referring to. I believe he's basing that on a lot of the
research that my office does. What we do and what we have done
is look at different groups of traders.
We can look beyond a simple, the commercial, non-commercial
data that we put out in our commitment of trader's reports. We
actually break down. Look at hedge funds, specifically. We look
at index funds now in this particular market. But we've done
our best job as we can to classify traders as a group, as
people have mentioned or claimed that they have an impact on
the market and look for their specific behavior from day to day
on whether they're buying or selling in the market and driving
prices one way or the other.
Senator Dorgan. Mr. Masters, Dr. Harris says that you've
just thrown everything into a bushel basket here and then added
it all up. Your response? I mean what you have described----
Mr. Masters. Sure.
Senator Dorgan [continuing]. For us is index trading that
moved a substantial amount of money in, in a dramatic way and
then just as quickly moved it out. So respond to Dr. Harris, if
you would.
Mr. Masters. Thank you. One of the interesting things Dr.
Harris suggests that there's other things in the report. The
name of this report is the Commodity Index Trader's Report. So
why you would name the report the Commodity Index Trader's
Report and then suggest that there's lots of other entities in
the report is beyond me.
But the bigger question here is, is that this is the CFTC's
data. This isn't our data. We just looked at the data and
analyzed the data. This is the CFTC's own data.
The Commodity Index Trader's Report has come out for the
better part of two and a half years. The Commitment of Trader's
Report, which is a broader report of which the CIT report is
the supplement has come out for over two decades. So the idea
that by doing a survey, a special survey in 60 days of
different entities around the street and asking them questions.
Then coming out and suggesting that all of the previous data
that you've put out for the better part of two and a half years
may be inconsistent, may be incorrect.
What is this public supposed to rely on? In fact, it's an
interesting quandary. We have on the one hand the established
data set, the CIT report. On the other we have a new survey of
data. What is the public supposed to rely on?
In fact, the U.S. Commodity Futures Trading Commission
submitted this report to all of these swap dealers. On it there
are numerous questions. In fact, there are questions about
speculative questions.
According to the testimony either we didn't get that
information. They didn't get that information. If they did get
the information, then they didn't submit it. It's not on the
record. We don't see any parts of it.
The----
Senator Dorgan. I think you made your point on that. I want
to come back to Dr. Harris in a moment. Mr. Gheit, you've
described previously what's going on, on the street with the
big firms. You've described to me and I think also before this
committee that massive hiring, a bunch of speculators, kind of
like hogs in a corn crib, a substantial amount of additional
speculation, making money by trading oil contracts.
Describe to me what you're seeing. I mean, you're there.
Mr. Gheit. Basically there's a trend--obviously to find a
way to make money in the commodities and especially oil was the
hot thing. I mean there were no checks and balances. There is
total disconnection from supply and demand fundamentals. There
were no shortages.
I talk to oil companies regularly, from the largest of them
all to the independent EOP companies and not one CEO of any of
these companies thought that oil prices should be a dollar
higher than the $60 a year ago. When they saw $100 oil, they
were absolutely amazed. Obviously when we see $148 oil, they
said the world has changed.
But having said that, in my round of talking to hedge
funds, their biggest worry over the last 3 or 4 months was will
Congress do something about speculation. They didn't want to
know anything about supply and demand. That is not, at all, a
factor in what they do.
They want to know if there is a cop on the beat and if
something is going to change. I said, I have no faith that
anything is going to change.
Senator Dorgan. Mr. Eagles, you hear Mr. Gheit describing
what's going on the street. You say, this is supply and demand.
Why would JP Morgan know that it's supply and demand and the
folks that run the oil companies, whose future and whose
success depends on trying to understand supply and demand, know
much less.
Mr. Gheit has said and incidentally we've had testimony
from CEO of Marathon from executives at Exxon and others who've
said exactly the same thing. So why would they miss the mark so
much and you describe it as normal supply/demand relationships?
Mr. Eagles. To describe it as simple supply and demand is
perhaps exaggerating it slightly. There are a number of many
complex factors which are going into this. Now first of all I
should say that if you take a look back at statements from
OPEC, from the International Energy Agency and many people,
they've looked to the oil price when it was $18 a barrel and
said that was far too high. All the way up you can see people
saying this price is not realistic.
At the end of each year when we get the consolidated
financial statements, people have started to see, particularly
since 2003, a very sharp escalation in the cost of production.
Now that's not speculation that is pushing that up. That is
real cost because we've had extreme bottlenecks in the
industry. We've had underinvestment throughout the 1990s.
When demand increased these companies simply couldn't get a
hold of the rigs. They couldn't get hold of the skilled man
power. They're having to bid up prices.
Senator Dorgan. But, I'm sorry to interrupt you. I
apologize. Would you tell us your assessment of July to July or
June to June, the doubling of that?
Mr. Eagles. Since July there are a couple of factors here.
One which was when I was at the International Energy Agency we
pointed out very rapidly the amount of supply that OPEC was
providing to the market was going to lead to severe tightness
in the second half of 2007. They didn't increase output.
Surprise, surprise, we had a tight market.
We also had a very sharp weakening of the dollar. We also
had what I think is probably one of the most important factors
in that we had a perfect storm in the diesel market.
Now if you want a prime example of how unresponsive
consumers are to prices, take a look at the European market
where they have increased taxes year after year after year
since the mid 1980s. Yet demand has continued to increase. They
have been paying at the pump prices of well over $200 a barrel
for many, many years.
It has taken very large price increases----
Senator Dorgan. But you're not sticking with the 1 year. I
just want to show you something.
Mr. Eagles. Yes.
Senator Dorgan. That chart, the red line, shows what's
happened to prices in that period.
Mr. Eagles. Yes.
Senator Dorgan. They've now since come down. The yellow
line and the dates of the yellow start in May 2007 to May 2008.
The yellow line represents the EIA assessment, Energy
Information Agency Assessment of where the price would be.
In every case that yellow line is almost straight across,
in some cases a bit down. These are the experts. We spent $100
million on this agency, by the way. Here's what they thought
was going to happen to prices. One would expect they would have
folks that would know what you have in CFTC as well analyzing
these markets.
But in every case, the real price of oil completely
eclipsed what EIA thought was going to happen. They didn't have
the foggiest idea where there line was going to go. There's
only, it seems to me that despite all the protestations,
there's only one possible reason for that. That is that the
supply and demand relationship that was evaluated with that
yellow line did not exist with respect to the red line.
Mr. Eagles. Could I ask you?
Senator Dorgan. Yes, of course.
Mr. Eagles. Could I ask you in terms of driving this, one
thing that we have to appreciate is the tightness in the
refining sector. We have had a lot of pressure put on the
diesel market. Now let me just give you an example. If we take
a very simplistic economic example----
Senator Dorgan. Are we talking about the 1-year period?
Mr. Eagles. I'm talking really about the 1-year period.
Diesel and gasoline have been tight for a long period. The
gasoline situation started to improve in July last year. But
the diesel situation has continued to be very tight.
Senator Dorgan. If that's the case then we need to get new
people in the EIA because----
Mr. Eagles. I think----
Senator Dorgan [continuing]. I assume they would have known
that as well.
Mr. Eagles. I think it's fair to say that what happened in
the diesel market wasn't to be expected. We had a number of
market failures, a number of market issues. We had in China, we
have capped prices for diesel and gasoline.
Senator Dorgan. Right.
Mr. Eagles. We have free market prices for fuel oil. There
are refiners buying fuel oil and turn it into low spec diesel.
The rise in prices put them out of business.
Suddenly China had to go onto the International market and
buy a very large amount of diesel. The Europeans have a
taxation system which encourages them to drive diesel cars.
Senator Dorgan. But----
Mr. Eagles. They're continuing to buy more. Then we have
had outages in Chili, South Africa, Australia, which have
forced our generators to use diesel.
Senator Dorgan. But JP Morgan would not have that exclusive
province to that information. The EIA would have known that. By
the way, I have another chart.
I've taken far more time than I should have, but I have
another chart that shows all that has happened that one would
have expected to put upward pressure on prices and it has not.
I want to just say to Dr. McCullough, I have had some questions
for you. I hope that I can get to them later.
But I've taken more time than I should have. It seems to
me, Dr. McCullough, you would look at all this and say, there
is no way this makes sense. I mean there's no way that there's
a classic answer of supply and demand that laces it up tight
and smartly. It just doesn't add up. Is that correct?
Mr. McCullough. Yes, Chairman. I'm pretty pleased to have a
chance to respond to Mr. Eagles.
The fact of the matter is I don't think we should fire the
EIA. I went back and reviewed the EIA forecast and detailed
against what really happened. I took the January forecast, then
I went through the actuals all the up to August.
They were not fools. To the contrary, they did pretty well.
They did better by the way than I did as a forecaster. They
were off on consumption by 1.6 percent. They had an error on
production of 0.8 percent.
The way they went, those offset each other. They did not do
a bad job. The fact of the matter is we don't have a clue of
how that relates.
Let's talk about tight refineries. Tight refineries mean
it's hard to actually get gasoline out of the oil. But it
doesn't put pressure on the oil.
It's in fact a crimp in the system. If the refinery goes
down, we will have oil unsold because we won't have any use for
it. We've had a hundred fanciful explanations.
As you know, I actually broke down over the summer and
started testing them statistically. In the main they do a
terrible job. As I noted, this morning I read every major
reporter's story on this from Jad Mouawad at the New York Times
to the Washington Post.
We lost 2 percent of the world's production because of
Hurricane Ike. The prices collapsed.
Senator Dorgan. Dr. McCullough, thank you. I apologize to
my colleagues. I took more time than I should.
Senator Murkowski.
Senator Murkowski. I want to continue with you, Mr.
McCullough. Because after your testimony you kind of wrapped it
up and said, you know, part of the answer would be quarterly
reports. Does that really help us?
Is that all we need to better understand that we have? You
can finish your comments there as you answer that question. It
just doesn't seem to me that it's as easy as this.
Mr. McCullough. It certainly isn't. Let me note to you on
the end of 1999 when Enron had some 60 percent of its risk
capital into one commodity in one location. We didn't know it.
The CFTC unfortunately stopped including the West Coast energy
forward markets in the COT at that time.
By the way, Senator Foyett of your staff had asked why and
they couldn't find the reason why they did it. They put it back
in place after Enron went bankrupt. If we had known that this
major position had taken place out of the blue, the first thing
we would have done is we would have called the FBI and have
them ask. It was a huge position, an inexplicable position.
The reason why it'd be good to have an oil quarterly report
is I'd love to have this debate with a detailed transaction
data that post-Enron, I now in electricity. Now is it
sufficient that we would have real facts in front of us to
answer the question, clearly not. If all of those facts were in
front of me, you might say, ok, I now know the answer. It was
``x.''
But absent that we're going to sit here and have this,
frankly, dubious debate because even with my 30 years of
experience in the energy business I would never have guessed
that Hurricane Ike would lower the price of oil. I said to a
staffer at the hotel this morning, shouldn't we have more
hurricanes. They said in broken English, I think this is wrong
answer.
[Laughter.]
Mr. McCullough. It is the wrong answer. But the fact is we
don't know. There are very bright people here. I certainly
respect them all, but we have no data.
Senator Murkowski. Ok. Let's go to the data and there was
some, a whole series of recommendations from the staff report.
Does that get us where we need to go?
Mr. Newsome, you suggested that you're in agreement with
these recommendations. That speaks to the transparency aspect
of it. But it's more than just transparency. It's compiling the
data, most clearly.
It seems that we've clearly got gaps on both ends. It's
probably easier for us to address the transparency side of it
than to figure out how we compile all this data. Am I correct
in that?
Mr. Newsome. We're certainly supportive of the CFTC
recommendations. But a big component of that, of making that
transparent, is collecting the data to make it sell.
Senator Murkowski. Making sure that data in the first place
is reliable data.
Mr. Newsome. Absolutely. I think, you know, Mr. Masters
uses an apples and oranges comparison to confuse people. The
Commitment of Trader's Report is exchange data that the CFTC
has collected for a long time.
The CIT data is index data, particularly in the
agricultural markets and to use that data to extrapolate what
he thought would occur in the energy sector to start this whole
debate 6 months ago. We now know based upon the real data from
the CFTC that his approach was completely flawed. That in fact
index speculation in energy did not drive higher energy prices
because that level was coming down as prices went higher.
So I think it's important to collect the real data, to use
real economic analysis, such as the CFTC has started. There's
still a long way to go, but I think that's the right path.
Senator Murkowski. Let me ask you, Mr. Masters, do you
think it was an apples to oranges comparison. If you have had
that data that we're speaking of, do you think that your
conclusion would have been different than the report that
you've issued?
Mr. Masters. Clearly, I mean we don't consider it an apples
to oranges data. This is publicly available data that we
received. It's index trader data.
All we really did is, you know, calculate the level of
energy crisis from the index. So we know in an index, we know
from these accounts, as Dr. Harris described their pension
funds, institution sovereign wealth funds. By and large the
vast majority of them follow the index almost with a religious
fervor. If something false----
Senator Murkowski. But is that true? I mean are they all
the same? Can they all be treated the same? Calculated in your
matrix the same? Or are there differences?
Mr. Masters. I mean as long as they're going to follow an
index, that is the case. Because if one component, if you know
just one component of the index, then you can find out what
every other component is. To give you an example, if Kansas
wheat is 1 percent of the Goldman Sachs commodity index and
that's a billion dollars, then you know the overall index is
$100 billion. If you know the waiting for crude oil is 40
percent of that index then it's easy to calculate that there's
$40 billion in crude oil.
So we just used the CFTC's data. We calculated it very,
very straightforwardly. We think it makes a lot of sense.
The idea that you could go out and do a survey in 60 days
and find other data that completely contradicts the data that I
and other people have been relying on. I mean, we're not the
only ones who came out with this data. Lehman Brothers, last
week, came out and said, there was a $42 billion outflow.
Citibank has used it. Goldman Sachs has used it. Lots of
different other large banks have used this same data and come
up with similar conclusions.
Senator Murkowski. Let me ask one last question here. This
is directed to you, Mr. Gheit. You stated that excess
speculation can destroy the market completely. I would agree
with you. So the question is, is some level of speculation ok?
Mr. Gheit. Absolutely. We need speculation to facilitate
transactions between commercial hedgers, airlines, the chemical
companies, the oil companies. You need that. Oil companies need
to secure their cash-flow so they can invest.
Senator Murkowski. So how do we make sure that we don't?
Mr. Gheit. Like anything else you need to grease the wheel,
but over greasing it, you skid all over the place. Too much of
a good thing is a bad thing. That's exactly what we have right
now is the tail is now bigger than the dog. So you don't know
which is wagging which.
But the point here is that we have to curb speculation. We
cannot eliminate it.
Senator Murkowski. Yes.
Mr. Gheit. We need body fat. We cannot survive without it.
Speculation is the body fat. We just can't eliminate it
completely. We need that.
Then the notion that it is not speculation. If it's not
supply and demand and it's not speculation, so what caused the
run up in oil prices? Obviously something must have caused it.
Now in this market perception is reality. Speculation
thrives on perception. There is no supply shortage, hasn't been
any supply shortages that cause oil prices to move up. All the
data pointed out that global demand was slowing down.
As oil prices came down sharply in light of all the events
that could have pushed oil prices higher. There was certain
disregard to market fundamentals that the threat to supply,
that things can go out of hand, didn't matter. Oil prices were
in a free fall.
Senator Murkowski. Mr. Chairman, it just speaks to the
extreme difficulty you have here. If we recognize that we're
not going to be able to eliminate speculation entirely, nor
would we want to. But you can't allow it to go too far.
So I guess it takes us back to part of this solution which
is a clear understanding as to what we're dealing with and
openness and the transparency. Again back to data that you can
actually rely on. Thank you, Mr. Chairman.
Senator Dorgan. Senator Cantwell.
Senator Cantwell. Thank you, Mr. Chairman. To go over the
data point because I do think that this is important if we
obviously want to have functioning markets. We do have to have
transparency.
It seems to me, Mr. McCullough, that you had some concerns
about the CFTC report because of the date range that they used
in the analysis and the data that they ended up collecting.
Could you expand on that?
Mr. McCullough. The first thing that occurs when you take a
look at the report, and I'm looking at Dr. Harris, is that it
goes through June 30. I understand that might have been a
factor in their data collection, but the issue we're all
talking about happened between July 3 and July--I think the
hourly peak in the price was the 14th or the 15th. So we
actually have the wrong time horizon here.
I know Mr. Masters has taken some punishment for a fall
that occurred in the first 6 months. But I'm actually a bit
more interested in the seventh month. I suspect the solution to
this is to have an ongoing data collection effort, not a one-
time response to congressional criticisms.
The fact of the matter is I fell for Mr. Masters when he
said, look, I'm relying on their report. We need to get those
reports standard. We need to get them precise. We need to get
them publicly available.
Senator Cantwell. But Mr. McCullough, can't all this be
done in real time and shouldn't it be transparent and shouldn't
it be available to the public?
Mr. McCullough. I don't think there's any question we can
do it in real time. We've got a tremendous amount of capability
out there. What we need to do is we need to have a systematic
process and your additional staff to work on it. We need to get
that information out so we don't have repeated hearings and
debates in the press about things that should be factually
clear.
Senator Cantwell. What was done post Enron in the
electricity market to improve reporting, particularly between
the physical market and the futures market?
Mr. McCullough. Almost everything. When we deregulated
electricity, FERC is part of its market license, had everyone
put in a quarterly report. Some of the quarterly reports were
almost amusing. One was actually turned in after it had been
left out in the rain. You could see the little raindrops in the
report. I won't mention the firm, but it was one of the major
Wall Street banks. Not yours, you'll be glad to know.
That was useless. After Enron, FERC established a strict
standard that is accumulated according to well understood
rules. It is turned in in Excel for those of you who are not
computer geeks, that is about the easiest data transformation
method known to man. At that point anyone, anywhere in the
world can go look up that data. That is a complete set of data.
If that's good policy for electricity, how can it be bad
policy for oil?
Senator Cantwell. What about the discovery of when this
information was reclassified for Vitol, what you're saying you
found out through the newspapers instead of through the data
that was made available. Why should we be concerned about that?
Why should we be concerned about this large a player in the
market and not knowing until it was reclassified?
Mr. McCullough. Fundamentally, as an economist, when you
teach ECON one or two, you're very worried about the question
of oligopoly. Paul Samuelson told us we have to have many
sellers and many buyers. By the way he also told us we have to
have transparent information.
If we had the price of oil being set by a half dozen major
players, oligopolous, we're very concerned. If it's set by
10,000 dentists, we're perfectly happy. At the moment we really
have very little to say on this.
The CFTC COT report uses their own form of market
concentration. It's not wrong or right. I criticized it a bit
the other day for not being HHI, the standard used in the rest
of the regulatory community.
But the fact of the matter is I was surprised to find what
a large scale Vitol had. I could have guessed backward that
some people do have that large position by reverse engineering
some of their numbers. But the fact of the matter is any trader
on the floor of the NYMEX has a pretty good idea of who's
playing. They had that information.
The only people who didn't have that information are
sitting in this room. That's the wrong answer.
Senator Cantwell. But what are the consequences of that
large trading position, of somebody who controls that large a
position in the oil market?
Mr. McCullough. Simply stated an oligopolist has market
power. He is able to change prices with his decisions.
Senator Cantwell. To drive the market.
Mr. McCullough. Yes. You know, Mr. Eagles noted that the
spot was a leading indicator on force. This is certainly not
news. But the key here is that Vitol has an enormous spot
position. This is what they've done traditionally.
Once we see that they have that enormous position then they
are able to execute gambits that can move the entire forward
curve. I've focused several times on Enron. The July 2001 Enron
exploit at the Henry Hub Natural Gas Market, easily one of the
most liquid markets in the world, where they ran an F spot out
in the natural gas market that they were able to change the
forward curve.
Then they sold on the forward curve, made enough money that
they were able to pay off the spot traders who had lost money.
This is an example of market power. We need the data to be able
to identify people who are doing this sort of things.
Now we've no evidence that Vitol could have done it, would
have done it, but we do know that whenever we see such a large
position concentrated in a few players, they have the
potential. We need to test whether the data is supporting that
potential.
Senator Cantwell. Isn't this what we saw with Amaranth too?
Didn't we see a large position in natural gas from a hedge fund
and was able to drive the market?
Mr. McCullough. Actually we saw two players fight over the
setting the price of natural gas. That's exactly the problem.
Of course the data came out only in the course of the
congressional investigation.
Senator Cantwell. Which brings me to the question, Mr.
Gheit, maybe you can answer. Should we be monitoring the
unwinding of the commodities market from these big players,
Lehman and AIG, because of--so we understand exactly what's
transpiring in the unwinding of these positions?
Mr. Gheit. Absolutely. But you also have very sophisticated
products that all the derivatives and things that pulls things,
so it is not going to be clear enough what else they have
there. But obviously more transparency would educate us, would
tell us exactly where they were hiding all of the skeletons.
But we need more transparency. We need more regulation. We
don't want to stifle them, but we just want to keep them under
control.
Senator Cantwell. Mr. Chairman, I am a big fan of markets
and markets functioning correctly. We have a Northwest economy
that has done quite well by people investing in a lot of
companies there. But we need to have transparency.
I think Mr. McCullough and Mr. Masters reports show that we
aren't collecting all the data that we need to collect. The
data that we are collecting, we aren't even collecting it
properly that when we aren't collecting the positions and
understanding who the major players are, that's only half our
challenge. The other half of the challenge, once you know who
the major players are, since so many of these individuals are
now involved in holding physical supply, or taking physical or
being part of buying physical supply.
We need to match up the information that we're getting from
the CFTC with other information from the Energy Information
Agency and others. I certainly plan on pursuing legislation on
data collection to make sure that this is very clear and that
the agencies will work together so that this is not a puzzle
for the American public and that they know that we are
protecting the markets and making sure that there is adequate
transparency in this country so markets can function properly.
So I thank the chair.
Senator Dorgan. Senator Akaka.
Senator Akaka. Thank you very much, Mr. Chairman. It's
great that this energy committee has been holding hearings on
this, especially coming from Hawaii. As you know we're 98
percent dependent on oil. We have the highest prices on oil
there. On the Island of Molokai we're paying over $5 per gallon
at the present time, even before that.
We pay for power there instead about 40 cents per kilowatt
hour. So we really under stress when the prices rise in a
country and it impacts Hawaii, especially. For these reasons
I'm very interested in what our witnesses have to say today. To
try to get to understand speculation in the oil markets and oil
is a commodity that we depend on a lot in Hawaii.
Let me ask this question to Mr. Newsome. I just want to
receive your evaluation on some of the comments that were made.
This was taken from an article published in Financial Times,
September 6, 2008, by Ralph Atkins in Frankfort. This has to do
with comments that were made by Mr. Trichet, who's the
president of the European Central Bank at the recent ECB
conference in Germany where he argued that it was ``reasonable
conjecture'' that financial investors had distorted commodity
markets leading to prices above those justified by
fundamentals, supply and demand factors.
In particular he said that financial investors encourage
sellers to accumulate inventories of delayed production so as
to take advantage of expected higher prices. I'm asking you for
your comments and your evaluation of the comments of Mr.
Trichet.
Mr. Newsome. I would address that a couple of ways,
Senator. One, particularly in the energy sector, we have seen
no collection of that underlying physical product that would
lead us to believe that any one financial players or others are
trying to manipulate the market.
Then second, when you talk about markets, you know, there
are a number of markets, the cash market, the over the counter
market, the futures market. Certainly I can only speak relative
to the futures markets because that's what we do. That's what
we have oversight for.
The futures markets are the most transparent component of
the markets in general. The CFTC as well as the exchange has
the view of all the major players within the market. I don't
think it should be unusual that the only two entities who have
access to the exchange information have said since day one,
that these higher prices were not being driven by speculators.
I think we have the information coming out now that certainly
proves that case.
With regard to over the counter markets, we've also said
since day one that we think there should be more transparency.
We've supported transparency of those markets. We were very
glad to see the CFTC in their report call for that kind of
transparency in those markets as well.
Senator Akaka. Let me ask, Mr. McCullough whether you have
any comments also on that, on Mr. Trichet's comments.
Mr. McCullough. I grew up on LaSalle Street, so I happen to
think very highly of the Chicago exchanges. But you know you
guys don't do spot. So the question of whether we would see a
spot for a gambit doesn't really show up on your desk.
When Enron ran the spot for a gambit in 2001, some of that
showed up on your exchange. But most of it probably didn't. So
you'll have no doubts using the smartest people around, it's
sort of hard for you to watch the whole world.
You know, I'm banging this drum for getting this data in
front of you, but I need to have Dr. Harris have a full data
kit. His agency prosecuted that spot for a gambit in July 2001.
Thank you very much. But they couldn't have done it without the
full data set.
Senator Akaka. Yes, Mr. Eagles.
Mr. Eagles. Could I just mention about one large position
which actually hasn't been mentioned here at all. That is
earlier this year when prices hit their peak King Fahd of Saudi
Arabia basically said, enough is enough and ordered Saudi
Arabia outside of OPEC to increase output by about 700,000
barrels a day. From the point that started to hit the market
prices started to fall. That's a very large increase in supply.
After this latest OPEC meeting we still have yet to--the only
comment we've had from Saudi Arabia is that they will continue
to meet demand for their crude oil.
It's a very large increase in supply. But I've also, in
terms of this stock argument that has been mentioned, before
joining JP Morgan in September, I worked at the International
Energy Agency. I've been very actively involved in data
collection on the fundamental side.
One thing that we do not have is information on stocks in
round about 45 percent of the consuming world. It is a dramatic
lack of data that we have. It's extremely important that we try
to improve transparency, not just on the financial side, but
also on the fundamental side which I think also echoes Senator
Cantwell's comments.
It's really important that we have every single angle of
this.
Senator Akaka. Thank you for your responses. Mr. Harris, I
want to thank the CFTC for their efforts to provide the staff
report. According to Commissioner Dunn, the data collected from
this survey highlights the need for greater transparency to
fully understand the activities of swap dealers and the effects
that their activities have on the markets.
Furthermore Commission Chilton recommends providing
specific statutory authorities allowing the commission to
obtain both data regarding over the counter transactions that
may impact exchange traded markets. Collecting this data will
allow more transparency in the market, of course. But what is
your evaluation of this proposal and will the increase in
transparency be useful?
Mr. Harris. I can perhaps benchmark to Mr. Eagles' comment.
He mentions that we have no data on 45 percent of the macro
consumption around the world. The comparative blind spots that
the CFTC faces minimal when we did our survey for this
particular swap, it wasn't a mere survey where we picked a
random event. We surveyed 100 percent of anybody who's trading
swaps and index traders in our market.
We then, therefore, got 100 percent participation rate,
cross referenced all their responses with the actual data we
put out in our index reports for the Ag commodities. So from
that standpoint this data in this report is 100 percent
comprehensive nature of what goes on in index trading in our
markets. So to that regard, I believe this is a good step to
sort of dispel some of these myths that may be out there that
what we don't know might be hurting us in some way.
In the first 6 months of this year, dispelled a myth that
index traders were actually driving prices up. These are
traders that were actually reducing positions in our market. So
I think the nature of the recommendations we have in the report
are to that extent. We continue to compile this data. We have
now gotten into the end of July and end of August data. We
continue to process that data and analyze that data.
I think that also points to one of the resource constraints
that we have. We took more than 40,000 or 4,000 man hours to do
this report. This took almost 10 percent of our CFTC staff to
produce this report last month.
This is not an instantaneously generated report. We have to
take unprecedented levels of looking at over the counter
positions, converting those positions into what we would
consider futures equivalents because the over the counter swap
market is by definition a swap is a very tailor made security.
To standardize all those things take quite a bit of manual
interpretation and analysis to produce a report.
So we do have strong data. We have comprehensive data. I
think we plan on continuing collecting data.
Senator Akaka. Thank you. Mr. Chairman, may I ask another?
Yes? Thank you.
I'd like to ask Mr. Gheit. Commissioner Chilton and I
mentioned Commissioner Chilton in that report he issued a
dissenting statement on Mr. Dunn's. But Mr. Gheit, Commissioner
Chilton suggests that at a minimum one of the Administrative
steps that the CFTC should take is to re-analyze the practice
of issuance of non-commercial hedge exemptions.
What are your thoughts on the current practice of issuing
non-commercial hedge exemptions? Should there be a special
category of hedge trade that differentiates the business done
to facilitate commercial traders like airlines and speculative
traders like hedge funds?
Mr. Gheit. What I suggested 6 months ago is that we have
two schemes. One for the commercial hedgers, should be the 5
percent. But non-commercial hedgers, the national players which
are needed to facilitate transaction, we should have them up to
50 percent.
We should also put trading limit. Suppose the market knew
only 10 percent or 15 percent of the financial players of the
total volume. We cannot make it 300 percent or 400 percent or
500 percent.
So therefore we will need speculators. But we don't need
too much speculation because they will control, ultimately will
control the market. You cannot have self regulated market that
will behave when there are billions of dollars at stake. It's
impossible.
The street is in the business of making money, not making
friends.
Senator Akaka. Mr. McCullough, would you care to make any
comment on that?
Mr. McCullough. You know I'm not smart enough to.
Senator Akaka. Alright.
Mr. McCullough. So I'll hold my peace on something that I'm
not an expert on.
Senator Akaka. Thank you. Thank you very much, Mr.
Chairman.
Senator Dorgan. Senator Akaka, thank you very much. I'm
going to come back just to a couple of additional questions.
Dr. Harris, again the report that you issued states this
preliminary survey is not able to accurately answer and
quantify the amount of speculative trading occurring in the
futures markets. Explain that to me if you would again?
Mr. Harris. Yes, the report in particular was determined or
the goal of the report is to quantify the amount of commodity
index trading in these markets. So my testimony actually
included data from our large trader reporting system that
actually does identify every trading position inspected of
positions. So the testimony and the graph that I provided there
actually shows that non-commercial speculative positions have
been coming down all year as well.
Senator Dorgan. So you are able to accurately answer and
quantify the amount of speculative trading occurring in futures
markets?
Mr. Harris. We have been able to quantify them to the
extent that we identify a trader and classify them.
Senator Dorgan. Right.
Mr. Harris. The report in particular didn't take that
comprehensive view.
Senator Dorgan. You indicate but if one is not classifying
them correctly or your classification system is a quarter
century old and weak and not particularly applied appropriately
or monitored appropriately than that would be a problem,
wouldn't it? So the question I would ask about classification.
The CFTC has indicated that trader classifications have grown
less precise over time. The classification system is weak.
So you appear to say with certainty something that appears
to me to be not very certain if your classification system is
weak.
Mr. Harris. I would say we're not 25 years behind the
times. This Commitment of Trader's report supplemental that we
do for index traders was just started as a pilot program a year
and a half ago. So in that regard although we've seen actually
quite----
Senator Dorgan. I understand.
Mr. Harris [continuing]. A few changes within that
category. I think that's one of the assessments that we have in
evaluating that particular report on whether it's providing
useful information. We've seen that it's been extrapolated into
other uses. We've provided the report originally for the
agricultural community to feel better about who's trading in
their markets, taking one step additional and now we're looking
at options in the report that we have and recommendations for
perhaps refining that looking forward.
Senator Dorgan. But I'm trying to understand, is the
classification system weak or do you feel?
Mr. Harris. I would say I'm very confident in the
classifications that we've made.
Senator Dorgan. Let me ask the question then about the
reclassification that was done in July that we discussed
earlier. Some of us were pretty surprised about that. It
appeared to me to be buried. A couple enterprising reporters
dug it out and found it.
But it was a very substantial reclassification, is that
correct?
Mr. Harris. Yes, we reclassified a trader in mid-July. I
wasn't actually surprised. There's a number of people that
follow our commitment of trader's reports.
We put out when we do reclassify traders, an announcement
in the Commitment of Trader's Reports. So people that were
following those reports would have had access to that.
Senator Dorgan. How large a difference in the commercial
verses speculative break down would that one reclassification
have made?
Mr. Harris. The reclassification moved approximately 12 and
a half percent of open interest from a commercial entity to a
non-commercial entity.
Senator Dorgan. So one reclassification affected over 10
percent of the assessment of what is commercial verses non-
commercial?
Mr. Harris. In our publicly reported data, yes. I want to
point out though that the Commission actually had record of
that reclassification a year prior. So as an entity we were
doing monitoring and surveillance on that entity that was
reclassified. So we knew the positions of that entity. We were
updating that position.
The surprising nature of that entity actually, the
reclassified entity was not short in the futures market for
almost the entire year. So the effect of that actually was to
move less or more selling pressure into the speculator
category.
Senator Dorgan. How did that particular entity get the
classification that it had before you reclassified it?
Mr. Harris. The specifics of that I think are market
surveillance team took on, each trader fills out a form with
the CFTC and declares themselves the type of trader that they
deem to be. We follow that and follow up with those and audit
those particular reports.
Senator Dorgan. Do you know when that particular trader was
originally classified?
Mr. Harris. I do not, no. I do know that August 2007 we
have record of that particular position moving from one entity
to another. So the market surveillance was aware of the
position size.
Senator Dorgan. Let me ask, you know, let me make a couple
brief comments if I might. The MERC, NYMEX, the futures market
itself, all very important elements of having the opportunity
to hedge risk between producers and consumers of a physical
product, perfectly reasonable and important to do. So when
those of us who discuss speculation talk about the evils of
speculation, speculation is necessary and speculation is a part
of what makes a market work.
But excess speculation, there are books written about it by
the way. I could give you some names of books written about it.
Unbelievable run up in excess speculation in various markets
over centuries as a matter of fact, starting with tulip bulbs
or perhaps even beyond.
That kind of activity can ruin markets and break markets
and so the first point I want to make is that this is not about
whether speculation is an element that is worthy or unworthy.
We will always have, I mean, someone who wishes to hedge is
probably going to have someone who wishes to speculate on the
back end of that hedge of a physical trader. So that's
important to understand.
But it's also a case that most people don't understand what
is at work in the regulatory function here because it is so
byzantine and complicated. You've issued all these no action
letters. I mean I've been critically of the CFTC as you know.
You no doubt have read that. I'm critical of a lot of
regulators who decided not to be very aggressive in order to
please the folks that appointed them.
We're now bearing dramatic results as a result that are
going to cost this economy a substantial amount of money and
the American people for that matter as well. The, Dr. Harris
the reason I have focused on these issues with you is I'm
reading from a Commissioner Chilton's dissent. He says
specifically, ``I have expressed doubts regarding the amount
and type of data received in connection with the special call
survey.'' I don't have the foggiest idea whether you have good
data or not. I know one Commissioner expresses reservation
about what kind of data you've received.
He points out, which I have known of course, the
international monetary fund released a report in May saying it
appears that speculation has played a significant role in the
run up of oil prices. I don't quote Alan Greenspan often
because we've had such significant disagreements. But Alan
Greenspan in August said, ``Financial speculation did play a
significant part in the rapid increase in oil prices.''
Yet what I find when you explore this issue you have some
interests who are determined to say no, speculation didn't
happen here in any excess degree. This is supply and demand,
market forces, despite the fact and Dr. McCullough, I used to
teach a little Economics as well. I would teach freshman in
college the laws of supply and demand, how the curve works and
so on.
What has happened in a number of the charts that you
showed, Dr. McCullough and some others, what has happened,
these markets have run in ways that are not explainable given
traditional supply/demand relationships. So that's why I think
there's concern here. It is the case, I think, and I feel that
at the end of today, no one has explained to me the so called
fundamentals'' or supply and demand relationships that
justified a doubling of oil prices. The consequences of which
were very significant for our country.
No one has described to me any plausible explanation other
than excess speculation for the doubling of the price of oil. I
would come back, finally, Dr. Harris. I'll give each of you a
chance to respond to this, to the EIA chart. The EIA chart, I
mean, Mr. Eagles, you talked about tight refining and so on.
As I said we spent $100 million a year for the EIA. They
got folks that all they do, all day long, is evaluate what's
going to happen. What are the fundamentals? What's the supply/
demand? What do we expect is going on in the world?
Then they plot a line and they say that's what we think is
going to happen. The red line is what really happened. That
many people can't be that wrong for that long without something
else explaining it. It just seems to me that's what's at work
here.
I just looked at the clock. I have to be somewhere in about
5 minutes. But if there's someone who won't sleep this evening
if I don't recognize a final comment, I'd certainly want to
call on you. Is there someone who needs to say additional----
Mr. Harris. I'd like to make a comment actually.
Senator Dorgan. Dr. Harris, yes?
Mr. Harris. From the CFTC's standpoint, I mean we are on
the market looking at these positions everyday. It's not for
lack of trying. I think our Commissioner and our Chairman have
been very forthcoming in saying we'd like to, sort of, have
dire consequences for anybody who's found manipulating or doing
anything nefarious in our markets.
We continue to do that. We continue to look. This is one
report that looks deeper than we've ever looked before. We've
got recommendations in there as an affirmative sort of action
to be able to try to do more and uncover more, to provide more
information for the marketplace.
Senator Dorgan. Dr. Harris you're here on behalf of the
Commissioners. I appreciate very much your testimony. You've
been very forthright. I hope you will accept my forthright
statement.
I think this has been a weak regulatory function, a very
weak function. I think in some cases a description of being
willfully blind in some areas. I don't mean that to injure a
lot of undoubtedly good, qualified people who work on the staff
of the CFTC, but I do believe this regulator has a lot to
answer for. I do.
Let me say to all of you, some of you've come a long
distance to be a part of this. I appreciate your contribution
to the discussion. As you know this discussion will begin
likely next week on the floor of the Senate as well as we take
up a good number of energy pieces of legislation.
So thank you for your time and the work that all of you
have done. This hearing is adjourned.
[Whereupon, at 4:40 p.m. the hearing was adjourned.]
APPENDIX
Responses to Additional Questions
----------
Response of Fadel Gheit to Question From Senator Murkowski
Question 1. How do you define speculation? And, is there a
difference between speculation and manipulation?
Answer. Speculation, in my view, is making a bet on a certain
outcome not based on complete, correct, or accurate information.
Speculators buy or sell future oil contracts betting that the price
will be as they predicted. Speculators do not deliver or receive the
oil in the contract, but settle their short position on expiration
date, and usually roll over their long position further. Oil
speculators are not investors. Future contracts become worthless after
their expiration date.
Excessive speculation could lead to market manipulation. When large
investment banks make oil price predictions, they usually influence the
future trading and skew the price in line with their predictions.
Investment banks, which are also large oil traders, clearing houses,
brokers, and owners of oil assets, face serious conflict of interest
issues. They can influence oil prices as their price forecast becomes
self-fulfilling prophecy, which amounts, in our view, to market
manipulation.
Responses of Fadel Gheit to Questions From Senator Domenici
Question 1. What would happen to the price of oil if non-
commercials were not allowed to participate in the market?
Answer. I believe that barring non-commercial players from trading
oil futures would more than likely reduce the oil price volatility. It
would also reduce the daily trading volumes, which would mean less
revenues and profits for the exchanges. The oil markets operated
efficiently for years before the exchanges were established and before
speculators poured huge sums of money, estimated at over $350 billion,
in oil futures. Given today's advanced telecommunications, I believe
the oil markets could operate probably more efficiently and with much
less volatility than in recent months, when future oil contracts held
by speculators significantly exceeded those held by commercial hedgers.
Question 2. In your testimony you state that oil prices have
declined recently despite supply disruptions and conclude that this is
evidence that speculation has disconnected oil prices from market
fundamentals. You also state that demand was reduced significantly this
summer in response to higher oil prices. And that high oil prices
previously reduced demand in most countries except China, India and
developing countries.
Doesn't reduced demand and significantly lower demand expectations
provide a logical reason for lower oil prices, despite short-term
supply disruptions?
Answer. The oil markets are not free markets, since more than 50%
of the world oil supply is controlled by OPEC and Russia, while demand
is skewed by taxes, as in the case of the U.S., Western Europe and
Japan, and by subsidies, as in the case of OPEC, China, India and many
developing countries.
Oil prices were in a free fall since their peak above $148/b in
early July to $92/b two weeks ago, before they turned sharply higher
after the financial bailout plan was announced, including a $25/b
surge, the largest ever, on Monday, September 22, 2008. In fact oil
prices were rising in the first half of the year, despite slowing world
demand and growing concerns about possible global recession.
On the other hand, the precipitous drop in oil prices, $56/b, or
38%, in the nine weeks from mid-July to the third week in September,
came despite events that caused, or were expected to cause, supply
disruptions, including:
The Russian invasion of Georgia
The shutdown of the Turkish pipeline, after explosion, which
disrupted the flow of almost one million barrels of crude oil
per day from Azerbaijan for ten days.
The shutdown of Gulf of Mexico production due to the
hurricanes
Rebels' attack on oil production facilities in the Niger
Delta.
______
Responses of James Newsome to Questions From Senator Murkowski
In your testimony you indicate that CME supports the CFTC's
recommendations to encourage greater clearing of OTC transactions as a
means of increasing market transparency and integrity.
Question 1a. Can you please explain the clearing process and [how]
this process would enhance market integrity and transparency?
Answer. Eligible participants who enter into OTC transactions have
the risk that their counterparty will not satisfy its obligations under
that contractual agreement. However, by submitting an OTC transaction
to a clearinghouse, a counterparty to an OTC transaction no longer has
concerns about the credit risk of its initial counterparty and instead
can enjoy the guarantee of financial performance offered by the
clearinghouse. Once a transaction has been accepted for clearing by a
U.S. futures clearinghouse, which is highly regulated by the CFTC, the
clearing of that transaction is then subject to CFTC review and
oversight. Thus, for example, transactions executed in the OTC market
that are accepted for clearing under the NYMEX ClearPort Clearing
business service are converted into regulated futures and options that
are subject to large trader reporting to the CFTC as well as to
position limits and position accountability levels, which enhances
market integrity and transparency.
Question 1b. Would adding a clearing process to the swaps market
add integrity and transparency?
Answer. We do believe that greater use of a clearing process for
swaps would promote both market and financial integrity and would
increase the transparency of these transactions to the regulator.
Question 2a. A number of individuals have suggested that a
persistent flood of net long investors in the commodities markets have
driven up the prices.
Does this view accurately reflect the basic principles of futures
trading-for every buyer there is a seller and for every seller there is
a buyer?
Answer. In any transaction, there is a buyer and a seller. What is
important to understand is that these assertions, which were being made
by a handful of commentators who were relatively unfamiliar with
futures markets, were based on theoretical extrapolations and were not
supported by any actual data. The reality, as definitively established
by the CFTC ``Staff Report on Commodity Swap Dealers & Index Traders
with Commission Recommendations,'' is far different. Reviewing data for
the first six months of 2008, the CFTC staff found that the ``aggregate
long positions of commodity index participants in NYMEX crude oil
declined by approximately 45,000 contracts during this 6 month period .
. .'' (emphasis added.) Based on the data reviewed, this amounted to an
approximately 11% decline.
Question 2b. And can you explain how an increase in net long
positions increased the price of crude oil?
Answer. As noted above, the premise of a recent increase in net
long index positions has been soundly refuted by the recent CFTC staff
report.
Question 3. Does your CME research indicate a correlation between
commodity prices and the participation in various markets by hedge
funds, pension funds and various non-commercial speculators?
Answer. NYMEX's Research Department has conducted extensive
analysis on the role of speculators in our energy markets. These
evaluations began in 2004 and included reviewing data from 2007 through
to the middle of 2008 for our core crude oil and natural gas futures
contracts. We found no evidence to support harmful impacts on price or
price volatility by non-commercial participants. Our analysis instead
disclosed that non-commercial participants are price takers. In other
words, they do not initiate movements in price or otherwise set prices,
but rather follow price movements that are generated by commercials. In
addition, our data indicate that trading by non-commercials or
speculators has had a moderating or braking effect on price volatility
in the products that were the subject of the study.
Other findings also support our conclusion that speculators are not
influencing the futures prices. First, non-commercial participants
historically have represented a smaller percentage of the energy
futures markets than commercial participants. Second, non-commercial
participation consistently has been relatively balanced between longs
(buys) and shorts (sells), so there has not been, for example, a
disproportionate push on the long side of the market, which would cause
the price to increase. Third, non-commercials generally are not in a
position to influence final settlement prices because they do not own
the physical commodity and therefore, must liquidate their open futures
positions prior to expiration of trading of the applicable expiring
contract month.
Lastly, with hundreds of commercial participants and instantaneous
price dissemination, any short term ``speculative'' price impact that
creates a discrepancy between the futures price and the price level
that would be anticipated on the basis of market fundamentals in the
underlying physical commodity market would be expected to be met in
reasonably short order with an equally strong ``commercial'' reaction.
Thus, if short-term prices in a futures market should happen to move in
a direction inconsistent with actual market fundamentals, a vast number
of participants, including energy producers, wholesalers and end-users
(as well as government agencies) would respond to ensure that prices
return rapidly to where the industry consensus believes they should be
to reflect supply and demand fundamentals. Questions from Senator
Domenici:
Responses of James Newsome to Questions From Senator Domenici
In your testimony, you reject Mr. Masters' analysis and conclusions
that the increase in net long investors has driven up the price of
crude oil.
Question 1. Can you summarize the most important defects that you
see with Mr. Masters' analysis, which in your opinion make his
conclusions incorrect?
Answer. As further detailed in our written testimony, earlier this
year Mr. Masters began a cascade of charges that commodity index funds
were responsible for unnatural price escalations in commodity markets,
particularly for crude oil. While Masters is dismissive of market
fundamentals, we have emphasized that crude oil is truly a global
commodity and that prices in crude oil futures markets are primarily
driven by the market fundamentals of the far larger physical market for
the crude commodity.
On September 10th, Mr. Masters updated his so-called ``analysis,''
including his allegations about crude oil market participation, price
determination and performance. On September 11th, the CFTC released a
detailed report that included definitive data and analysis regarding
index-long market participation in a group of commodities, including
crude oil. Unlike Mr. Masters who guessed at or simply assumed the
facts, the CFTC report by contrast provided definitive and unambiguous
information as to whether the index funds were increasing or decreasing
their positions in a manner that could support Mr. Masters' claims. In
addition, the CFTC report provided futures price information that
enabled readers to perform the equivalent analysis that Mr. Masters
purported to perform in reaching his conclusions. The information the
CFTC provided also was sufficient to enable readers to evaluate the
methodology Mr. Masters purported to perform in reaching his assertions
about index-long participation in commodities markets.
The unambiguous result of the CFTC analysis and its direct
implication is that Mr. Masters was wrong about everything; about
participation by index-longs, about the price impacts from index-longs,
and about how to even count participation by index-longs. Mr. Masters
has successfully captured a number of headlines by trumpeting the
supposedly massive inflow of funds by index traders into the regulated
futures markets. Yet, as detailed in the CFTC report, index trader
positions were actually declining during this period.
Question 2. In your opinion, does the fact that a vast majority of
speculators do not take physical delivery of crude oil, make a
difference in how Congress should view the impact of speculators in the
commodity markets?
Answer. To be clear, because speculators lack the wherewithal to
make or receive delivery of a physical product, no speculator can take
physical delivery of crude oil on a futures market. On the other hand,
the vast majority of positions in crude oil held by commercials do not
go to delivery of the physical oil. Futures markets are structured to
provide hedging and price discovery services and are not intended to
provide delivery of the physical product as a routine matter. Perhaps
the most salient consideration for Congress concerning speculators
being unable to participate in the delivery process is that speculators
must sharply reduce their open positions as the termination of trading
approaches in an expiring contract month. Consequently, speculators
have a reduced ability to have any impact on the determination of the
final settlement price for the expiring contract month.
Question 3a. Some view swap dealers as illegitimate users of the
CFTC's hedge exemption.
How do you view swap dealers with regard to their use of the hedge
exemption?
Answer. Swap dealers do have legitimate market price risk exposure
as a result of their swap activity. Consequently, we do believe that
the CFTC was warranted in permitting swap dealers to apply for hedge
exemptions for their corresponding futures positions on CFTC-regulated
exchanges, while preserving the discretion of exchanges to review such
applications on an individualized case-by-case basis.
Question 3b. In your opinion, are swap dealers fairly characterized
as commercial, non-commercial, or some other type of market
participant?
Answer. As noted in the recent CFTC staff report, swap dealers
serve an important market role by acting as market makers both to
commercials and to speculators who are seeking to enter into swap
transactions. We agree with the CFTC report that the lines between
commercial and non-commercial have been blurring in recent years,
including with respect to the role of swap dealers. Thus, as noted in
that report, a number of swap dealers now have acquired physical
facilities and thus have the wherewithal to participate in transactions
in the physical cash commodity market. Accordingly, we believe that
there may be merit in further delineating the traditional categories
that have been used by the CFTC in its Commitment of Traders reports.
Question 4. Do you agree with the CFTC's recent report that
recommends that we do not have enough data to draw hard and fast
conclusions about how to best categorize swap dealers for the purpose
of the exemption?
Answer. The CFTC staff collected an enormous amount of data in
connection with their report. Our understanding is that the real
difficulty in categorizing swap dealers may be less a matter of the
quantify of the data but rather that a good number of swap dealers are
involved in a variety of transactions and thus may not fit neatly into
the traditional commercial and non-commercial categories that have been
used by the CFTC for its Commitment of Traders Reports to the public.
We believe that the CFTC's preliminary recommendation calling for more
delineated trader classification categories has some merit and warrants
further study.
Responses of James Newsome to Questions From Senator Akaka
You testified that transparency and disclosure of trading and
position information to a regulator will deter manipulation of the
market. Commissioner Chilton recommends providing specific statutory
authorities allowing the commission to obtain data regarding Over-The-
Counter (OTC) transactions that may impact exchange-traded markets.
Going a step further, this data will link a bank's hedge to a swap,
thereby allowing more transparency.
Question 1. What is your evaluation of this proposal?
Answer. In calling for additional data to be obtained regarding OTC
transactions, Commissioner Chilton's proposal is similar to several of
the preliminary recommendations suggested by the CFTC in its recent
report. We believe that it is useful to consider a number of approaches
regarding the data to be obtained and regarding the use of such data in
making OTC activity more transparent to regulators, and we are
committed to working with Congress to promote transparency of OTC
transactions to the CFTC.
Question 2. In his testimony, Mr. Gheit recommended that non-
commercial hedgers should have a five percent margin, whereas non-
commercial hedgers should have 50 percent. Do you think these margins
are adequate? If not, why? What margins do you propose?
Answer. In recent weeks, there has been tremendous upheaval in the
financial markets. The stock market has declined by more than 12% in a
very short period and, as has been widely reported, a number of large
and reputable investment firms have gone out of business or have been
acquired by another financial institution. Yet, U.S. futures
clearinghouses have performed extremely well throughout this demanding
period. So we have serious concerns about mandates being imposed by
Congress that would interfere with and undermine the core purpose of
margins in futures markets, which is to ensure the financial integrity
of transactions executed on or subject to the rules of U.S. futures
exchanges.
As to Mr. Gheit's statement, we understand the question to be
whether non-commercials should have significantly higher margin levels
than commercials. Given the figures that he is suggesting, we question
whether Mr. Gheit understands that futures margins serve as performance
bonds and thus provide a distinctly different function from that
provided by securities margins. Regardless of the intention underlying
Mr. Gheit's suggestion, the clear result would be to harm U.S markets
by pushing volume and liquidity to less transparent and less regulated
markets overseas. Consequently, by reducing liquidity on U.S.-regulated
markets, if Congress actually followed through on Mr. Gheit's proposal,
the ironic result would be that price volatility would actually
increase.
______
Responses of Robert F. McCullough, Jr., to Questions From Senator
Murkowski
Question 1. In your report you mention that Enron's market
manipulation of the Henry Hub futures market in 2001 might be a
relevant model to understanding the increase in crude oil prices. But
the Enron case was a situation of manipulation. In your opinion, is
there a significant difference between market manipulation and
excessive speculation?
Answer. ``Excessive speculation'' is a term that doesn't have a
very solid definition, nor is it a phrase used in the literature. When
investors base their expectations on the premise that price increases
will continue forever, this certainly seems excessive.
Given the current absence of data on spot and forward markets in
oil, it is not possible to determine if the problem is manipulation or
unbridled enthusiasm by speculators. There are reasons to be concerned
that it might be the former. In tulip bubbles http://en.wikipedia.org/
wiki/Tulip_mania speculators tend to hold their positions through the
boom and the bust. In the Enron-created price excursions during the
Western Market Crisis of 2000-2001, Enron liquidated its positions
before the bust.
A similar story played out in the NYMEX non-commercial positions in
2008. All in all, non-commercial speculators showed a suspicious
prescience concerning the unforecasted oil price spike on July 3, 2008.
Their prescience was all the more surprising since the EIA forecasts of
supply and demand for the same period were accurate.
The situation with Hurricane Ike on September 13, 2008 is no more
reassuring. Prices fell as the hurricane took out 1.3 million barrels
per day in the Gulf and increased when oil and gas production was
returned to service (see graph). These anomalies would appear to go
beyond speculative enthusiasm and verge upon market manipulation.
Question 2. In your opinion what regulatory policies 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. Thank you for this question. We have had 160 years of
experience with spot and forward market abuses at the Chicago Board of
Trade.
First, shifting from open pit to electronic trading reduces
transparency. Open pit trading provides a great deal of trading
information to market participants. The information is asymmetric--it
benefits exchange members more than the general public--but it is
available. Attempts to corner the market such as the one that we
suspect occurred on Monday, September 15 are more difficult in an open
pit venue because traders can quickly guess where the problem lies.
Since electronic trading is here to stay, it is important to make
sure that everyone sees the transaction data. This includes the public,
decision-makers such as yourselves, and regulators. A good template for
transaction data transparency can be found in the FERC's Electric
Quarterly Report (EQR). You can find a detailed description of the
report and its methodology at http://www.ferc.gov/docs-filing/eqr/com-
order.asp. If the CFTC, etc. had such a weapon in its arsenal, the
debate on the causes of the recent price spikes would be moot.
Insiders often argue that transparency is contrary to the public
interest because it makes collusion easier; and secrecy is needed to
prevent predatory pricing. Neither argument is justified by history or
economic analysis. In opaque markets such as the electricity market
operated by the Province of Alberta, Enron simply gave its market data
to its fellow conspirators. Making the transaction data secret does
nothing to prevent conspirators from sharing their data. It only makes
detection of collusion more difficult.
Predatory pricing is just as illusory. Most financial transactions
such as forward markets have no secret cost structure to use in a
predatory pricing scheme. Where there is production data that might be
useful in competitors pricing, the market participants are free to keep
the data to themselves. Their transactions, however, do not identify
their production costs. Thus I emphasize. . .
If transparent transaction data is good policy for electricity, it
is clearly good public policy in oil, where market concentration and
inexplicable price changes raise significant doubts that the market is
functioning efficiently.
I also believe that one regulatory agency needs to be given the
mandate to collect all of the data and regulate all of the relevant
markets. As Lawrence Eagles, of J.P. Morgan Chase said during your
September 16 hearing, spot markets lead forward markets. Asking the
CFTC to regulate forward markets without access to spot transaction
data makes the commission unable to successfully fulfill its
responsibilities. Posting two policemen on one beat is fine if they
work together. At the moment, four police walk this beat--the CFTC, the
FTC, FERC, and the EIA--with inconsistent powers, mandates, and
information. Their current reports are contradictory and confusing.
Since the start of the runup in oil prices, EIA forecasts have been
accurate as to quantities (imports, exports, consumption, and
international demand) but are wildly inaccurate in terms of prices. If
there is no problem with oil markets, as the CFTC claims, the EIA is
incompetent. If the EIA is correct, the CFTC and the FTC are
incompetent. This is a terribly ineffective solution for market
surveillance.
The Enron loopholes of the 1990s must be closed. If the CFTC is to
regulate forward exchanges it must regulate all transactions. A simple
solution would be to make forward contracts enforceable only if
reported to the CFTC. There are many precedents for solutions of this
type in the U.S. economy from patent law to land ownership. The CFTC
must be given explicit powers over ICE and the OTC markets.
Response of Robert F. McCullough, Jr., to Question From Senator
Domenici
Question 1. In your report, you state that there is a need for more
reliable data and analytical tools to accurately determine the link
between market fundamentals and speculation. In your opinion, does Mr.
Masters' September 10th report change your assertion that there is a
lack of data to support a conclusion that speculation has been the
primary factor in the increase in crude oil prices?
Answer. Market surveillance in the oil markets suffers from a
paucity of data. Part of the problem is the confusion of missions. None
of the four police on the beat have a clear and complete mandate or
access to even minimal levels of data.
A case in point is the successful corner of the oil market on
September 15 now under investigation by the CFTC. Such corners occur
when a market is sufficiently concentrated that one or more players can
make it impossible for forward contract holders to fulfill their
contracts. The outcome was a short-lived $25/barrel spike in oil
prices. Since the October contracts settled at the high price, the
speculation raised oil prices for a substantial share of U.S.
consumers. Moreover, the spike adds to an already high level of
volatility. The CFTC did not know the crisis was coming, nor could it
have known because the commission has no spot data. It only has partial
data from ICE and effectively no data from over the counter markets.
On the other hand, electricity market participants file quarterly
reports describing all of their transactions. So we have the market
with a high level of risk with little or no data for market regulators
and the market with a lower level of manipulation risk with extensive
data for regulators. It is very possible that the problems in the oil
market may be the result of inadequate regulatory surveillance and the
absence of market data.
Michael Masters's report uses a poorly designed and documented CFTC
data set to match speculative positions to price changes. At the
hearing he was severely criticized for relying on this official CFTC
source. As I remember, Senator Domenici, you were a primary critic. Mr.
Masters' conclusions mirrored my own, which relied upon a different
CFTC data source--the Commitments of Traders report. I think an honest
answer is that this is a case of ``[i]n the land of the blind, the one-
eyed king is blind.'' The CFTC report is poorly designed and
documented. But it is important to understand that this is all of the
data the CFTC had until the CFTC report released two weeks ago. Even
that report was fragmentary and incomplete--ending the month before the
price spike.
The question is not whether speculation is bad: speculation is a
reasonable economic function. The question is whether something was
wrong with a massive run-up in oil prices this year when fundamentals
did not remotely provide an explanation for the increase. Mr. Masters's
work would indicate one possible explanation. With additional data it
might well be possible to determine if his hypothesis is correct.
It is important to note that something beyond pure speculation is
at work, here. During last week's hearing I noted several times that
the loss of production from Gulf of Mexico drilling rigs was actually
correlated with a fall in prices. On Monday, as you are aware, about a
third of the rigs had returned to service, but oil saw an unprecedented
25% increase. This clearly indicates that policy makers, such as
yourself, will have work ahead of them in upcoming days.
It would be very wrong to choke off your investigation before
assembling all of the data. Today we only have scarce data and
insufficient manpower, with the result that our ``speculative'' debates
suffer from inadequate research.
______
Responses of Michael W. Masters to Questions From Senator Murkowski
Question 1. In your report you discuss the Hunt Brothers attempt to
corner the silver market, which they tried to do by buying physical
silver and storing it in a warehouse. i.e. they stockpiled or hoarded
the commodity. Do you have any evidence that speculators are hoarding
or stockpiling physical crude oil, or any physical commodities for that
matter?
Answer. My understanding of the Hunt Brothers attempts to corner
the silver market was that they purchased futures contracts in very
large quantities and took physical delivery against those contracts. By
accumulating physical silver in addition to their silver futures
contracts they were able to reduce the deliverable supply and corner
the market. In doing so this made their large futures position even
more valuable. Silver prices rose from around $10 to about $50 and when
the COMEX and CFTC intervened in the silver futures market to force the
Hunt Brothers to stop accumulating silver futures at that point the
price of silver (both futures and physical) dropped back to $10 within
a few weeks.
I do not have any evidence that proves speculators are hoarding or
stockpiling physical commodities nor am I in a position to gather such
evidence as a private citizen. We turned over to the House Energy
Committee and the CFTC marketing documents from Credit Suisse that
detail investments in commodities like iron ore which do not have
liquid futures contracts. In order to hedge these investments, Credit
Suisse and other swaps dealers would need to buy physical commodities
and hold them or contract with physical suppliers for the purchase of
physical commodities.
Index Speculators do not have to purchase physical commodities in
order to influence and inflate physical commodity prices. The CFTC
states on its website that ``In many physical commodities (especially
agricultural commodities), cash market participants base spot and
forward prices on the futures prices that are ``discovered'' in the
competitive, open auction market of a futures exchange.'' (``The
Economic Purpose of Futures Markets and How They Work--Price Discovery
or Price Basing,'' Commodities Futures Trading Commission Website,
http://www.cftc.gov/educationcenter/economicpurpose.html) Platts, which
is the leading pricing service for the energy industry, describes it
this way: ``In the spot market, therefore, negotiations for physical
oils will typically use NYMEX as a reference point, with bids/offers
and deals expressed as a differential to the futures price. (``Platts
Oil Pricing and Market-on-Close Methodology Explained--A
Backgrounder,'' Platts, A Division of McGraw Hill Companies, July 2007,
page 3. http://www.platts.com/Resources/whitepapers/index.xml) So when
futures prices go up then physical prices for grain and energy also go
up because physical prices of these commodities are based off of
futures prices.
Question 2. How do you explain the rapid increase in prices of
commodities that are not traded on futures exchanges or over-the-
counter markets, such as iron ore (up over 200% since 2001), rice (up
over 400% since 2001) and even onions, which are legally prohibited
from being traded on exchanges in the U.S. but still are significantly
up in price this year?
Answer. Economists refer to this phenomenon as either the
``substitution effect'' or the ``crosselasticity of demand.'' It says
simply that if the price of something rises then consumers will shift
consumption to alternatives, which then leads to an increase in the
price of the alternatives. So if the price of aluminum goes up then
manufacturers will choose to substitute steel for aluminum. If the
price of natural gas goes up then some power plants will choose to burn
coal to heat the steam that turns the turbines. If grain prices rise
then people will consume more rice, which will cause these prices to
rise.
These relationships are so strong and established that even though
there is not an existing futures market the people who trade these
physical commodities are actively aware of where the substitute
commodities are trading on the futures exchange and adjust prices
accordingly. In addition, as I mentioned in my answer to question 1,
there are investors attempting to invest in non-exchange traded
commodities such as iron ore.
Responses of Michael W. Masters to Questions From Senator Domenici
Question 1. In your opinion, do commodities markets require both
physical hedgers and speculators to function properly?
Answer. Commodities futures markets were created by and exist for
physical hedgers. If physical hedgers are not part of the commodities
futures markets then the markets lose their legitimacy.
Speculators are also a necessary part of the commodities futures
markets and that is why I have never argued for the elimination of
speculation. Speculation is needed in adequate amounts. Too little
speculation and there will be insufficient liquidity and bid-ask
spreads will reflect this. Too much speculation and the opportunity
exists for speculative bubbles to form. That is why we need sufficient
liquidity but not unlimited liquidity.
What I have advocated is that speculative position limits apply to
every market participant in every market that trades derivatives based
on U.S. commodities. So for instance, I believe that speculative
position limits are necessary in West Texas Intermediate Crude Oil for
speculators on NYMEX, ICE and in the over-thecounter swaps markets.
I agree with the findings of Congress in the 1936 Commodity
Exchange Act that determined that speculative position limits were
necessary to protect the commodities futures markets from excessive
speculation. I see my proposals as simply updating that 1936 Act to
reflect the modern world we live in.
Question 2. On the futures exchanges, every buyer has to be paired
with a seller. In your opinion, from whom were the speculators buying
earlier this year, and to whom have they been selling?
Answer. Unfortunately, because I do not have access to the same
data that the Commodities Futures Trading Commission has access to, I
am not able to truly determine who is a speculator and who is a
physical hedger. The reason is that swaps dealers trade with both
speculators and physical hedgers but they are classified in the
Commitments of Traders report as ``commercial'' which until recently
was thought to equate to ``physical hedgers.'' So all of the
speculation that is taking place through swaps dealers is masked as
``commercial.'' The CFTC has acknowledged this problem and proposed to
report a separate swaps dealer category in the COT reports but
unfortunately that still does not solve the problem because we do not
know what portion of a swaps dealers positions corresponds to
speculators and what portion corresponds to physical hedgers.
Compounding this problem is the fact that we have no COT data on the
ICE and we have no data on the over-thecounter swaps markets.
It is for this reason that we have focused on the actions of one
subgroup of speculators, the index speculators, which we can track to
some extent using the CFTC's Commodity Index Trader reports. We do not
know who these index speculators were buying from and selling to for
the abovementioned reasons but we feel confident given their size that
their actions had an impact on the marketplace.
______
Responses of Jeffrey Harris to Questions From Senator Murkowski
Question 1. Some have recommended that an increase in position
limits is the key to preventing excessive speculation in the futures
market. What are CFTC current rules on position limits? And can you
explain the effects of these limits on the market?
Answer. Most physical delivery and many financial futures and
option contracts are subject to speculative position limits. Section
4a(a) of the Commodity Exchange Act (``Act'') provides that, for the
purpose of diminishing, eliminating, or preventing sudden or
unreasonable fluctuations or unwarranted changes in the price of a
commodity, the Commission may impose limits on the amount of
speculative trading that may be done or speculative positions that may
be held in contracts for future delivery. Pursuant to this authority,
the Commission has established specific limits for several markets
(corn, oats, wheat, soybeans, soybean oil, soybean meal, and cotton),
which are set out in Federal regulations (CFTC Regulation 150.2).
Furthermore, Section 5(d)(5) of the Act requires designated
contract markets to establish position limits or accountability
provisions to reduce the potential threat of market manipulation or
congestion where necessary and appropriate. The Commission has adopted
``Acceptable Practices'' for the establishment of exchange-set limits
(Appendix B to Part 38 of the CFTC's regulations). Violations of
exchange-set limits are subject to exchange disciplinary action.
Violations of exchange speculative limit rules that have been certified
by an exchange or approved by the Commission are subject to enforcement
action by the Commission.
Finally, as part of the 2008 Farm Bill Congress recently added
Section 2(h)(7) to the Act, which includes a requirement that Exempt
Commercial Markets establish position limits or accountability
provisions for contracts that the Commission has determined perform a
significant price discovery function. The Commission is currently in
the midst of a rulemaking to implement these amendments.
Under CFTC Regulation 150.2 speculative limits for the listed
agricultural markets are set for the spot month, all months and all
months combined levels. Speculative limits in physical delivery markets
are generally set at a more strict level during the spot month (the
month when the futures contract matures and becomes deliverable).
Stricter limits in the spot month are important because that is when
contracts may be more vulnerable to price fluctuation caused by
abnormally large positions or disorderly trading practices. The
Commission's Acceptable Practices specify that spot month levels for
physical delivery markets should be based upon an analysis of
deliverable supplies and the history of spot month liquidations, and
should be set at a level no greater than 25 percent of estimated
deliverable supplies. For cash-settled markets, spot month position
limits should be set at a level no greater than necessary to minimize
the potential for manipulation or distortion of the contract and the
underlying commodity price.
Guidance for the establishment of speculative position limits in
individual non-spot months and in all-months-combined typically is
found in Commission Regulation 150.5. In particular, the level is based
on an ``open interest formula'' calculated as 10% of the average
combined futures and delta-adjusted option month-end open interest for
the most recent calendar year up to 25,000 contracts, with a marginal
increase of 2.5% thereafter.
Question 2a. The CFTC data reports the actual positions and trades
of swap dealers and their clients.
Mr. Harris, can you give the committee a sense of how you collected
this data and how this data will improve the reporting of these
positions. How will this improve your regulatory oversight and better
inform investors?
Answer. As detailed in the recent ``Staff Report on Commodity Swap
Dealers & Index Traders with Commission Recommendations,'' the
Commission used its `special call' authority (Reg. 18.05) to compel
large swap dealers and index funds to provide information on index
trading and OTC swaps tied to U.S. futures markets. The responders have
an on-going obligation under the special call to file these data
monthly, and if resources become available, the Commission will be able
to add market transparency about the amount (notional value and
equivalent futures contracts) of index trading. These efforts will
better inform investors compared to our existing supplemental report to
the Commitments of Traders report, which covers only 12 agricultural
markets and is a less accurate representation of index trading. DMO
Question 2b. What does this data tell us about the trading behavior
/ trading positions of swaps dealers?
Answer. It shows that swap dealers and index funds, in aggregate,
were reducing long positions in the crude oil futures market as prices
(and notional values) were moving sharply higher in the first six
months of 2008. It also shows that significantly more than half of the
clients for crude oil swaps are commercials in the physical market.
Responses of Jeffrey Harris to Questions From Senator Domenici
Question 1. Does the CFTC have data that indicates a correlation
between commodity prices and the participation in various markets by
hedge funds, pension funds, and various non-commercial speculators?
Answer. The Commission has price and position data for all
categories of participants in commodity markets, including those you
mention. On May 22, 2008 we presented an analysis of the correlations
between prices and participant positions for a number of agricultural
products. The CFTC has also been working with an Interagency Task Force
that includes the Federal Reserve, the Securities and Exchange
Commission, the Department of Agriculture, and the Department of Energy
on a comprehensive study that analyzes this price and position data. In
July, the Task Force decided to accelerate the crude oil portion of
that study in order to provide the public with greater transparency on
the factors underlying the high prices that were seen at that time. The
reports are attached in their entirety. Both studies found little
evidence to support the proposition that the position changes of
traders classified as noncommercial were systematically causing price
changes. OCE
Question 2. In the first half of 2008, we saw a dramatic increase
in the price of crude oil, but there has been a decrease in net
speculative positions. Can you please explain how such a reduction
would normally be expected to impact prices?
Answer. The theory of supply and demand dictates that prices can
rise with an increase in demand or decrease in supply. We know that the
supply of futures contracts (the open interest of futures combined with
options on futures) was growing in the crude oil markets during the
first half of 2008. Although overall demand for futures positions was
rising, as you note demand from commodity index funds (speculators, to
some) was falling over the same period of time. In this regard, a
reduction in demand might be expected to result in lower prices.
However, as skeptics of the theory, we also test whether changes to
net speculative positions affect price changes.\1\ The specific
procedure we apply is a test for ``Granger Causality'' which seeks to
determine if events in one period predict events in a subsequent
period. In crude oil, we tested whether position changes by various
categories of traders could predict price changes for the following
day. We found no evidence that non-commercial or other speculative
position changes preceded price changes during the first half of 2008
or in the years prior. As our report indicates, there are limitations
to this test, the most important being that the price changes could
come on the same day as the position changes rather than the following
day. Nevertheless, we are working to improve our data in order to
conduct the same test to determine the intra-day price effects from
position changes.
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\1\ This is a summary of the Interim Report of our Interagency Task
Force. The full report is attached.
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We note that some have argued that demand for futures contracts is
the same as demand for crude oil. This is simply not true. As noted
above, the supply of futures contracts was increasing during the first
half of 2008, but that says nothing about the actual supply of crude
oil. Similarly, demand for futures contracts only indicates demand for
hedging risk in the crude oil market, and does not indicate demand for
crude oil as a product. Since the aggregate supply of and demand for
crude oil is not affected by futures positions, the theory of supply
and demand predicts that futures trading will have no impact on crude
oil prices. OCE
Question 3. The CFTC's staff report makes several recommendations
for swap dealers and index traders. What effects will these
recommendations have on trading in futures commodity markets?
Answer. The Report makes eight recommendations. These are listed
below.
1. Remove Swap Dealers from the Commercial Category and
Create a New Swap Dealer Classification for Reporting Purposes:
In order to provide for increased transparency of the exchange
traded futures and options markets, the Commission has
instructed the staff to develop a proposal to enhance and
improve the CFTC's weekly Commitments of Traders Report by
including more delineated trader classification categories
beyond commercial and noncommercial, which may include at a
minimum the addition of a separate category identifying the
trading of swap dealers.
2. Develop and Publish a New Periodic Supplemental Report on
OTC Swap Dealer Activity: In order to provide for increased
transparency of OTC swap and commodity index activity, the
Commission has instructed the staff to develop a proposal to
collect and publish a periodic supplemental report on swap
dealer activity. This report will provide a periodic glance at
swap dealers and their clients while simultaneously identifying
the types and amounts of trading that occur through these
intermediaries, including index trading.
3. Create a New CFTC Office of Data Collection with Enhanced
Procedures and Staffing: In order to enhance the Agency's data
collection and dissemination responsibilities, the Commission
has instructed its staff to develop a proposal to create a new
office within the Division of Market Oversight, whose sole
mission is to collect, verify, audit, and publish all the
agency's COT information. The Commission has also instructed
the staff to review its policies and procedures regarding data
collection and to develop recommendations for improvements.
4. Develop ``Long Form'' Reporting for Certain Large Traders
to More Accurately Assess Type of Trading Activity: The
Commission has instructed staff to develop a supplemental
information form for certain large traders on regulated futures
exchanges that would collect additional information regarding
the underlying transactions of these traders. This would
provide a more precise understanding of the type and amount of
trading occurring on these regulated markets.
5. Review Whether to Eliminate Bona Fide Hedge Exemptions for
Swap Dealers and Create New Limited Risk Management Exemptions:
The Commission has instructed staff to develop an advanced
notice of proposed rulemaking that would review whether to
eliminate the bona fide hedge exemption for swap dealers and
replace it with a limited risk management exemption that is
conditioned upon, among other things: 1) an obligation to
report to the CFTC and applicable self regulatory organizations
when certain noncommercial swap clients reach a certain
position level and/or 2) a certification that none of a swap
dealer's noncommercial swap clients exceed specified position
limits in related exchange-traded commodities.
6. Additional Staffing and Resources: The Commission believes
that a substantial amount of additional resources will be
required to successfully implement the above recommendations.
The CFTC devoted more than 30 employees and 4000 staff hours to
this survey, which the Commission is now recommending to
produce on a periodic basis. Other new responsibilities will
also require similar additional staff time and resources.
Accordingly, the Commission respectfully recommends that
Congress provide the Commission with funding adequate to meet
its current mission, the expanded activities outlined herein,
and any other additional responsibilities that Congress asks it
to discharge.
7. Encourage Clearing of OTC Transactions: The Commission
believes that market integrity, transparency, and availability
of information related to OTC derivatives are improved when
these transactions are subject to centralized clearing.
Accordingly, the Commission will continue to promote policies
that enhance and facilitate clearing of OTC derivatives
whenever possible.
8. Review of Swap Dealer Commodity Research Independence:
Many commodity swap dealers are large financial institutions
engaged in a range of related financial activity, including
commodity market research. Questions have been raised as to
whether swap dealer futures trading activity is sufficiently
independent of any related and published commodity market
research. Accordingly, the Commission has instructed the staff
to utilize existing authorities to conduct a review of the
independence of swap dealers' futures trading activities from
affiliated commodity research. This will be reported back to
the Commission with any findings.
Recommendations 3 and 6 address staffing needs so as to enable the
Commission to fulfill its greatly increased responsibilities.
Recommendations 1, 2 and 4 focus on increasing transparency by
making improvements on the reporting of the positions carried by
commodity index funds. My office views these transparency improvements
as very important. Though our analyses thus far have found no price
impact from index activity, we do feel that a more informed marketplace
will be better equipped to discern information-based trades from those
that mimic the various commodity indices. Improved transparency
benefits market participants, observers and policy makers alike.
Recommendation 5 seeks additional information. Many have questioned
the hedge exemptions afforded to swap dealers, arguing that these
exemptions undermine speculative limits that would otherwise limit the
positions undertaken by commodity index traders. The Commission is
leaving no stones unturned as it investigates this policy issue.
Like others, recommendation 7 contributes to transparency by
establishing a central point for the collection of information about
commodity swaps. This enables more rapid determination of the extent of
swaps positions, as well as who holds these positions . This would
substantially improve our surveillance capabilities. In addition, the
futures industry has long recognized the benefits from centralized
management of credit risk. Among those benefits is the enhancement of
liquidity. When questions arise regarding counterparty ability to pay,
markets can seize up. A central clearinghouse enables positions to be
transferred or terminated much more rapidly.
Recommendation 8 also seeks additional information but is primarily
putting the industry on notice. The rapid growth of commodity index
funds raises the prospect that fund operators might become able to
front run customer orders. The Commission takes this concern seriously
and is informing industry participants that it will be looking for and
prosecuting such activity.
Response of Jeffrey Harris to Question From Senator Akaka
Question 1. Mr. McCullough testified that there should be an Oil
Quarterly Report, comparable to the FERC's Electric Quarterly Report
that contains all transaction by market participants, down to
locations, quantities, and prices. This Oil Quarterly Report should
include spot and forward trades for bilateral transactions, at both
NYMEX and ICE. He feels that having this data ``would allow policy-
makers to proceed on the basis of facts.'' Would it be possible to
compile this type of report? If not, what should be done to improve the
transparency in the market?
Answer. FERC's Electric Quarterly Report (EQR) and the transparency
provisions of Section 23 of the Natural Gas Act contribute to market
transparency in their respective wholesale physical markets. It is
important to emphasize that the EQR and the proposed report on natural
gas include only physical trades, not futures or financial swaps. Thus,
they exclude transactions performed or cleared on the NYMEX or cleared
by ICE. In terms of transparency required for regulation and oversight,
the CFTC has access to all the futures and cleared swaps transaction
data from NYMEX and ICE Futures Europe. Provisions proposed for
Significant Price Discovery Contracts (SPDC) will address some
information shortcomings already identified by CFTC staff. Furthermore,
as a result of the special call, the Commission is now collecting
information on related OTC positions held by large futures traders.
In terms of providing the public more information on futures and
swaps, a comprehensive quarterly report of the type FERC publishes is
not feasible, but the Commission is (per its Recommendation #2) in the
process of developing a new periodic report based upon the information
that it is receiving from swap dealers and index funds who are large
futures traders.
______
Responses of Lawrence Eagles to Questions From Senator Murkowski
Question 1. In your testimony you mention that there is a link
between the physical and futures markets. Could you please explain this
link and its importance? And how if any it is this related to the price
of crude oil?
Answer. A prime reason for the creation of futures markets was to
add price transparency to a murky physical market characterized by
prices ``posted'' by producers or OPEC pricing. With hundreds of crude
grades available, all with different delivery points, sulphur content
and product yield properties, there was little liquidity in individual
crudes--which in turn increased the potential for price manipulation
and price volatility.
The introduction of a standardized futures contract provided a
focus for trading activity, and therefore greater price discovery.
Traders of individual crudes are offering their physical material for
sale at a premium or discount to this futures price when making a
transaction.
It is this link that has led to the misperception that futures
prices can dictate the level of physical prices.
However, while it is always possible that there could be a day-to-
day influence, basic economics shows it is not possible for futures
prices to push oil prices away from the price that matches supply and
demand, without distorting the market.
This is because the spot physical market has to clear. If futures
markets were pushing prices to artificially high levels, then either
physical demand would be reduced, leading to a stock build, or the
premium of futures prices would be at such a level that it created a
risk-free opportunity to hold stocks (thus artificially inflating
demand and building stocks).
There is a further relationship--in WTI, the contract is physically
deliverable. Any speculator holding crude oil futures to expiry has to
deliver the crude oil into Cushing, Oklahoma, the delivery point for
NYMEX futures. Again, futures prices have to gravitate back to the
realities of physical supply and demand.
This is why, when crude oil prices rose from $70/bbl to nearly
$150/bbl, it is important to note that crude oil stocks were drawn down
during the first part of the move, and then only rose by around 1/3 of
the seasonal norm during the second quarter, when stocks are typically
seasonally replenished.
The price was also exaggerated by a series of serious disruptions
which caused a surge in diesel demand.
Further, futures prices were predominantly below physical prices
for most of this period, and futures prices were never, at any point
over this period, at a level that would have offered the risk-free
financing of physical stock holdings that would have been needed to
declare that futures prices were pushing physical crudes higher.
(Note, while I was working at the International Energy Agency in
Paris, we warned in the first half of 2007 on many occasions that low
levels of OPEC production would lead to tight crude markets--so to see
prices rise when the markets tightened was no surprise. OPEC raised
production in November 2007, but strong demand kept stocks low through
to the spring. Despite further opportunities early in 2008, OPEC left
output unchanged. It was only when prices rose above $135/bbl did they
raise output. That being said, we believe the extreme tightness in the
diesel market contributed as much to the tightness in the oil price as
crude oil tightness).
Question 2. In your opinion would driving speculators out of the
market have any unintended consequences?
Answer. Yes.
It would dry up liquidity, creating more volatility in the market
(the spike in crude prices on the expiry of WTI is an example of the
sort of trading that can occur when there are only a few parties
trading crude oil prices, albeit exaggerated by the extreme
difficulties in delivering crude in the aftermath of Hurricane Ike).
Greater pricing power would be given to producers.
Producers and consumers would find it harder to hedge their risks--
a factor that could reduce the financing available to producers for new
exploration and production, which could in turn lead to lower supplies
in future years--a critical issue when the world needs 2.5 mb/d of new
oil every year just keep output steady.
Speculative limits would prevent the natural growth of the futures
markets.
Question 3. What type of energy regulation, or oversight, would be
either most damaging, or most beneficial?
Answer. Improved transparency of both financial markets and supply
and demand fundamentals is critical to the understanding of market
action. The CFTC was unable to draw any conclusions about the impact of
investment funds on oil prices until it engaged in a thorough data call
and more precise classification of financial positions. Importantly,
after intense analysis it concluded that during the period that crude
prices rose to $150/bbl, fund flows actually declined. While such data
collection comes at a large cost for financial institutions, it is
important.
Other non-US futures exchanges should be encouraged to offer
similar transparency and regulators should exchange data and conduct
cross market analyses.
The slow pace of release of fundamental data (outside of the US)
also means that it takes time for a full understanding of market
fundamental positions to emerge. In particular, relatively accurate
European supply and demand data is only available two months after the
event. Data from many developing countries is incomplete and with very
little inventory information--often it is only available 18 months
later. Given the importance of stocks in providing a supply cushion and
in setting price levels, full transparency is vital.
All producers should be encouraged to adopt transparent pricing
mechanisms.
However, regulators need to know if a distortion in commodity
markets is evolving through higher fund flows. While each of the
following events below could be caused by market fundamentals, if they
are simultaneously true, then warning lights should be triggered.
Simultaneously rising prices and rising inventories
Absence of obvious factor that encourages hoarding (eg: war
in producer country, shortage diesel/gasoline)
Futures prices at sufficient premium to spot prices to
encourage stock building
Positive causality between large fund flows and prices
Market functioning would be harmed by the following:
Banning or permanently restricting speculative flows. This
would reduce liquidity and therefore could distort price
discovery, increase price volatility and limit the time frame
in which producers (and consumers) could hedge risk. This could
ultimately lead to lower future production and supply
tightness.
Speculative limits: Same effects as above, but in addition,
this could force regular portfolio rebalancing, which could
increase volatility and could shift trading volumes overseas--
thus reducing oversight and damaging the US economy.
Speculative limits could limit the natural growth of the US
futures business.
Response of Lawrence Eagles to Question From Senator Domenici
Question 1. Could you please explain the difference between the
spot price and futures price in the market? And the impact that
Hurricane Ike has had on these prices?
Answer. Spot prices are the price agreed for a physical
transaction. The spot market has to ``clear'' each day, with prices
being set at the level at which buyers and sellers are prepared to
take/make delivery of physical crude.
Futures prices are set by the buying and selling of paper contracts
for the future delivery of a commodity. The contracts are traded on a
registered exchange and are for a standardized grade and quantity of a
physical commodity (or financial instrument). There is no fixed supply
of futures contracts, so as long as a buyer and a seller can be found,
a new contract can be created. As there is always a buyer and seller
for each contract, these contracts offer a zero sum gain. Many futures
contracts offer the opportunity to settle the contract by delivering
the physical commodity to a pre-specified destination. The futures
contract then becomes a spot contract.
By 3 October, the crude oil supply losses caused by Hurricanes Ike
and Gustav totaled a cumulative 36.7 mb. However, with a cumulative
loss of 89.5 mb of refining capacity also shut by the hurricanes, the
net impact was, ironically to reduce the demand for crude oil by more
than the crude oil supply loss. Refining outages however tightened the
product markets, albeit with the mitigating impacts of both a sharp
drop in US demand and the announcement by the International Energy
Agency that it was standing ready to act if the disruption was serious
enough.
The hurricanes also coincided with the financial crisis, which
prompted distressed selling of physical and futures positions,
restricted credit availability and raised concerns of a global
recession.
The hurricanes were also a major factor in the unprecedented price
spike on the expiry of the NYMEX WTI October futures contract. Low
crude oil stocks in the US Midwest were exacerbated by delivery
difficulties following the hurricane.